While the Indian equity market went through one of the toughest phases in the last three years, it has seen a significant vibrancy in mood after a series of announcements from the government in the recent past. Straddling between high conviction and confidence riding on the India story on one side, and economic fundamentals and dynamics in politics keeping sentiment low on the other side, the equity market saw poor participation from the domestic investors while foreign investors continued to cement their confidence in the Indian market. Perhaps thanks to the poor growth in some other countries which made India more attractive on relative comparison.
The equity market reflects economic sentiment and activities much deeper both in the bull phase and the bear phase. Looking at the returns over the last five years, investors may feel a little disappointed. However especially over the last few quarters, they are beginning to realise the importance of this asset class. If people knew just how to time the market, I am sure there would be more members in the million dollar club. What would hold investors in good steadis to stay invested in the markets for as long as they can. As Warren Buffett said, Time in the market is much more important than timing the market.
Let us now examine some of the fundamentals.
The Indian growth story based on demographic dividend, infrastructure development, growing middle class, high savings and investments rate has been retold many times. Most people, however, assumed that the good times would continue in a linear fashion and neglected to account for variable change, i.e., persistently high inflation, governments lackadaisical approach and global volatility. The current set of people at the helm of the government and politics have seen it all over two decades and they have done it in the past the task of reviving the economy when the issue belonged only to us exclusively as a country. This time around, the issues are slightly of a different nature.
First and foremost is inflationsomething which is created by us and something bought by us from global prices. Inflation pressure is also created by the changing consumer behaviour of the Indian middle class. The dependence on electricity has been rising but the production of power has not been keeping pace with the demand. The governments efforts towards removing poverty and providing employment have seen labour cost increase significantly across the country. All these aspects and more put the country in a changeover game. I would assume that this is a transitional phase and there is no choice but to get adjusted.
In this backdrop, some of the key economic variables of the country are being challenged. They are mainly, inflation, lack of policy reforms, twin deficit (fiscal and current account) etc. To address these challenges, several steps were taken by the GOI in the last few years in putting an institutionalized policy frame-work.Most of them I would assume structural in nature, which would, ideally speaking, benefit the economy in the long run.
At the same time, the central bank i.e. RBI, has been continuously focusing on ensuring that the interest rate is kept at such a level that Indian savers/consumers are made to earn something extra to pay for the inflation. The real interest rate would not have been positive but for RBIs action, in keeping the interest rate high while addressing some of these issues which are domestic in nature. The global economic slowdown did have an impact on commodity prices in a big way. However, we were not fortunate enough to benefit out of this due to the falling rupee, caused by the Twin Deficit.
While in the recent past, all such issues are being addressed, we are encouraged by the spate of reforms announced by the government over the last six weeks and hope that these steps can restart our investment cycle and re-accelerate our GDP growth.
To put the importance of our investment cycle in perspective, almost half of the 8-9% GDP growth in the 2005-2007 high-growth phase was due to high investment growth. Thus, we look forward to the government instituting the National Investment Board (NIB) and thus unclogging the significant backlog of stalled projects. According to the latest CMIE data, we have almost R9 trillion of investment projects that have been stalled due to various reasons such as environmental and regulatory clearances, land acquisition, etc.
India stands out across major global economies as a nation that is still suffering from high inflation despite the 400bps in growth slowdown over the last few quarters. The first point is that while Indias inflation at 7.5% remains high by global standards, there has been moderation in inflation as compared to the 10% inflation levels experienced in 2011.
Second, a number of global and local factors have contributed to inflation remaining sticky. We are a significant commodity importing nation and thus the 20% depreciation in our currency over the last 18 months have significantly increased raw material costs for our manufacturers. Third, inflation has been pushed upward in recent months due to the release of suppressed inflation as exemplified by the power tariff and diesel price hikes over last few months. Finally, India is suffering from an elongated and persistent period of high food inflation. Food inflation has averaged almost 10% for the last seven years, indicating increased protein demand from certain segments of the population and also indicating the need for India to increase productivity levels at our farms and food transportation supply chains. Our sense is that inflation will remain sticky close to 8% levels for the next few months before starting to moderate in 2013.
We are at a crossroads. Policy makers have to calibrate a fine balance between revival of growth and fighting inflation while keeping the interest rate low to kick start the economy. Liquidity in the system is getting better, resulting in short-term rates to ease off. Naturally, this is leading to the lending rate coming down into some pockets of the borrower. While RBI has taken a calibrated approach in easing the liquidity between cut in CRR and purchase of government securities from banks, it is time for a rate cut in the form of reduction in repo rate. If the slowdown continues beyond a point, it will add to the pressure. At the same time, consumer inflation cannot, beyond a point, be controlled through monetary action. We therefore expect around 75 bps policy rate cut from RBI, on account of persistent slowdown.
Investors allocation towards various asset classes now needs renewed attention, especially in the changing scenario. Equity asset class needs to have higher exposure or allocation in the investors portfolio. Let me explain why.
As the cycle starts to pick up and eventually reaches normalised level of 6.5-7.5% p.a., corporate earnings growth is likely to recover sharply. In such scenarios, value stocks tend to do well as their earnings also normalise, banks asset quality improves and erstwhile bad assets are recovered, businesses start planning new expansion plans. This is also accompanied by an expansion of valuation multiples for such stocks, thus giving a kicker to equity returns. The more conservative approach is to consider that over a reasonable time frame, say five years; corporate earnings grow in line with nominal GDP growth. Assuming a modest growth of 12%, (6% in real GDP + 6% inflation), no valuation re-rating and current Sensex dividend yield of 1.5% can deliver 13.5% CAGR on a post-tax basis. In our assessment, no asset class can come close to delivering similar returns on a post-tax basis over this time frame. I would urge investors to differentiate between investments meant to create wealth for future use and those meant to generate income.
The part of ones capital meant to generate income can be invested in fixed income funds which will benefit out of a falling interest rate scenario. Income funds and Gilt funds are the best asset class for higher allocation from investors with 1- 2 years investment time frame. While there is a merit to up the exposure to equity schemes, the allocation could very well made between large cap focused diversified equity funds and dividend yielding funds. Dividend yield funds investment strategy is differentiated through a different stock selection process which generally does well over multiple cycles.
Being optimistic and staying disciplined in this market through right allocation will reward investors significantly in the long run. Let me here reiterate what Warren Buffett had said, Time in the market is much more important than timing the market.
The writer is CEO, Birla Sun Life AMC