We are cautiously optimistic on the equity markets ahead and believe that it is a good time to build a portfolio of quality stocks with a medium term perspective. The equity markets have suffered over various issues domestic and globalin the past two years. But the negative spiral of multiple issues on the domestic front namely sticky inflation, high-borrowing rates, policy and administrative inaction/logjam, fiscal deficit concerns, weak INR and an overall subdued investor and corporate sentimentsare showing early signs of unwinding and therefore our view has become cautiously optimistic.
In the last few weeks, the government markedly sprang into action with a slew of measures. These measures have helped change investor sentiment and the equity markets have responded with a 8% rally since early September. About $4.5 bn of FII inflows have come in and the INR has appreciated after a long gap and there are signs of revival in the corporate sentiment tooimportant for the capex cycle to start improving. We discuss many of the macro issues important for the markets below.
A key issue is, when will RBI resume the rate-cut cycle
While its difficult to predict the extent of rate cuts over the short term, rate cuts will resume soon and should go down meaningfully over the next two years unless oil prices and other global commodities play spoilsport again and inflation proves stickier. Due to adequate liquidity, the borrowing rates have been coming down and wholesale lending rates are down 200bps from the peak and about 100 bps over the last six months. Plus more announcements by the government on fiscal consolidation and supply side policy measures should create elbowroom for RBI to restart rate cuts soon. Risk to the above is the government not staying the course and going back to welfare economics in a hurry.
Another big question is, when will GDP growth accelerate
We think that for Indias GDP to accelerate significantly from current estimate of about 5-6%, the capex cycle needs to revive on a multi-year basis. For this to happen a lot more issues need to be resolved and the recent announcements are the early positive steps in that direction. We think that the government is aware that regulatory issues have contributed to the slowdown in the infrastructure space--projects have been stalled over land acquisition, environment clearances, fuel shortage, etc. These issues are being addressed and one can expect resolution in times to come. For example, setting up of a National Investment Board (NIB) that can act as a single window clearance can be positive for the infrastructure sector and additional resolution on coal and associated problems are the key to reviving the investment cycle in the utilities and power equipment suppliers vertical.
So while somewhat corporate and investor sentiment has revived, it may take a while for the corporates to start investing--our feedback suggests some are now re-evaluating dropped investment plans. Inflows from investors could also support capex recovery through equity capital raising, leading to balance-sheet repair and availability of promoter funding. However, we believe that for corporate capex to recover on a multi-year basis and on a big scalea lot of legislative reforms like land acquisitions bills, labour reforms, GST, etc. would be required, for which currently there is weak visibility. It seems that many of the administration linked reforms will be easier to implement than the legislative reforms given the current political environment. Big ticket reforms are critical for India to go back to 7-8% GDP growth path in our view.
On the global front, two key announcements recently have led to sentiment improving on the global equity markets. Global indices surged after the German Constitutional Court approved the proposed Euro zone bailout fund and US Federal Reserve announced quantitative easing (part 3) to support the economy and the markets. While the China slowdown remains a matter of concern, the silver lining is that it could help Indias infrastructure build out if commodities like metals cool off due to lower global demand, especially from China. While there is some interim relief on the markets from the global front we think that they will remain on a risk onrisk off mode in the medium term as news flow on the underlying economy and politics are likely to be mixed and could lead to bouts of volatility in the markets.
On the domestic earnings front, clearly, the pace of corporate earnings downgrade has slowed in the recent months versus the beginning of the year. We believe that 5-6% real GDP growth and inflation of 5-7% should be supportive of early double-digit earnings growth for benchmark indices. For corporate India, Ebitda margins seem to be bottoming out after nine quarters and with rate cuts ahead interest/Ebitda should start declining from its recent peak, leading to better earnings growth. Also, according to Crisil, the end of the credit quality cycle is around the corner. Crisils credit ratio (ratio of upgrades to downgrades) declined to 0.66 in H1 of FY13 from 0.91 in H2 of FY12, primarily on account of slowdown in the economy and should improve with a rise in corporate profitability. The valuations in the market are in line with historical averages and thus for meaningful upside from current levelsearnings upgrade cycle to beginwe remain hopeful. The government has also indicated of announcing more reforms and more fiscal consolidation measures, which will dictate the near-term movement of the bourses.
The author is CIO, Bharti AXA Life Insurance