There will be stock-specific opportunities than a general re-rating

Gopalakrishnan S

Equity performance is driven by four factors: the earnings likely to be generated; investors confidence in those figures; the quality of earnings; and to what extent these are discounted by the prevailing price.

Last year, around this time, the consensus estimates for FY13 suggested an earnings growth of over 15% for Nifty. Over time, the estimates have been downgraded and the actual growth is now probably in low single digit. The earnings expectation for FY14 is again in the 15%-plus range. Again, this high optimism has a very high probability of ending in disappointment.

The valuations in terms of P/E and P/B are below the long-term average for Nifty, while in terms of dividend yield, valuations are around the long-term average. The total BSE market capitalisation to nominal GDP is now around 0.68x and this measure was 1.7x in the previous peak.

Prospects of economic growth, state of competitiveness and the likelihood of the twin deficits?fiscal and current account?will drive investor confidence. We are right now in a state of all-round slowdown, falling private consumption, extremely low investment spending in the economy and a poor fiscal state not giving enough room for the government to assume any meaningful expansion in capital expenditure.

This has resulted in a negative profit cycle for our businesses, leading to poor financial health of the corporate sector. These are reflected in the high NPA levels of the banking system, general slowdown in credit demand and reduced capital spending. A recent study by Jim Walker of Asianomics showed that the debt-to-operating cash flow of Indian corporate has gone to an alarming level of over 6 times. At the current level of profitability, it will take over six years to repay the current debt.

The quality of earnings, produced with excess debt and inflation, has always disappointed. The environment for earnings growth fares better in a situation of real GDP growth accompanied by a very benign inflation and manageable debt. A recent IIFL study of the profit cycle over two decades brings out that growth of corporate profits is strongly linked to real GDP growth. The high inflationary environment has eroded competitiveness to a large extent. Large depreciation of the currency has not brought a desirable impact on exports. The outlook for equities depend on how things pan out on all of these areas.

From August 2012, the government has began to pull all strings to bring the economy on track by initiating measures to propel capital investments, activate stalled investment projects in the system and control fiscal deficit. Still, a Ficci survey shows a fall in business optimism. Over 77% of the respondents felt that the current business environment is not favourable for capacity expansion. Political and governance instability, corruption and labour are the key risks cited by the survey. Political stability is uncertain ahead of the next general election. And this is likely to remain so throughout 2013.

Credible measure has to be taken on labour reforms, including training and development, without which it will be difficult to attract large foreign investments in areas where significant employment opportunities can be generated. These are long-term in nature but right steps will bring about a change in investor sentiments.

A fiscal consolidation process has commenced and the government managed to show an optically better deficit in FY13. The projected 4.8% deficit for FY14 looks very optimistic, so does the projected growth of over 19% in tax revenues. There is high reliance non-tax revenues, besides PSE divestment. The recent movement in crude oil price augurs well for bringing the deficit under control. As there is the fear of a sovereign rating downgrade, the government will be determined to control the fiscal deficit within the projected 4.8% with the help of favourable external factors emerging. The current account deficit at a historic high of over 6% reported for Q3 is alarming. Financing the current account is a function of confidence in the economy placed by the external trading partners. However, a sustainable CAD cannot be as high as 5 to 6%. There are structural problems, besides high oil prices and gold imports causing the deficit to be of this order. Added to that, the CAD is funded with heavy reliance on short-term debt and portfolio flows, which are volatile. The oil imports moved from around $80 billion in FY08 to $170 bn in FY13. Similarly, gold imports moved from around $16 bn in FY08 to $50 bn in FY13. The recent correction in these commodities is expected to bring down the CAD by around $20 bn. However, the external account still remains a concern due to falling forex reserves, and any reversal in the unabated monetary easing by the Fed, ECB and BOJ can cause a big fall in the rupee.

Inflation has been a major problem, and the huge divergence between the consumer and wholesale indices brings its own problems. Consumer inflation has a significant influence on household inflation expectations and it acts as a barrier for policy easing. Core inflation has already begun to ease but food prices remain high. Falling private demand and global commodity prices are likely to keep inflation concerns down. But, any significant fall in rupee will take away the benefits of softening commodity prices.

Falling commodity prices will have implications for corporate earnings as around 30% of earnings weights in the index are commodity-driven. However, earnings outlook will improve only when there is a good real GDP growth with a proper balance between consumption and investment. Financial savings need to improve, which needs an environment of benign inflation, real growth and sustained job creation.

This year (2013) is likely to be a year of work in progress on all the above areas and a divine help might change the sentiments as is being expected by many currently. Falling crude, gold and commodity prices in isolation might benefit India the most but things don?t necessarily pan out on a smooth path. It is going to be another year of stock-specific opportunities than a general re-rating of equities.

Domestic financial savings remain very low, and within that ownership of equities is very low. FIIs own almost 50% of the equities held by the public which is both positive as well as negative. It is an endorsement of India growth story by external investors. It is a negative as it can cause huge volatility during a global crisis of any kind.

The author is chief-investments, ICICI Lombard GIC