In Diwali 2010, Indian markets were in a euphoric mood. The Sensex was at a new high of 21,000 points and the Sensex P/E was at 25% premium to the 15-year average, with foreign institutional investment at an all-time high of $29 billion for calendar year 2010. As we celebrate Diwali 2011, the Indian market is down 19% and figures among the worst performing global markets. Fund flow has dried up (nil net FII flow in YTD CY11), cash traded volumes are down 39%, and valuations are 10% below long-period averages. Looking back, it was almost as if the markets had added excess flab of optimism, and required a series of workouts to get back into shape.
Dumbbells of rising inflation and catch-up rate hikes: Inflation is at a 13-month high, but a cool-off is on the cards as quantitative easing (QE-II) impact is wearing off on global commodities and global growth outlook is moderating. Repo rates are at a 36-month high; expect rates to peak out in 3QFY12 and start easing, as inflation cool-off would lead to real interest rates going well above the long-period average. There has been a sharp impact on the earnings and valuations of interest-rate sensitive sectors like financials, autos and infrastructure.
Treadmill of policy and political headwinds: Over the last one year, policy and political headwinds appeared in three broad forms: Unearthing of a series of scams; secondly, “policy holiday” with little or no progress on key reforms and thirdly, likely fiscal failure due to no/lower disinvestment proceeds and slowing down of revenue collections. This has adversely impacted capex/infrastructure-related sectors and the valuations of public sector entities have been downgraded.
Weight-training of global headwinds: In the last 12 months, Indian markets have directly and indirectly borne the brunt of several global headwinds. The major ones among them are: the US QE-II, political deadlock over government debt ceiling, and rating downgrade. The sovereign debt crisis in the euro zone and the global growth slowdown are some of the other headwinds. The impact of these headwinds have resulted in plunging FII inflows and the rupee going into a tailspin.
Cycle of earnings downgrade: Since 2QFY11, Sensex EPS for FY12 has been downgraded by 9% and for FY13 by 10%. We now expect earnings growth of 11.8% in FY12 and 16.9% in FY13. The earnings downgrade cycle has continued in 2QFY12 as well, with FY12 earnings down 1% and FY13 earnings down 2.8%. Market P/E is down 28% y-o-y, and is at a discount to the adjusted long-period average.
Having gone through the year-long toil, valuations are now below historical averages and risk-reward has turned favorable. Also, the Indian markets have witnessed a sharp valuation divergence across sectors, given the prolonged phase of several macro issues and global headwinds. There has been a strong preference for ‘certainty amidst uncertainty’. The worst performing sectors have been infrastructure and engineering, as they are direct plays on capex and business fundamentals have been impacted by policy paralysis. Consumer facing sectors have been the best performers, given increased disposable incomes and continued pricing power.
Some of the underperforming sectors like financials, metals and capital goods provide long-term investment opportunities, either driven by the interest rate cycle peaking out or their worst case scenarios getting discounted in stock prices. Technology and autos have by-and-large performed in line with the broader market. Despite global macro weakness, we expect top-tier technology companies to grow their US dollar revenues by 12-18% in FY13. Telecom, healthcare, and consumer have been the top performing sectors. Improving competitive environment and increased data usage led by 3G rollouts should drive better revenue growth and margin expansion for Indian wireless companies. While we are positive on consumer demand growth, sectoral valuations have run ahead of fundamentals.
* The writer is CMD, Motilal Oswal Financial Services