HSBC believes that 2010 will be a year of two halves for the BRIC markets; in spite of high inflation, India managed to outperform its BRIC peers in the first half of 2010 because it benefitted from rising global risk aversion. At the end of June, India had outperformed Brazil, Russia and China by 18%,13% and 10% respectively. While investors were anxious about excessive growth, consequent tightening in China as also a possible hard landing, the peripheral European sovereign debt crisis also weighed on them. India, however, was insulated from both risks. Looking ahead, HSBC points out that Indian authorities are struggling to control inflation and the danger for the central bank is that, having increased interest rates by just 100 basis points since March, it risks getting behind the curve and will ultimately need to do more to get inflation down. That will be negative for equities.
There are other reasons why the Indian market right now appears to be vulnerable to a correction and its liquidity alone that holding it up. For one, it?s somewhere close to a two-and-a-half year high, and more importantly, trading close to the top of the trading range ? one year forward price-earnings multiples are at around 16 times compared with the long-term average of 15 times. And it?s beginning to look really pricey. Just for some perspective, India now trades above its five-year trailing average and its 12-month trailing PE premium, versus the EM, was at 49% at the end of July.
What?s more, the valuation risk could increase because earnings are clearly going to continue to moderate what with the base effect wearing off and interest rates going up. Nomura points out that real activity or industrial tracks liquidity conditions in the system with a lag of four to six months and expects relatively weak IIP readings going ahead; to be sure if money is tight and interest rates move up, demand could contract resulting in a lower growth in factory output.
A glance at the data for the June 2010 quarter numbers shows that this time around, there has been less of a boost to the bottom line from other income; also outflows on account of interest are higher. For a sample of 1250 companies, expenses on interest have risen 17% year-on-year in the three months to June 2010 whereas in the March 2010 quarter, they fell 2.5%. With interest rates set to rise, firms will be forking out more for working capital.
For sure, the top line growth in the June quarter has been fairly good at 24% year-on-year albeit lower than the 31% seen in the previous quarter; some of this has to do with higher prices of commodities. If prices do come off it would help margins of user firms. Also, while there are companies that have pricing power, competitive intensity in spaces such as two wheelers or FMCG, are constraining firms from being able to pass on the higher cost of inputs, so the increase in the top line too could moderate somewhat. As such, if earnings for the broad market are to increase by about 25% for 2010-11, it means earnings from here on need to grow at roughly 29-30%, which is twice the rate at which they have risen in the three months to June, at about 14-15%. And that won?t be easy.