Any shortfall in estimated GST collections or higher inflation is likely to keep yields elevated, thereby adversely impact market valuations.
Domestic markets have witnessed positive gains led by better than expected earnings. Gains were restricted owing to concerns related to higher crude prices, hardening of yields and impending election schedule in Karnataka. The US 10-year and short-term yields also moved up thereby adding volatility to global markets but markets were supported by strong earnings.
Rising yields have resulted in increasing the cost of capital and hence, going ahead, we expect earnings to drive markets as scope of multiple expansion is limited owing to higher cost of capital. Earning revival is likely to be led by sectors such as banking (with faster resolution of NPAs), IT (on rupee depreciation) as well as commodity sector (owing to higher realisations) while downside risks to earnings are likely to come from higher oil prices, higher interest rates and corresponding slowdown in demand revival (if any).
In the near term, markets would continue to focus on the outcome of Assembly polls in Karnataka along with oil prices, yield movement, rupee depreciation while for medium to long term, volatility may continue to remain with state elections in H2CY18 amid focus on earnings recovery, fiscal deficit, interest rate movement as well as demand revival ahead of general elections scheduled in May, 2019. Markets are currently trading at 20x/16.3x FY19/20(estimate) earnings which is still towards the higher end of the historical valuation range given the volatility expected in near to medium term.
The best approach is to use this volatility to add stocks expecting large earnings recovery and likely to benefit from government spending (infrastructure companies), rural spending (tractors, farm products), consumption revival (consumer companies), and financialisation of savings (to benefit insurance companies, mutual funds and broking firms) with a long-term view. Key risks to our recommendation would come from adverse outcome of state elections, further rise in oil prices and yields, shortfall in earnings or decline in liquidity from FIIs and domestic mutual funds.
The 10-year G-Sec yields have been on an uptrend owing to concerns over government’s fiscal imbalances, higher inflationary pressure. Domestic yields also moved up further after RBI released the minutes of April monetary policy meeting stating upside risks to inflation which may come from MSP increases, crude price increase and resulting fiscal slippage. Improvement in GST collections on e-way bill implementation is expected to be positive in terms of managing fiscal situation but continued rise in crude prices and rupee depreciation may play spoilsport.
Going ahead, the focus would remain on how government manages the fiscal deficit situation. Any shortfall in estimated GST collections or higher inflation is likely to keep yields elevated, thereby adversely impact market valuations.
Edited excerpts from Market Strategy by Kotak Securities