The 10-year bond yields shot up to 7.94% on Tuesday, a 17-month high. Bond yields have firmed up even after the government announced its intentions to keep the deficit in check at 5.5% of GDP in 2010-11 and to lower it to 4.8% in the following year. That’s probably because the government’s Rs 3.45 lakh net borrowing amount for 2010-11 is lower than last year’s amount, is in itself a fairly large sum. Moreover, a fairly large chunk is expected to be picked up by the government in the first half of the year. Also, the pace of fiscal consolidation isn’t too quick and that could prompt the Reserve Bank of India (RBI) to increase rates sooner than the market is pricing in, given that inflation remains high.
The move, to be sure, isn’t very sharp yet, and moreover, the equity markets appear to be willing to live with a move to around 8.3-8.4%. Upto that point, the market may not be unhappy since the economy is on a recovery path and a move of 100 basis points or so should not derail growth. Neither is borrowing by the private sector expected to get crowded out. However, the market will keep an eye on bond yields to see if they move beyond 8.5% because not only is the Sensex fairly valued at current levels, trading as it does at 16 times forward, a rise beyond 8.5% could hurt growth and therefore, upset earnings estimates.
The danger of rising interest rates is one reason why although the Budget has cheered the markets, there’s no reason to believe everything’s hunky dory. With the fear of any fiscal mismanagement gone, the bears have rushed to cover. But, as of now there is not much reason for the market to get re-rated especially in the absolute sense and it’s unlikely the Sensex will trade very much above its long-term average forward multiple of 15.5 times for a sustained period. That’s because even if the government’s intentions are right and there’s a road map in place, it still needs to deliver on its promises. Once the 3G auctions are held and the government pockets its Rs 35,000 crore, confidence will grow and will rise further once some disinvestments take place and say even a sum Rs 15,000 crore is mopped up. But, at 16,772, the Sensex trades at just under 16 times estimated 2010-11 earnings of Rs 1,050, and is not cheap. Also while earnings are growing at a smart 20% plus growth over 2009-10, the quality of earnings isn’t great because it is skewed towards energy and materials. Until capital investment picks up and the economy grows at a sustained 8-9% an absolute re-rating is unlikely. Other reasons that may prevent a re-rating just now include geopolitical risks as also internal security issues. As for a relative re-rating, or a re-rating vis-a-vis peers in the region, India has for some time been among the more expensive markets in the region.Currently, Korea trades at 9 times forward, Taiwan trades at 13 times forward while China trades 15 times. India is fairly expensive relative to Korea but less so when compared with China. A relative re-rating means India will see more than its fair share of global inflows. If the government gets its act together, there’s a fair chance it will happen.