The market reaction to the political outcome will be out of the way soon and it will be time to focus back on fundamentals.
By Rajiv Singh
After a long and exhausting election schedule, results are finally out, with the incumbent government coming back to power. However, the market had largely anticipated this event; with foreign investors having invested USD 7.4 Bn in equities since March. Domestic institutions were a little shy, having withdrawn Rs. 110 Bn in the same period. However, this has been an event risk for the market, VIX rose to 30% on the 22nd of May. While the market has rallied, we anticipate some profit taking, especially by market participants who made bets on the political outcome.
The market reaction to the political outcome will be out of the way soon and it will be time to focus back on fundamentals. While there are opportunities, the markets face headwinds in the near term which may cap the upside in the coming months. India is facing a liquidity driven cyclical slowdown which is a concern for investors as well as the companies. The world economy is facing risks as well. Trade wars between the US and China, the two largest economies in the world have the potential to derail the economy globally. The recent sanctions imposed by the US on Iran have the potential to cause crude oil prices to rise towards a new 2019 highs and to a point where it becomes a concern for growth. To top it all there are concerns of a growth slowdown for the global economy. Even without these factors, hard data out of China, Japan and Europe indicate a soft patch for the global economy.
The immediate challenge for the government would be to tackle the liquidity driven slowdown caused by a credit crunch post the crisis in the NBFC sector, deposit growth lagging credit growth and FII outflows in 2018 and early 2019. Recent data regarding auto sales and quarterly results of FMCG firms indicate some softness. Recent IIP data which declined by 0.1% has been especially worrying. India has faced an unexpected slowdown in consumer demand leading to an inventory build-up. An Inventory correction, which we believe is under progress, can exaggerate the extent of the slowdown in final demand.
While the government has made progress on fiscal consolidation which has come down from 4.6% of GDP in March 2014 to 3.4% of GDP in FY2018-19, it remains high and leaves little room for the government to pump prime the economy. However, it can certainly help in reviving the economy as government spending had slowed down ahead of the elections. Much of the heavy lifting has to be done by the RBI, which has conducted OMO and FX swaps to restore liquidity. Low inflation opens the door for rate cuts. Overall, we believe that with the joint efforts by the RBI and the government, the economy can revive in a couple of quarters.
Trade wars and sanctions on Iran can cause a major risk and along with local challenges, we expect markets to move into a broader range. With high valuations, markets may pause for a breather. Despite downside risks, the Indian economy remains resilient compared to other economies, and thus can continue to attract foreign inflows, especially from long only funds, which should cap the downside.
Interest rate sensitive sectors are likely to do well, not only from a policy perspective but from an economic standpoint as well. The economy has been driven by personal consumption but the drivers for growth are changing. Capacity utilization remains low at 75.9% but has been rising. The rate of growth in fixed capital formation remains strong at 10.6% for Q3FY2018-19 though this may slowdown for a couple of quarters due to the liquidity crunch as well as companies being in the watch mode ahead of the elections. Capex spending should rise, leading to a pickup in the economy. Thus cyclical sectors like capital goods, real estate and cement should gain. We also expect credit demand to remain high and along with the NPA issues having peaked, banks should gain. The Rupee is likely to strengthen and bonds may rally. Gains in the Rupee may lead IT and Pharma to underperform and FMCG sector may take a hit because of expensive valuations. G-Secs would be a good space to invest in.
Also the conditions for mid and small caps to outperform are broadly in place. The first is that markets should be in a risk-on mode later this year, and secondly that valuations should be favorable compared to large caps.
Equities are a marathon, not a sprint; we believe that the longer term outlook remains bright. We also believe that the government is likely to further its reform agenda, which will provide the economy new drivers of growth and equity markets are likely to do well. However, in the near term, we do expect that markets will pause for a couple of quarters.
The author is CEO, Stock Broking, Karvy. The views expressed are the author’s own.