Dr. V. K. Vijayakumar
2017 was an excellent year for equity investors globally. Globally, equities were up by 25 percent and emerging markets were up by 38 percent in dollar terms. India too did very well with the Nifty posting 28 percent returns. Nifty Midcap and Nifty Smallcap indices appreciated by around 48 and 55 percent respectively. Fabulous returns indeed! 2018 has begun well with Sensex crossing 35000.
A unique feature of the global rally in 2017 has been the surprising absence of major volatility. The synchronized global economic growth, good earnings growth and low interest rates ensured sustained buying in the markets. A major factor powering this global bull run is the humongous liquidity sloshing around in financial markets. This liquidity is the consequence of the ultra-loose monetary policy (Quantitative Easing), which major central banks of the world resorted to following the global financial crisis of 2008 and the Great Recession of 2008-09. The leading central banks of the world injected $15 trillion into the financial system. Bond yields touched record low levels and equity valuations rose to a ‘new normal’. The synchronized global growth upswing in 2017, after a gap of nine years, facilitated accelerated flow of funds into equity and consequently equity markets in US, Europe and most emerging markets reached record highs.
Outlook for 2018: Global growth to remain robust
Outlook for the global economy looks good for 2018. The World Bank has projected global growth improving to 3.1 percent in 2018 from 3 percent touched in 2017. The 2017 growth rate of 3 percent was a 10-year high, with the exception of the rebound in 2010 from the contraction in 2009. A positive factor favoring the bulls is that there are no signs of financial instability in any major economies. Even though the Chinese debt issue remains a concern, it is far more subdued than what it was a year ago. In US, growth was robust at 2.3 percent in 2017 and unemployment is at very low levels. In 2018 US is likely to post a growth rate of 2.5 percent with near full employment. European Union grew by 2.4 percent in 2017 powered by good growth in Germany, France and UK. China slowed down to 6.8 percent, but since China now is a $12 trillion giant, China added hugely to global growth. The recovery in global economy is likely to continue in 2018.
India: an outlier with 4-year low growth
India’s GDP growth will drop to a 4 year low of 6.5 percent in 2017-18, according to CSO’s advanced estimates. Growth has been impacted by the twin shocks of demonetization and GST. Of course, we can derive consolation from the fact that the economy is on the recovery path: Growth rate has picked up from 5.7 percent in Q1 of 2017-18 to 6.3 percent in Q2 and is expected to gather momentum and rise above 7 percent average for Q3 and Q4, mainly assisted by the base effect. The economy is on the cusp of a rebound and corporate earnings are set for smart recovery.
Indian economy is at an inflection point in the macro cycle
Apart from the double whammy of demonetisation and GST, the other major constraint on India’s growth has been the excess capacity in manufacturing. When there is excess capacity, capex will be poor and even a highly accommodative monetary policy will have limited impact. This was the reason why monetary stimulus didn’t lead to capex. With capacity utilization climbing, this will change in 2018. India is on the road to achieve growth rate of around 7.3 percent (World Bank estimates) in 2018.
Liquidity has pushed up valuations
Due to poor growth, earnings growth has been tepid for last 3 years; but the huge domestic liquidity ensured ‘buying on dips’ and every correction was bought into in 2017. Financialization of savings and increasing preference for equity as an asset class are facilitating increasing flows into the capital market. Sharp spike in stock prices, in the absence of earnings growth, has pushed up valuations. It is a fact that valuations are stretched. In pockets of mid and small caps, valuations are excessive. With market trading at high valuations, some sharp corrections are possible in 2018.
Aggressive Fed tightening can be a trigger for correction
A major factor influencing markets in 2018 would be, again, liquidity. There is a possibility of a divergence in fund inflows in 2018: FII inflows are likely to be muted and DII inflows are likely to remainrobust. There is a risk of FII inflows turning negative towards the end of the year when some leading central banks initiate the process of re-balancing their balance sheets. A known risk in the market is the Fed tightening. If the Fed raises the rate thrice by 25 bps each and takes it to 2 to 2.5 percent range in 2018, that would be on expected lines. But, if the tightening turns aggressive due to inflation concerns, it might trigger capital outflows from emerging markets, impacting stock and currency markets.
Unemployment is US is very low at 4.1 percent. Soon it might reach full employment levels. Economic theory warns us that at full employment levels, inflation gets triggered. The fiscal stimulus underway in US – the Trump tax cuts along with increased infra spending – has the potential to free the inflation genie from the bottle, forcing the Fed to tighten aggressively. This is an important risk in 2018, particularly in the second half.
Domestic concerns
There are domestic concerns too: hardening crude prices, fiscal deterioration, rising inflation and the RBI turning hawkish can adversely impact the market. A populist election-budget, perceived negatively by the markets, and some major tinkering with the long-term capital gains tax are other risk factors. Another major influence on the market would be political: the outcome of the assembly elections in some key states.
Sensex at 35000: Play a defensive game
Investment strategy in 2018 should be, ideally, defensive. Aggressive lump sum investment should be avoided at the present levels of valuations. Lump sum investment may be done through Systematic Transfer Plans (STPs). Smallcaps and pockets of midcaps are over-valued; many are in bubble territory and highly risky. Systematic investment in mutual funds should be continued.