Over the last 16 months, market has been extremely edgy with midcaps and small caps taking most of the brunt, down over 15% and 29%, respectively. Over the last few months, in particular, the markets have gone through churns with some optimism seen on strong global inflows compared to the domestic flows, a phenomenon seen after many months. However, this was ebbed by nervousness on elections outcome and flood of news on downgrades and defaults. Weak global environment has also superseded the local issues with US ending waiver for Iran and heightening of US- China trade wars.
Indian markets rallied from its lows (+12% since October), broadly doing a catch up rally with global counterparts. However, this rally has been extremely narrow with investors preferring only blue-chip companies due to low risk appetite. The narrowness in rally could be sensed with the number of stocks contributing at least 75% to index returns was low at just five stocks in FY19. The current narrow market is also due to bereft of catalysts to trigger a broad-based rally in stocks – such as big-bang policy reforms, global/domestic demand environment, surge in private investments, strong credit cycle, rising operating leverage or earnings cycle.
Consequently, consensus has become extremely cautious in the near term. Like most times in equity market, in this case also, the consensus expectation is not what lies ahead for the market.
Current market environment is pretty nervous about the outcome of elections. Markets, in general, position themselves appropriately and most often conservatively ahead of the elections. Consequently, since start of this calendar year Nifty is up nearly ~3% while midcaps are down 7%. Historically, we have seen rally post-election. In last three instances, 6 months post elections, the minimum movement in Nifty and NSE midcap has been up +15% and +26%, respectively. Though the linkage between election outcomes and corporate profits is weak in near term, however higher visibility on policies and reduced uncertainty post-election, could spur the sentiment for investors. Moreover, media consensus currently indicates the incumbent government are favourites and will continue, lending continuity in policies. This could further aid sentiment quotient of market participants.
Equities over long period simply track the nominal GDP growth. In the last 5 years as well, Nifty returns have been in line with the average nominal GDP growth of ~11%. The controlled inflation regime over last few years has resulted in sustainable real GDP growth and this could further accelerate from current average of ~7% through fiscal and monetary stimuli. Central bank, through its monetary policy is on path to spur growth with first round of rates cuts seen in beginning of this year and has space to do more on this front. Simultaneously, post-election, it could stabilise tight liquidity conditions that could give a boost to the economy. Though space of fiscal expansion currently seems to be lower, however some of the earlier reforms such as GST should pay off in coming years to give additional headroom. The other bogey in the bag is monsoons, which IMD is forecasting to be near normal. This too could lower rural stress and drive consumption.
India’s corporate earnings growth story had hit a soft patch over last few years with consensus earnings being revised downwards every year. Corporate net profits to GDP too have fallen from a peak of ~8% in 2008 to ~3% in FY18. Slow resolution of asset quality issues of corporate bank have resulted in subdued single digit credit growth for the banking system over FY15 to FY18. IBC reform has strengthened the asset resolution process and started to reflect in corporate credit off-take which rebounded to 13.3% in FY19, the highest in 5 years. As we have come to an end of the NPA recognition cycle, provisioning has started trending downwards and is set to be lower than last year. Next year should be a near-normal year for profitability of these banks resulting in sharp uptick in Nifty earnings compared to previous years.
As a conundrum for Nifty earnings continue, one should not rely solely on P/E multiple as valuation metric as it could lead to misleading conclusions. Other metric such as market cap to GDP is currently at fairly attractive levels and P/BV multiple is also closer to mean which suggests market valuations are not frothy. Moreover, India’s valuation premium to EMs too has compressed and is much lower now at 47% (closer to long-term average) versus the 70% peak six months ago.
On risk side, locally, we believe defaults in NBFC space due to liquidity squeeze can derail market flows. This can have contagion impact across sectors where leaderships will be challenged leading to volatility. Externally, the impact of trade wars is unknown and typically believed to result in risk off behaviour for investors which can impact foreign flows.
We are entering a period where there will be host of catalysts for the market to look upon which could trigger a broader rally in markets. The investors could capitalize these weak sentiments and load up risk to play for upside. For investors, who are looking to reduce near term volatility, they could spread investments across months or alternatively can look for asset allocation funds which can manage equity and debt allocations dynamically depending upon market conditions.
From the desk of Bharatt Lahoti, Fund Manager, Edelweiss Asset Management Limited (EAML)