This column was written by Sunil Singhania, CIO - Equity, Reliance Mutual Fund, for the India Markets Observer.
The year started on an upbeat note on the back of a very good 2014. With optimism in the air on the political and policy front, backed by global and domestic investor interest, the going looks promising for the Indian equity market, despite trading at an all-time high.
Our positive stance can be summarised in three major buckets:
- The macroeconomic turnaround
A year or two ago, almost all macroeconomic indicators for India were negative: the twin
deficits, currency, GDP growth, inflation and interest rates.
The CAD has fallen from a high of 5% to below 1%. Thanks to the measures taken by RBI Governor Rajan in September 2013 and the sharp fall in the prices of oil and gold, the CAD is no longer talked about as a problem. In fact, reports suggest that India might declare a current account surplus for the January-March 2015 quarter, something unimaginable a while back even to the perennial optimist. Concerns over the fiscal deficit have time and again been put to rest by finance minister Jaitley.
The INR has been the most resilient currency amidst global volatility. It is amongst the very few currencies to have appreciated marginally against the USD and significantly
against the euro, pound and yen.
The IIP and the GDP numbers have started to show an uptick and will get better as the
economy gathers pace.
The biggest positive has been the collapse of inflation. The WPI has reported an almost
unthinkable number of zero and the CPI has also started to trend in the 4% range. Buoyed by this, the very conservative RBI governor sprang a surprise by effecting the first rate cut; more are expected going ahead.
- Non-linear positive events
For the first time in 30 years a single party managed to get an absolute majority in parliament. This gives the Modi-led government significant strength in pushing through economy boosting reforms, something a coalition government battles with. The resolve of the government in kickstarting the economy through measures such as Make in India, ease of doing business, FDI in defense, railways and insurance, and the Swacch Bharat mission,
would provide the much needed fire power.
These bold moves were aided by the sharp fall in crude prices, indicating that fortune indeed favours the brave. The drop in crude from $115 to $48 translates into a saving of almost $60 billion for India, providing ample fiscal ammunition to undertake
infrastructure building programmes. The fall in input costs and reduction in interest rates will boost consumer demand and lead to a virtual growth cycle on the lines of what we witnessed during the early 2000s.
Skeptics still dispute the potential of the Indian equity market, citing the almost 17PE. We believe corporate profits will massively surprise on the upside over the next few years. Corporate profits of Indian companies as a whole tripled in the six years between 2002 and 2008 (CAGR of 20%+). During this period, the Sensex went up by almost six times, due to the fact that the market tends to give a higher discounting when earnings growth is consistent and high.
Between 2008 and 2014, earnings of Indian corporates, ex IT and Pharma, grew 5%, sales at 16%, operating profits 10%, and net profits 5% (all CAGR). This was due to the fact that companies had set up huge capacities but could not utilise them due to slower economic growth and lower demand scenario, making operating leverage a headwind. Similarly interest rates went up levying a higher interest burden on corporates impacting net profits. Both these factors are now turning into a tailwind.
With the improving demand scenario, companies that have capacities will be able to sweat them more leading to higher operating leverage led profits. With interest rates coming down, the positive impact of financial leverage will lead to a higher growth of net profits. Backed by operating and financial leverage, the Sensex EPS of 1350 in FY14 can grow to 3500-4000 by FY20, which is a growth of 18-20% CAGR. Thus for a long term investor, the PE multiples are still reasonable.
Surprises and risks
In the near term, positive surprises can emerge. The first interest rate cut has already been taken by the RBI but expectations on the number of cuts going ahead are still muted. Going by the sharp fall in commodity prices globally and the reining in of inflation in India, the quantum and pace of rate cuts by the central bank could surprise.
India’s rating upgrade by Moody’s and S&P is a question of when rather than whether. Any such step will ignite the Indian market in the same way the interest rate cut did. President Obama’s visit aroused renewed optimism and it is expected that with a lot of strategic tie-ups culminated during his visit, large investments by U.S. companies can be expected into India. We expect long-term strategic announcements to be the theme of this month’s Union Budget.
The biggest risk stems from global volatility, whether it’s Russia or the euro region or the
Middle East. Financial volatility will impact our capital deficit economy. The failure of the BJP government to push forward key measures to kick-start the economy would be the other risk, though the probability looks unlikely.
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