A lot of negative news all over the globe and in India. So what is the problem here? Simply put, assume Government is a person. It has borrowed beyond its means. Which means it has more expenses than the revenues it can generate. Which is known as Fiscal Deficit. Also, we are the only country in Asia to run a current account deficit, which means we are saving lesser and investing even lesser.

Like Theoden (King of Rohan - Lord of the Rings) mentions - "How did it has come to this?" (I LOOOVE LOTR!!! Except the silly hobbit Frodo...but that is a seperate post!)

Well, as a nation, we are always capital starved. We grow if we have abundance of capital. But for a typical growth or emerging economy like ours, we tend to overheat occasionally. This requires a firm pat on the head by RBI in the form of interest rate hikes, which in turn cools inflation till things are manageable. So in between the 5 yr bull market of 2004 to 2009, we had an interest rate hike period between Mar 06 & Mar 08. Then a series of cuts all the way till sub 5%.

Of late when inflation started rising again from Mar’10 to Oct’11 we had a series of 13 hikes all the way back to 9%. So this saga continues and there is nothing new in it. Only thing is, this time we were dealing with some mutant form of inflation. A culmination of what started out as supply push and then also involved demand pull inflation. RBI was fighting with ineffective weapons to counter this. What we needed a year back and what we need NOW are fiscal reforms. Simple. There is only so much RBI can do!

So in conjunction with the global weakness, where governments tried to revive economies by pumping money, Companies back home got hit by the twin evils of higher RM costs and Interest costs. Now they are also getting hit on the growth front as private capex has all but vanished due to government crowding out by its massive borrowing program.

 We have enough comfort on valuations. Sample some of this-  

1.      The benchmark indices are trading at below median values. Nifty has traded between 10x and 24x PE band with median of 14.5x, now we are quoting at12x PE (FY13E). A good way of seeing that markets are undervalued.

2.      Another measure we can look at is market cap to GDP ratio. At its peak this ratio was 1.2x and averaged 0.9x and presently its 0.6x, indicating markets are not overvalued.

3.      Market PER of 12x translates into a earnings yield of 8.3% which is roughly equal to G Sec yield. It was below G Sec yield for the past few months. Historically whenever this has happened, we have had mean reversion i.e. markets usually bounce from those levels.

4.      If earnings growth continues at same pace and markets do not de-rate further (less than 12x), then we could see doubling of current market levels in a span of 5 years. This level could move higher if the PE re rates from 12x to 14x (median levels).

I sincerely believe that corporate earnings in India are very resilient. So historically earnings are twice of GDP growth. Even assuming a piffling 6.5% growth this year we should be in the 12-15% range for corporate earnings.

So why are we not buying by truckloads? Well, market multiples are a funny animal and are driven by GDP growth and debt yields, both factors have caused de rating recently. There are serious issues which need to be sorted at the macro level and those take time.  While broadly it’s the twin deficits, other micro issues would be sorting out are the fuel issue for power plants and regulatory road blocks, FDI in retail and aviation, implementation of GST etc. to name a few.

Fiscal Deficit – scary scene when the official figure is Rs5.1tn (5.1% FY13E GDP), my figure would be Rs6tn fiscal deficit on my own GDP estimate so that will translate into a deficit of 5.9%. Similar to FY12, UNLESS we have oil prices coming off drastically or the GOI does a hefty re auction of spectrum or sells a lot of FPOs. Very difficult to see that happening, right?  Oil prices would be crucial here on the subsidy front as the Govt. has targeted subsidies to be 1.7% of GDP in FY13E i.e. Rs1,730bn. Oil may have Rs1,130bn under recoveries in FY13 of which how much the government bears is a fluid question.

But then, money in equity markets is made when valuations are inexpensive. Valuations get inexpensive only during times like these! So when conviction is high and macros are good, we will not get good valuations. Key is to believe that these issues will be resolved in a reasonable time frame.  So it is more of being patient and holding your nerve in these markets. And yes, corny as it may sound….believing in the India Growth Story! Happy Investing…