Extrapolating Economic Events to Equity Markets

The last 4 years have been unforgiving for equity investors. Markets have not been able to scale the peaks set in Dec 2007. So, typically, when we talk of equity markets giving superior inflation adjusted returns (15% as per long term average return of Sensex/Nifty), we give a time horizon of 2-3 years at least which classifies as a long term investment. So what has gone wrong? More importantly, will we ever get meaningful returns out of equity markets? Let us put a few things in perspective here. Every decade, we have a bull cycle and a bear cycle. Equity returns are non linear and hence deliver returns erratically. For instance, in the decade of 1990 to 2000, markets returned point to point 44% CAGR (fuelled by economic liberalisation) and in the Decade 2000 till date (actually 13years), markets have delivered a more humble 18% CAGR return (still best in class returns comfortably beating inflation). However, there have been very dry periods in between. Had the investor pulled out just before the rally in 2005/06? He would have lost money for the decade. The point I am making here is what is important for equity investors is not “timing” the markets but “time in” the markets.

Let us shed some light on the recent few years. 2004 onwards we had a bull market fuelled by a booming global economy which lasted nearly five years. Mar 06 onwards Inflation was the biggest issue for us and hence to prevent over heating RBI tightened rates from Mar 06 to Mar 08 from 6.5% to 9% and then when things were under control, cut from 9% to 4.75%. Again, to prevent overheating of the economy, from Mar 10 till Oct 11 RBI hiked key rates 13 times (4.75% to 8.5%). However, inflation has barely been managed.

Inflation’s unique issue recently has been that it started out as a supply side phenomenon and mutated into a demand side issue as well. What are we looking at going ahead? We will be having wage inflation for next 2 decades. 64% of WPI is manufacturing inflation so raw material effect will be rather pronounced. Food prices rose recently mainly in proteins n veggies not cereals. But food inflation will also be elevated above normal levels. For a growth economy like India, we have to learn to live with the new normal of elevated inflation for some time till we mature as an economy.

For now, commodity prices softening should help India as a whole since we are net importers but rupee effect is neutralizing all that. Rupee’s weakness understandably stems from the state of our economy and not necessarily from increasing trade deficit. So what has happened is in the last 2-3 years, corporates have been hit by twin evils of higher RM costs (thanks to massive global monetary easing) and Interest costs (RBI rate hikes & liquidity deficit).

Historic multiplier for GDP to corporate growth is 2-2.2x, so with an 8% growth, companies grew 12-15% barring 2009. Even now, with sub 7% growth they should grow 12-14%. This effectively means, barring a black swan scenario, in 4-5 years markets should double. Market multiples are driven by GDP growth and debt yields, both factors have caused de rating recently. An uptick in either could potentially better our equity gains going ahead.

So how do we get there? The approach has to change from the past, which was essentially fuelling the deficit and growth coming from consumption. Now, it should be more policy driven which would revive the extant private capex, thus creating a virtuous cycle and easing pressure on rupee and fiscal deficit. Pruning of government expenses like subsidies is a must. Regulatory road blocks which need immediate sorting would be the fuel issue for power plants, FDI in retail and aviation, implementation of GST and more astute pricing of diesel and LPG.  

So basically fiscal deficit, which government’s estimate will be 5.1% of GDP in FY13 (assuming present Rs95tn GDP growing at 8%) has to come down. My own sense is as things stand, fiscal deficit would be 5.9% of GDP, similar levels of FY12 (Rs6tn deficit on FY13 GDP of Rs101tn). So what can save us? For one, things under government control - non plan expenses. Major portion of which is subsidies, largely untouched in the budget. GOI assumes it will be Rs1.7tn in FY13, i.e. 1.7% of GDP. This has upside risks if oil under recoveries stay where they are. With total under recoveries of Rs1.1tn, where government may bear Rs0.7tn, it will be an uphill task. Fuel price hikes, reduction of subsidy (fuel, food, fertilizer) will help assail the gap.

The government is also assuming that it will undertake divestments in PSUs to the tune of Rs30bn in FY13 (aggressive in my opinion, given current market conditions). It s also assuming auction of excess spectrum and re auction of 2G to garner Rs580bn. This could be achievable if things go as per plan. Spreading tax receipts across various heads means that the GOI could garner its intended target of Rs459bn.

What is disturbing is most of the deficit will be fuelled by government borrowing which is crowding out private capex. The latter is essential for sustaining growth. Growth rates have reduced from double digits to low single digits. Addressing regulatory bottlenecks would help at this juncture more than monetary measures. We have not had serious capacity expansion in the last 4-5 years and many companies in various sectors are running at near peak capacities. This capex cycle would set the ball rolling on generating growth.

Money in equity markets is made when valuations are inexpensive. 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.  The issues enumerated above can potentially ease out in the next 2 years assuming oil prices are benign, policy measures are underway and private capex picks up.

Market multiples are attractive. We are presently trading at 12xFY13E, which is lower than our 14x median PER and the range has been 10x to 24x. Also M Cap to GDP ratio is 0.6x (India GDP $1.73tn, Nifty Mkt Cap $1tn). Historically this ratio has ranged between 0.25x to 1.1x and averaged 0.93x. So from a valuation stand point, we seem pretty well placed.

Tactically one can play rupee deficit themes in the short term through exporters like Pharma (Cipla), Auto (Bajaj), IT (HCL) , upstream oil (Cairn) and Metals (Hindalco). Medium term one can start nibbling in beta plays which are beaten down – capital goods (L&T, Crompton), private banks (ICICI Bank) and auto (Maruti, Bajaj).  Long term almost all sector leaders look attractive.