A necdotally, talking to industrialists and policymakers, one gets the sense that we have passed the point of maximum scepticism and cynicism about the country. The constant refrain that India is a basket case where no large project can be executed has stopped…Many think the Rajasthan elections have delivered a clear message to the political class that populism on any scale, without governance, will not get votes. The political class ultimately has to react to what voters want. When the message is as unambiguous as the recent one, change will happen…
The year 2014 is going to be fascinating for India. We will have an incredibly important election and the possibility of markets finally breaking out of their six-year trading ranges. But before we look at the prospects for India, it is important to set the context in order to gain an understanding of the major trends that will impact markets globally. It is now clear that global growth will accelerate in the coming year. Leading indicators are improving; fiscal tightening is moderating; and, though structural issues remain, they should not prevent a short-term improvement in growth. Global gross domestic product (GDP) growth accelerated to a quarterly annualised pace of 3.8 per cent in the third quarter (Q3) of 2013 (from 2.5 per cent in Q1 and 3.5 per cent in Q2), and all signs seem to point to this momentum being maintained in the current quarter as well.Growth should come in at 3.5 per cent in 2014 as against the 2.9 per cent expected for this year.
An acceleration in global growth will have important implications for investment, including early moves to normalise monetary policy led by the United States Federal Reserve. Quantitative easing seemingly dampened the sensitivity of long-end yields to any macro strength. However, as soon as “taper” talk began, long-end yields became extremely sensitive to any positive growth surprise. With the commencement of tapering imminent, and if global growth is indeed strengthening, long-term bond yields should rise sharply. Ten-year bond yields will likely cross three per cent – many market observers are even calling for 3.5 per cent. Ultimately, long-term yields will finally settle at a much higher level.If yields do rise, it will limit the scope for price-earnings (PE) multiple expansion, which has been the main driver of global equity markets in the past couple of years. In a normal cycle, we first have PE multiple expansion as equity markets pre-emptively discount an improvement in earnings.
After that, earnings drive the next stage of the market rise. The problem for the US in particular is that this business expansion is already five years old; profit margins are at an all-time high. There is limited scope for strong earnings growth to offset PE multiple compression (as yields keep rising). Thus, prospective returns for US equities will be lower than those in the last few years. The prospects for earnings growth and hence equity returns are far better outside the US.As for India, there is a real chance that the bull market has already begun, given the type of price action that we have seen, with mid-caps and more cyclical stocks and sectors leading the market over the last month.
Sector rotation has begun, with the huge dispersion in performance between defensive sectors (especially consumer stocks) and those with economic sensitivity starting to narrow. Given the extent and duration of the performance differential, this rotation will take months to complete and will throw up new market leaders. It is also heartening to see mutual fund advertisements once again. It is astonishing that the entire Indian mutual fund industry has equity assets under management of only $25 billion in a $2-trillion economy with annual household financial savings of over $150 billion.Mutual funds have been able to raise approximately Rs 1,500 crore in the last few weeks in close-ended mid-cap-oriented products, and the never-ending redemptions are hopefully coming to an end. Indians have never owned less equity. Given our demographics, the asset allocation is totally skewed.
In any company today, anyone owning even a few thousand shares will be among the top 100 shareholders. Almost a quarter of all equity folios/demat accounts have disappeared in the last five years. As domestic investors return to the market, they will broaden the rally and we will move away from the current phenomenon in which only 50 stocks matter. Trading volumes will rise and our total dependence on foreign flows to determine market direction will abate. It seems both growth and earnings estimates have bottomed out. The last quarter was the first of the last nine quarters where earnings actually stood slightly ahead of expectations, with earnings upgrades for the broad market. Similarly, after more than two years, I saw some GDP growth upgrades from global investment bank economists.The cycle of both earnings and GDP estimates being cut every month seems to have ended. Given how poorly corporate earnings have fared recently (eight out of the last nine quarters have experienced negative year-on-year growth, according to ESS) and considering the extent of operating leverage, any growth revival will drive a strong earnings recovery.
On the macroeconomic front, it seems the current account at the end of the year will be about $45 billion, almost half the $88 billion in 2012-13. At 2.5 per cent of GDP, this is eminently financeable. India now looks far less vulnerable to any type of tapering, and the finance minister seems determined to maintain the sanctity of the fiscal deficit target of 4.8 per cent of GDP. The Reserve Bank ofIndia Governor has huge credibility among investors, who trust him to find the right balance between protecting growth and resetting inflation expectations. Rates will hopefully move down in the coming 12 months. Anecdotally, talking to industrialists and policymakers, one gets the sense that we have passed the point of maximum scepticism and cynicism about the country. The constant refrain that India is a basket case where no large project can be executed has stopped.
Most people believe that growth will accelerate over the coming 18 months. There are some signs of movement by the Government in clearing projects, and public sector undertakings are accelerating capital expenditure plans. Capital goods companies, while acknowledging that the coming two quarters will remain difficult, are feeling increasingly confident of seeing a pickup in ordering afterwards. Most are increasingly certain that exports will become a big driver of growth in the long term.
Though foreign institutional investors have poured money into India, there is enough of a wall of worry there and angst towards emerging markets to make me confident that flows will continue if India gets its act together.We are seen as a country that has enough low-hanging fruit – if governed more effectively, our markets can do well, irrespective of the sentiment towards emerging markets.
The elephant in the room remains the elections. Thankfully, most people now think a very fractured and fragmented third front leading the nation is unlikely. As long as we have decisive and cohesive leadership, that will be enough to rekindle the animal spirits. Many think the Rajasthan elections have delivered a clear message to the political class that populism on any scale, without governance, will not get votes. The political class ultimately has to react to what voters want. When the message is as unambiguous as the recent one, change will happen. Earnings and growth are at an inflection point; valuations are reasonable, if you know where to look; macroeconomic risks are receding; and signs of political change are visible.
The building blocks of a sustainable and significant market rise are in place. We can only hope that we do not let this opportunity slip away.
(The writer is at Amansa Capital.)