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Stock Market – Time For a Reality Check

15 July, 2009
As a heady quarter for equities has drawn to a close, it is important not to get carried away. The spurt has been akin to August – October 2007 aided by liquidity from foreign portfolio investors.
 
Inflow of close to $ 8 billion helped erase the outflows suffered in January and February and the net FII investment is close to $ 5 billion; money has been taken out in the past ten days.
 
This number is quite heady and comfortably in excess of what used to be the money that came India’s way till 2003.
 
This is not a number to be scoffed at and indicates the fact that India figures prominently in the calculus of global investors even after the meltdown of 2008 and a reduction in risk appetite.
 
Such just liquidity-driven uptrend has to be eventually backed up by underlying trends in the economy. In this respect, it is a story of not so much FY 2010, but FY 2011 that could deliver numbers that may provide an underpinning to the sharp rise in stock prices.
 
What is important is the rally has priced in much and now we need to have fundamentals play catch up. We would closely track this aspect.
 
This is still not an environment for investors to get exuberant about any asset class. Even if one takes a look at India, the situation based on underlying economy could have been different but for the clear nature of Verdict 2009 in the Lok Sabha elections.
 
In this backdrop, it is important for investors to have a well defined asset allocation plan and stick to it. This will ensure that exuberance and mistakes are avoided to a great extent.
 
REALITY CHECK
What are the issues that confront us, and have they changed since the new government cam into power, and what are the key issues people are concerned about now.
 
Our view is that markets appear over-valued in the short term, especially in the large-cap space and offer limited scope for appreciation. The “hope” aspect on India has, however, gained ground leading to most of the stocks correcting 10-15% from the peak and not more.
 
FUNDAMENTALS BRUSHED ASIDE
Longer term fundamental issues remain but have been brushed aside in this liquidity-driven rally – excess capacity in most countries leading to an eventual loss of pricing power, and longer-term implications of the concerted action by governments to jump start the economy.
 
We think that the global rally has been a relief rally rather than one backed by a fundamental improvement in profitability of the corporate sector around the world.
 
It may be that this rally was also on the back of news not being as bad as expected which has led to this rally. Be that as it may, we need to confront certain issues which will have much longer-term implications than what this liquidity driven rally may suggest:
 
IT’S DIFFERENT IN DEVELOPED WORLD
The developed world will have to consume less and save more leading to a definite deflationary environment setting in over the medium term, as they still are the largest consumers of commodities. The hope that demand from China and India will nullify the contraction in the West is far fetched.
 
The resultant loss of pricing power for companies in the Western world will result in significant job losses, which could lead to a further downward spiral in demand destruction and increase in protectionism, which could dampen growth in developing economies.
 
Companies will be forced to cut back capacities for the medium term and this could lead to distressed asset sales, which can have a domino effect across the globe on asset prices regardless of the earning power of these assets.
 
Longer term capital flows may move into emerging markets to chase growth, which could be a silver lining for India, too, in an otherwise gloomy scenario.
 
RESILIENCE IN INDIA
From India’s point of view, the resilience of our economy has surprised us all. While post facto analysis may throw up a number of reasons, India’s under penetrated economy for many goods and services and also good pricing power is attractive.
 
India’s capacities across various sectors are very small compared to those in China, and hence there will be a rush to build capacities as and when money is available as is the case now.
 
MONSOON + EMPLOYMENT + CAPITAL = CONCERNS
Monsoons will set the pace for rest of the year, and a weak monsoon could push India into a high inflation regime once again, straining government finances and reducing discretionary spending which was responsible for helping the economy in FY 2009.
 
Already, India stares at a weak sugar crop as also higher fuel prices will only push consumers to become defensive once again.
 
There are signs of growing unemployment, especially in the middle class, as they were largely dependant on India’s growing IT sector which has cooled off considerably. It remains to be seen if they are gainfully employed or not. State-owned enterprises are actively recruiting, as their employees retire and they need to fill in the vacancies, but will they be able to make a smooth transition remains to be seen.
 
We remain worried on this score. We expect companies to raise a significant amount of capital over the next few months to recapitalize themselves for costly acquisitions and raise money for domestic expansions.
 
TILTING BALANCE IN THE MARKET
In this backdrop, market performance in the short term will be capped with risks on the downside rather than the upside. As equity money is raised, the return on equity drops and it will take time for this to go up.
 
Stock price performance typically maps incremental return on equity and if that is negative, it is difficult to imagine a positive stock performance.
 
BUDGET 2009-2010
What will be important will be the quality of implementation, which has not been very encouraging in the past. All eyes will be on India’s fiscal deficit and how the government bridges the gap.
 
Can there be a shortage of capital? India’s 10-year G-Sec paper is now thinly traded with yield going in excess of 7% indicating that the market is expecting a big fiscal deficit.
 
Capital availability at low cost is unavailable for Indian companies to implement infrastructure projects at a reasonable cost. Compare this to Chinese companies that are able to raise money at yield between 3-4% and the differences are stark.
 
If the Finance Minister manages to retain foreign investor interest, then low-cost foreign capital could come through to augment resources for the large capital expansion planned.
 
We estimate a requirement of 20-30 billion dollars annually for the planned capex programs in India. If this were to happen, then India could escape the global slowdown mildly.

PHASE OF CONSOLIDATION
To summarize, we think Indian markets will be in a phase of consolidation for some time to come as new capacities come on stream and equity dilution take place eroding the return on equity for existing holders.
 
This will be a good opportunity to build positions in a gradual manner, as markets move within a trading band. While India benefits from a low commodity price regime, a large proportion profits for India’s listed companies are commodity linked, lead to a dichotomy – what is good for the country is not good for the markets.
 
We think that the next big move could take place after a gap of twelve to eighteen months as companies begin to start commercial production of their new projects, which could start the virtuous cycle of fresh cash flows and lower interest costs. Until then, we will have to be content with dividends and trading profits.

 


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Stock Market – Time For a Reality Check

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