Earning downgrades seen, PE de-rating unlikely

The current state of the market is a cumulative result of a worsening macro environment, evaporating foreign institutional investment (FII) flows, negative news on scams and a decision paralysis in the government.

At the start of the calendar year, the economy was beset with aspects of a domestic liquidity crunch, a widening current account deficit (CAD) and sticky inflation. Inflation, being a supply-side phenomenon, and CAD, seem to be largely under control and should taper off in the later part of the year. The GDP estimates seem on course to meeting the consensus. The transmission mechanism has finally started kicking in, as there is a lag between policy action and its effect on the economy.

We are at the fag end of the rate rise scenario, with a couple of more rises to go. Portfolio flows from $29 billion last year should halve, which could have a bearing on our CAD. However, the flip side is our flow quality could potentially improve with possibly more FDI.

While the consensus earnings estimate for Nifty has not been shed and there still might be some more pain left, we do not believe there will be a massive de-rating of the one-year forward Nifty PE from 16 times to about 12-13 times. In other words, the markets look reasonably priced but not terribly cheap.

The lag in policy implementation has delayed the capex cycle, hurting infrastructure and related sectors. Lending rate rises have accentuated the pain. Thus, companies are realising the twin evils of hardening input costs and capital costs, which are affecting their bottom line. This would cloud the interim earning cycle.

We have to look at equity markets with a longer time frame in mind. The immediate outlook is definitely challenging, being clouded with both macro and other aspects. However, we have to keep the larger picture in mind. A large consumption-oriented economy and a skilled labour catchment are ripe for a demographic dividend. Long-term catalysts for growth in terms of corporate earnings are intact.

Constituents of the bellwether indices are market leaders in their respective sectors with a strong corporate governance, managerial and earning track record. Keeping this in mind, we believe 2011-12 can see 12-15 per cent growth with certain stocks performing more than others, and this growth will be back-ended. The first half will see volatility due to government functioning, liquidity tightness and other hindrances, but once the capex cycle is under way and companies start delivering earnings growth, things should largely fall in place.

The best bet would be to remain invested in the larger market, either through buying blue chips represented in the market index or through index funds.

The author is the MD & CEO of IDBI Asset Management.

The views, opinions and expressions made are in his personal capacity