Equity outlook: Good time to correct under-allocation to equities

The Indian economy has been under-performing and continues to display mixed signals. There is a combination of concerns and favourable developments.

Indian inflation has been sticky in the recent past, despite the efforts of the government and the Reserve Bank of India (RBI). The chief contributors to inflation are food and fuel. The Centre's fiscal deficit is another source of concern for the economy. The April-to-August period has already seen the deficit near the 75-per-cent mark of the projected amount. But the finance minister's repeated assurance that the deficit would be contained at the budgeted level of 4.8 per cent of gross domestic product (GDP) is reassuring. The continued low GDP growth, though a cause for concern, is expected to be reversed by the reform initiatives and policy actions expected of the government that would come to power in 2014.

There are, however, some positive signals that are emanating from the economy. The Current Account Deficit (CAD) was a major contributor to the fall of the rupee's value, which added further fuel to inflation. Fortunately, the trade deficit, the prime mover of India's CAD, has been showing a downward trend in recent months. The finance minister recently projected a much lower CAD at $60 billion, against the original estimate of $70 billion and the previous year's figure of $88 billion (4.8 per cent of GDP). This should stabilise the rupee and prevent further import of inflation. Recent austerity measures announced by the government, estimated to save Rs 20,000 crore, are an indication of the willingness to take difficult decisions.

Where the markets are concerned, Indian corporates have turned in a decent second-quarter performance. While sales and operating profits have increased marginally, high interest cost has eroded the bottom line. One-year forward price-earnings ratio (P/E Ratio) of the Sensex is now below the historical average, and so is the market cap/GDP ratio. These two are favourable indicators for the return potential of equities.

The equity markets witnessed a recent upturn, purely driven by foreign institutional investor (FII)'s money. These funds predominantly went into large-cap stocks, and that too only in select sectors. This has created large valuation gaps between the various sections of the market, making the situation ripe for attractive value-picking.

Though foreigners have poured in money by the billions, the Indian retail investor is still reluctant to invest in equity. Over the past few years, retail investors have been focusing on physical assets, like real estate and gold. It is our belief that physical assets cannot outperform financial assets over a long period. In the last five years, physical assets have outperformed financial assets. In our opinion, we are currently at a stage where financial assets have become extremely attractive from the long-term investing perspective.

There are a number of reasons for this: First, the Indian economy seems to have bottomed out in the second quarter of this financial year. Periods of low economic growth have historically been a good time to invest in equities. Equity markets typically tend to move ahead of the economy. By the time the news of good economic performance hits the headlines, the market may well have raced away. Historical indicators prove this contention.

Second, though retail investors have been staying away from the market due to pre-election volatility, historical indicators show equities have given good returns after elections.

In the near term, the markets could stay volatile due to state elections on December 8, the possibility of the US Federal Reserve going ahead with its tapering in bond buying, the slowdown of China's economy and the 2014 national elections in India. However, given the good pointers to potentially high returns from equities in the coming years, this is a good time for retail investors to correct the severe under-allocation to equities.

Despite the risk of sounding repetitive and the lacklustre equity returns in the recent past, the fact that equity as an asset class has proved to be the best wealth creator over long term needs emphasis. Retail investors have mostly missed the bus in the past and this hopefully would not be the sad story again.

The author is MD & CEO, ICICI Prudential AMC