Indian equities: Quo vadis?

It is useful to assess the possible course of the Indian equity market, based on its four key drivers — liquidity, interest rates, earnings and valuations.

On the issue of liquidity, though there were some robust inflows from foreign institutional investors (FIIs) in the first few weeks of 2012, the post-Budget scenario on inflows has been disappointing, with marginal net outflows. Domestic institutions have been net sellers during the first five months of 2012, with some marginal buying in June.

Efforts at a solution to the sovereign and banking problems in the Euro zone are not making enough progress. The dynamics of winning a popular mandate in Germany in 2013 and in the US over the next few months can only delay the right economic decisions from being taken. With the international safe haven bonds continuing to trade at near-zero yields at the short end, the rather low appetite for risk does not appear to be set for a dramatic change in a great hurry. While there could be bouts of volatility in FII inflows, based on short-term news flow, given that such flows are a function of global risk appetite and the attractiveness of the Indian market, the possibility of sustained robust inflows does not appear very bright at this juncture.

On the domestic front, the overwhelming negativism on the government’s ability to revive the confidence on the economy is keeping investors away from equities. And, there are no indications that the situation is set for an immediate change.

Interest rates in India continue to rule high, on the back of stubbornly high inflation that appears to be somewhat structural in nature. With liquidity conditions in the money market continuing to be stretched and most of the rate cuts having been front loaded in April, there does not seem to be a good case for aggressive rate cuts in the short term, despite moderating economic growth.

The ongoing economic slowdown and sub-normal monsoon are unlikely to generate much optimism and several large companies have started talking down the already low earnings expectations. The earnings outlook for sectors with large index weights like financial services, oil & gas, information technology, automobiles and engineering & capital goods are decidedly downbeat, on the back of looming recession in the developed world and a slowing domestic economy. The news flow, of late, has been quite depressing with mounting stressed assets of the banking system, waning chemical margins, falling capacity utilisation in the auto sector, indefinite delays in project completion and widespread postponement of capex plans regularly making the headlines. The consensus Sensex earnings growth estimate for the current year at the mid teens is, therefore, likely to be at considerable risk and may end up being a low single-digit number.

At under 14 times current year earnings, the Sensex may appear fairly valued, based on historic averages. But juxtaposed with single-digit earnings growth and continued firm interest rates, the upside on a fundamental basis appears limited.

In sum, the confluence of liquidity, interest rates, earnings and valuation does not suggest a robust and sustainable market rally. However, a possible quick solution to the Euro zone crisis and some purposeful policy action in India can significantly change the economic outlook and help generate good returns for investors.

The author is managing director, Dalton Capital Advisors (India) Pvt Ltd