Market confronts reality, trims double digit earnings estimates

Single digit earnings growth increases the risk of a multiple de-rating for India

At the start of the new fiscal year, the markets believed that finance minister P Chidambaram would kick-start growth with his magic wand so to speak. Equity analysts bought into this theory and factored in higher earnings growth for FY14 and FY15, despite the fact that the Sensex ended FY13 with an earnings growth of 3%. Markets estimated higher earnings growth on the back of higher better GDP growth forecasts made by the government and central bank. 

 

According to consensus estimates, Nifty companies are estimated to report an earnings growth of 15% in FY14 and 16.5% in FY15. If anything, this may be called the ‘irrational exuberance’ because the first quarter has seen a year-on-year fall in earnings. Less than six months into the new fiscal, the market is realizing that these steep earnings estimates need to be trimmed to more sensible levels. Ridham Desai and Sheela Rathi of Morgan Stanley have cut their Sensex earnings growth estimates from 10.5% to 4.1% for FY14 and from 19% to 12.7% for FY15. Based on these new earnings estimates, the brokerage has arrived at its 12-month forward Sensex target of 18,200. What this essentially means is that the markets will go nowhere for the next 12 months. 

 

In their bid to fight a new crisis every month, policy makers have forgotten that what matters in the end is growth. Till growth returns, financial markets will continue to roil. With interest rates moving up in the US and growth picking up, India has lost its TINA (there is no alternative) factor. 

 

Dhananjay Sinha of Emkay Global says historically, portfolio flows into emerging and developing markets are inversely correlated with change in the US rate cycle. With earnings and GDP growth decelerating in emerging markets, foreign investors may not pump in the disproportionately high amounts of money into emerging markets like India as they did between 2007 and 2008. 

 

Earnings downgrades by themselves are not a bad thing. But persistent downgrades pose the risk of a downgrade in India’s multiple. India’s superior growth meant that Indian equities commanded a premium to other EMs. Now with earnings slowing to single digit levels, the market’s premium valuation is at risk and if that falls, then broader indices would correct even further. Emkay's Sinha believes continued contractions in earnings estimate will likely compress multiples further. Mahesh Nandurkar of CLSA along with Rajeev Malik write that outflows driven PE derating is a bigger risk than earnings downgrade. 

 

Both the government and central bank need to bring growth back on track, as liquidity is surely not going to fuel markets any more.