US Fed rate hike: Cloud over India's premium valuations

Premium valuations era started in 2006 and went hand in hand with decline in the US interest rates

The Dalal Street saw a relief rally after the rate increase by the US Federal Reserve but the optimism could be short-lived. A rise in benchmark interest rate and the resulting hardening of the interest rate in the US could turn the tables on the valuation premium that the Indian market enjoys over its American peers.

The benchmark S&P BSE Sensex is currently trading at around 20 times of its trailing earnings per share, higher than S&P 500 index's price to earnings multiple of 18x. At its peak in December 2007, Sensex was valued at nearly 28x, a premium of 600 basis points over the underlying valuation of its American counterpart. One basis point is 100th of a per cent.

For the better part of the last decade except for a brief period during the 2007 Lehman Crisis, the Sensex has traded at a premium to S&P 500 valuation. The era of Indian markets trading at a premium to US markets started in 2006 and it went hand in hand with decline in the interest rate in the US.

The analysis is based on the calendar year-end (except for the current year) yield on US generic 10-year treasury bond and trailing price-to-earnings multiple of the S&P 500 Index and BSE Sensex. The index earnings-per-share is calculated by inverting the respective valuation multiples.

Yield on 10-year US government bond declined to 2.1 per cent from a high of 4.7 per cent at the end of the 2006 calendar year. Now that the interest rate cycle is turning in the US, there is a likelihood of India's premium vanishing from the bourses.

"There are a lot of moving parts to the India valuation story and things can move in either direction. We sustained a premium valuation due to relatively better macros than other emerging markets and a prospect of a cyclical upturn in growth in corporate earnings. If corporate earnings revive in the next few quarters as expected, India will retain its premium despite a rise in US interest rates," says Anoop Bhaskar, head equities UTI Mutual Fund.

But not everyone is as optimistic as Bhaskar.

"Corporate earnings have been below expectations in the last few quarters thanks to poor growth in GDP at nominal prices indicating a deflation in the economy. Things should improve in the next few quarters though we have to watchful of events such as further devaluation in Chinese currency and resulting upheaval in emerging market currencies," says Nitin Jain, head Global Asset & Wealth Management Group at Edelweiss Capital.

Sensex companies' underlying earnings are down 15 per cent on year-on-year and near-term outlook remains challenging due to a dip in global commodity prices, a bad monsoon, decline in global merchandise trade and high corporate leverage. In comparison, S&P 500 companies underlying earnings is flat (down only 0.8 per cent on year-on-year basis).

This has further accentuated the negative correlation between US interest rates and Dalal Street valuation and could weigh on equity returns even if corporate earnings began to grow. For example, the Sensex is up only 29 per cent from the highs of 2007 despite a healthy 74.1 per cent growth in underlying earnings during the period.

S&P 500 shows a similar wedge between index returns from its dotcom highs. The index has delivered annualised returns of two per cent 1999 much lower than 5.1 per cent compounded annual growth (CAGR) in index underlying earnings. The culprit is the decline in the index valuation during the period.

The data suggest that India's premium has began to diminish in line with rise in the US bond yields from the lows of 2012. Any further rise in yields in step with subsequent rate hike by the Federal Reserve could accelerate the process.

Bulls, however, remain optimistic. "The worst is behind the Indian market given our strong macro, a domestic demand focussed economy and public finance driven economy recovery," says G Chokkalingam, chief executive, Equinomics Research & Advisory. Let's keep our fingers crossed.