Valuations will drive the market

A degree of optimism is evident in the equity markets. The government’s actions in mid-September — fuel price hike and allowing foreign direct investment (FDI) in retail in the face of political opposition — seem to have buoyed market sentiment. This was also helped by the benign external backdrop created by key central banks earlier last month. The Nifty rose as much as 8.5 per cent in September, but that does not capture the full story. The Bank Nifty index shot up 14.7 per cent, symptomatic of a switch to cyclical stocks.

Such a strong market reaction is largely explained by the initial condition of very low expectations from the government. It now appears that the government intends to keep up the news flow momentum by announcing a series of reformist measures that will be welcomed by the market. While positive news flow is a relief after months of negativity, one should not get carried away about its impact on the ground for corporate India. After such a long period of policy paralysis, leading to drying of capital investment, it will take months, if not years, for government announcements to make any changes on the ground. Also, promoters and managements might be wary of committing fresh capital investments just before the elections, especially when a different political alliance might rule post-elections (based on recent opinion polls).

So, in the near term, the main driver of return for the equity markets is likely to be valuation change,rather than earnings progression. Sell-side forecasts of earnings per share (EPS), cut relentlessly over several quarters (to reflect deteriorating fundamentals), have now been declining at a slower pace but the direction is still negative. Based on Bloomberg consensus estimates, EPS growth on a 12-month forward basis is now about 10-11 per cent. On a 12-month forward basis, the Sensex is trading at about 14 times earnings- still lower than the long-term trading average of about 15 times.

It is possible that the economic growth may have bottomed out. It is also possible that with the government initiating a few tough measures, the Reserve Bank of India (RBI) might signal a change of stance on the policy rates leading to a more benign environment for corporate India. Whether this will be enough for EPS estimates to start getting upgraded or not looks uncertain at this moment. While there is reflexivity in the relationship between markets and the economy; a robust growth in earnings led by improvement in investment cycle looks unlikely in the near term.

Despite the euphoric reaction by the markets we should not overlook the fragility of the political situation. If a few more political allies change their minds about supporting the government, political instability will be triggered and the reforms momentum might reverse. In any case, many observers believe the next Budget might turn out to be a typical populist pre-election one. That might act as a dampen on the market sentiment.

Despite the negativity over several quarters, foreign flows into India have been robust for a variety of reasons. Net cumulative FII flows year-to-date are now over $16 billion. While liquidity remains benign for now, one needs to be vigilant about how long the ‘risk on’ trade continues.

The author is executive director and head (equities) JP Morgan Asset Management (India).
The views expressed herein are the independent views of the author