Caveat emptor

Investors need to be cautious and look beyond market highs

A weak rupee, a rising current account deficit, slowing exports, and rising interest rates don’t seem to add up to a big bull market. Yet, despite all these negative factors, the Sensex and Nifty have soared to all-time records. Moreover, financial services firm Morgan Stanley estimates the Sensex could move up by another 30 per cent in calendar 2023 if a few conditions are met.
 

Foreign portfolio investors (FPIs) have pumped Rs 35,000 crore into equities in November. This represents a major attitude reversal, given that they had sold a net Rs 1.68 trillion in the previous 10 months. Domestic investors have been optimistic through 2022, with institutions buying a net Rs 2.58 trillion (including Rs 1.56 trillion in investment by equity funds) to more than balance FPI sales. Retail investors have also been net buyers in direct equity and via mutual funds and unit-linked insurance plans. Investors are ignoring the negatives and betting on some positive signals. High-frequency indicators like goods and services tax collection, power consumption, and rail goods traffic indicate the economy will achieve the high end of growth estimates in 2022-23. Inflation shows signs of levelling off as energy prices stabilise. This could also imply a pause in the central bank’s cycle of rate hikes.
 

From a global perspective, India is also benefiting from the there-is-no-alternative factor. In the view of FPIs mandated to keep emerging markets’ weighting in their portfolio, India looks like the most attractive destination at this instant, with its deep, liquid equity market. Among large economies, it has the highest growth rate, and, indeed, the only one with high growth. The US is struggling to contain inflation, and suffering massive, highly publicised layoffs across its tech sector. China has seen a deep drawdown due to its harsh zero-Covid policy, and that, in turn, has sparked widespread protests, shocking the regime. The EU and the UK are grappling with the consequences of the Ukraine war.
 

The Morgan Stanley estimate of 30 per cent upside for Indian equity comes with several caveats. The financial institution believes this is possible if India is included in the JP Morgan Global Bond Index in the Emerging Markets category; India’s companies generate 25 per cent earnings growth in the next 12 months; and global commodity prices (mainly oil and gas) moderate from current levels.
 

India’s bond market suffers from disqualifiers like low liquidity, complicated tax treatment, and restrictions on foreign participation. However, the massive government borrowing programme lends substantial scale to the primary bond market. Moreover, these are risk-free sovereign instruments and, hence, attractive. An inclusion in the global index would lead to inflows of $20 billion per annum as every FPI with EM bond weighting would seek an India exposure. Inclusion is very likely, and sooner rather than later. Gas and crude oil prices could trend down, given the fact that the global slowdown is reducing demand, and the global economy has successfully found alternative sources to replace sanctioned Russian gas and oil.
 

But the earnings growth rate of 25 per cent looks unlikely. The July-September 2022 quarter saw corporate profits decline year-on-year across a wide variety of sectors. Corporate managements were also noticeably cautious in guidance. The bears would point out that valuations are very high.
 

The Morgan Stanley report projects a 30 per cent return as a “best-case” with 10 per cent return as the most likely “base case”. The “worst case” (no bond index inclusion, high energy prices and low earnings) could mean a 15 per cent decline. Investors should bear all three scenarios in mind and proceed with appropriate caution.