Low growth: The new normal

Indian equities set to lose premium valuations as earnings and GDP growth forecasts are downgraded.

IN recent years, investors have taken India’s above eight per cent GDP growth and expensive stock market valuations for granted. High growth rates justified the premium its equity markets commanded over other emerging market peers. The average price/earnings ratio of the Sensex has been 20.5 times. Even after a spate of corruption scandals broke out and risk aversion increased among global investors this year, Indian equities commanded a 40 per cent premium compared to other emerging market economies.

Vikas Khemani, president and head of wholesale capital markets, Edelweiss Capital, says the high valuations India commanded were justified as it was a balanced growth story, unlike other emerging markets that were heavily dependent either on some commodity play or exports. However, some of the pillars of this story are now looking weak.

But, this is set to change, thanks to the slowing GDP growth. For a long time, the state machinery maintained high inflation was the new normal, as India was a high-growth economy. Now, it seems that low growth could also be the new normal, as corporate profitability has been hit by rising interest costs among other cost pressures. The earnings per share of Sensex companies, which has grown at 15 per cent for the last several years, could now grow in the 9-13 per cent range, claim analysts. Anish Damania, head of institutional equities at Emkay Global, explains: “Given the growth slowdown, the market will be impacted both by earnings downgrades and multiple compressions.”

The timing couldn’t be worse for this slowdown, which has as much to do with domestic issues, as it has with the global headwinds. Even as the government maintains that there is no policy paralysis, brokerages and economists are fast downgrading their GDP growth forecasts for FY12 and FY13. In a note, Deutsche Bank says: “While we note a trend GDP growth rate of 8-9 per cent has been embedded in investor expectations of India’s earnings growth/return on equity trajectory, policy uncertainties, conflicting demands and compulsions of a popular democracy on the government and India Inc’s growing discouragement are increasing the risk of India’s medium-term GDP trajectory slowing to around seven per cent.” Macquarie’s Tanvi Gupta Jain’s GDP forecast for FY13 is 6.9 per cent.

To make matters worse, private sector investments have come to a near-standstill. A report by Dhanlaxmi Bank on capital formation explains that India will find it difficult to return to a high growth trajectory if investments don’t increase.

The report says: “Achieving a sustainable nine per cent GDP growth rate has become a difficult task with stagnant investment rates. Assuming that capital productivity remains unchanged at 4.5, achieving nine per cent annual growth rate requires an investment at 40.5 per cent of GDP.”

Given the new normal for GDP growth, which could hover around 7 to 7.5 per cent in the medium term, equity strategists expect the average PE multiple of the market to average around 14 times. So far, 14 times PE has been considered an attractive level, but now this lower band of PE will be the new normal for Indian equities.