New year, optimism and concern

Earnings growth is expected to accelerate as lingering toxic effects of note ban ease off and GST settles down. However, stock valuations are high and that means market is also overdue for correction

Investors had cause to celebrate going into the Christmas weekend with the indices edging to all-time highs.  There’s cause to be optimistic about the new year but there’s also several areas of concern. Earnings growth is expected to accelerate as the lingering toxic effects of demonetisation ease off and the new goods and services tax (GST) settles down. However, stock valuations are incredibly high and that means the market is also overdue for a deep correction.

The last calendar year has seen the Nifty up by 28 per cent (January 2017-December 2017). It’s been outperformed by the Midcaps Free Float 100 (up 44 per cent) and the Nifty Smallcaps 250 (up 53 per cent). This has occurred despite subdued earnings growth, weak macroeconomic data and cuts in consensus forward earnings estimates.

We saw one of these rare periods when domestic institutions, foreign portfolio investors and retail investors were all bullish. Domestic institutions have brought Rs 90,713 crore across the last 12 months while FPIs bought Rs 49,835 crore of equity and Rs 1.47 trillion of rupee debt as well. The enthusiastic participation of retail, both directly and via the fund route, was responsible for the smallcap surge.

 

It wasn’t just the secondary market that did well. The primary market has seen 120 issues in this fiscal (April-December 2017) as well, raising over Rs 75,000 crore. One sector, which is soon guaranteed to find representation in the largecap indices, is insurance. There has been a spate of issues from insurers with over Rs 35,000 crore raised so far. Equity mutual fund assets under management (including Equity ETFs and ELSS Equity schemes) swelled from Rs 5.34 trillion in January to Rs 8.03 trillion in November.

 

There’s a rising volume of money pouring into the market and it’s chasing a limited number of stocks. As a result, valuations are at mind-boggling levels. The Nifty is at PE 26.8, (last four quarters EPS weighted by free-float) while the Midcaps are valued at PE 53.5 and Smallcaps at a mind-boggling PE 90.75.

The Nifty EPS growth in the past seven quarters (January-March 2016 to July-September 2017) amounts to just 6 per cent total. Bloomberg’s consensus growth estimates for 2018-19 have been cut by 2 per cent. At best, the optimists are looking at high-teens EPS growth for large-caps in 2018-19 and perhaps, 25-30 per cent for midcaps.

Those valuations are very hard to justify. Interest rates are expected to stay stable or rise. Inflation at 4.8 per cent in November exceeded the RBI’s projected band of 4.2-4.6 per cent for the second-half of 2017-18. Food, fuel and commodity prices are expected to rise through much of calendar 2018.

Global prices of industrial commodities like non-precious metals, rare earths  (and silver which is important industrially) have risen by 11 per cent in the past year. This is because of first world growth recovery leading to higher demand. Crude prices are expected to stay at current levels or rise, given that OPEC has negotiated an agreement to not increase supply while demand has edged up.

Strong economic projections from the USA, the European Union and Japan augur well for recovery in exports, assuming that the GST glitches that led to a working capital crunch are sorted out. However, the quantum of flows from the first world to emerging markets may ease, given hard-currency investment opportunities. Hard-currency liquidity could also drop.

The US Federal Reserve will hike rates in measured fashion and it also has a schedule for deleveraging its balance sheet. This will mop up USD. The European Central Bank and Bank of Japan are not going to tighten just yet. But there is every chance that the ECB and BoJ will hike policy rates in 2018; both have positive (but low) inflation to contend with, and negative policy rates. Japan may also cut the quantum of its Quantitative Easing programme. The ECB has cut its QE quantum and intend to review in September 2018. The UK is the one laggard; it is suffering from slow growth and high inflation as Brexit negotiations drag on.

Tax collections under GST may be undershooting targets by about Rs 36,000 crore, according to the West Bengal Finance Minister, Amit Mitra, who’s part of the Council. The fiscal deficit and the current account deficit could both exceed Budget targets.

More worryingly, the direction of public policy next year could see a shift to populism. The Gujarat election results had two key takeaways. One is that rural discontent with the BJP is running high. The second is that Narendra Modi would be prepared to spend inordinate amounts of time on the campaign trail to lock in victories in assembly elections. This led to postponement of Parliament’s Winter Session.

There are Assembly elections scheduled in Rajasthan, Karnataka, Chhattisgarh and Madhya Pradesh. Attempts to assuage agrarian discontent could  mean big increases in MGNREGA funding, more farm loan waivers, and more infrastructure projects for rural areas. It could also lead to the PMO becoming a travelling circus with Modi criss-crossing those states on the campaign trail.

The technical position is easy to state with the market running at record highs. This uptrend will only be broken by a sharp change in sentiment that leads to a sell-off. As and when that happens, and it will happen at some stage, there will be a deep correction since valuations are excessively overextended.