A roaring rally

Investors should not lose sight of fundamentals

The Sensex achieved a statistical milestone on Thursday as it crossed the 50,000 mark before profit-booking pulled it down. At its intraday high, the index has nearly doubled from its low in March last year, when corporate India was deeply concerned over business activities, which came to a standstill due to pandemic-induced lockdowns. The proximate cause for optimism now is the anticipation of good third-quarter corporate results, and the introduction of market-friendly measures in the forthcoming Budget. However, the disconnection between buoyant market sentiment and the real economy that’s limping back to normal is stark. The market price-earnings ratio for major indices such as the Sensex and the Nifty is running at around 35x. There will be an earnings bump through the next two quarters due to the contraction experienced during the lockdown. That should indeed lead to double-digit growth, year-on-year, given the base effect. Nevertheless, these valuations seem excessive as demand is still weaker than normal and the economy will grow back to around December 2019 levels only by the end of the next fiscal year.

Core sector performance and the index of industrial production indicate persistent weakness. On the external front, exports remain under pressure, and the trade balance has stayed under control only because imports have dwindled due to low demand. While companies hope to cash in on pent-up demand through the next few months, there are doubts over its sustainability. Maruti Suzuki, for instance, has sounded a note of caution about unsustainable demand over the medium term, and as India’s largest auto manufacturer, it must be taken seriously in terms of assessing consumption trends. The Reserve Bank of India (RBI) has also raised the red flag. The latest Financial Stability Report makes it clear that the banking sector would be under stress. This will affect credit and overall growth in the economy. The RBI has its task cut out. Apart from an increase in non-performing assets, it has to manage inflation during a period of low and negative growth. On the one hand, it must keep policy rates low to support the government borrowing programme and to encourage private consumption and investment. On the other hand, retail inflation has been persistently high, until a dip in December offered a little respite. The RBI also has to keep an eye on currency risk. The rupee is overvalued, which is impeding exports. But if there’s a sharp drop, that could lead to other problems.

The government will also have to juggle multiple policy priorities in the Budget. In the coming year, the government might have to recapitalise public-sector banks in a big way. There would also be expenditure on the vaccination programme. A significant increase in taxes could affect consumption and demand. If there’s an attempt at pump priming via an infrastructure roll-out, the fiscal deficit will expand even further. These risks and challenges to growth, and to public finances, are known, and smart money may have discounted them to some extent. Indeed, many domestic institutions have been net sellers through the past four months, though the momentum has been sustained by retail investors and overseas players. Foreign institutional investors put in $23 billion in 2020 ($13.2 billion in 2019), the highest among emerging markets. In 2019, the inflows were $14.2 billion. The continued expansion in valuation would, however, make the stock market riskier. If the Budget disappoints, there could be a correction in the market and investors must be prepared for that.