As we close out the last few trading days of 2010, it is time to turn our attention to 2011. The year 2010 was a decent year for the markets with most broad indices up between 12 and 15 per cent, in line with the long-term trend rate of market appreciation.
I, however, have a sense that 2011 will be a lot more difficult, at least in the first half of the year.
First of all, I believe that the Indian economy will slow in calendar 2011 and not accelerate further as many believe. A combination of the base effect and law of large numbers, the lagged impact of RBI tightening, regulatory cholesterol blocking project implementation, withering international competitiveness and a slowdown in decision-making across the government complex, will all combine to slow down the economy. Already the first signs of demand moderation are being seen and discussed. The talk of the Indian economy hitting a growth rate of 10 per cent is, to my mind, fanciful in the absence of some long-pending reforms. In reality, I don’t believe the Indian economy, as structured today with our fiscal, governance and infrastructure deficits, can grow much beyond 8-8.5 per cent, without the wheels starting to fall off. We need reforms in governance, the fiscal, quality of government expenditure, skills building, project implementation etc to raise our trend rate of growth, but unfortunately there seems to be no visibility of movement on any of these fronts. There is also a non-trivial probability of a serious spike in the commodity complex, especially oil, which would force RBI to aggressively hike rates and further ingrain inflationary tendencies into our psyche. Already the inflation issue in India is threatening to become structural in nature, being very sticky on the way down. Further tightening of financial conditions will only cement the outlook for a slower growth trajectory in 2011 than the current consensus expectation.
Combined with a slower growth outlook, I think corporate profit margins will be under pressure in 2011. Higher commodity prices, rising cost of debt, surging wages and increased competitive intensity across sectors will combine to put margins under downward pressure. Historically, corporate India has protected itself from surging commodity prices, through high top line growth and the ability to leverage fixed costs through operating leverage. With a slower macro backdrop and huge cost push on fixed costs, this operating leverage dynamic is unlikely to play out in 2011. Thus, earnings growth, much beyond 15-18 per cent for the broad market in 2011 looks tough. Once again, stocks levered to consumption seem best positioned to deliver on earnings growth, with the investment cycle likely to continue to disappoint.
In terms of flows, I feel there is a real possibility that the developed markets, particularly the US, will outperform the EM markets for a period, especially the first half of 2011. Most economic commentators have revised upwards their growth outlook for the US, and many top-quality blue chips in the US trade at far more reasonable valuations than their EM counterparts. It is not inconceivable that some capital may flow back into the US. While there is still considerable debate about the sustainability of the US growth outlook, many investors will take a short-term view to play the expected growth acceleration in 2011, before re-assessing their longer-term outlook for the US. With global growth accelerating, EM flows into Asia will also be more North Asia-centric, and India’s perceived domestic demand drivers less attractive from a relative perspective. I don’t think portfolio flows will be negative, but are unlikely to hit $30-billion run rate again, especially in the first half of the year.
I also feel that our markets will find it difficult to hold current PE multiples. With interest rates rising, earnings and growth below current consensus, and flows not particularly strong, multiple compression is far more likely than expansion. All our recent scam-related adventures are also going to have an impact on PE multiples. We simply cannot have the highest multiples in the EM universe, with the type of governance and institutional corrosion displayed over the last few months. We are also as an economy far too leveraged to global financial conditions and risk appetite, when the going is good all is fine, but in a global shock we are very vulnerable. Being so pro-cyclical an economy also argues against elevated valuation multiples.
Thus, taking all of the above, the markets will probably still deliver positive returns, but multiple compression combined with slower earnings growth will force returns to be quite modest. I think in a low-return environment, stock-picking will again come to the fore as stock-specific performance will vary considerably, and all boats will not rise. Expect the current focus on high quality and high returns on capital business to continue.
What could change this outlook? First of all, the US economy could disappoint in 2011, longer-term structural issues drowning out any short-term stimulus-driven rebound. In such a situation, the EM carry trade will come back on, capital will flow out of US equities and India will be a major beneficiary, just like 2010.
If global growth disappoints, commodities may not spike and the extreme pressure on Indian earnings, macro and inflation will subside.
The government may also surprise us and actually push through some fundamental reform. The Budget will be a test case of this. As of now, no investor believes the government has any chance of meeting its outlined long-term fiscal and public debt targets. In the absence of GST, no movement on food/fuel/fertiliser subsidies and no signs of expenditure reform or targeting, the numbers do not add up. If the finance minister can deliver on some of these issues, that can be a trigger to re-rate markets. Another trigger could be some positive outcomes coming out of all the scam-related investigations. Judicial reform, greater accountability and measures to strengthen institutions are all steps which would enthuse the market and give investors greater confidence on the sustainability of our growth trajectory and thus allow PE multiples to expand.
I think there is too much complacency in India, we are told that 9 per cent growth will take care of everything from the fiscal (through tax buoyancy) to the current account (by attracting capital flows), to greater inclusion, but are we taking the steps needed to hit this 9 per cent number? What happens if we slip back to 7 per cent growth (still a good number)? How will the fiscal and current account be financed then? Our leverage to growth and international capital flows is sometimes underestimated in my view.
The year 2011 looks to be a year of consolidation, the economy, corporate houses and policymakers will all get some breathing space to build on the next phase of growth. It is not necessarily a bad thing to have a year of slightly slower growth to build capacity, optimise organisations and let infrastructure catch up to surging demand. To ensure that this is only the pause that refreshes and not a permanent slowdown, concrete action is needed by policymakers across a whole spectrum of policy issues. Hopefully, we will seize the initiative. The consequences of not doing so are dire indeed.
The author is the fund manager and CEO of Amansa Capital
