The Indian economy in the past four years has steadily declined, owing partly to tepid global growth and partly to uncertain policy actions. It has reached a critical juncture where the election outcome could define the path for the next five years and beyond. In the past two years, gross domestic product (GDP) growth has become inconspicuous amid slowing personal consumption, as evident from falling automobile sales numbers and incapacity of the government to expand fiscal policy owing to a high fiscal deficit. Inflation has been in abundance with the sticky Consumer Price Index (CPI) headline number around eight per cent, resulting in a tighter monetary policy by the Reserve Bank of India (RBI) and interest rates at the higher end of the five-year range. Earnings growth has fallen to single digits and the banking system, critical to the growth of the economy, is facing heat as policy paralysis hits the debt servicing capacity of the companies. Rating agencies are critically watching the elections and have warned of a downgrade in case of a fractured mandate.
Against this economic backdrop, let us ascertain what the equity market is pricing in at current levels. The Nifty has rallied 10 per cent in the past two-three months, to trade at 15 times the one-year forward price-earning ratio (P/E), which has been on the higher end of the range in the past four years. Foreign institutional investors (FII) have pumped in close to $5 billion and cyclical (banking/capital goods) stocks have outperformed the defensives (information technology/fast moving consumer goods/pharmaceuticals) by 30-50 per cent in the the past couple of months. Hence, the market is pricing in a favourable National Democratic Alliance (NDA) government, expected to start the investment cycle (without which any pick-up in GDP growth would be inflationary and so, not sustainable) and roll the economy on to a new sustainable, salubrious and multi-year growth path.
The trajectory for the markets would be shaped by:
P/E expansion: The Nifty is presently trading at a one-year forward P/E of 15 times, a fair valuation. It would require a P/E expansion to sustain the move higher. The expansion may come either through fall in interest rates or pick-up in growth or both. Let's analyse both factors:
a. Interest rates: Under the inflation scenario, is still facing the risk of a weak monsoon due to rising probability of El Niño, interest rates are expected to remain sticky for the next six-nine months. This creates an opportunity cost of 9-9.5 per cent for Indian households to invest in equity markets, resulting in tepid flows (domestic institutional investors are marginal sellers even at new highs).
b. GDP growth: Languishing at sub-five per cent levels for the past seven quarters, it requires some strong and tough action from the new government to see a pick-up. At present, it is difficult to envisage a major turnaround in a short period and we expect GDP to grow 5-5.5 per cent for 2014-15.
2. Global factors: On the global front, developed countries' GDP growth is expected to fare better. China, struggling from internal financial leverage, might fall behind the targets. Given this, the US is slowing the injection of liquidity by tapering of quantitative easing (QE) while China is providing stimulus to provide a base to faltering economic growth and Euro zone stands ready to fight the deflation threat and could take over from where the Federal Reserve might leave after the QE taper. From the perspective of Indian equity markets, the global factors are rather neutral, except for geopolitical issues such as Ukraine.
To sum it up, the Indian economy is at a crucial juncture, whereby the mandate by the people would determine the direction for the next three-six months. A strong NDA government would provide a boost as markets would likely price in higher economic growth and a resultant P/E expansion to 17-17.5 times (the Nifty may trade in a P/E range of 14-17 times) but the sustainability would be dependent on the economic policies outlined in the months to come. On the other hand, a fractured mandate might result in tepid market sentiment and a possible rating downgrade and resultant P/E contraction towards 12-12.5 times (the Nifty might trade in a P/E range of 12-15 times, i.e. 5,700-6,700).
The author is executive vice-president and chief information officer, ICICI Securities
Against this economic backdrop, let us ascertain what the equity market is pricing in at current levels. The Nifty has rallied 10 per cent in the past two-three months, to trade at 15 times the one-year forward price-earning ratio (P/E), which has been on the higher end of the range in the past four years. Foreign institutional investors (FII) have pumped in close to $5 billion and cyclical (banking/capital goods) stocks have outperformed the defensives (information technology/fast moving consumer goods/pharmaceuticals) by 30-50 per cent in the the past couple of months. Hence, the market is pricing in a favourable National Democratic Alliance (NDA) government, expected to start the investment cycle (without which any pick-up in GDP growth would be inflationary and so, not sustainable) and roll the economy on to a new sustainable, salubrious and multi-year growth path.
The trajectory for the markets would be shaped by:
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1. Domestic factors: Strong government formation at the Centre: With the current macro economic situation, a strong government at the Centre is a "necessary" but not a "sufficient" condition to start the growth cycle. A revival in the currently stalled investment cycle would require strong decision making; hence, a strong government is the need of the hour. A weak coalition with less than 220 seats for the NDA could trigger a sharp fall in the market. Some of the FIIs which invested in anticipation of a positive political outcome might withdraw owing to an apprehension that tough economic decisions required to pull the economy out of downward spiral may be difficult to come by. On the other hand, a strong government with more than 250 seats for the NDA will instill confidence in market participants of the direction of the economy.
P/E expansion: The Nifty is presently trading at a one-year forward P/E of 15 times, a fair valuation. It would require a P/E expansion to sustain the move higher. The expansion may come either through fall in interest rates or pick-up in growth or both. Let's analyse both factors:
a. Interest rates: Under the inflation scenario, is still facing the risk of a weak monsoon due to rising probability of El Niño, interest rates are expected to remain sticky for the next six-nine months. This creates an opportunity cost of 9-9.5 per cent for Indian households to invest in equity markets, resulting in tepid flows (domestic institutional investors are marginal sellers even at new highs).
b. GDP growth: Languishing at sub-five per cent levels for the past seven quarters, it requires some strong and tough action from the new government to see a pick-up. At present, it is difficult to envisage a major turnaround in a short period and we expect GDP to grow 5-5.5 per cent for 2014-15.
2. Global factors: On the global front, developed countries' GDP growth is expected to fare better. China, struggling from internal financial leverage, might fall behind the targets. Given this, the US is slowing the injection of liquidity by tapering of quantitative easing (QE) while China is providing stimulus to provide a base to faltering economic growth and Euro zone stands ready to fight the deflation threat and could take over from where the Federal Reserve might leave after the QE taper. From the perspective of Indian equity markets, the global factors are rather neutral, except for geopolitical issues such as Ukraine.
To sum it up, the Indian economy is at a crucial juncture, whereby the mandate by the people would determine the direction for the next three-six months. A strong NDA government would provide a boost as markets would likely price in higher economic growth and a resultant P/E expansion to 17-17.5 times (the Nifty may trade in a P/E range of 14-17 times) but the sustainability would be dependent on the economic policies outlined in the months to come. On the other hand, a fractured mandate might result in tepid market sentiment and a possible rating downgrade and resultant P/E contraction towards 12-12.5 times (the Nifty might trade in a P/E range of 12-15 times, i.e. 5,700-6,700).
The author is executive vice-president and chief information officer, ICICI Securities