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Interest rates hold the key

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Devangshu Datta New Delhi
Last Updated : Feb 05 2013 | 12:35 AM IST
The feel-good factor could disappear if interest rates keep on rising.
 
Trailing post-budget research advisories, one thing is clear. The herd instinct is strong. Everybody has learnt the tricks of the valuation trade from the same textbook and nobody is really willing to go beyond that.
 
Earnings projections for 2007-08 and 2008-09 are within a narrow spread, usually near-linear extensions of growth trends of the past 4-6 quarters. So are share valuations - some version of discounted cash-flow or sum-of-parts have been used to derive "fair-value" in each case.
 
The money managers expect roughly 15-20 per cent EPS growth across 2007-08 (a deceleration in terms of the past two fiscals) followed by a sharp earnings acceleration in 2008-09.
 
The mutual fund industry is sitting on top of huge amounts of cash "�between December 31, 2006, and February 28, 2007, investors pumped over Rs 29,000 crore into various schemes (including income funds).
 
That money has to be deployed somewhere and a fairly large chunk of it will come into equity. The sectors of choice in no particular order appear to be telecom, capital goods, IT, banking, power, retail, auto and auto ancillaries.
 
Banking is only good from a long-term perspective, so to an extent is auto. Both sectors have uphill tasks, generating big growth in 2007-08. Automobiles are running into capacity constraints "� by end 2006-07, unit volumes will be well above 100 per cent of rated capacity. And, it will be difficult for auto-makers to pass on all increased input costs.
 
Banking appears set to hit multiple barriers in 2007-08. There will be capacity constraints unless credit demand, which has grown at 30 per cent plus for three fiscals, cools off.
 
There will be more "loans" to the priority sector going sour "� the pressure to offer handouts will increase due to election considerations. And, there will be upward pressure on interest rates, which is always bad for lenders.
 
That brings us to the major area where differences in opinion exists "� the direction of interest rates or rather, the levels at and the time frames within which the cycle will top out. Rates have been rising for quite a while, through the past nine quarters in fact.
 
It's got to the stage where retail consumption seems to be easing off and that means the effect on demand could be significant in the first-half of 2007-8. The home-loan approvals rates for January-March 2007 will be illuminating. Consumers are getting wiser to floating rates; there are many horror stories of EMI hikes and tenure extensions in the public domain.
 
The consensus appears to be that rates will top out in the coming fiscal. Most money managers feel that there could be another 150 basis points upside over the next two or three quarters.
 
However several contrarians are betting that the rate cycle is flattening already, after the recent inaction of the US Fed, which refused to hike dollar rates. Quite a few people believe that the rate cycle will flatten in the next two quarters and top out at about 100 basis points up from here.
 
That difference of opinion is enough to cause a wide variance in expected price levels (as opposed to valuations) in the next fiscal. The rate optimists think that with an expected EPS gain of 15-20 per cent and a current PE of 20, the Nifty is near fair-value at current levels.
 
The rate pessimists think that the Nifty needs to drop to a PE of about 12-13, after factoring in expected EPS gains of 15-20 per cent. The mildly contrarian types would say that the Nifty is marginally over-valued and suggest that the PE will drop to about 15 after we factor in EPS gains of 15-20 per cent.
 
Put it all together and the Nifty's expected 2007-08 variation could be anywhere between 3,000-4,800 depending on who you talk to!
 
However, one factor seems to have been left out of the reckoning by most estimates. Demand in a consumer-driven economy is largely dependent on perceptions of interest rates and the average consumer is afraid of being burned.
 
The feel-good factor is ebbing. If rates do spike for another quarter or two, I suspect the feel-good factor will disappear.
 
That could mean two things. One is that rates will indeed level off earlier than consensus expectations because credit demand will ease off along with inflation.
 
The second thing is that EPS growth across 2007-8 will be at the lower band of current expectations. To my mind, that adds up to a big bull market in 2008-09 coupled with low returns in the first half of 2007-08 at the least.

 
 

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First Published: Mar 25 2007 | 12:00 AM IST

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