Managing volatility

The sharp spikes and steep declines in the markets are a short term reaction. The Indian growth story continues...

The volatility in the markets is increasing. What could explain a 1,000 point whack to the Sensex two weeks ago followed by a 600 point rebound to be accompanied by 900 point dip immediately after? Taking an investment decision based on events in the preceding two weeks in a volatile market is not a good idea. The best way to figure your way out of this mess is to look at the problems that have led to this crisis, the impact they may have on your portfolio and decide on your investment outlook for the medium term.

The credit squeeze
The loss from the subprime crisis which came about due to rapid increase in American real estate prices and subsequent cooling off is estimated at $150 billion. While hedge funds and banks such as Bear Stearns, Macquarie and BNP Paribas have been affected, its impact on the US economy is expected to be minimal. In this context, why did it create a global market meltdown? With delinquencies and underlying bonds falling in value there has been a squeeze on liquidity and a flight of safety to assets that are less risky, and thus the volatility.

This has also played out in India, with institutions preferring to park their assets in safer instruments. Should you be worried? With nearly half of the fund flows into the country coming via the participatory note route, it is unclear which hedge funds are involved and what their exposures are to the Indian market. For the next four weeks, there will definitely be a squeeze on the money available for investments in emerging markets.

FIIs pumped in nearly Rs 24,000 crore in July and this figure was more than their investments in six months preceding that. What were the reasons for such strong inflows? Says Manish Sonthalia, vice president- market strategy, Motilal Oswal Securities, "Interest rate arbitrage is the main reason why we are seeing massive capital inflows and combined with the 10 per cent rupee appreciation against the dollar, the returns become phenomenal." While the appreciating rupee vis-à-vis the dollar is keeping the flow of greenbacks coming in, it is having a negative impact on the export dependent sectors. In this context, its movement will have a bearing on liquidity, inflation and interest rates.

Rising rupee
The large inflows on account of rupee appreciation has been the major source of volatility and is a major headache for policy makers. The RBI started intervening to plug rupee appreciation and between April 2006 to May 2007, it bought greenbacks to the tune of $33 billion infusing equivalent rupees in the system. When this happened, liquidity, credit and inflation went up. The RBI let go the rupee to control inflation and the resulting rupee appreciation made our markets even more attractive.

The appreciating rupee which was threatening to break the nine-year high of Rs 40.20 was reined in by tightening ECB norms. The rupee now trades closer to the Rs 41-mark. So where is the rupee headed? Subir Gokarn, chief economist, CRISIL, believes the ECB measure and the extra funds available under the market stabilisation scheme will ensure that the rupee stays in the Rs 40-Rs 41 band. Unlike other emerging markets like China, a $50 billion trade deficit will ensure that the dollar will continue to remain over the Rs 40 mark. While sectors that have a competitive advantage like software will ride out a hit to their export earnings due to high margins, industries such as leather and textiles will suffer. The only way for these sectors to tackle the situation, believes Ritesh Jain, head of fixed income at Kotak Securities, is to improve efficiencies and move up the value chain. While the rupee is an external factor has there been a change in India's growth story?

Growth worries
The numbers, be it the index of industrial production (IIP), slowing down of credit growth or the decline in export realisations are not too encouraging. What has dented the high levels of 9.4 per cent GDP growth in FY07 in the current fiscal? Three reasons: First the rupee appreciation. IT exports stand to lose and cheaper imports mean a threat to the local manufacturers. Second, the tightening of credit by RBI has pushed up interest rates and affected sectors such as auto, real estate and consumer durables making purchases more expensive and finally the government's poor response on the supply side is stalling growth as infrastructure struggles to catch up with demand. Parallels are being drawn between the situation now and those prevailing in 1997 when the growth process was derailed as high interest rates and new capacities had few takers and GDP growth went under 5 per cent from a high of 7.81 per cent. Could there be a hard landing?

In better shape
A hard landing is unlikely. The conditions this time are different and the lower numbers should not be a cause for worry. Says Madan Sabnavis, chief economist, NCDEX, "The numbers are coming from a higher base.

This is a lean season and production will pick up as demand starts improving after the kharif season (October). Finally, high credit growth last year means investments have taken place, and there would be a time lag before investments fructify into output." The only cause for worry, believes Devendra Nevgi, CEO and CIO of Quantum Mutual Fund, are supply-side constraints. Unless infrastructure comes through to match the expansions and capacities, we could have a problem and the situation will be tested in this fiscal and the next.

Two other issues, oil prices and interest rates can cause problems. Crude prices have been above the $70 to the barrel for some time now while prime lending rates have moved up 200 basis points over the last one year to 13.25. Gokarn, however, believes that both are manageable. "In FY05, oil prices peaked but we were able to manage the price rise." RBI by leaving the interest rates untouched twice in a row has indicated that it is comfortable with the rate. While the central bank has estimated India's GDP growth at 8.5 per cent for the current fiscal, experts believe that in the long term, growth could revert to trend rate between 6.5 per cent and 7.5 per cent. What will this mean for India's corporate earnings?

So far, so good
With capacity utilisation at its peak, Indian corporates have been reporting excellent numbers on profitability, return on assets and return on equity. According to CMIE, the debt to equity ratio for corporate sector (non-financial companies) has significantly improved from 1.13 to nearly half that in the last five years. Net profit to sales has also shown a dramatic increase growing six-fold to 6.74 per cent. While sales has been growing consistently at over 15 per cent over the last three years, gross profits of the private sector have been registering a 20 per cent growth every year in the same period. However, with the next phase of expansion under way, bottom lines could be affected due to high fixed costs, depreciation and interest charges.

Says Shriram Iyer, head of research, Edelweiss Securities, "Operating leverage and pricing power will come down with a increase in supply." In case of a slowdown, companies will start offering discounts and promotional schemes to clear inventories which could put realisations under further pressure.

The impact would, however, vary from sector to sector with cement and automobiles, which are in expansion mode likely to be affected the most. Industrial growth and earnings, experts believe, will be muted and could perk up when expansions come through in FY09.

Where to invest?
With triggers for growth to come from consumption, infrastructure-related spending and offshoring, analysts are bullish on stocks in sectors such as capital goods, engineering, power, banking and construction. They are underweight on petrochemicals, realty, utilities and information technology.

What about valuations? Despite the sharp correction, the Sensex at 15000 levels discounts current earnings by an expensive 21 times. But if we are to go by the Bloomberg EPS estimates of Rs 855 for FY08, the benchmark index is trading at just under 18 times, which matches its earnings growth. The future growth is thus priced in. A further correction would take it to levels of 15-17 times FY08 earnings and will be considered cheap. Advice for investors? Hold on to your investments. Analysts warn against short term trading in this choppy market and instead advice that you add quality stocks in your portfolio preferably in the defensive sectors (pharma and FMCG) and reduce risk.