How will markets perform in 2018? Oil and Fed raise risks to equity rally

Analysts expect recovery in earnings, pickup in private sector capex

In 2016, a large section of the investment fraternity worldwide expected the tide to turn against global equities. Markets had been on a roll for eight consecutive years since 2009 and it was time for the onset of the historical eight-year bear cycle. 

It’s been two years since and the bears are yet to emerge out of the woods. While the doomsayers are making themselves heard, the bulls seem to be very much in control as we enter 2018. 

Just like many of its peers worldwide, Indian equities are likely to surge for a third consecutive year in 2018. The end of easy money globally, however, could mean the gains do not match the outsized returns clocked in 2017, and the busy election calendar back home may create more than an occasional wobble.

Be that as it may, there are several positives to count on. 

For one, an earnings revival and a bump-up in private capex may be on the cards, factors which could justify the ‘rich’ valuations somewhat. 

“After spending nearly seven years mostly in negative territory, earnings revisions breadth is finally almost in the positive zone. Corporate India’s earnings and balance sheet recession are ending and free cash flow is very strong, setting the stage for private capex,” says Ridham Desai, managing director at Morgan Stanley India.

 

Anand Radhakrishnan, chief investment officer, Franklin Equity, Franklin Templeton Investments, India, adds: “The case for revival in private capex stems from improving corporate earnings, better lending capability of public sector banks post-recapitalisation, and favourable market for equity issuances.” 

The Sensex currently trades at 25 times its 12-month trailing earnings, compared with the past five years’ average of 19x.

In the past few years, sectors such as industrials, metals, public sector banks, telecom, and information technology (IT) have underperformed and pulled down the earnings to a large extent, which is why valuations look optically elevated, according to experts. “Even a marginal improvement in the numbers for some of these sectors could boost earnings figures in the next 12-18 months and make valuations look more reasonable,” says Ravi Gopalakrishnan, head–equities, Canara Robeco Asset Management. 

The deluge of domestic money through mutual funds is likely to continue as investors shift to financial assets from traditional products such as gold, real estate, and fixed deposits, which have given muted returns in the past few years. “India remains in the midst of a domestic liquidity supercycle. The $420-525 billion in domestic equity inflows forecast over the next 10 years could have the power to keep India’s relative multiples higher for longer,” says a note by Morgan Stanley.

The interest from foreign portfolio investors, or FPIs, may be harder to gauge. The US Federal Reserve is likely to opt for three rate increases next year, effectively choking the supply of easy money flowing into risky assets, somewhat. The impact will magnify if other central banks such as European Central Bank follow suit.  According to Bank of America Merrill Lynch’s India equity strategist Sanjay Mookim, the US Federal Reserve’s liquidity infusion is likely to peak in Q2, which could impact global asset inflation, hurting Indian equities. “India is joined at the hip to the global tide, irrespective of its differentiated long-term potential. Foreign investments (into India) have been pretty volatile and increasing return on equity in US, if and when the Fed hikes rates, may shift the flow of funds,” Mookim says. 

Until now, global markets have been sanguine about the surge in crude oil prices, the Fed’s easing of its quantitative easing programme, the threat from North Korea, the slowdown in China, and the impact of Brexit. “No one quite knows how these factors will play out in 2018,” warns U R Bhat, managing director, Dalton Capital Advisors (India).  

Brent crude oil prices have surged about 20 per cent to $66 per barrel in 2017 and a sustained upmove to $75-85 per barrel could roil Indian equities, feel experts.  Back home, a disappointing earnings show could put the brakes on the market’s upward trajectory. “If earnings disappointments continue, the premium valuations may prove difficult to sustain,” says BNP Paribas’ Asia Pacific equity strategist Manishi Raychaudhuri. 

The progress on banks’ asset quality resolution, the extent of execution of government’s infrastructure projects and the revival in private capex will be closely watched. A spending spree by the government in the run-up to the 2019 national elections could throw the fiscal math off course, and may be viewed negatively by investors. 

“If the Bharatiya Janata Party is not able to hold on to some of the states, we may see some volatility going ahead,” adds Bhat. Considering that the market is entering uncharted territory, experts believe that investors should prefer stocks with earnings visibility, structural positive triggers, and reasonable valuations. “We suggest staggered investments to benefit from intermittent volatility,” says Radhakrishnan. His advice: opt for diversified equity funds with core exposure to large caps.  

Canara Robeco’s Gopalakrishnan is betting on infra and rural themes, considering the government’s push for job creation and possible sops for the rural economy in the months ahead: “A rise in rural income will benefit FMCG as well as consumer discretionary companies in the automobiles, entertainment, and durables goods space.”