Rising risk premium may cap upside

The increase in risk perception and cost of equity suggest that investors will prefer to remain underweight on Indian equity markets unless the risk-adjusted return turns favourable

Indian equity markets’ risk premium, which is used to gauge how much additional returns investors want from the markets over and above the risk-free rate of return, is on upward trend due to increasing concerns over interest rates, commodity prices, political uncertainty and rising crude oil prices. Following these events, research houses, especially international, have increased their equity risk premium for the Indian markets, which now stands at about 6-8 per cent compared to around six per cent at the start of the year. In the light of these events, the cost of equity, too, has gone up and the markets which were seen to be in fair value zone are now perceived to be expensive.

"Many of the brokerage houses who were considering India relatively safe and used to give equity risk premium in the range of about 3-4 per cent have now started to re-assess the risk attached to Indian markets and moving their equity risk premium closer to 6-7 per cent, which effectively means a cost of equity at around 14-16 per cent compared to 10-11 per cent in the earlier case" Says Saurabh Mukherjea, Head of Equities, Institutional Equities, Ambit capital.

Cost of equity, which is the sum of risk-free rate of return and equity risk premium, has been on the rise lately. "Because as a result of expected hike in the interest rates (our forecast for the ten-year bond yield is 8.5 per cent) the risk-free rates for the India has gone up a bit and there also been a slight increase in the risk premium due to political and currency risks. As a result, the cost of equity has gone up slightly," says Rahul Singh, managing director and head of equity research India, Standard Chartered Securities India. A rise in the cost of equity signifies higher return requirement from investors (and vice versa), otherwise they could choose to invest in safer assets.

India, however, is not alone and there are other markets which are seeing a similar trend. "It is not only India, the equity risk premium is increasing across the emerging markets given the geopolitical risk," says Harendra Kumar, Head - Institutional Equities & Global Research at Elara Capital. Analysts also reckon that in times of higher crude oil prices India’s risk premium tends to increase given its dependency on the imports and impact on inflation and corporate earnings.

Increasing risk to inflows
The equity risk premium reflects the investors; fundamental reasoning about how much risk they perceive in a market or economy and the price they attach to that risk. As the risk increases and expected returns shrinks the global portfolio money or investors tend to decrease their weightage on such markets and shift allocation to less risky and high return markets. This is also a reason that in the recent past we have seen foreign money pulling out of the Indian markets. "Probably, the equity investors are saying look the US and European markets are not looking so bad, let me reduce some weightage on India as the risks have gone up," says Singh.

EPFR in its fund flow report said that political turmoil in the world's key oil producing region during the week ending first week of March prompted many investors to revisit their previous assumptions for inflation, interest rates and economic growth. Emerging Markets Equity Funds extended their longest outflow streak since third quarter of 2008 as year-to-date outflows moved over the $21 billion mark.

Falling expectations with increasing premium
Typically, given the risk associated with it, equities should give more returns compared to returns generated on the fixed deposits or the risk free bonds. "As the equity risk premium increases your cost of equity goes up and thus it reduces the expected future cash flow and fair value of the stock. Also, as a result of this the investors tend to give lesser price to earnings for each stock," says Mukherjea.

Considering the increase in risk premium and interest rates, investors expect the Indian equity markets to provide at least 14-16 per cent returns, which is 6-8 per cent over and above the 10-year government bond (the benchmark risk-free asset) yield at about 8 per cent. However, in the inflationary and high interest rates environment there are risks to such expectations. The downgrades in the next year’s Sensex earnings have already started and analysts expect another 5-10 per cent cut in estimates, in which case the Sensex earnings would not grow more than 5-8 per cent in 2011-12 to about Rs 1,125-1,185. In this backdrop, it is apparent that valuations have to become attractive (markets to decline) or earnings to become supportive enough to get the requisite returns from equity investments. Unless this happens, it could act as an overhang on the markets.