Akash Prakash: Macro versus micro

Despite the fireworks, caution on the Indian economy would not be misplaced.

The Indian stock market is at a very interesting juncture, poised within striking distance of 13,000 on the Sensex, and having confounded most market observers throughout the entire rise from its mid-June low of approximately 9,000. This rally has been powerful and surprising in that it has had limited retail participation, and till last week none of the hype and hoopla of the previous peak in May 2006. Most market observers have been caught out, and the market has followed the classic pattern of climbing a continuous wall of worry. I have yet to meet anyone who thought that the market would bounce back so quickly from the damage of May-June, and even today you have a huge chunk of money waiting for that elusive 10 per cent correction.

The markets are poised very delicately, because depending on whether you approach the markets from a top down (macro) or bottom-up (micro) perspective, you get a very different answer on the risks and upside to investing in the Indian equity markets today.

If we first take the macro view, then caution would seem to be well-advised. Emerging markets are basically still a play on global growth, and there is no doubt that, led by the US, growth is slowing across the world. This would normally be an environment wherein emerging markets would be expected to struggle. Given how leveraged the Indian equity markets have become to overseas flows, any hiccup in the emerging markets asset class will undoubtedly hit India as well. The asset class has also had a dream run over the last three years and thus a simple catching of breath may be in order.

As for India specifically the macro concerns are many. First of all the markets are clearly no longer cheap, how expensive they are depends on your vantage point, but no longer cheap, for sure. There are also serious concerns on the sustainability of growth; can we continue to grow at 8 per cent plus without overheating? Can we grow at 8 per cent, without interest rates spiking, and infrastructure collapsing? When will the lack of progress on reforms over the last 24 months come back to bite us? Markets have more than tripled, we have to have a negative year sometime, nothing goes up in a straight line. There is a bubble in real estate, in all types of Indian assets, and India has hit the cover of every magazine of repute in the last six months.

The much-hyped return ratios are all headed south, RoEs (return on equity) have peaked as has free cash generation and incremental returns on capital are trending down. The new wave of capex will ramp up competitive intensity across sectors, further pressuring margins. Anyone thinking that Indian companies can continue growing earnings at 25 per cent and maintain greater than 20 per cent RoEs are misguided at best or naïve at worst.

These are some of the common negative soundbytes one hears from the macro crowd, and each one is valid and not something you can dismiss lightly. The takeaway from a macro perspective is clearly to exercise caution, and to not get carried away.

When one turns to a micro perspective, things however look a little different. I have never seen corporate India more confident in the last 15 years, or more aggressive. The Tata-Corus deal is just one more manifestation of this. Look out for more such deals as the Tatas have shown everybody just how ambitious corporate India can become. Every company we meet talks of exports, global benchmarking and global scale. Corporate India is convinced that 8 per cent growth is here to stay, and while infrastructure is a constraint no one seems to feel it can torpedo their growth trajectory. All companies seem to be targeting 20-25 per cent earnings growth, and building capacity to sustain this trajectory. Companies are also very confident on their growth visibility, saying it has never been better. The entrepreneurial energy is obvious and global relevance a goal across an increasing number of sectors.

A week spent with corporate chieftains will convince anyone that we are only at the beginning of a long cycle of growth. They point to demographics, changing income pyramid and globalisation as the building blocks of a multi-year growth cycle. The continued influx of returning Indians only seems to confirm the bullish view. Why is paying 16-18 times earnings so foolish for an earnings stream that can grow at greater than 20 per cent for a decade, argue the bulls.

So which perspective is right""the raw bullishness of the bottom-up view or the caution of the top-down?

Just as a norm, at turning points, macro is normally better at calling a turn in the cycle than a bottom-up perspective, as very often companies do not detect any change in their business until it is too late. The early warning signs of change are picked up much better by macro.

However, macro also tends to work using regression to mean as its base concept. Meaning that all events or observations are assumed to have a mean value around which they will oscillate. It operates on the principle that any substantial deviation in either direction will get regressed back to the mean value over time. Thus macro is not good at picking up a paradigm shift, wherein an economy for example moves to a whole new plateau of growth. Macro will always think that this growth is unsustainable simply because it has never been achieved before. It will not pick up a sustainable uptick in productivity for example, which is something I think India is experiencing.

To be comfortable in ignoring all the warning signs being flashed by the macro gurus, one has to believe that India has truly broken out and that its economic history is of limited relevance in judging the growth potential and trajectory of the economy. That is a brave and possibly premature call to make as one has lost count of the number of times people have perished saying that "this time it is different". Maybe it is different this time, who knows? But that is a clear leap of faith many of the super bulls are making today. Only time will tell whether they are right.