Bullish, but don't bet too much on it yet

If good sentiment erodes, market can see correction as fundamentals can't justify current valuations

The market zoomed past the Nifty 10,000 mark despite increasingly disturbing macro data and the index ended Friday above that level, despite some unloading from tired bulls. Valuations are optimistic to say the least, especially in the face of an open-ended disruption like the goods and services tax (GST) implementation. Globally, there are storm clouds hovering over the US, with President Donald Trump looking increasingly likely to be called out for “Russia-gate”.

The Purchasing Managers’ Indices (PMI) for July hit multi-year lows in both the services and manufacturing segments. Both indices fell below the 50 mark and this indicates a trend of contraction across the entire economy. At least part of this is due to businesses holding off large commitments during the GST transition.

But the economy was not doing particularly well anyway. The Index of Industrial Production (IIP) for May indicated there was a slowdown and the data for the eight core sectors in June suggest that slowdown became more marked. The IIP was down to 1.7 per cent year-on-year in May and the eight core industries, which contribute a large chunk of the IIP, were down to 0.4 per cent year-on-year in June.

Inflation was also down to 1.54 per cent in June for the Consumer Price Index (CPI) and that was well below the tolerance level of the Reserve Bank of India (RBI), which looks to keep consumer price inflation between the band of two and six per cent, with an ideal target of four per cent. Given the slowdown and the low prices, the Monetary Policy Committee was expected to cut rates. It did, reducing policy rates by 0.25 per cent. However, there were bulls speculating about the possibility that the RBI would cut by 0.5 per cent and/or reduce the Cash Reserve Ratio as well. So the policy review led to some disappointment and a brief sell-off, followed by a recovery.

The policy statement makes for interesting reading. It has plenty of doom and gloom but it retains the projection of 7.3 per cent gross domestic product (GDP) growth for the financial year. Given the rest of the document, that’s hard to believe. 

Even prior to the rate cut, the system was sloshing with liquidity. There is around Rs 200,000 crore sitting with the RBI on the repo account and banks would surely prefer to lend that money out at higher interest if possible. A token rate cut will not supercharge such a muted credit cycle.

The statement speaks of “loss of speed in manufacturing”, “deficiency in demand” for electricity generation, “contraction in consumer durables” and “retrenchment of capital formation in the economy”. The bank’s industrial survey indicates waning of optimism. The capex cycle has collapsed. Infrastructure continues to suffer from slow clearances and the usual issue of land acquisition. The non-performing assets situation, where banks are struggling to cope with massive bad loans, will be exacerbated by the farm loan waivers, which are now the flavour of the day.

Inflation is expected to rise from here on and monetary policy projects CPI running at 2.0-3.5 per cent in the first half of 2017-18 and 3.5-4.5 per cent in the second half. Household inflation expectations are also much higher — no surprises given that Indians are terrified of inflation and the price of tomatoes has gone through the roof due to the demonetisation disruption. Indeed, demonetisation is probably responsible for some of the slowdown and apprehensions about GST are contributing to the caution. Incidentally, the RBI’s own annual statement is delayed, supposedly because it hasn’t finished counting the currency returned during that disastrous experiment — an excuse that has been met by polite and not-so-polite disbelief in many quarters. 

The bright spots in the economy are services including foreign tourism and also a pick in the external trade cycle.  Global conditions are better. Europe is seeing decent growth, despite the stronger euro. China seems to be doing well in July, which is a bellwether for the global economy. The bearish triggers here could be geopolitics. Brexit is a serious unresolved issue. The investigation into the Trump campaign’s collusion with Russia is gathering steam and expanding in scope.

The GST will completely disrupt the Budget projections of February and, if it does trigger a prolonged slowdown, fiscal deficit could expand significantly. The questions here involve the speed of implementation. Every analyst and sane investor will have made allowances for GST and most seem to be expecting two quarters of disruption. History, meaning the European experience, suggests it could be longer and patience might run out if GST impacts earnings adversely for a fiscal year or even longer.

Valuations are off the scale despite all the doom and gloom. The Nifty is trading PE25-plus; mid-caps are trading at PE32-plus. Foreign institutional investors took some money off the table in the last fortnight as they were net equity sellers. But foreign portfolio investors continue to buy rupee debt. Domestic institutions remain positive and retail is massively optimistic, with huge contributions to equity mutual funds and via the direct equity route. 

By definition, a market that’s trading at all-time highs and trending up is bullish and will remain so, unless sentiment changes. If sentiment does change, however, this market could see a deep correction because fundamentals cannot justify the current valuations.