The Indian markets are at an interesting juncture, where macro uncertainty is mounting pressure on equity sentiments. The concerns are plenty — governance deficit, high inflation, high current account deficit, falling rupee, growth slowdown. All these clouds have only darkened over time. Let’s examine each concern and understand how the market is likely to navigate through these.
While debating the effect of government decisions on recent growth, it is pertinent to look at the role played by the federal structure of India’s democracy, since state governments wield considerable influence. This is visible in the widely differential growth rates of states’ gross domestic product (GDP). The electorate is also evolving. A rising section of the middle class demands better governance, as it cannot be influenced with populist largesse. These are early signs of this structural change visible in state elections over the past few years. Democracies are self-correcting and as the current polity recognises this, we believe there is no alternative but to take decisive steps to address concerns related to the economy and industry. FY13 is the last big opportunity for the government to up its ante on investment-focused policies, as next year, being the pre-general election year, the focus will likely be on consumption-boosting measures.
The other cause of concern is Inflation. India’s WPI inflation has strong correlation with global commodities inflation. Global commodity indices indicate that commodity-fuelled inflation is coming off in rupee terms, which has started to translate into lower trajectory in WPI inflation and even lower in WPI manufacturing inflation (RBI’s measure of core inflation). Both crude and coal prices have seen a 25 per cent correction year-to-date in dollar terms, while some of it has been negated by rupee depreciation. The structural decline in energy prices is positive for containing inflationary pressures.
India’s dependence on global capital flows, combined with persistent negative current account balance, have led to depreciation of the rupee. But a lower rupee is likely to provide huge incentives to exporters and for import substitution, in turn, helping domestic industry. A $30 fall in oil prices for the full year benefits the current account balance by $26 billion, or 1.5 per cent of GDP.
Post-liberalisation, there have been four occasions where growth has slowed significantly (below five per cent). These were accompanied by major global developments. But each time growth recovered from the lows to average 6.5 per cent. It is reasonable to assume this is India’s growth potential, if not higher.
The market currently trades at a P/E of Rs 13.5 times one-year forward earnings (significantly below the long-term average). We feel valuations reflect the concerns. Analysts have largely factored in slower economic growth and further risk of significant earnings downgrades in FY13. The risk-reward is in favour of serious long-term equity investors, with a high probability of generating above average returns over the next three to five years. But investors should be prepared to handle a six to eight per cent correction arising out of any tail risk event. Volatility is here to stay but it can be used to our advantage. As Warren Buffet, says, “Look at market fluctuations as your friend, rather than your enemy; profit from folly, rather than participate in it.”
The author is Co-Chief Investment Officer, Birla Sun Life Asset Management Co Ltd
