THE BIG FIGHT

There is little disagreement about the fact that it is global politics which drives the economies of various countries and thereby the stock markets. In recent times, however, this has gained more prominence. We saw this happening in Japan where the equity market rose just before and after the election of Prime Minister Shinzo Abe; similar was the case with other countries like Indonesia and Mexico where the voting of new leadership ignited a stock market rally. The Indian market was no different and we have witnessed a one-sided rally since the day Narendra Modi was announced as prime ministerial candidate in September 2013, which continued after his victory in May 2014. Nonetheless, in the last two months i.e. March and April we saw the first major crack in the otherwise smooth rally till now. In these two months the BSE Sensex was down by 5 per cent and 3 per cent respectively and is almost 10 per cent down from its recent peak.

Once again, the primary reason for such a fall is attributed to politics. The government’s inability to get through some of the important bills and issuance of tax notices to some FIIs to pay minimum alternative tax (MAT) for prior years is hurting the sentiment. After a thumping majority of the BJP-led NDA in the general election last year, it was widely believed both among foreign as well as domestic investors that the change in leadership would kick-start a new era of reforms to unlock the growth potential of a country that houses every sixth person of the world.  The enthusiasm was clearly visible in the performance of the Indian equity market and FIIs’ inflows. In 2014 the Indian equity market remained the best performer among the emerging markets. 

According to MSCI Emerging Markets Index which captures large and mid-cap representation across 23 emerging markets’ (EM) countries, Indian equity gave the best return of 32 per cent in dollar terms compared to a mere 2.5 per cent by the overall EM index in the same year. As we know, FIIs follow the returns (someone may argue the other way round) and they pumped in USD 16.2 billion into Indian equities in 2014. Even for the first three months of 2015 FIIs invested net Rs 36,472 crore into Indian equities. For the month of April, however, FIIs’ net investment was to the tune of Rs 11,720 crore, if we exclude big net inflows of Rs 16,353 crore on April 21 on account of FIIs buying Daiichi Sankyo’s stake in Sun Pharmaceutical. In fact, FIIs have been net sellers in the month of April, which has continued even in the month of May – it was Rs 3018 crore till May 4. What spooked FIIs’ inflow is definitely the MAT issue, which again raises the concern of ‘tax terrorism’.

Besides, the government is also facing a daunting task of getting some of the important bills such as the Land Acquisition Bill, GST, Real Estate Bill, etc. passed through the upper house of parliament where it lacks the required numbers. Even in the best case scenario wherein the NDA repeats its 2014 general election performance in the upcoming state elections, it won’t be able to manage a majority in the Rajya Sabha before 2018. What this means is that the present government will continue to face some headwinds in passing some of the important bills in its current form. This has become explicit and is weighing on investors’ decisions who believe that the factors of good leadership, stable government, fast decision making that made India an attractive investment destination have run their course.

However, we believe that there are other ways in which the present government can definitely overcome its inadequate numbers in the Rajya Sabha. The experience of the NDA government during 1999-2004, when again they were in minority in the upper house, shows that good government floor management, trying to build consensus, changing the narrative, and calling a joint session of parliament in some cases can resolve most of the issues. We saw the passing of the Prevention of Terrorism Act 2002 (POTA) in one such joint session. Therefore, all is not lost and we believe many of these bills will see light of the day.
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THE OTHER EMERGING MARKET FACTOR

Regardless, we believe that the FIIs are turning away from Indian equity market due to better opportunities elsewhere. For example, the MSCI Chinese Index has moved up by 43 per cent year till date (May 6, 2015) compared to 14 per cent by the MSCI India Index. The People’s Bank of China has cut interest rates for the third time in six months on May 11 and that will again make equity investment attractive there. What might also have accentuated the selling by FIIs is a slew of IPOs worth USD 376 billion in China till May 11. Besides China, indices of other countries like Hang Seng of Hong Kong, KOSPI of South Korea and Tiwan Taiex have outperformed Indian equity indices year till date in dollar terms, which is making the Indian market unattractive from the FIIs’ perspective. But in the longer term the Indian growth story is sure to remain intact.

MACRO-ECONOMIC FACTORS

There was a confluence of factors apart from the election of a strong government that acted as tailwind for the Indian equity market last year. In particular, during the second half there was a fall in commodity prices. Crude oil, the most important commodity from India’s economic standpoint, went through a price decrease of more than 60 per cent from its high of USD 115 per barrel in the month of June 2014 to less than USD 50 per barrel in less than a year. This had a cascading impact on the economy and finances of both the government as well as India Inc.  India imports more than three-fourth of its crude oil requirement that forms one-third of the country’s total import basket.

In FY14, India spent almost USD 168 billion to buy crude oil at an average price of USD 105 a barrel. Nonetheless, in FY15 there was sharp drop in the oil prices that helped the government to contain its fiscal deficit at 4 per cent of GDP for FY15 and the current account deficit below 1 per cent. For corporates other than upstream and downstream companies, theoretically it reduced the input cost directly or indirectly and hence boosted their margins. In the case of state-owned upstream companies like Oil India and ONGC, it reduced their net margins substantially whereas for downstream companies like IOCL, BPCL and HPCL the fall in crude oil prices helped to improve their financial performance as it reduced their working capital requirements and related debts.

On the macro-economic front, cheaper energy prices helped the country to moderate its inflation rate. Inflation measured by the Wholesale Price Index (WPI) and Consumer Price Index (CPI) has witnessed a considerable fall since the start of CY14. CPI has already fallen from over 10 per cent in late 2013 to below 6 per cent over the past seven months and for the month of April it was 4.87 per cent while the WPI has been recording negative growth continuously since November 2014. There is direct correlation between crude oil prices and WPI and as crude falls, WPI should also follow.

Therefore, the recent spike in crude oil price, which is trading at its 2015 high and is 40 per cent above its recent low, has spooked the equity market and fuelled the expectation that inflation will rise again and that further rate cuts are going to be delayed. Nevertheless, you should not read much into this rise in prices as the fundamentals of oil have not changed and supply still exceeds demand by almost 1.5 million barrels every day. Moreover, we do not see demand picking up substantially from any part of the world. What will also limit any price rise is the new role played by the US’ shale oil industry as the world’s ‘swing producer’, which means supplying more oil in the market whenever prices increase. Therefore, the recent rise in prices is a temporary phenomenon and we are not going to see Brent crude oil prices breaching USD 100 per barrel level any time soon.
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MONSOON IMPACT

In addition to rise in crude prices what else is also feeding the higher inflation expectation is unseasonal rainfall along with expectation of lower than average rainfall second year in a row.  The India Metrological Department (IMD) in its first forecast for 2015 said that rainfall in the monsoon season from June to September is expected to be below normal i.e. 93 per cent of the long period average (LPA). It further said that currently weak El Nino conditions are prevailing and are likely to persist during the entire monsoon season. India gets over 70 per cent of its annual rainfall in the monsoon and any shortfall in rains causes crop failure which in turn has a cascading effect on a host of sectors and causes a spike in inflation and delay in rate cut.

However, looking at the impressive performance of the NDA government in managing food inflation by releasing food stocks, cracking down on hoarders, and using import in case of shortage, make us believe that food inflation will be tackled in an appropriate manner without impacting inflation much. Though unseasonal rains in the month of March 2015 and deficient rain during the last monsoon season resulted into two bad crops in FY15 will put pressure on food inflation, it will remain within the comfort level of the central bank. Therefore, the interest rate cut cycle started by the RBI with the start of 2015 will continue in FY16, though it will be delayed by one or two quarters. On the demand side, rural consumption will remain subdued due to muted minimum support price (MSP) hike, stable MNREGA spend, and poor agriculture output in FY15. This will impact the industrial demand of sectors like automobiles, consumer durables and FMCG.

EXTERNAL FACTORS

It’s not only the domestic factors that have made the market nervous; international developments too have played their own role in creating volatility in the market, the most important of them being the expectation of the rate hike by US Federal Reserve. We have already witnessed during May 2013 the US Fed’s intention to unwind its unconventional monetary policy. This led to sharp corrections in the equity prices of all the emerging markets due to expectation of large reversal of capital flows. This was accompanied by huge depreciation of the currency market along with rise in bond yields. Investors, however, punished particularly those countries with larger macro economic imbalances, exerting severe pressure on countries like Brazil, India, Indonesia, Turkey and South Africa dubbed as the fragile five.

According to a report by IMF, these five countries saw on an average bond yields rise by 2.5 percentage points, equity market fall by around 14 per cent and exchange rates depreciate by more than 13 per cent while reserves declined by 4.1 per cent during May 22 to end of August 2013. These reactions were to the news of tapering the rates and now there is news of increasing the interest rate which has frightened some of the market participants as it means money will flow out of risky assets, including emerging market equities. This is evident from a rise in the 10-year treasury yield of the US from 1.897 per cent on April 20 to 2.366 per cent on May 12. However, we believe that this time the reaction will not be as sharp as in 2013 because there is a marked improvement in the macro economic imbalances, namely current account balance, fiscal balance, inflation, and foreign exchange reserves that existed then. We are better placed in each of these parameters now than in 2013.

The second international factor that is playing on the minds of investors, particularly in emerging economies, is about the possible default by Greece in loan repayment and its exit from the euro zone. This could cause a domino effect for other debt-choked European economies like Portugal, Spain and Italy. This would spark panic among global investors and we will not remain insulated to this. Nevertheless, we believe a solution should be reached between Greece and its euro zone countries on the final Euro 7.2 billion tranche of its Euro 240 billion bailout package. Until then the sword of Damocles will keep hanging over the market.
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EARNINGS AND VALUATION

The sharp correction of almost 10 per cent in the frontline indices is not only due to the above-mentioned facts. The fourth quarter earnings are also not supporting the equity market. IT and cement sectors have clearly disappointed with decline in volumes, while some of the private sector banks have performed well. We are still in the midst of the result season and nothing conclusive can be said right away about the results. However, the initial numbers at best present a mixed picture. Other leading indicators such as core sector growth, which for the month of March de-grew by 0.1 per cent (lowest in the last 10 years), clearly suggests that recovery will take its own sweet time. All these factors are definitely weighing on the minds of investors.

Regardless, this fall has aligned the valuations of the Indian equity market with the long-term averages. The BSE Sensex now trades at a price to earnings of 15.9 times which is at its historical average of the last 10 years. In terms of price to book value, the Indian equity markets are trading at 2.5 times, slightly lower than the 10-year average of 2.7x. The forward return on equities of BSE Sensex is currently at around 16 per cent against the average of 18.3 per cent and is showing signs of improvement from the lows of FY14.The fillip side of this year lower EPS growth is that for FY16, the EPS growth estimate has been upgraded to around 18 per cent to Rs. 1668. This makes current valuation of Indian equity market attractive.

We believe that the factors that have led to such volatility in the market are transient in nature and will not impact performance beyond a quarter. It’s a fight between the bulls and bears of the market, wherein currently though the bears seems to have the upper hand. Ultimately the bulls will win. This also reminds us of the boxing match between Floyd Mayweather, Jr. versus Manny Pacquiao, which was also billed as ‘The Fight of the Century’, wherein Pacquiao displaying aggressiveness in the initial round forced Mayweather to the ropes many times but eventually it was Mayweather with his use of defense and accurate punches who defeated Pacquiao.

We believe that a similar thing will happen in the equity market too and this correction has presented a right opportunity to retail investors to enter the market in a staggered manner and build a portfolio for the long-term.