What's In Store For The Markets ?

The Indian equity markets have remained quite volatile in the past one month, keeping investors on their toes. The Sensex, which is the barometer of India’s financial health, has actually declined by more than six per cent in the last one month. In fact, the scenario has been much worse for the other indices like Mid-Caps and Small-Caps, which have actually witnessed an almost double-digit decline.

Naturally, the sudden and sharp fall in the markets has raised many doubts in investors’ minds. While the leading indices are already taking a decline, individual portfolios are also significantly lower. No wonder investors are baffled and are looking for some sort of direction. We, at DSIJ, have always remained at the forefront in guiding our readers, as we seek to do through this report too.

Among the many events that have been guiding the direction of the markets at this point, the first and foremost is the sudden and sharp depreciation of the rupee against the USD. The prospect of tapering of quantitative easing (QE) has only added to the woes, the impact of which is evident in the sharp decline witnessed in the global equity indices immediately after the US Fed’s announcement.

While these are the global factors, there are some domestic factors also in the mix too. Higher current account deficit (CAD), the overhang of political risk, and last but not the least, downgrade fears on the earnings front are a few of them. Let’s try to understand the impact of these variables on the markets.

Rupee Depreciation: A Worrisome Pace

A depreciating rupee against the US dollar has been the major concern for the Indian markets. While it is true that this is not a new phenomenon, what impacts the markets is the pace at which the currency declines. This time around, the INR has declined quite sharply and suddenly against the USD, falling 7.37 per cent on a month-on-month basis (next only to the Brazilian Real, which has depreciated by 7.90 per cent). The scenario is worse on a yearly basis, with the INR down 11.52 per cent, the strongest dip among its peers.

In a rather unfortunate joke doing the rounds now, the rupee is said to have attained ‘senior citizen’ status. Investors would be curious to know what the reason behind the sudden fall in the rupee could be. Here, Tirthankar Patnaik, Director, Strategist and Chief Economist, Religare Capital Markets says, “One should not be viewing the rupee depreciation and QE tapering separately. The QE taper by the US is the main trigger that is causing both the events, i.e. rupee depreciation and the market’s decline. With the Fed indicating towards reducing capital pumping into the markets, the markets are worried globally. This worry is translating into dollar strengthening”.

We, at DSIJ, second the opinion that this dynamic is simply a demand- supply game. With the US going ahead with a zero interest-rate policy (ZIRP) for a long time and pouring in USD 85 billion into the system every month, there was carry trade happening in the dollar. With the Fed reducing the flow, the supply will naturally dry up. Apart from this, there are signs of improvement seen in the US markets, and this is directing capital flows back to the US. Patnaik avers, “It is the US economy which is showing some signs of growth, not the Euro zone and Japan. There is a scenario of global risk aversion and even the real yields are improving in the US as inflation is coming down. As a result, capital flows are not going back to USD".
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N R Bhanumurthy (Professor & Secretary, Indian Econometric Society, National Institute of Public Finance and Policy) opines, “In the recent sharp depreciation in the rupee, the domestic factors are very minimal. As there is huge volatility in the international market due to the confusion created by the Federal Reserve Chairman, there is a significant capital outflow happening from emerging markets like the Asian markets, South Africa and Brazil to the US markets. Due to this, there is an overall demand for the US dollar. I think this is not as big a decline in the rupee as it was in 2011, when it depreciated by nearly 20 per cent, which was a kind of crisis”.

While this was the past, investors would be more interested in what is to happen ahead. Where are we heading in terms of the rupee? For this, we need to look out for certain factors. The prime one among these is the CAD.

CAD: A Major Concern

When we are looking at currencies depreciating against the USD, the CAD is a maker or a breaker. The higher the CAD, the more severe will be the depreciation. If CAD is greater, more capital flows are needed, else the central bank has to adjust through reserves.

The graphs make it clear that South Africa and India have higher CAD. Sure enough, it is these countries’ currencies that have depreciated the most on a yearly basis, with the South African Rand down 19 per cent.

As for India, we do not expect any improvement on an immediate basis on the CAD front. We are also of the opinion that the flows to Indian markets are not expected to improve as FIIs will have to bear the brunt of two sorts of risks going ahead. First, the risk in terms of returns from investment that they are already taking, and secondly, rupee depreciation. Hence, the capital inflows may dry up. This may not happen immediately in equities as they have a longer gestation period and the losses are notional. However, for fixed income investors, the coupon rates immediately reduce. No wonder a huge chunk has gone out from Indian debt instruments (See figure: FII Investment in Indian Equity and Debt Market).

On the CAD front, Andrew Holland, CEO, Ambit Investment Advisors adds, “The good news is that gold prices are down and there are curbs on imports. But my concern is that the improving US economy may lead to higher crude oil prices. So, I do not see a huge recovery in the CAD. But I don’t see a further deterioration either”.

Considering these factors cumulatively, there seems to be no respite for the INR against the USD in the near term. With regard to the rupee movement, Patnaik says, “India until now enjoyed a capital surplus world. If QE is tapered, you will see countries like India that are highly dependent on capital flows taking a hit, resulting in currency depreciation. Our base case is we can go to 65 very easily by next year”.

However, Bhanumurthy maintains, “For India, it is a problem of confidence rather than a financial one. If Indian policymakers are able to boost confidence, the situation can improve dramatically”.
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Life After QE

Surely, investors would want a more specific scenario of a post-QE world. Patnaik reflects on this saying, “Life after QE will be a world of capital scares. Over the last two to three years, we have seen large amounts of capital coming in. The stoppage of QE is a certainty; it cannot continue at these levels. Naturally, emerging market currencies, especially the INR, are at a greater risk”.

While this is one impact, we feel that the announcement of QE tapering should be viewed positively. While there could be some pain in the short term, the long-term impact would be positive. In fact, the Fed has defined a time limit for moderating the pace, and has not pulled the rug from below our feet. It is now up to the global economies to figure out ways to keep afloat without short-term solutions like QE repeatedly bailing them out.

Earnings: Will They Look Up?

When a currency depreciates, costlier imports and scarce capital flows impact the GDP growth as well. India is a net importer, and hence, it could see a greater impact. Patnaik holds that, “The slower GDP growth impacts the earnings and the slower earnings would impact the valuations”. We concur with this view and expect to see an impact on India Inc.’s earnings at least for the June 2013 quarter.

In our results analysis for Q4FY13, we had expressed the hope that things would start improving here on. But from the way the rupee is faring today, we now expect quite a few shockers in the June quarter. Andrew Holland also says, “We were expecting things to start picking up. However, India Inc. has borrowed heavily offshore. With rising interest rates in the US combined with the rupee depreciation, there are expected to be more negative surprises than positive ones”.

Many are expecting the IT and pharma companies to compensate for the losses. However, we feel that this balance may not be maintained as some of the IT companies are also witnessing pressures on the contract front. Hence, one can expect the numbers to be negative. The bigger firms that are over-leveraged are going to be the worst affected. Patnaik adds, “Our expectations of the bottom-up numbers are of 13 per cent growth in EPS. However, we will be happy to see even nine per cent growth”. 

But experts feel that we could see the situation turning around if growth comes back meaningfully across sec- tors. Policy initiatives can be paced up if there is change in government, which can take firmer initiatives with a clearer mandate. This brings us to the last factor about political risk.

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Political Scenario: No Real Risk 

The political scenario is of key significance, as FIIs tend to avoid markets facing a political risk. With both the leading political factions in India (UPA II as well as the NDA) facing issues, there was perceived to be some political risk. While the ruling party is tainted with scams and held back by policy paralysis, the opposition is still mired in a leadership paradox. It will be no surprise if this leads to a hung Parliament. 

These factors notwithstanding, there seems to be no political risk in sight at least in the near term. There is a common voice about the government completing its tenure and one can expect the polls to happen only after February-March 2014. There are some hopeful signs on the political front too, like money flowing into the economy ahead of the elections. This would help in some sort of a revival in rural spending. 

The Silver Lining 

Though we have talked only about the negatives, there are a few positive factors on the horizon too. First and the foremost among these is a good monsoon, which is expected to result in better agricultural growth. The monsoon has panned out well till date. In the preceding year, agricultural growth was slower than estimates. Apart from that, the factors that may provide an impetus are a faster clip for reforms and an improvement in the CAD supported by stronger government initiatives.

Some actions are being taken on the infrastructure front. A coal pricing policy is being finalised. Infrastructure projects worth Rs 7 lakh crore are being put on the fast track. These factors may help in setting off a revival. However, the sentiments at current levels of the market are rather fragile, and hence the indices may continue to witness some amount of decline (5250-5300 levels on the Nifty). 

As regards the valuations, in the past we had predicted the FY14E Sensex EPS to come in at Rs 1475. After considering the latest developments on the rupee front and subdued GDP expectations, the FY14E EPS numbers are between Rs 1375-1410. Some downgrade may also happen as the June quarter results pour in. At the lower end too, the current Sensex value results in a P/E of 13.50x. Accounting for some negatives in the June quarter results, the indices may see some decline in the short term.

All in all, though there seems to be some pain on an immediate basis, there is some recovery in sight. At the current levels, investors would do well to stay put and remain on the sidelines with cash to buy at the right time. On the sectoral front, one can take some exposure to stocks in the IT, pharmaceuticals and capital goods sectors.