In this monthly outlook, let us discuss the following topics:
- Indian economy has strengthened in the last 15 years after Lehman and 10 years after the first taper tantrum
- Macro environment
- How do the markets behave ahead of the general elections and immediately afterwards?
- Valuations and flows
Over the past period equity markets have moved up and indices have made new highs. At the same time, oil prices have also been up. Typically, a bump up in oil prices has been a cause of a market correction. A question thus arises if the market up move is sustainable in light of crude prices rallying to around USD95/ bbl.
To try and answer this question, we would try and have a look at the various economic indicators over the past period to see how we were positioned as a country when oil prices spiked and how are we positioned at the present.
At the same time, we would have a look at valuations and market compounding over a period of time to see if markets are running ahead of valuations.
Indian economy has strengthened in the last 15 years after Lehman and 10 years after the first taper tantrum
Ten years back when FED started to tighten, INR had faced a severe pressure and had buckled 20% in a short period of time (between May and Sep’13). This time around, it has been different.
Last year in 2022, emerging markets were subject to another bout of pressure when the Fed started hiking in 75-bps increments, which sucked capital away from the “periphery” to the “centre”, and caused the U.S. dollar to surge. Simultaneously, the Russia-Ukraine conflict caused oil prices to spike. For a capital and commodity importer such as India, a stronger dollar alongside higher crude prices – a phenomenon observed again in recent weeks – was a double-whammy, pressuring both the current and capital account simultaneously. While the external sector was under sustained pressure for much of 2022, it did not show up in outsized Rupee depreciation vis-à-vis other emerging markets. In fact, the Rupee depreciated among the least compared to its peers when the pressure was on because the RBI aggressively intervened and sold dollars – to the tune of almost ~90 billion across spot and forwards – between June and October last year. Nothing cracked in India. No extraordinary interest rate defence was necessary. In fact, the interest rate differential between India and the United States progressively narrowed over 2022 and the Fed upped the ante. No external capital had to be mobilized and no special measures had to be invoked in India.
Key lesson from the last taper tantrum was to create adequate forex buffers from 6 months of imports in 2013 to 10.5 months of imports in 2023, swelling to USD670bn from USD280bn which gave RBI credible firepower to defend the INR. Today we are again seeing higher crude prices and stronger USD. However, this is happening when our current account is expected to be more balanced, in FY24, vs earlier. Our CAD has continued to stay below 2.5% levels over the past several years while earlier it had a tendency to shoot up, causing a crisis. in FY24 it could be around 1.23%, lower than FY23 level of 2%. Hence, we should be able to withstand this current stress with a good prospect of maintaining our forex reserves (@USD87/bbl oil price) and without having to increase interest rates any further. A USd10/bbl increase in oil prices increases the current account deficit by 0.35% and hence oil prices would have to be kept under watch. But as of now, it implies that the economy can continue its growth momentum. Once again, as we have been pointing out previously, good forex reserves keep the external volatility out and give us policy freedom and should constantly be under watch. A decline in forex would enforce tightening which would be negative for growth.
Stress on banks on account of NPAs was the key consequence of Lehman collapse. Over the years, we have seen banks clean up their books and today the bank NPAs are the lowest ever with several banks having overprovided for bad debts in their books.
Macro environment
In the US, the economy continues to be strong in spite of FED tightening and there are prospects of interest rates staying higher for longer. Higher crude prices would again seep into inflation.
In India, Rainfall has been below normal and as of end of August there is a deficiency of 11% vs long period average. This has led to lower reservoir levels which could impact summer cropping season. Government has acted proactively and has announced several measures to contain ag-flation such as continuing ban on wheat exports and levying a 40% duty on onion exports. This should keep inflationary trend in check.
Overall, RBI has set for itself inflation targets and we have seen inflation stay within the band for most of the period and this period should also be taken care of. As noted earlier, the state of the economy is good and RBI has greater degrees of freedom.
How do the markets behave ahead of the general elections and immediately afterwards?
General elections are around 6 months away. Past trends of the elections have shown that markets stay buoyant in the run-up to the election and have a good chance of continuing the trend after the elections if the incumbent gets re-elected. More importantly, markets respond to policy making. We have seen disruptive reforms (while necessary) cause the market to decline while supportive policy making cause them to cheer. Continuity reduces the chances of disruption.
Policy making continues to be pro-growth in-spite of the stress, as discussed above. It is business as usual for India Inc and breadth of earnings should remain good. There is a chance that RBI keeps the policy rates unchanged going forward and that should help growth assets. Broad market earnings are expected to be more than the NIFTY earnings and hence broad market performance should be better than the large cap indices and we continue to believe that it is Time for Alpha.
Valuations and flows
We expect FPI flows to continue to be volatile, given the higher interest rates prevalent abroad and lower interest rate arbitrage available from Indian markets. Domestic flows however, continue to prove structural. Interestingly, SIPs now account for a larger part of inflows (vs one-time investment) and are more structural. This provides the market with a lot of strength.
Valuations are now at the upper end of the sustainable band. Our construct for the market is 18-18.5X one year forward earnings which gives us a target of around 20350 for Nifty on 1100 nifty earnings for FY25. This level has broadly been achieved six months before time. This leads us to expect a slightly lower than earnings growth returns over the next few years. However, the earnings growth over this period should be faster than long period average. Midcaps are trading at a small but sustainable premium over large caps. Given the strong presence of the growth themes in the midcap space, we do expect the space to continue to perform on a relative basis.
Thank You
Happy Investing
May the Good Times Continue
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