Indian equities—a lot going in their favour

The Indian equity market is heading into the second-quarter earnings season for 2012-13 with mixed sentiments — positive domestic cues and muted global cues. The euro-zone crisis has continued to cast a shadow on the global equity markets even as the US economy has been staring at the prospect of a fiscal cliff towards the end of this calendar year. There are clear indications of a global growth slowdown as is evident from the moderating Chinese economy and anaemic growth across the developed world.

As a response to the deteriorating global macro scenario,central banks around the world have resorted to coordinated monetary easing in some form. The liquidity so created would be finding its way into risky asset classes including emerging market equities and global commodities and this has kept Brent crude prices buoyant at around $115 levels despite the global slowdown.

Fortunately for us in India,things are far from gloom and doom. While GDP growth has moderated over the last couple of quarters,there have been justifiable reasons for optimism,especially in recent weeks. The Indian government has announced several long-awaited reform measures such as a hike in diesel prices,opening up of foreign direct investment (FDI) in many sectors including multibrand retail and approving divestment in some public sector units. It has also proposed upping the FDI cap from the current 26% to 49% in insurance and pension and approved effective amendments to the Companies Bill. The Cabinet also approved the 12th Five-Year Plan which focuses on big-ticket infrastructure creation with an aim to achieve an average economic growth rate of 8.2% during the Plan period. While these actions have a limited impact on the fiscal deficit,it is a clear signal that the government wants to keep the fiscal deficit as close to the budgeted 5.1% of the GDP as possible. This was further reinforced by the unchanged second-half government borrowing calendar.

The government’s commitment to reform measures have arrested the fall of the rupee,boosted business confidence among India corporates and could act as a catalyst to spur the investment cycle. In September,the Indian equity market has been among the best performing equity markets globally and the positive or ‘risk on’ sentiment was evident,especially in interest sensitive sectors like realty,capital goods and banks,which outperformed the indices even as the defensives like healthcare and FMCG struggled to keep pace.

Market experts are now seeing a decreasing possibility of what looked to be an imminent sovereign downgrade from Standard & Poor’s. The market is now bracing for key reforms such as implementation of the goods and services tax and the rolling out the direct taxes code in a bid to raise the GDP growth trajectory further and increase the tax to GDP ratio. That said,these reforms require parliamentary approval and if passed will lead to a marked improvement in India’s macroeconomic indicators like GDP growth and the fiscal deficit.

On the ground,the positive sentiments could improve the environment for raising capital for mid-tier corporates and this could act as a key growth enabler. As briefly discussed earlier,global liquidity due to the unlimited quantitative easing (QE III) by the US Federal Reserve will find its way into asset classes including emerging market equities and it is likely that India could be a disproportionate beneficiary of the same,extending the robust $18-billion foreign institutional investor inflows seen in the calendar year to date.

The Reserve Bank of India on its part is bound to react to the fiscal consolidation initiatives of the government and nudge policy rates lower sooner than later,and keep liquidity in the comfort zone through a combination of open market operations and a cut in the cash reserve ratio.

At current levels,the market trades at around 14 times one-year forward expected earnings,which is close to the long-term average. That said,there is a stark divergence in the valuation of defensives as compared to cyclicals and as investors begin to recognise the re-emergence of Indian equities,we could see these divergences narrowing.

The second-quarter earnings season could see yet another weak set of numbers with revenue growth tapering off to a three-year low at around 13%. The Sensex earnings growth could be about 6% on a year-on-year basis as against a more robust 13% registered in the first quarter. The earnings growth would increase to 13% if one were to exclude the oil companies,as against the 17% registered in Q1. Going forward,we could see the stabilisation of both the operating margins and the interest costs as a percentage of earnings. The earnings downward revisions have played out over the last two years and may be largely a thing of the past.

To summarise,we believe that the reform glass is half full rather than half empty and believe that the government has signalled its commitment to reforms. The market is expecting a continuation of the reforms process,especially in speeding up of big-ticket infrastructure projects,kick-starting capex cycle with public sector units at the lead and other issues plaguing the power sector. More efforts in fiscal consolidation could be expected to rein in the fiscal deficit,enabling the RBI to bring down interest rates in the medium term. All things considered,Indian equities still continue to offer an attractive entry point for a long-term investor with a three to five year view.

The author is chief investment officer,Tata AIA Life Insurance Company