Dark clouds,but with a silver lining

But for most investors whose portfolios consist of a much broader set of companies the returns are much lower. To top it all,investors have been consistently spooked by the global macro events from 2008 and by the governance and macro problems within the country in the last few years.

In contrast,hard assets—like real estate and gold—have delivered above average returns compared to their long-term historical averages. As a result net household investments to equities have fallen to a record low below 3%.

However,the recent macro events globally as well as in India have brought some silver linings. Future equity returns will be driven by a combination of the cost of money or interest rates,earnings and growth expectations. The cost of capital or interest rates would depend on inflation and inflation expectations.

The fear of withdrawal of easy liquidity coupled with slowing growth in China has ended the bull market in commodities and most commodities have corrected sharply,including gold and crude oil. This trend,if sustains,would potentially have a favourable impact on both inflation and interest rates. From an earnings perspective,lower interest rates and raw material costs should flow through to margins and lift earnings. However,this logical flow-through of benefits has been intermittently halted by the slide in the rupee.

The full pass-through of the softer commodity costs has not yet happened. In fact,in the short-term a weakening rupee could lead to lower margins and one-time mark-to-market losses on dollar liabilities of companies. But when the rupee stabilises or inventory and pricing adjustments are fully effected,the follow- through of lower commodity costs will be transmitted to corporate earnings. Also,we are hopefully blessed with a good monsoon,though it is early days. If the follow through is good it would take some pressure off food inflation.

Other than agriculture,which will help growth in the current year,the more important issue is to kick-start the investment cycle and solve some of the structural issues dogging the infrastructure sectors of power,oil & gas,transportation and telecom. Here,the government,though belatedly,is working hard to re-start the momentum and taking some administrative steps to clear large projects. While there could be incremental improvements,any significant pick-up will happen only when interest rates fall dramatically or well after the elections.

Also,there is enough spare capacity in several industries to warrant any aggressive capex. Hence,we should not be very bullish on this top-down driven capex model because we are not good at it (unlike China where it is a far more successful model). I think the bottom-up-led capex model driven by market impulse—for example setting up capacities for greater indigenisation and creating capacity for more exports in autos,auto components,light engineering,textiles and pharmaceuticals—is more likely to fructify.

Some impulse to growth will also come from higher government spending in the second half of the year. The finance minister had put the breaks on any additional spending since November last year in order to reign in the fiscal deficit. Now that he has been successful in bringing the number to lower than 5% of GDP,it gives him more room to spend in a pre-election year. The government both,directly as well as indirectly,is a large buyer in many industries and any revival in government revenue expenditure should also help in easing liquidity in the system.

Lastly,the effort to open up many sectors to FDI and increase FDI caps in several sectors is a big,long-term positive. Though there is healthy skepticism as to the benefits of these measures in the short to medium term with regards to attracting investments,given the nature of India’s polity and policy-making,it is still significant. Because no matter who the government of the day is,FDI once opened up are never reversed.

As many have rightly argued,India’s reform process works in spurts and more so when there is a macro-economic crisis and hence perversely the current macro pressures will force the government’s hand to reform and open up the economy. In a globalised world once you open up you have to be more accountable to markets and capital-providers.

As far as expectations of overall economic growth go,they have now considerably moderated from a year ago and most people are reconciled to the probability that India will grow in the range of 5.5% to 6% near term. Earnings growth consensus downgrades should also bottom out in a quarter or two. Valuations in the broader markets and not just the Nifty/Sensex are now approaching 2002 levels. The risk-reward is now squarely in favour of equities and the relative return potential of this asset class is far better from this point onwards. One only has to recognise the silver lining and not be drowned in the clutter and noise surrounding the dark clouds.

The author is director & CIO,Alchemy Capital Management