Is it different this time? Market and economy doesn’t appear overheated
This week, India’s benchmark Nifty touched five digits for the first time
ever. Are markets overheated? In USD terms, the Nifty is about 3% below the
previous peak and 8% shy of peak valuations reached a decade ago. The
market cap/GDP ratio is close to the average and lower bond yields
partially explain the high PE. Several other parameters such as credit
growth, earnings growth, inflation and foreign flows appear to be at
cyclical lows so the economy is far from overheating. Several
reforms/actions such as GST and financial inclusion are in place which
argues for higher growth for longer. Housing affordability is the best in
decades and a housing boom appears imminent. Sticky domestic flows should
sustain multiples and market returns should follow earnings growth.
External shock (viz potential shrinkage in the Fed balance sheet) appears
to be the key market risk. A potential populist turn by the government, a
surge in equity supply and delay in NPL resolution are the risks on the
horizon from an India perspective.
Nifty at a high but several market parameters sober q The Nifty is up 17%
in the past 12 month but has underperformed the MSCI AxJ by 2ppt and is
in-line with MSCI EM, in USD terms. Foreign flows are quite moderate as
compared to 2005-07. q The current high PE is based on low cycle corporate
earnings. q MSCI India PE premium to MSCI EM is 40%, within 5% of the
long-term average. q Market cap/GDP ratio is reasonable at 90% as against
150% at the Jan-08 peak. q High-quality (ROE) stocks have outperformed, so
no irrational exuberance seen as yet. The earnings yield–bond yield gap at
0.9ppt is still close to the 10yr average.
Economic parameters do not show any sign of overheating q Inflation was at
a low of 1.5% in June ’17 (4.5% in FY17) vs 6.2% in FY08. The RBI is still
in a rate-cut cycle. In 2007, the RBI was already in tightening mode. q
Corporate earnings growth averaged only 2% over FY15-17 against 24% over
FY06-08. Corporate ROEs are also down by c.12ppt from the FY06-08 average
to 13% now. The corporate earnings recovery cycle has yet to play out. q
The capex cycle remains subdued. GFCF as a percentage of GDP is down 7ppt
from its peak to 27% in FY17.
Launchpad for growth revival in place q Political stability gives high
visibility to policy continuity well beyond 2019. q The GST reform
implemented on 1 July significantly improves the ease of doing business in
India as multiple taxes reduce and inter-state business improves. q
Financial inclusion has been a key gov’t priority and, with c.300m
no-frills accounts opened in three years, formalisation of a greater part
of the economy is happening. q Housing affordability is at a two-decade
best and a multi-year housing boom appears imminent (link), helped by gov’t
What could go wrong? q We believe that the potential doubling of equity
paper supply to US$15bn-17bn in FY18 would still be manageable given sticky
domestic inflows. A surge in equity paper supply towards US$20bn is a risk.
q Possible populist measures (viz the spread of farm loan waivers,
stringent anticorruption measures) ahead of the May ’19 elections could
impact business sentiment. This risk is low as Mr Modi strengthens his
political position. q Delay in NPL resolution. q Mid-cap valuations have
crept up and trade at an 8% PE premium to large caps. Any sharp correction
here would be negative, particularly from the perspective of a domestic
investor who has a mid-cap bias. q Escalation of the geopolitical situation
at the India-China border.

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