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India Equity Strategy
Year ahead 2011: Bumpy ride to continue
• We expect Indian equities to grind higher over 2011: We set a Dec-
11 fair value target of 23,500 for the BSE Sensex (based on 16x FY13E)
– implying an upside potential of 17% from current levels.
• But the ride could be bumpy, particularly over 1H: Inflation remains
stubbornly high and local liquidity is tight. Surging commodity prices
are adding to the pressure. We expect monetary tightening to continue.
Into FY12, the fiscal situation could be stretched in the absence of asset
sales and rising subsidies. And the Government has limited policy
flexibility over 1H, as the political calendar picks up with five states
scheduled to go to the polls over March-May.
• 2H should be better: As in 2H the policy leg room available to the
Government should improve substantially, we believe sustainable
returns will be back-ended. Current valuations are in line with historical
comparatives. We expect broad market returns to be driven mainly by
earnings growth forecasts (18% over FY12E-13E).
• Policy priorities: Kick-starting the investment cycle should be the key
priority, not only to sustain growth, but also to tame inflation. Funding
investments is unlikely to be an issue due to benign global liquidity
conditions as long as a stable policy environment is provided.
• Key portfolio themes for 2011: Global sectors are likely to remain the
focus of investor attention early in the year, while local sectors suffer
from risk aversion. The weakness expected over 1H would be an
opportunity to overweight financials and the investment cycle on
expectations of a recovery into 2H. We expect consumption to underperform
through the year given demanding valuations and headwinds
from inflation, tight liquidity, and potential withdrawal of fiscal stimuli.
• Key risk: A reversal in global liquidity: Given India’s dependence on
external capital to fund the current account deficit and savings
investment gap, this would be a key risk.
Economic outlook – Mixed
We enter 2011 with mixed views on the economy. Growth over recent quarters has
surprised positively, particularly in the services and agriculture sectors.
Export growth has revived meaningfully and global growth appears to be on a much
better footing. Also it appears that policy makers in the developed world will sustain
easy monetary policies through the year. This is critical for India, given its
dependence on external capital.
But the choppy trend in industrial production, particularly capital goods production
and the weak revival in the private sector investment cycle have been a cause for
concern.
In this backdrop, the deterioration in the political environment over the last few
months, following exposes on various corruption scandals, also needs to be watched.
If the drift continues, it could impact policy making and business confidence.
Inflation – Remains a concern
Another cause for concern has been stubbornly high inflation. Core inflation has
been consistently moving up due to stretched industrial capacities. Global
commodity prices (particularly crude oil) are rising rapidly as the growth outlook
improves. And food inflation is surging again, after a pull back, due to global factors
and unseasonal rains.
Going forward the trend herein could remain stressed for a while. Even if the
investment cycle were to revive immediately, it would take 12-18 months for
capacities to be created and ease supply side constraints. Global commodity inflation,
particularly rising crude oil prices, have always presented policy makers with
substantial challenges given the impact on the twin deficits and on interest rates and
the currency.
Also, after a sedate CY10, the political calendar is reviving, with five states going to
the polls over March-May. Consequently we believe that tough decisions pertaining
to increasing prices and reducing oil and fertilizer subsidies may have to wait until
the second half of the year.
Stressed rate environment
The RBI raised benchmark rates by 150bp over the last year to tame inflation. But
given current inflation expectations, we expect benchmark rates to be increased
another 100bp over CY2011.
Monetary normalization by the RBI, coupled with a pick-up in credit growth, has
resulted in the bear flattening of the Government securities yield curve over the past
few months. The corporate yield curve is currently inverted.
Also system liquidity remains tight and the banking system currently borrows more
than US$15B everyday from the RBI. This is despite a reduction in SLR and OMOs
conducted to ease system liquidity. Borrowing rates have been rising sharply as a
result, more so at the short end. A pick-up in the investment cycle and rising global
crude oil prices will likely add to the pressure.
Fiscal deficit – Uncertain outlook
A related concern going into FY12 pertains to the fiscal deficit. The enthusiastic
response to the telecom auctions enabled the Government to raise nearly US$20B
and should help reduce the deficit meaningfully over FY11 (to 5.5%). But this was a
one-off initiative.
And with expenditure levels likely to remain elevated (and higher global crude oil
prices could add to this), the Government’s ability to raise resources and reduce the
deficit in line with the 13th Finance Commission’s recommendations (to 4.8%) will
be tested. Relying on high growth rates alone may not work.
We believe the key priority for the Government going into CY11 is to revive the
investment cycle. This would be imperative not only to sustain the growth rates
forecast, but also to tame inflation.
Earnings growth to moderate
A robust recovery in earnings is estimated over FY11E (Consensus 28%; JPM 25%)
off a low base.
But into FY12E-13, growth rates are likely to moderate to 19-20% yoy. Revenue
growth should remain healthy due to a) stable GDP growth rates forecast for the local
economy (J.P. Morgan economists estimate GDP growth of 8.5% and 8.8% over
FY11 and FY12 respectively), and b) healthy growth rates for international sectors as
the global economic revival gathers momentum. But margins are likely to come off
due to rising input costs (crude oil, metals, agri commodities) and higher interest
costs.
Global sectors - Materials and Energy - are expected to drive earnings growth over
FY11. This follows a sharp recovery in commodity prices off a low base. Into FY12,
the skew is forecast to decrease, though, with most sectors expected to post healthy
earnings growth.
The recent surge in global commodity prices (particularly energy) and tight local
liquidity conditions pose the key risk to current earnings estimates for FY12.
From a broad market perspective, Financials would be the sector most vulnerable to
these trends. The RBI has been in tightening mode to tame inflation and the trend
could continue, and liquidity is expected to remain tight over the near term. Energy
sector earnings could also be volatile depending on the trend in global crude oil
prices and the Government’s stance on subsidy-sharing by the state-owned
companies. Consumption-related sectors would be vulnerable to rising inflation and
interest rates too.
Valuations – at middling levels
Indian Equities have been consolidating over the past three months in a narrow
range. Current valuations at about 16x forward earnings are largely in line with
historical comparatives, seen since May 2004 when the long-term capital gains tax
was abolished.
Currently valuations face headwinds from stubbornly high inflation, tight domestic
liquidity and rising global crude oil prices. The trend in these variables poses risks to
current earnings growth estimates. Also we believe the Government has limited
policy flexibility over 1H due to distractions with recent corruption allegations and a
packed state election calendar over 1H - five states go to the polls over March-May.
Against this backdrop, we believe that market performance for a large part of
CY2011 will likely be driven more by earnings growth rather than re-rating.
We do not expect a meaningful de-rating though. The structural growth story driven
by improving demographics and infrastructure investments cannot be denied. Also
global liquidity is expected to remain benign. And India stands out amongst peer
group for its absorptive capacity of foreign capital due to a meaningful current
account deficit and savings investment gap.
Also RoEs have been under pressure over the last two years due to muted earnings
and a higher capital base as companies deleveraged. With a revival in earnings
growth forecast over the future, RoEs are expected to improve.
December 2011 Sensex target of 23,500
Based on our current earnings estimates, we estimate a fair value of 23,500 for the
BSE Sensex for Dec 2011 – implying an upside of 17% from the current level.
The fair value estimate is pegged off 16x forward earnings.
The event calendar for 2011 suggests a more demanding 1H, given the current
pressure points and the limited policy flexibility. 2H offers a better opportunity from
a policy perspective, in our view, both to take tough decisions and pursue reforms as
the state-level elections would have concluded by then. Consequently we believe that
sustainable returns for the equity markets could be back-ended.
J.P. Morgan Economists forecast the INR to appreciate by 6% through to the end of
the calendar year. An appreciating currency would add to the gains for foreign
portfolio investors.
Any reversal in global liquidity remains the key risk to our outlook for 2011, given
the dependence on external capital.
Specific to the equity markets, foreign portfolio flows will likely continue to drive
market direction. Local institutions have been on the sidelines for much of CY10 due
to changes in regulations and distribution charges, adversely impacting inflows. The
trend will likely continue over 1Q as products are re-jigged.
Key macro portfolio themes for 2011
Global sectors are likely to be the focus of investor attention early in the year, given
the improving data points on global growth and rising commodity prices.
Local sectors on the other hand could see some risk aversion, given the headwinds
facing the economy – a distracted Government, tight local liquidity and rising
inflation. A substantial state election calendar over 1H also implies limited policy
freedom to deal with these issues.
Also data available for the last quarter (ending September) suggests that global
sectors are under owned and local sectors are over owned. While anecdotal evidence
suggests that subsequently there has been some rotation from the latter to the former,
we believe the trend could continue some more.
But as highlighted earlier, from an event calendar and policy perspective, 2H CY11
should be much better. Also it would be imperative for the Government to kick-start
the investment cycle meaningfully not only to boost growth, but also to contain
surging core inflation. And there is a political imperative to do so too, as the state
election calendar remains substantial over CY12 and CY13 as well.
We expect to see a meaningful revival in order flow, particularly from the Roads and
Power sectors towards the end of 1Q. Order flow from the private sector could
remain inhibited, though, until the political controversies die down.
It is also worth highlighting that companies can and are increasingly accessing the
global financial markets to fund the investment cycle. Liquidity offshore remains
benign and is expected to remain so through CY11.
Consequently we believe the weakness through the early part of 1H offers a good
opportunity to buy into sectors and stocks associated with the investment cycle and
financials.
The Budget session of Parliament would be a good pointer of the way forward, both
in terms of political order being restored and the Government’s stance on important
issues including the fiscal deficit and inflation.
We remain cautious on consumption for CY11, though. After two years of solid outperformance,
we expect the sector to run into multiple headwinds including a high
base effect, increased competition, high inflation and rising input costs, and tight
liquidity and rising interest rates. The consumption sector is also vulnerable to a
further normalization in excise duties. This may be required to sustain the
improvement in the fiscal deficit, as the one-off gains from the telecom auction will
not be available in FY12.
What’s in the price?
Current sector valuations present an interesting picture on the extent to which nearterm
risks and rewards are priced in and where there could be potential opportunities.
1) Materials and Energy sector valuations are at mean levels witnessed over the last
six years, while IT services and Healthcare are approaching their highs. This would
suggest that while global sectors in general will continue to outperform early in the
year, the former perhaps offer a better ‘laggard’ opportunity to benefit from
improving global growth as compared to the latter in relative terms.
2) Consumer staples and consumer discretionary are trading at their medium-term
highs, suggesting that the headwinds building up including potential dampening of
demand due to sustained high inflation and higher interest rates and margin pressure
due to higher input costs are not getting factored into valuations, hence our
underweight stance.
3) Industrials have de-rated to valuation levels that are nearly one standard deviation
below mean, and Financials have de-rated to mean levels. While there could be some
more de-rating to go for these sectors in the early part of CY11, we believe that
phase would be an opportunity to buy into these sectors.
Sectoral valuations
Indian market valuations have been range-bound over the
past 12 months at around 16x forward earnings – mean
levels seen over the last six years. Consumer Staples,
Telecom and IT Services sectors have re-rated, while
Industrials, Materials and Financials have de-rated.
Key sectoral valuation trends can be summarized as
follows:
Consumer Staples is the only sector trading
above one standard deviation higher than the
historical range.
Most sectors are trading at between their
historic average and one standard deviation
higher / lower.
Consumer Discretionary, IT services,
Healthcare and Utilities are trading at between
mean levels and one standard deviation higher.
Energy, Materials and Financials are trading at
mean levels.
Industrials and Telecom are trading at between
mean levels and one standard deviation lower.
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