Fasten Your Seat-Belt, It May Be Just A Temporary Turbulence
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The lamps were lit, fire-crackers made enough noise, parties were like never before, celebrations all around, prayers were strong enough and optimism was high—the new year was welcome in the very best way possible. But then suddenly it all got lost in darkness and the equity markets in India, governed by a stable government, made one of its worse beginnings in the recent past. Enthusiasms were found steadily disappearing, debates over uncertainty looming large began and investors suddenly started shying away from the markets to miss the Casino Effect.
Some even came forward to draw a comparison between the markets’ behaviour in 2008 with 2016, some started talking about astrological forecasts, few even resorts to numerology talking about the number ‘8.’
But then is it too fast, too early to guess—it well may be. It even may not be the case. Analysts, brokers and experts have started hard debates, storms over cups of tea are now felt across the length and breadth of the country, among the investors. When debates brew, arguments are exchanged and analysis being done all over, can Dalal Street Investment Journal be far behind. We have not. And so, regardless our analysis reveals that predicting yearly returns just by observing first few days of returns will not lead us to a meaningful conclusion of yearly returns. If we see last 15 years’ data, the first week of January has not been particularly well and out of last 15 years, nine years we have seen a negative return. And out of these nine years, the yearly returns were positive for 67 per cent of the time. Moreover, historically the large falls have always preceded by major gains. This time, however, we have actually seen Indian frontline equity indices down by around five per cent in 2015. Hence, many of the past facts does not have resemblance this time and there is no need to predict apocalypse.
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Enter the (Chinese) dragon
Besides, every time markets fall sharply, it is a different factor that impacts the fate of the markets and this time it is the volatility in China’s economy and their currency along with sharp fall in the commodity prices is to be blamed for the heightened volatility in the global equity markets. In last seven years, after the global financial meltdown, China remained the prime contributor to the world’s economic growth rate. Depending upon the year, it has ranged from 20 per cent to 33 per cent or one fifth to one third of growth rate of world GDP. In last couple of years, however, this growth engine has faltered. After growing on an average of 10 per cent every year since 2003, Chinese economy for the first time in last 24 years may report growth rate below seven per cent. This will have a serious repercussion on the global economic growth, which is so much dependent on China for its growth. In-addition to the moderation of growth, what is also building anxiety is how Chinese economy will shape up going forward.
Over the decades, growth of China has come from the sectors relating to investment and exports. Now as world economy is slowing down and there is little growth in the demand of Chinese goods, government there wants to re-engineer its economy away from investment towards consumption. To help this transition the policymakers there considered one of the option as a ‘stock market boom.’ This would have helped both corporates and billions of households. The Chinese corporates, which are highly leveraged, will use the equity market to deleverage themselves while the rising equity market will make feel households wealthier which may increase the consumption. The story had a perfect script till June 2015, when the Chinese equity market had doubled in one and half year. The small cap companies index has increased by three fold in the same period. But the melt-down in the equity market last June played the spoilsport. After that every attempt to lift the market only worsened the condition.
Under these circumstances, the Chinese government tried to use its currency to prop up the economy as their attempt to rebalance the economy was not working as they anticipated. This has also raised question about the aptness of the Chinese government in resolving such issues. Then in a surprise movement, China devalued its currency by 2 per cent on August 11. Now China being the largest trading country along with largest exporter will now start exporting deflation to other countries. The fall in crude oil prices along with cheap export from China will make condition worse for the world economy. What is also worrying the market participants is, it has been estimated that between USD 1-2 trillion of unhedged carry trades may been floating in the Chinese economy, which essentially means person who have borrowed in US Dollar and invested in Yuan interest rate to capture the interest rate differential, by the end of 2014. A sharp and swift depreciation in the value of the yuan can cause these players to panic, which may lead to a situation of run on the financial system. We have already seen huge outflow from China last year. According to a recent report compiled by Morgan Stanley, equity position has fallen from USD740 billion in first quarter of 2015 to USD 554 billion in the third quarter of 2015. Foreign investors also reduced their currency and deposits from USD 436 billion to USD 383 billion in same time period. This may further accentuate in case of Chinese government take any missteps. Therefore, every time Chinese market sneezes, the world market gets cold.
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Nonetheless, we believe that a large depreciation of yuan is not possible as of now. Gopal Agrawal, Chief Investment Officer and senior fund manager at Mirae Asset Global Investments explains the reason as “this is because if Chinese currency is led to depreciate further it will lead to huge exodus of forex in an environment where fed is increasing its rate and USD is getting stronger. I am very confident that it will not go beyond seven [yuan against USD] even in the worst scenario. If it breaks this levels it will have its own impact. Therefore, there will be a gradual depreciation of the yuan and will trade in a range and will not create a tremor in the market.”
Desh ki Dharti
India being a part and parcel of the global emerging economy will not remain immune to such outflows and will too see outflow. FIIs from the second half of CY15 have already increased their selling and sold to the tune of Rs 30,284 crore in last eight months of CY15, after investing Rs 48193 crore in first four months of CY15. The selling has continued even in month of January 2016 and till 18th, FIIs have sold Indian equity worth of Rs 3483 crore. What does this mean for the FIIs inflow for the entire year? We believe, India being part of the emerging market is getting such treatment and some other issues which does not alter India’s attractiveness. According to Dr VK Vijayakumar – investment strategist, Geojit BNP Paribas Financial Services, inflows from FIIs are likely to be negative in the initial few months of 2016, unless the market crashes and value buying emerges. The reason is that some of the FIIs like Sovereign Wealth Funds from west Asia are selling heavily due to their budget deficits caused by crash in crude oil prices. Some pension funds are also selling in Emerging Markets due to better prospects in Developed Markets.” Even, S Naren, CIO, ICICI Prudential AMC, explained, “it’s not a reflection of fundamental of India and they are forced to sell as they need money for different reasons.”
Going forward, we believe that we may see the continuation of the selling pressure from the FIIs, at least in near term. Prices of crude oil will play an important role in the FIIs movement. As explained by Dr VK Vijayakumar, “Inflows from FIIs are likely to be negative in the initial few months of 2016, unless the market crashes and value buying emerges. The reason is that some of the FIIs like Sovereign Wealth Funds(SWF) from West Asia are selling heavily due to their budget deficits caused by crude crash. Some pension funds are also selling in emerging markets due to better prospects in developed markets.”
What is also true about FIIs is that they chase returns and not the other way round. If we consider the last five years’ returns provided by emerging markets, there are only five countries that have given positive returns out of 38 country’s indices that is tracked by MSCI index. And if we take last three years returns of the emerging market index that has given positive returns, drops to four. India too has not given positive returns in the above mentioned period. The number of developed markets that have given positive return in the same period are 15 and 16 respectively. Therefore, we are seeing such aggressive selling that will continue for some period. This will also be because till now we have not seen any significant selling by SWF (although it is not possible to exactly pinpoint their selling number as they buy and sell through different route including mutual fund) in the Indian market, however, oil dipping below USD 30 per barrel we may see some selling. Moreover, there are redemption pressure coming from the emerging market funds and as India is still not decoupled with other emerging market, selling from FIIs will continue.
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Nonetheless, it will not continue for the entire year as Dr VK Vijayakumar believes- “India is structurally and fundamentally different from other emerging markets and therefore, India will soon be treated differently by FIIs. When this happens, FII flows will resume once again”.
However, in all this turmoil where foreign money is moving out of India unabatedly, we found that domestic inflows to the Indian equity market remained robust. In year 2015, mutual funds alone have made net investments of around Rs 70,000 crore, which is four times more than FIIs inflow and two and half times of what they had invested year before. The inflows were so robust that equity assets have crossed Rs four lakh crore mark for the first time in the history of Indian mutual fund industry. This is even after there is no significant rise in the market to mark gain. One of the reasons for such resilience is the under-performance of the other asset class mainly physical assets such as real estate and gold.
Regardless, the equity as an asset class too, in last one year has not given much return and this will pose a problem for the future domestic inflows. However, according to S Naren, “inflows have continued till now and they have not dipped”. Anecdotal evidence suggests that although, mutual funds are not witnessing any redemption or dip, flows are moderating. The number of SIPs are not growing the way it was growing few months back.
Next is what
We believe that market performance will be the key determinant in attracting and continuation of the domestic flows. The much needed support to the markets should come from the earnings growth that have remained sluggish in the first two quarters of FY16. Although, in last quarter we did not see much of the negative surprises, downgrades were still higher than the upgrades. A deeper analysis shows all is not bad and almost half of the sectors are showing improvement. These are the sectors that have got the benefit of either fall in the commodity prices including crude oil or the government actions. Sectors such as urban consumption and certain manufacturing units saw their net earnings improving due to lower input cost mainly from lower commodity prices. While there are certain sectors and company that are being benefited by the increase capex by the government.
The government is trying every bit to improve the growth of economy. It has even suggested to change the goalpost for the fiscal deficit target. In a major shift from the previous years, instead of pruning capital expenditure to reign in the fiscal deficit, government thus far has been aggressive on its capex plans (they spent Rs 1.3 trillion in first half of FY16, which is a multi-year high for first half. Bulk of the capex has been directed towards developing infrastructure like roads, highways and railways. All these efforts will start bearing fruits soon.
The road sector has also seen increased capital expenditure under this Government. Approximately, 10,000km of roads project were awarded by the Central Government in FY16 (compared to 8,000km awarded in FY15) of which 6,000km is on track for completion. In FY17 the Central Government plans to award a length of approximately 15,000km roads project. Similarly, Coal India will continue to maintain healthy levels of investment and should be able to meet production targets. fruits. The railways too are on track to deliver its plan spending in FY16 and FY17. Most of the capital expenditure in the railways has been for decongestion (doubling or tripling) of tracks on the busiest routes.
Therefore, despite all the criticism against the government, they are doing every bit to bring much needed boost to the economy. According to Motilal Oswal, “Although our expectation from government is high, they have their own limitation. I will rate them high on intention but low on implementation as government has other constraints too.” He further explained that “They tried to push GST and land reforms but unfortunately they do not have majority in the upper house and hence failed. They are taking lot of actions which do not require parliamentary approval.”
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Nonetheless, there are areas where government has failed to justify their action and especially the rural areas, where conditions has been aggravated by two consecutive failed monsoons and three consecutive years of sub-5 per cent hikes in Minimum Support Prices. Even in the case of Public Sector Banks’ (PSBs) recapitalisation, the government has no concrete plan of revival. These PSBs account for around 70 per cent of credit outstanding in India are capital constrained and cannot grow their loan books by more than 10 per cent.
We believe that government may touch some of these issues in their union budget. Besides the fiscal policy, the budget will also be important from the monetary policy perspective. The stand of the government on what they do with the savings in subsidy and hike in excise duty on crude oil will help RBI governor in deciding the further course of key policy rates, especially after the recent rise in the consumer price index. According to S Naren, “we feel that there will be a rate cut in next few months as growth need to be kick started”. Even Motilal Oswal is of the view that “I see some 50 basis points of rate cut this year.” India also remains one of the few major economies where there is still scope of rate cut.
We have already seen RBI has cut the key policy rates by 125 basis points last year, however, it is estimated that only 60-70 basis points of that has been passed to the final consumer. We believe that this year we may see translation happening. According to S Naren,“meaningful earnings recovery will happen only in FY18 led by better capacity utilisation, resolution of the NPAs issues and front loaded rate cuts”. The lower interest rate will also help to stimulate demand in the economy and hence the corporate earnings. We believe that there will be no ‘V’ shape recovery and earnings will improve steadily.
Fasten your seat-belts
Equity market is slave to the earnings, however, equity market returns always precedes the earnings recovery. Therefore, though, earnings will take some time to rebound market may rebound earlier. Currently frontline indices are trading at price to earnings ratio of around 15 times, which is near its long term average. Nonetheless, looking at all the steps taken by government to revive sagging economy, expected fall in the interest rate and comfortable valuation, equity as an asset class looks attractive with long term investment horizon.
We see market to be volatile for some time now and hence our readers to be cautious while investing. Divide your investment amount into six equal parts and start investing in a staggered manner in next six months. Motilal Oswal suggests, “Whether it is mid cap or large cap does not matter. Any company that is run by quality management and exhibiting growth should be looked at now. Therefore, mix of large cap and mid cap can make and one should remember that “longer holding period makes more money than timing the market.”