This rise, however, has not been backed by any substantial improvement in corporate performance as is evident from the fact that the price to earnings (P/E) multiple have been rising steadily and recording one of the steepest rises since 1991.
The current spike, like the previous one in 2007 can mainly be attributable to huge flow of liquidity. After the market tanked last year, sentiment was reversed when it was realized that despite a slowdown, India was still in a much better shape at a relative level when the entire developed world went into a recession and the developing economies in East Europe were simply vanquished, what with a handful of them being forced to approach IMF for bailouts. India, like China, stood out in the midst of severe devastation all around. Then out came the results of India’s general election and the mere fact that the left parties were routed was perceived as reason enough to believe that all necessary reforms would see the light of the day and India would revert to the 9% plus growth, sooner rather than later. Added to this was the stimulus provided to the economy by the new government, as deficit concerns took a back seat.
As the sentiment improved, liquidity began to move in. More specifically FIIs. In the first two quarters of this financial year, total FII inflow crossed USD 35 bn, with majority of inflow taking place post the election.
Another channel of flow of foreign liquidity is through the Participatory Note or P Note route. For the uninitiated, P Notes are instruments used by investors or hedge funds that are not registered with the SEBI (Securities & Exchange Board of India) to invest in Indian securities. Herein, Indian based brokerages buy Indian-based securities and then issue PNs to foreign investors. Hence these are instruments that are used for making investments in the stock markets. However, they are not used within the country. They are used outside India for making investments in shares listed in that country. The inflow through the PN route has nearly doubled from Rs. 658.12 billion to Rs. 1.1 trillion. Clearly these are hot money, highly susceptible to sentiments and herd mentality.
The surfeit of liquidity is, however, not entirely of foreign origin. There’s also ample liquidity in the domestic market what with loose monetary policy followed domestically. This is exemplified by deposits growing at a faster pace while credit growth remains muted. In fact, non-food credit growth has been on a declining trend since October 2008 and only in the month of July is there some hint of reversal.
And, despite a pick-up in non-food credit growth in July, the CDR was down by 80 basis points, indicating a much faster growth in deposits. Clearly, credit flow into the real economy fails to give the confidence of a higher GDP growth that the market is expecting.
I have, on a couple of occasions earlier http://www.atimes.com/atimes/South_Asia/KI04Df02.html, http://kunalsthoughts.weebly.com/uploads/1/9/2/3/1923881/dsj_-_aug09.pdf) enumerated my concern why the GDP growth this financial year will be below 6% and nothing much has changed since then to warrant optimism. On the other hand monsoon worries have been justified. For the monsoon period June 1 to September 30, India experienced a deficient rainfall of 23%, a three and half decade low. It was way back in 1972 that the rainfall was deficient by 24%. And the problem does not end there. The Southern states received heavy rainfall toward the end of the monsoon period, as a result they ended up being the least deficient region (at 4%). The problem, however, was of a different nature. Rather than the rainfall being spread across the period, it was very heavy toward the end, resulting in widespread flood. The states of Andhra Pradesh and Karnataka have been the worst affected. This has resulted in tremendous amount of crop loss. Initial estimates coming in from Andhra Pradesh pegged the estimated loss at Rs. 2 billion, and this can go up further. Situation in Karnataka is hardly different.
Despite the highly optimistic prediction of the government officials, this year’s GDP growth would struggle to cross 5.8%, which is the level I am expecting.
The stock market, on the other, hand seems to be far more optimistic on the growth prospect. Earnings growth of even 20% plus will not be sufficient to justify a P/E of 20. Hence the expectation seems to be quite unrealistic. Last quarter’s good corporate performance had a lot to do with stringent cost control measures undertaken by the companies and increased focus on reducing leverage. On the contrary, the topline hardly grew. There’s no indication that there will be dramatic improvement in topline in the next two to three quarters. Margin growth through pure cost control measures is not sustainable. Sustenance requires consistent topline growth, which does not seem possible in the short to medium term.
Currently, therefore, the market valuation seems to be quite stretched and corrections are expected. In the long run, however, India’s growth story remains intact, despite the constraints like weak governance and inability to carry forward meaningful reforms. Improvement on those fronts will perk up the growth rates even higher. In the longer run, Indian equity markets remain well placed. However, caution is advised on the short run.