India: The Economic Cycle Turns And The Sensex Bull Rages Onwards

by: Shiv Kapoor

August is now behind us. The Sensex closed July up 1.89%, and built up the quarter-to-date gain for the two months ended 8/31/14 to 4.82%. The Sensex bull rages onwards.

Last year at about this time (8/21/13) the Sensex languished at 17,906. A year on, it trades at 26,638, up almost 48.8%. We have had a great run, and the market as always has predicted a turn in the economic cycle well ahead of the turn.

In August 13, we knew that GDP growth in June 13 languished at 4.4%. That was the fifth quarter of sub 5% growth in a row. And yet the market commenced a strong rally. A sixth, seventh, and eighth quarter of subdued sub 5% growth were recorded in subsequent quarters, and the market rallied through the depressing growth data. And now, in August 14, we finally have a GDP growth print of 5.7% for the June 14 quarter, which suggests that the economy is beginning to accelerate, just as the market had predicted.

GDP growth remains well below the six year average of 6.54%, and even further below the ten year average of 7.55%. The reversion to mean has a way to go still. But there is risk too, for the GDP growth rates are now within a whisker of the six year median levels.

I remain optimistic. But I grow wary as I fear expectations might soon start running well ahead of where they ought to be. The GDP growth at 5.7% was encouraging. But the monsoons have been weak. And the impact of a weak monsoon on the influential agricultural growth component of GDP won't show up in the June quarter. It will show up in the coming quarters. In addition, a significant part of the GDP growth was driven by government spending. This is nothing unusual: government spending is normally elevated in the first quarter of a new fiscal year, after deferral of spending the final quarter of the prior fiscal, to make sure budgets and deficit commitments are met. The cynic in me also expects that election spending during the first fiscal quarter of 2015 will have played no small role in the growth acceleration.

At the same time there is no cause for despair. The rate of growth acceleration may slow, but confidence and investment intent suggest that the trend should remain upwards.

In the RBI policy statement early in August, they said that the prospects for reinvigoration of growth had improved for several good reasons. And they highlighted downside risks on account of geo-political tensions, the weak monsoon, and weakness in the global recovery. They maintained a central estimate of GDP growth of 5.5%. In the policy statement, I noticed an interesting conflict between words and pictures! Their words maintain a 5.5% central estimate for GDP growth, however when you look at their picture, the center of the 50% confidence interval is probably closer to 5.7% to 5.8%.

The inflation and interest rate cycle also remain supportive. Wholesale price inflation during July was 5.19%, well below the ten year average of 6.52% and the six year average of 7.08%. And while there is a risk that inflation might start reverting upwards to mean, this risk is low. Inflation expectations are falling. And while wholesale price inflation is low relative to historic levels, interest rates are high.

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Chances are that the combination of low inflation (historic context) and high interest rates (historic context) will urge inflation downwards, until such time that a rate cut might be warranted. The ten year government security yields near 8.5%: 50 basis points ahead of the six year average and over 70 basis points over the ten year average.

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Real interest rates tell an interesting story too. Real interest rates using wholesale price inflation are at over 3%. Well over the historic six year average of 0.89% and the ten year average of 1.22%.

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Such generous real rates often precede a rate cut. And a rate cut expectation makes long-duration bonds attractive.

However, on a post-tax basis, bonds deliver a deeply negative real return unless the securities are held for over three years. Equity gains on the other hand remain tax free provided that listed shares are held for over one year, and sold on an Indian exchange with payment of a very nominal security transactions tax. Thus, with conviction in the growth cycle building, it is likely that equities will remain the preferred asset class.

Why are interest rates high, when inflation when viewed in a historic context is low? The reason is simple. The Reserve Bank of India is focusing on consumer price inflation which is running at near 8%. While this level of inflation is below long-term average consumer price inflation, it is quite rightly viewed as being too high. The informal target for consumer price inflation is 8% by Jan 15 and 6% by Jan 16. If the 6% objective is met, I expect to see the reverse repo rates cut to 6.25% to 6.5% from where they stand today at 7%.

Whether the 6% objective can be met is questionable. The positive is the potential for lower import cost inflation - if the US Dollar strengthens versus a global currency basket as I expect, one impact might be contained Dollar commodity costs. That would be a big plus for India. At the same time, if the GDP growth differential versus US continues to expand, we could see a widening in the total factor productivity differential, which would give strength to the Rupee versus the Dollar. That would be an added advantage lowering import driven inflation. And of course, a narrowing US India inflation differential would also give strength to the Rupee versus the Dollar, which would be a positive for India.

But there are negatives too. Firstly, there is the weak monsoon which could add to inflationary pressures going ahead. This would be non-core inflation, and perhaps lacking in persistence. It might not lead to a rate hike, but since it will keep consumer price inflation high, it will almost certainly discourage a rate cut. Secondly, there is growth. As growth accelerates, we will see immense wage pressure build up. And in all likelihood, such wage pressures will not be offset by meaningful productivity gains. Unfortunately, the labor force in India is quite small relative to the population, on account of under-investment in education and training. Lastly, there is the Goods & Services tax (NYSEMKT:GST) that might be implemented by 1 April 2015. While GST is expected to be near revenue neutral, I expect a one off bounce in inflation as corporate India passes on the GST while not passing the full benefit of taxes subsumed by the GST. There are numerous other supply side constraints (roads/ports/transportation etc.), which need to be addressed through policy: I don't expect further deterioration, and would anticipate improvements, and so that might be a positive for both growth and inflation in the longer term.

Here is a chart of how inflation is perceived by the Reserve bank. I would say they are targeting 8%, but believe there are risks to the upside. And I believe their take on consumer price inflation is solid.

My take is that there are some upside risks to the 8% inflation target, but far higher risks to the 6% target a further year down the line. While I believe there is scope for accommodation, I am not at all convinced that it will be significant.

Interest rates play in important role in the growth cycle. Are domestic interest rates high enough to kill consumer spending? In my view, with growth and confidence in growth, consumer spending will not be hugely restrained with interest rates where they are at present. At the same time, savers do quite well if they have a long-horizon: there is no financial repression at any rate.

Will domestic interest rates kill the investment cycle? I think not: with cheap liquidity available globally, I doubt the growth cycle will be arrested by domestic interest rates. On the other hand, the growth cycle could face challenges if liquidity tightens globally. While U.S. rates can have a meaningful impact come mid 2015 the liquidity out of Japan and Europe could provide some relief.

Leaving aside global liquidity, 10 year corporate AAA bonds traded at end of July traded at a spread of 57 basis points over the 10 year government bonds, which yielded 8.55%. The 10 year corporate AA bonds traded at end of July traded at a spread of 95 basis points over the 10 year government bonds. Cost of borrowing for AAA borrowers of 9.12% (8.55% plus 0.57%) and 9.5% (8.55% plus 0.95%) for AA borrowers is not particularly onerous in comparison with long-term averages of 9.45% and 10.43% for AAA and AA rated borrowers respectively: in fact, current cost is lower than the long-term average cost! Ultimately, what matters is credit availability and liquidity: which is available to those without overly stressed balance sheets.

What does all this mean for the markets?

The markets have run up over 48% since late August 2013, primarily on expectations of sound policy executed by a government with a clear mandate, resulting in a turn in the economic cycle. The turn in an economic cycle has now commenced. Event occurrence is often a good time to book profits.

At the same time, the market is tending towards expensive, though not excessively so. Over the past ten years, the Sensex has closed at an average PE (TTM) of 18.06 (Median 16.56), having reached an average high point of 20.93 (Median 18.71) and an average low point of 13.57 (Median 12.02) over the course of the year. The average for the Hi/Lo/Close is 17.52 on average and 15.76 at median levels. A market trading at 26,638 is at a pricey multiple of 19.23 times TTM earnings of 1,385 on 6/30/14. And it reflects a multiple of 18.60 times TTM earnings of 1,432 expected by 9/30/14.

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I believe it is too early to sell. As of now, I believe the earnings growth cycle has yet to gain momentum. And until it does, the multiple is unlikely to contract. In addition, consensus growth expectations are in my view conservative. Thus while multiple expansion is less likely, faster than consensus growth, plus an elevated multiple being maintained are likely to drive further gains.

Present consensus earnings expectations for the year to 3/31/15 are at just over 1,500. This indicates growth of just 12.2% over the year to 3/31/14. I am looking for 3/31/15 earnings of at least 1,525. Multiples are unlikely to contract in a market where the earnings cycle is in upgrade mode.

Looking ahead to the year to 3/31/16, consensus earnings estimates are at 1,762. This represents growth of about 17% over 3/31/15 consensus estimates. I will be looking for upgrades to closer to 1,800 in the months to come.

While I don't believe the market ought to be sold just yet, I do believe it is time to add some churn into portfolios. While the market is up over the past couple of months, the volatility at stock level has been huge. And so it is time to churn portfolios to lighten up on stocks that have run far, and buy stocks which might have become more reasonably valued.

From amongst the stocks that have had a significant run up, in my view the healthcare sector led by Sun Pharmaceuticals and Cipla is now expensive. So is Hindustan Unilever, a classic defensive play now trading at a multiple of 40 times 3/15 earnings estimates. Tata Motors remains well valued despite the run up in prices. However, it is expensive on a risk adjusted basis: this is a highly volatile, high beta stock, with a low quality balance sheet. Mahindra & Mahindra is a well governed, high quality company backed by solid growth prospects and a low beta. While it trades at 22 times 3/15 earnings estimates, this is not too bad on a risk adjusted basis.

From amongst the stocks that have been beaten up, I believe Jindal Steel & Power is looking like a well valued cyclical play. This stock has been beaten up on a Supreme Court ruling which ruled that all coal mines allocated by the government to various private sector participants since 1993 were illegal. I believe the decline provides a nice entry opportunity. I also believe Tata Power is now a reasonable buy candidate.

What forward return expectations to expect?

In the short-term, I suspect we will see robust gains. With Diwali coming up on October 23rd, and the Sensex in bull mode, I would be hugely surprised if the markets exhibit near-term weakness. Even the longer-term return potential remains robust.

By 3/31/15, I would expect the markets to trade at a range of 27k with upside to 30.5k.

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And by 3/31/16, I would look for a range of 31k with upside to 35k. Thus I am working on an annualized return of at least 11% with upside to 19.5% between now and 3/31/16.

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Of course, there are risks. And there is no better way to address risk than through sensible asset allocation. At present I am working with a standard allocation of 54% to equity and 46% to debt. Because I believe we are still in the early phase of a growth cycle, I cyclically adjust the standard allocation to carry an equity weightage of 61.5%, with a debt weightage of 38.5%. Within equity, I lean 30% to small and midcaps, and 70% towards large caps. And within debt, I am light on long duration and ultra-short term bonds, with a preference for mid duration (2.5 years to 4 years adjusted maturity) bonds.