Inside the Paradox: Economy Down v/s Market
at All Time High | Welcome to 2020!!!

Hello Everyone,

In multiple discussions with clients, investors and market participants, we have seen widespread disbelief at the seemingly paradoxical combination of new highs in the stock market v/s a slowing economy. It is perplexing for sure, however we believe there are fundamental and technical factors that NIFTY will remain relatively expensive and the broader markets have good scope of re-rating. There are certain risks to this view of course and we would like to take this opportunity to summarise our thoughts on this front.

To begin with, the market valuation is a function of a profit pool and a multiple. The profit pool is driven by several considerations related to revenue growth, margins, capital structure, tax rates and so on. The multiple on the other hand is driven by sentiment, liquidity and relative considerations. Conventionally, we agree that if you get the first part of profit pool and its direction right, you are going to be eventually correct in your return expectations and the direction of the stock price movement. However, when you actually experience the cycle on a day to day basis, one appreciates the role of sentiment and the powerful result one can get by adding understanding on liquidity flows to the profit pool opinions. One general caveat in this discussion is that a call on profit pool is more local and fundamental in nature while on the liquidity front, there are several global factors and one has to be fairly alert in reviewing the opinion and thought process on this count.

An opinion on the corporate profit pool (↗):

We agree that we are in the midst of an economic slowdown right now. The slowdown may have been caused by cleansing initiatives and reforms like Demonetization, RERA, IBC and GST. However as Arvind Subramaniam points out, the key trigger has been the drying up of liquidity post the IL&FS crisis. As per his recent paper, fiscal and monetary incentives will not work and getting the right long term systems for kick starting lending growth should be the priority. In some ways, one can see various meetings of governments with public and private banks and financial institutions and subsequent announcements as steps in that direction. Market pundits and industry experts across the board have mentioned that the NPA cycle is past its peak. The government has also taken several fiscal and monetary steps along with that for reviving the economy.

We see the slowdown as a changing of orders with a shift to formalization and high value addition. NIFTY Companies have reported EPS growth of 10-12% and >15% v/s nominal GDP growth of 11% and 7% v/s NIFTY returns of 14% and 5% for FY19 and H1FY20. So while there is a broader economic slowdown, NIFTY earnings have been rising and there is a clear market share shift to larger, better prepared and organized companies. It is important to bear in mind that Indian corporate profits languish at 3% of GDP compared to global average of 5%. One can expect the corporate profits as a %age of GDP to rise from current levels.

Going ahead, we expect base effects to come in the picture and the economy should resume its growth march in the coming quarters. The path to revival may involve agriculture inflation and there might be certain global factors which lead to commodity inflation. We should see productive capex and participation of global capital to ensure that government balance sheet is not over burdened. We believe that attracting global MNCs to set up base in India is an important step to create an ecosystem where there will be a multiplier effect for infrastructure creation. On the whole, India is transitioning towards a robust long term growth base where companies are improving on the counts of efficiency, professionalism and credit and tax compliance.

*An opinion on the liquidity: (↔)*

Just like liquid fills the vessel it flows into, liquidity inflates the prices of the assets where it gets absorbed. In the prevailing market construct where in growth and inflation are both low and Central Banks continue to ease and print money, there has been a tendency to opt for passive indexing in ETFs and liquidity has flown into various asset classes by way of ETFs. This has resulted in higher valuations for some of the underlying instruments. This liquidity situation is unlikely to reverse in the near term unless inflation rises. We would generally expect global growth and inflation to rise first before one sees a reversal in the form of a tightening. Besides there are political considerations related to US elections and Trump’s actions to paint a rosy picture with regards to the economy and the markets. Due to all these factors, one can expect the existing liquidity position to remain benign in the coming 1-2 quarters.

On the back of these phenomena, we agree that several major global stock indices seem over-valued in terms of multiples. NIFTY’s multiple of ~28.5x P/E is on the higher side while Nifty Mid Caps and Small Caps are reasonably valued at 20-23x P/E. The multiple may be discounted by 12-15% due to the recent tax cut from 35% to 25%. On the other hand, the broader markets have corrected and Nifty Mid Caps and Small Caps are trading 20% and 40% lower than their all time highs while NIFTY is at an all time high. In the near term, we can expect NIFTY to deliver steady returns in a scenario of continuing liquidity and rising profit pools. The broader markets are valued cheaply and we expect a mean reversion of liquidity here at some point. In some ways, a potential regulatory move by SEBI to expand the eligible list from 250 stocks to 400 stocks could begin the institutional flow led re-rating. In the meanwhile, we would expect value pickers and HNIs to keep accumulating relatively cheap and high quality small and mid caps.

The key risks to the liquidity view would be any geopolitical dislocation and any successful attempt to de-stabilize the dollar. Ultimately, the endgame of the easing game being played by Central Banks will be fairly unpleasant for the underlying assets since there has been a liquidity led bubble here. Indian equities would also come under pressure at that time since there is high correlation across equities, however one can expect relative outperformance from India if domestic capex and GDP growth have picked up by then.

On the technical front, we are seeing healthy sector rotation. Autos, Cap Goods, PSU Banks are seeing technical green shoots and the odd small/mid cap is rallying to 52 week highs. DIIs continue to be net buyers with ~USD 7.5bn of flows while FIIs have actually sold ~USD 700mn in YTD FY20.

As the New Decade rolls in, we are fairly confident that India will cross the much talked about USD 5 trillion level this decade and every incremental trillion will be faster, this will be a highly rewarding journey for the patient investor and CHEERS to that!!!


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