Jun 12, 2017
“More money has been lost because of four words than at the point of a gun. Those words are ‘This time is different.” – Carmen Reinhart, Eight Centuries of Financial Folly
This month we focus on some of the key drivers contributing to high valuations to assess the sustainability of the current investment environment.
We can’t help but think much of the world is living in a fishbowl. This ten year period will be analysed by future generations for the extraordinary dislocations and shifts that have taken place in the U.S. and Europe. Our primary focus is the effects on the Indian economy and markets. A deeper understanding of the various forces driving markets – and high valuations – can be instructive in constructing an appropriate forward looking investment strategy.
Equities
Massive Liquidity in Developed Markets Has Led to Accelerating Foreign Institutional Flows to India
In the past 7 years, cumulative FI flows into Indian equities have quadrupled. Fixed income flows are also up dramatically from a low base. The Great Rotation late last year out of India and emerging markets is now looking like a blip in an otherwise steep and consistently rising trajectory.
Alongside the invigorated FI investor, domestic investors have become equally strong contributors. Our anecdotal data points and conversations with fund managers suggest that participation is likely to accelerate, broaden and deepen to second and third tier towns.
U.S. Money Supply Growth Has Accelerated Post 2008…
Leading to Cumulative Foreign Flows into India Accelerating Since 2008
Meanwhile, Generational Low Interest Rates in Developed Markets Have Reduced Domestic Cost of Capital
We’ve spoken often enough about the secular cycle in developed market interest rates. With the discount rate being a key input for valuation, we’ve witnessed PEs in developed markets rise. Justifiably so. As Warren Buffett stated quite simply recently, if interest rates remain artificially low, by extension, one can expect PEs to remain artificially high.
The follow-on observation is pertinent for Indian markets. As the global cost of capital remains at generational lows, it must follow that valuation will be impacted equally in emerging markets like India where this capital is finding a home.
Generational Lows in Cost of Global Capital Are Elevating PEs
The Nifty50 PE Troughed Alongside the S&P 500 PE in the Low Double Digits…
…Since Then, Both S&P 500 and Nifty 50 PEs Have Risen In Tandem
That’s precisely what we’re noting. Both the Nifty50 PE and the S&P 500 PE peaked in 2000, at roughly similar absolute levels, proceeded to bottom in 2009 at roughly similar levels, and have since been rising in a generally similar fashion.
Further, India’s Stand-Out Demographics & Fundamentals Demand a Premium
P.M. Modi took office in May 2014. Despite two painful corrections in 2015 and 2016, the markets have bounced back strongly both times, now making new highs. In contrast, PEs corrected strongly from peaks in 2000, 2007 and 2011. Something different is clearly at play. This is also the most sustained period of high valuations that we have witnessed in the past 17 years.
The Nifty 50 PE Has Averaged 20.57 Since 2009 to Present…
…Staying Resolutely Above 20 Times Since 2014
So Is the Nifty50 Approaching a Top?… Technically, We Are Yet to Hit 2 Standard Deviations on Overvaluation…
Moreover, Earnings at the Index Level Are Skewed Due to Index Constitution
It’s difficult to make the case that the market is nearing a top today for a few reasons. First, the Nifty 50 is somewhat flawed in its construction. It happens to own underperforming private banks, significant loss making telecom companies, loss making PSU banks, as well as loss making commodity stocks. These companies have reported deep losses recently, and the impact on index earnings is significant, thereby masking the strong performance of the broader market. In contrast, the U.S. uses the S&P 500, an index of 500 stocks.
In most quarters, we’ve made adjustments for these exceptional cases with huge losses, to get a sense of the broader market, and in each case we’ve found that the broader market is doing far better than represented by the index.
We’d also suggest this as the reason active managers find it reasonably easy to outperform the index in India. U.S. data are very clear. Around 90% of managers usually underperform the market, hence index funds like Vanguard have done exceptionally well. Not so in India.
Finally, Macro Indicators Suggest We’re Still Somewhere Mid Cycle
What gives us some additional comfort is that macro indicators are nowhere near cycle extremes. The fiscal deficit is at 3.9%, versus 6.5% at the past cycle top. Credit growth is hardly accelerating, and is in fact anemic at 4%~, versus 26% at the prior cycle top in 2011. CPI is declining year over year, again not an indication of a business cycle turn. Auto sales, investment, manufacturing and services are all generally plodding along, and plenty of capacity still remains available. Hardly the stuff of cycle tops.
Valuations Are Being Artificially Elevated Due to Large Losses By a Few Companies in the Index…
…Depressing NIFTY50 Index EPS growth vs. the long term growth rate
CNX 500 Company Performance Is Now Only 50/50…
50% Meeting Expectations and 50% Negative Surprises
While 60% of Nifty 50 Companies Have Delivered Negative Earnings Surprises
Fixed Income
Rate Hikes Are Out
We can safely surmise from the RBI commentary that any possibility of a rate hike is remote. There is some likelihood of a rate cut later in the year, but it would be driven by weakening data. This gives us further comfort in our preference to stay the course in equities. Any weakening should lead to a rate easing move by the RBI. As of this writing, status quo on rates is the expected scenario.
Bonds Rallied on RBI’s Commentary
Strong FPI inflows, lower-than-anticipated inflation at 3%, a good monsoon forecast helped bond yields last week. The new 10-year benchmark bond ended the month at 6.66%. The old 10-year benchmark bond ended the month at 6.79% compared to 6.96% at previous month’s closing. Both CPI and WPI readings declined in April’17 driven by falls in food inflation, primarily vegetables and pulses.
The Steepness of the Curve Presents Adequate Protection & Opportunity
The yield curve today remains steep enough to provide attractive carry and offers protection against a moderate rate hike cycle that may occur down the road. For instance, there is a 75 bps spread between overnight and 3 year AAA rates, and a similar buffer exists between GSecs and corporate bond yields. This carry buffer provides adequate protection against modest rate hikes that we may potentially encounter later in the business cycle.
With the fading likelihood of a rate hike, investors may be tempted to play duration. Here too, it seems hard to see a dramatic move in the rate structure. So we remain positioned in accrual bonds, corporate bonds, and select AT-1 bonds.
Outlook
Positive News on The Global Front, Oil Falls, Europe Picking Up
As expected, Crude Oil has been unable to sustain any upward momentum and the latest drop in Crude Oil prices was a result of concerns over rising surplus in 2018. This drove Brent oil prices back to below $50/bbl, slightly above their year-to-date May lows.
We are also heartened to note Eurozone activity momentum picking up, as seen in PMIs, which are suggesting a pickup in economic growth. Emerging markets are equally interesting, showing decent momentum. China seems to have woken up again, demonstrating a willingness to write a $500 billion check on its Belt and Road initiative. Consumption trends remain stable.
Domestically, indications appear strong that it will be a good monsoon. While the uncertainty on rates seems to be over, we’re certainly concerned about the short term confusion that will reign over the live roll-out of GST.
With GST rates for most of the industries close to their existing tax rates, the gains from lower GST rates look to be limited. The more important benefit seems to be in increased productivity and the shift of market share from unorganized to organized.
Market Direction Will Be Driven by Earnings Growth
We think investors will look past GST related one-off items. Should an indication arise that earnings are sputtering, we expect a correction, and it could be sharp. Markets remain over-valued and will derive direction from earnings growth. Should earnings growth disappoint, we would look for the RBI to step in, which will buffer any fall. We expect earnings to improve in the second half of this year. We remain invested in quality growth stocks at reasonable prices.
Should a correction materialize in the short term, it would be a mid-cycle correction and as such, we would consider it an opportunity to deploy capital. We remain focused on the long view, with stock selection being the other key determinant for outperformance.
Technical Strategy
The Nifty closed flat for the week at 9668 levels. Index has formed doji candlestick pattern for the week, suggesting market may continue to remain sideways in the near term. But the trend still remains up with the higher top higher bottom formation remaining intact. Momentum indicators have flattened out on daily chart as it usually happens when there is a steady uptrend; but on weekly chart momentum remains strong. On the upside 9700 Call option has highest open interest for calls which is acting as resistance for the market. If Nifty sustains above 9700, the next level for the market is seen at 9880, while 10,040 is the target on the upside. Nifty 9600 and 9500 strike price Put options have highest open interest suggesting as the base for the market. Overall, the recent low of 9340 becomes a critical support for the market. Put/Call ratio of Nifty option open interest is at 1.21 which is above neutral level of one, but below last months high of 1.41, suggesting market still has room on the upside. INDIA VIX continues to remain at all time lows, but major any spike will be negative for the market.
