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What's the outlook for Indian markets
Jitendra Kumar Gupta in Mumbai
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February 23, 2009
With growing concerns over global economic growth and further cuts in earnings estimates, a recovery in markets is not expected before end-2009.

Unlike previous estimates of a revival by June, the road to recovery is seen stretching to the end of the year. 

Continuous deterioration in the global economic outlook coupled with increasing concerns over the domestic economy and corporate earnings has been weighing heavily on the markets.

"Right now, looking at the current investment numbers and demand, I think that an economic recovery could take longer.

The first half of the fiscal year 2010 would be difficult and, a recovery could only come in third and fourth quarters. This is due to the fact that the impact of the fiscal measures is yet to play out fully.

Also, by that time, the impact of lower interest rates and stability in corporate sentiments could be triggers for the revival," says Yashika Singh, Head Economy Analysis Group, Dun & Bradstreet.

In this scenario when the markets are already below 9,000 levels, the questions that come to mind are future direction of the markets and the investment strategy that needs to be followed.  

The Smart Investor spoke to some of the prominent names on the Street to gauge their assessment of the current situation, the extent of impact of various measures undertaken by the government and RBI (Reserve Bank of India [Get Quote]), the implications of recent developments, the future course of market and what investors should do. Read on to know more.

Earnings risk

India's valuations may look attractive with the BSE Sensex currently trading at a PE of 10 based on estimated FY09 earnings. However, even if the market remains at current levels, there is a probability of the PE ratio rising to about 13 times even as we go ahead into the next fiscal, thanks to the possibility of a further cut in earnings estimate.

Earlier, in March 2008, the consensus earnings estimate for the Sensex companies for FY10 was about Rs 1,200. But, over the months as the economic conditions deteriorated, the same have been significantly downgraded (in phases) by 30 per cent to about Rs 850 now. Given that Sensex earnings fell by 8.2 per cent in Q3 FY09, its worst decline in over five years, it is not surprising that some analysts have even pegged the Sensex earnings for FY10 at about Rs 600-700.

This is nearly half of the earnings estimates done in March 2008, or 17-30 per cent lower than expected earnings for FY09. Among the not so pessimistic views are those of Manish Sonthalia, Senior VP Research & Strategy, Motilal Oswal Securities. "Considering the current scenario, our conservative estimate is about Rs 850 per share. I do not think the Sensex earnings could fall to Rs 600-700 levels." Although not many see a dramatic fall in the earnings, opinion is equally divided (between 0-10 per cent and -10 to 0 per cent; see results of poll) over the growth in earnings for FY10. This in turn, suggests that a significant deceleration in earnings could be a reality only if things worsen from hereon.

Are fundamentals improving?

It is thus, imperative for investors to be cautious in terms of interpreting the valuations and growth numbers as there is no justifiable recovery in the fundamentals of companies and demand in sight. In fact, companies in sectors including auto, cement, metals and real estate among others have shown significant deterioration in revenue and earnings quality.

Additional proof of this is the industrial production number, wherein growth rates fell from about 5-7 per cent in July 2008 to a negative two per cent in December 2008. Although, there has been some recovery in a few core sectors such as cement and steel, it could be short-lived. "Even if there is recovery in the industrial numbers during some months, it would not sustain as corporate confidence and demand is still low," says Yashika Singh.

"We would have to look at more data points before commenting on a trend, as one month data could be misleading. Manufacturing is likely to remain under pressure over the near-term, due to growth slowdown and fall in exports," says Sukumar Rajah, CIO - Equity, Franklin Templeton.

Andrew Holland, CEO- Equities, Ambit Capital believes that the increase in capacities (in cement and steel) has led to higher production, and it is not necessary that it is due to higher demand. Hence, higher inventory is exactly what's going to happen.

Even on the GDP front, the government officials are eyeing GDP growth of about 7 per cent in FY09, which is possible given the robust economic performance in the first half. However, the challenge now is to prevent a sharp slowdown in FY10. The International Monetary Fund (IMF) is expecting the Indian economy to grow at just 5.1 per cent in 2009, which is far lower than 9-10 per cent growth seen in FY08.

Among factors that could indicate a recovery include pickup in credit, sustained rise in industrial output and better employment outlook on the macro front. An improvement in consumer and business confidence would be the key towards improvement in fundamentals.

Helping hand

Positively, the decline in commodity prices (metals, crude oil, etc) is helping companies contain costs, the benefits of which will be visible from Q4 onwards. Likewise, the RBI's monetary measures such as cut in the cash reserve ratio, repo and reverse repo rates and statutory liquidity requirement towards improving liquidity and lowering interest rates, should help corporate raise funds and save on interest costs. But, here too, the full impact is yet to be seen, which will happen only if consumers start spending (leading to improved demand), which is a prerequisite for companies to make new investments.

Additionally, it is largely the public sector banks, which have cut their prime lending rates. Whereas, an across the board cut in interest rates is yet to seen. The private banks are still lending at relatively higher rates of 13 per cent, depending on the borrower's profile. The easing by RBI has not been completely transmitted in the form of lower lending rates.

Experts though expect private sector banks to start cutting lending rates from the beginning of FY10. Says Seshadri Sen, associate director, Macquarie Securities, "We think that aggressive monetary easing will drive lending and deposit rates down by 200�300 basis points over the next two quarters. This, in turn, could trigger a mild economic recovery in the second half of FY10."

Also, since inflation is now below four per cent and expected to fall further, experts believe another round of rate cuts by the RBI. "In our opinion, the RBI still has enough room to ease rates further. Few more negative macroeconomic variable (exports, industrial production) coupled with further fall in inflation will pave the way for further cuts.

We may see the RBI in action even before the end of the month. We foresee a 100-150 basis point reduction in rates by the Q1 FY10," says Vikram Kotak, CIO, Birla Sun Life Insurance Company. Overall, there are some positives, but for the real impact to be felt, it could still require two to three quarters.

Fiscal stimulus

Besides the monetary measures, the announcements by the government are equally important. As it was apparent that the economy is headed for the slowdown and that corporates will face tough times, it was the turn of the government to take the initiatives. We have seen the government so far, announcing two fiscal stimulus packages.

The first one included a Rs 20,000 crore (Rs 200 billion) package involving a four per cent cut in the Cenvat rate across product categories, and aimed at revival of the economy. Also, the cut in fuel prices (Rs 5 per litre on petrol and Rs 2 per litre on diesel) was aimed at helping corporate India to cope up with the slowdown.

But, experts believe that most of these packages were short on expectations and insufficient to tackle the current scenario. Instead, there are concerns being raised with regards the growing fiscal deficit, increased spending and duty cuts. This was in addition to the fiscal spending (about 1.5-2 per cent of GDP) due to farm loan waiver, fertiliser subsidy and implementationof the Sixth Pay Commission.

This fiscal deficit is considered to be high (about 5.5-6 per cent of GDP in FY10) especially, in times where revenue receipts of the government is expected to be lower on account of slowdown and a cut in excise. Also, in this context, there is increasing risk or further downgrade in India's sovereign rating by global rating agencies.

FII trends

Should India's rating get lowered, it could only add to the country's woes. The deteriorating economic outlook coupled with increasing earnings risk will also impact the flow of foreign money into Indian markets. The FII investments are crucial for any kind of recovery in the market.

During January 2009, the FII outflow (in cash market) was Rs 4,245 crore, which so far in February 2009 has been Rs 860 crore (compared to an inflow of about Rs 350 crore till mid-February) primarily due to the selling of about Rs 1,100 crore (February 16 to 19). FIIs may continue to sell or at best, not invest fresh money considering the issues pertaining to the domestic and global markets.

While putting some reasons to this, Cameron Brandt, senior global markets analyst with EPFR says, "It is our sense that this has less to do with India, though the Satyam [Get Quote] scandal and the impending elections are giving some FII's pause for thought, and more to do with the sheer scale of the economic problems facing the global economy."

Global worries

While global events will continue to play an important role in providing a direction to Indian stock markets, experts believe the liquidity crunch could remain for some more time as the impact of stimulus packages announced by the central banks and their respective governments is yet to be felt.

Also, with each passing day, there is a growing event risk and there is no clarity as to how deep or severe the global slowdown could prove to be (or when the pains will get over), and how will it impact the developed and emerging world.

Says Holland, "In terms of global economic growth, there is no stability at the moment, because every day we are seeing forecasts being reduced, particularly in Asia and Eastern Europe. I don't think that the situation has stabilised at all. And, I don't think it will, for some time."

He adds, "I don't think any one's got a clue how bad it could be. Thus, it means that liquidity can't be stable in that environment. I think, there are a lot more packages to come and a lot more things to be done," says Andrew Holland.

While the frequency of numbers getting revised downwards has increased, the latest IMF's projections have pegged global growth for CY2009 at 0.5 per cent, which is lowest since World War II.

Little wonder, some money is also seen getting into safer havens like gold, where prices have moved up recently and are hovering close to $1,000 an ounce; in India, it is about Rs 15,600, after touching an all-time high of Rs 16,015 per 10 grams.

Impending elections

Among the short-term domestic worries for the markets, including FIIs is the outcome of the upcoming general election in May 2009, which is crucial for the investors as this will provide some direction regarding future policies and government spending. Predicting market reaction during these times becomes extremely difficult.

A hung parliament or an unstable coalition, whose survival depends on the support from other smaller parties, will have implications on policy decision and the final manifesto of the new government. "With elections coming up, most people and companies may want to see which party comes to power, what packages they bring, what initiative they will get going forward," says Holland.

Strategy and outlook

By now, one thing is very clear, which is that things aren't looking good, at least for the near-term (up to 8-9 months) and any recovery could take about a year more. A majority of the experts we spoke to, the most common recommendations were "wait and watch", "hold some cash", "buy good and safer companies" and "keep your eyes open for opportunities in the market".

Investors will thus, need to wait till there is convincing evidence that the worst is over. This could be in the form of a sustainable and more predictable trend emerging from the leading indicators of the economy and corporate earnings, which as of now are believed, could take another two to three quarters to reflect.

Says Vijay Gaba, Equity Strategist, Banc of America Securities-Merrill Lynch in his research report, "Be cautious, this is also the period when excesses of the past cycle are cleansed. The cleansing process is still on. Some of it might already have happened, some more will follow." Thus, for those with lots of patience (2-3 years)and an appetite for risk, hunting for investment opportunities (and investing in small bits) could make good sense.

With inputs from Vishal Chhabria and Ram Prasad Sahu

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