After having witnessed the general election results, NSE’s volatility index, India Vix, fell as much as 29% to 19.6 on Thursday.
Yet, even though the markets got what they wanted—a win by the ruling Bharatiya Janata Party—the Nifty fell 0.7% on Thursday. What gives?
While the uncertainty of the election outcome is out of the way, investors are now faced with the uncomfortable question of what they should focus on.
The landscape isn’t very pretty. Beyond the elections, the focus shifts to fundamental issues such as consumption slowdown, unemployment, the liquidity crisis and the country’s fiscal position. Besides, investors also need to grapple with a global slowdown, higher oil prices and trade wars.
“As we can see, the initial rally has fizzled out, clearly indicating that the focus is on fundamentals and global markets, which have a bearing on local markets. While the market sentiment may have improved for now, it is wishful thinking that FIIs will make a massive comeback only on the basis of a thumping electoral victory. Improvement in FII flows may happen based on enhanced economic and corporate fundamentals,” said Tushar Pradhan, chief investment officer at HSBC Global Asset Management (India).
Rahul Singh, chief investment officer (equities) at Tata Asset Management, said, “Nothing much has changed for the market with this election verdict even though the mandate is quite decisive. Given the consumption slowdown and the liquidity crisis, we expect consumption-related themes to give moderate returns in the near term as we await the government’s initiatives to overcome the slowdown. While the market would want a quick fix to these problems, it may not be easy. “
Fiscal balance and rates
The government faces the difficult choice of providing a fiscal stimulus to drive economic growth, while at the same time having to be prudent as far as the fiscal deficit goes. Comments by some market participants suggest the best of both worlds, where India remains fiscally prudent and is also able to provide a stimulus. Instead, it’s quite likely that investors need to be prepared for a negative surprise on the growth front or on fiscal slippage. “There is limited scope for broad fiscal stimulus given India’s high and persistent fiscal deficit, faltering tax revenues and broken business models in agriculture and infrastructure,” analysts at Kotak Institutional Equities said in a note to clients.
Perhaps it can try and strike a balance. “We expect government spending to be targeted towards infrastructure than populist measures,” said Sahil Kapoor, chief market strategist at Edelweiss Investment Research. Kotak’s analysts say a fiscal stimulus should be directed to specific sectors such as housing, for example.
Bond traders share this view. They believe that the clear majority for the ruling party gives the government enough firepower to avoid populist measures. That said, the biggest support to bond yields has been from the Reserve Bank of India’s (RBI’s) purchases and this is likely to continue. Moreover, with the benign retail inflation outlook and an expected cut on policy rates by RBI next month, yields could go further down, according to traders. That said, there are headwinds that need to be addressed and the policies of the government will come into focus now. “After the results, attention here on will return to the to-do list, key amongst which is the need to address the ongoing cyclical slowdown in growth and continue with the reform agenda,” said Radhika Rao, economist at DBS Bank.
Hopes are also riding on an easing of the liquidity situation to try and address the NBFC (non-banking financial company) crisis. Some of the recent slowdown in growth rates at automobile makers and consumer goods firms is said to be partly because of the tight liquidity in the system, what with a number of non-bank lenders being constrained in their finances.
“Economic growth should be led by bank credit growth. We need banks to be back to lending. For that, liquidity policy needs to change. Liquidity is important and the solution should go beyond just a rate cut by RBI,” said Jayesh Mehta, head of treasury at Bank of America Merrill Lynch.
While analysts expect RBI to cut interest rates in its forthcoming monetary policy in June, they also expect some other measures to boost liquidity in the system to buoy the NBFC sector. However, the central bank recently refuted reports that it is considering a credit line for NBFCs, and it remains to be seen how the liquidity crisis will be navigated.
Valuations and stock picks
For over a year now, large-cap stocks have had a runaway rally, while mid-cap and small-cap stocks have lagged. In the process, valuations of large-cap stocks have risen to extremely high levels.
The Nifty 50 index trades at a one-year forward earnings multiple of nearly 20 times, which is totally out of sync with the single-digit growth rate in earnings in recent years. Even if earnings growth rises to higher levels, it will still have much catching up to do, given where valuations are.
In this backdrop, some analysts expect a broad-based rally, where stocks outside of the top few also participate. While this makes sense, it’s also true that smaller firms have been affected more by the liquidity crisis. So unless the dust settles, it may be premature to jump into the above narrative and buy small-sized stocks en masse.
As always, investors will be best served by pursuing stocks that are fundamentally strong and are better placed than competitors in navigating the multiple challenges in the economy.
As for corporate earnings, the March quarter results haven’t been very impressive. “The quarterly results thus far indicate an all-round slowdown in consumption…with a significant contraction in profit margins. The consensus earnings for FY19 have been cut by 11.4% since the start of FY18. The earnings cut is the highest recorded in the past three years. We also note that the intensity of the earnings cuts has accelerated over the past five months,” Nomura India said in a report on 17 May.
With earnings growth continuing to be weak, the markets are riding on hope. Fundamentals have a lot of catching-up to do for current valuations to make sense.