On a Weak Base

Equity markets are buoyant in spite of mayhem in the real world. But the risks building up are too big to be ignored

Illustration by Raj Verma Illustration by Raj Verma

There is an old saying that when a pigeon sees a cat, it closes its eyes, and assumes that it is safe. Indian equity markets are being just that pigeon, ignoring risks and overlooking facts. Despite reality staring in the face, investors refuse to pay heed to economic and financial risks due to the disruption from the second wave of coronavirus. Defying the rising death count, case load and slow pace of vaccination, the benchmark BSE Sensex reclaimed mount 50K even as daily official deaths hit an all-time high of 4,329 on May 18 and state after state announced lockdowns to slow the spread of the virus.

With this, Sensex is up 5.1 per cent since the beginning of the calendar year, trading at a price to earnings (P/E) multiple of 32 times, becoming one of the most expensive equity indices in the world. Sensex is nearly 25 per cent higher than the 25.5 times that Dow Jones Industrial Average, the worlds top equity index, is trading at. Sensex is also among the most expensive in Asia and nearly twice as expensive as the Shanghai Stock Exchange Composite Index (see The Risks).

The rally in second and third tier stocks has been even more ferocious. BSE Mid-Cap Index is up 18.3 per cent year to date (YTD). It is trading at nearly 55 times trailing earnings per share. BSE Small Index is up 26 per cent YTD; its P/E multiple is 62 times.

Since domestic investors largely bet on small- and mid-cap stocks, while foreign portfolio investors (FPI) focus more on large-cap and index stocks, there are indications that domestic investors have been far more optimistic about India Inc.'s future than foreign investors. In their optimism, they are overlooking several big risks staring them in the face.

A 2020-like Rally? Not Easy

The rally in 2020 was fuelled by expectation of a V-shaped recovery in corporate earnings and India's economic growth in second half of FY21 and FY22 after a washout in first half of FY21 due to the Covid-19 lockdown. The optimism around corporate earnings was boosted by a sharp dip in commodity and energy prices in first half of FY21, mostly due to sharp fall in demand, and an equally sharp decline in interest rates that had continued for most of FY20.

This combination of lower finance and input costs enhanced margins, leading to double-digit growth in net profits despite lower revenues. Corporate profits rose 27.3 per cent in FY21 despite 2 per cent decline in net sales. Raw material costs for manufacturers fell around 7 per cent in FY21. Many companies also profited from decline in labour and sales & marketing costs and other overheads in FY21 due to the pandemic and adoption of work from home.

These tailwinds are gradually turning into headwinds as commodity and energy prices rise sharply, increasing input costs, even as the second wave of Covid-19 lowers corporate India's growth potential. "If infections do not decline to more manageable levels, lockdowns may increase in scope, leading to a more severe impact on earnings recovery. This will weaken rated companies' earnings and derail the recovery seen over the last six months," Moody's Investors Service analyst Sweta Patodia says in a report on May 18. Also, interest rates are going up globally. All this raises a question mark over the unbridled optimism among equity investors.

Steady rise in commodity and energy prices also pose a risk to corporate earnings. Brent crude oil has doubled to $70 a barrel in the last 12 months. Industrial metals such as aluminium, steel, copper and zinc rose 80-100 per cent during this period. Higher commodity and energy prices will translate into rise in costs and lower margins for manufacturers in FY22. "Rising costs could pose headwinds to companies as they recover," says Dharmakirti Joshi, Chief Economist at Crisil.

Most non-essential services as well as manufacturing activities have come to a halt in most parts of the country either due to Covid-19 lockdown or diversion of industrial oxygen for medical purposes. This is expected to hit corporate revenues and profits in first half of FY22. "Production will decline in industries such as steel that use oxygen," says Patodia of Moody's.

Declining GDP

Stock markets are also ignoring forecasts of decline in GDP, which means corporate performance will be hit as well. Shankar Sharma, Co-Founder and Chief Global Strategist, First Global, says there are significant risks because it is not clear how long the second Covid wave will last. Almost 90 per cent of the country is under lockdown. "There aren't enough vaccines and inoculating the whole population will take a long time. This year appears to be washout without doubt," he says. Sharma says 10-11 per cent GDP growth projections for FY 22 will be lowered. "You will have more like mid-single digit growth of 5-7 per cent, which means that on a two-year basis, the economy is still down," he says.

On May 11, Moodys Investors Service slashed the GDP growth forecast to 9.3 per cent, from 13.7 per cent in February this year, saying the second wave of coronavirus will hamper economic recovery. S&P, too, said India's growth rate could drop to 9.8 per cent under the 'moderate' scenario and 8.2 per cent in the 'severe' scenario if Covid cases peak in late June; it had projected 11 per cent growth earlier. Joshi says the second wave is a healthcare and economic challenge.

Overvaluation Risk

Despite worsening macroeconomic indicators, there has been no let-up in the rally on Dalal Street. What is compounding the risk is that most top index companies are now more expensive than they were before the pandemic. In the information technology (IT) sector, which accounts for nearly one-fifth of index market cap, P/E multiples are now 50 per cent higher than before. For example, Tata Consultancy Services (TCS) is trading at a P/E multiple of 36 times as against 24 times at the end of January 2020. Infosys' P/E has jumped from 21.6 times to 31.4 times during the period. TCS' 15-year average P/E multiple is 22 times while Infosys' long-term average P/E multiple is 20.4 times.

Another heavyweight, Reliance Industries, is now valued at 44 times earnings as against 25.4 times before the pandemic. In pharma, P/E multiples have doubled during the period. This means investors are expecting a dramatic rise in earnings of pharma companies in FY22, ignoring the downside risks from the second wave of Covid. "One-year forward Nifty valuation stands at 21.4 times earnings, which is at the higher end of the historic range, posing a downside risk if earnings disappoint in FY22," says a fund manager at a leading mutual fund.

The Indian equity market remains one of the most expensive globally as well. For example, China's Shanghai Composite is trading at a P/E multiple of 15.7 times, half that of Sensex, while South Korea's Kospi is at 19 times. In India, the index P/E is 11 per cent higher than the pre-Covid peak of 28 times and nearly 65 per cent than the valuation at the end of April last year.

Amid these risks, fund managers say investors should take a stock-specific approach. "There are companies that make you money every year regardless of the macro outlook and there are those that rarely make you money regardless of the external environment," says Saurabh Mukherjea, Founder & CIO of Marcellus Investment Managers.

"So, at any given point in time, there will be a handful of stocks where you stand a good chance of making money."

Inflation Is Back With a Bang

Rising commodity and energy prices are also putting pressure on retail inflation. In April, wholesale price index-based inflation surged to an all-time high of 10.49 per cent due to low base effect amid rising food and commodity prices. "Wholesale inflation in April 2021 scaled up to 10.5 per cent compared with 7.4 per cent in March 2021 and -1.6 per cent in April 2020. This growth has been the highest since 2012," says Madan Sabnavis, Chief Economist CARE Ratings.

Rising inflation has already started affecting India Inc.'s operating costs. "Rising crude oil prices not only push up fuel inflation but can also keep core inflation high by pushing up transportation costs. International prices of metals and edible oils have also risen sharply. This is raising manufacturing costs," says Joshi of Crisil. Higher inflation also means lower purchasing power, lower demand for goods and services and thus pressure on corporate earnings. It could also lead to currency depreciation and higher bond yields, both of which are considered negative for equity markets.

Retail inflation is also inching up. Consumer Price Index inflation rose to 5.03 per cent in February after falling to a 16-month low of 4.06 per cent in January.

FII Outflows

Not surprisingly, foreign investors have turned cautious on Indian markets. FIIs turned net sellers in April and May after being net buyers in first three months of 2021. FIIs sold shares worth Rs 8,836 crore (on a net basis) in April and have sold Rs 6,144 crore worth of shares in May so far, according to data from National Securities Depository Ltd. Since FIIs own nearly a half of all free-float shares (in terms of value), this may keep markets under pressure. FII actions usually are a big factor in market movements in India.

A combination of high valuations and poor corporate earnings in FY22 could also give a jolt to Dalal Street, especially if the Federal Reserve begins to tighten its monetary policy due to surge in inflation in the US.

It's time for equity investors in India to turn cautious after a year of over average returns. The risk-reward ratio is not in favour of bulls any more, unlike in March last year when valuations had fallen to the lowest level since 2014.

(Rashmi Pratap is Co-founder & Editor of