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Scary on the Top

Liquidity rush from major central banks has pushed markets into a high valuation zone. Why investors should tread cautiously as India gets into pandemic fatigue

Illustration by Raj Verma Illustration by Raj Verma

Covid-19 was just a seven-month event for equity markets. From a three-year low on March 23 to fresh high on November 6, the 30-share BSE Sensex and its broader peer, NSE Nifty 50, have shown that the only thing certain in stock markets is uncertainty.

While the sharp decline in February and March this year was triggered by fear of a sharp contraction in economic activity and corporate earnings, the rise has been driven by hope of a quicker-than-expected recovery in headline macroeconomic and corporate parameters.

The Sensex climbed 315 points to reach a fresh high of 43,952 on November 17, while the Nifty moved up 94 points to a new high of 12,826. Nifty has risen 1,231 points, or 10.6 per cent, in November.

Indian stock markets had been rising steadily after the slump on September 24 that was caused by warnings from US Federal Reserve officials regarding sluggish economic recovery. The rally got a shot in the arm from victory of Joe Biden in US Presidential elections on November 7. As a result, the combined market capitalisation (m-cap) of all listed and traded companies on the BSE reached an all-time high of Rs 170.6 lakh crore, as against the pre-Covid high of Rs 163 lakh crore. This is despite the fact that corporate profits during the September 2020 quarter were 18 per cent lower than pre-coronavirus levels. The combined net profit of listed companies, excluding telecom operators Bharti Airtel and Vodafone Idea, was up 18.8 per cent, marking a sharp turnaround from 53 per cent dip in June 2020 quarter and 41 per cent in March 2020 quarter. Net sales, however, fell 5.5 per cent, the fifth consecutive quarter of revenue contraction.

Two factors were behind such strong growth in profits. "One, corporate tax cut in September last year showed up in numbers this quarter. Two, fall in operating expenses for a considerable number of companies, a trend not likely to sustain once the economy completely unlocks and businesses reach their pre-Covid levels," says Nirali Shah, Senior Research Analyst, Samco Securities.

"Market has a habit of over-reacting in the short term, but once things normalise, the pace of PAT growth should shrink and prices will follow suit," she says. And so, investors should tread carefully in the current scenario.

Record High Valuations

At close of trading on November 17, Nifty 50 was trading at a record high valuation of 35 times its underlying trailing 12 months earnings per share (EPS). In comparison, Nifty's average P/E multiple in the last 10 years has been around 22x. The price-to-book value of the index is also at a premium to its historical average.

Prior to the pandemic, Nifty's highest valuation was 30x in June 2019. BSE Sensex is trading at 31.4x trailing EPS. This is its highest since the days of the Harshad Mehta rally in early 1990s, though the index structure and its calculation were completely different then and the numbers are not strictly comparable. "High valuations remain the key concern as liquidity rush may have pushed us ahead of fundamentals," says Amit Shah, Head of India Equity Research, BNP Paribas. So far, in 2020, India has seen inflows of $8.6 billion after outflow of $8.3 billion in March itself. This has aided market recovery (barring China, all Asian countries have seen net outflows), he says.

Interestingly, there is high correlation between growth in US Federal Reserve balance sheet - which determines liquidity in global markets - and Nifty 50. The Fed resumed balance sheet expansion in July this year after contraction in June. Its balance sheet hit a high of $7,175 billion on November 11; this coincided with Nifty touching a fresh high.

Given this, it is tough to say whether only liquidity is driving markets or investors really expect record high corporate earnings and cash flows next year. "In a liquidity-driven environment, this may not be a big premium, but earnings estimate for FY22 over FY21 is where we are worried. Street estimates 40 per cent growth in earnings of Nifty 50 companies in FY22, which seems a stretch to us, making current Nifty levels a bit expensive," says Amit Shah.

Nifty 50 companies' earnings had grown at a compounded annual growth rate of around 3 per cent from around Rs 385 in January 2015 to Rs 450 in January this year. A part of even these meagre gains came from cut in corporate income taxes in September 2019.

But optimistic investors expect India Inc. to report much faster earnings growth for the next two to three years. For them, Covid-19 related dip in revenue and profits is transitory. Nirali Shah says markets will continue their momentum as quarter-on-quarter recovery in earnings with opening up of the economy, lesser contraction in growth, record GST collections and improved Purchasing Manager's Index (PMI) figures show that things are normalising and returning to pre-Covid days. Manufacturing PMI touched an all-time high of 58.9 in October 2020 after a record low of 27.40 in April this year. "Moreover, a number of macro factors like ample liquidity, record low interest rates and expectations of fresh stimulus are acting as tailwinds," she adds.

Others, however, caution investors about reading too much into this. "PMI captures near-term and sequential bump-up in orders and is blind to longer term manufacturing output trends. Companies are right now flooded with orders due to pent-up demand and restocking by dealers, which is showing in PMI, but this is likely to vanish post Diwali," says G. Chokkalingam, Founder & MD Equinomics Research & Advisory Services. Not surprisingly, index of industrial production grew just 0.2 per cent in September, indicating a subdued industrial sector.

Rotation Amid Pandemic

All these factors have also changed the dynamics of equity market as new sectors gained prominence while India navigated its way through the pandemic. "Sector rotation is usually a sign of a healthy market. Coming out of the lockdown, we saw consumer staples, pharma and IT do well. Then, as the lockdown ended, autos and retail lenders led the rally. In the near term, we think there will be sector rotation once again into defensives like IT and pharma as market valuations appear to be stretched," says Shah of BNP Paribas.

The markets also continue to remain polarised as the largest chunk of inflows is going into stocks in benchmark indices. The rally in the pharma sector is likely to continue due to steep downslide in the past few years on account of US pricing/regulatory pressure and the pandemic.

BFSI, especially private sector banks and a few NBFCs, also have scope to drive markets higher as they are comparatively undervalued. "Bank Nifty, in fact, still has the potential to touch its 52-week high. That can take private banks higher," says Nirali Shah. Banks and NBFCs have nearly 40 per cent weightage in the Nifty; a rally in these will surely push markets higher.

Vinit Bolinjkar, Head of Research, Ventura Securities, sees clear earnings visibility in IT, telecom and, to some extent, pharma. "Globally, organisations have started investing more in IT infrastructure to improve workflow from home, which has increased order book of companies. Similarly, increased use of retail internet packs has significantly improved the earnings potential of telecom companies. Pharma is expected to gain on Covid vaccines and sale of immunity booster drugs," he says.

The announcement of a vaccine for Covid-19 has given a big leg-up to markets, reducing the threat of the pandemic alongside. Serum Institute of India is looking to prepare 100 million doses of AstraZeneca's Covid vaccine by December this year. "I don't think the market is expecting any disruption due to the pandemic any more, more so after the announcement of the vaccine. Hence, if a second wave leads to a severe lockdown, we may again see a big correction. In absence of that, I don't expect any big correction," says Santosh Kumar Singh, Head of Research, Motilal Oswal Asset Management Company.

Amit Shah agrees that second and third waves of Covid, unless very severe, will largely be a non-event as India begins to get into the pandemic fatigue zone. "Moreover, the current economic recovery is fairly sustainable, as indicated by most high frequency indicators that we track in addition PMI and IIP. They all indicate a steady recovery not driven by pent-up but actual steady demand," he says.

The Reserve Bank of India data on bank credit, however, suggests the economy and the corporate sector are back to the pre-Covid trajectory of slow growth rather than breaking into a new territory. The credit flow to the industrial sector has been stagnant between April and August this year, which means fewer companies are building new units or expanding capacity, two things that can drive future growth. And as always, non-food credit growth is being driven by personal loans, which is not a sustainable way to grow. Total non-food credit rose 6 per cent till August this year as against 12 per cent growth in FY20.

Betting on Biden

But the market is not focused on these details. It has received a fresh boost with election of Joe Biden as US president. Analysts believe that Indian markets, along with their Asian counterparts, will benefit from more measured policy announcements. Biden, even as Vice President in the Barack Obama government, has been a proponent of stronger ties with India. Singh says if the new government decides to push ahead with globalisation, it could be a positive for Indian businesses. Low interest rates and high liquidity will further support markets here.

While it is widely believed that the Biden government will be more India-friendly, the impact may actually be muted in the long term. Indian businesses and markets can be disappointed by failure of Democrats to acquire majority in the US Senate. Both Republicans and Democrats have equal number of members and Republicans are not expected to approve any fiscal policy from Democrats, both as a matter of principle and politics. "Because of the Senate stalemate, the US fiscal stimulus would be lower than what was expected if Democrats had controlled the Senate," says Shah of BNP Paribas.

In such a scenario, it is important for investors to place their bets carefully. "Currently, the biggest risk investors are facing is uncertainty from structural changes in habits and consumption patterns of consumers in the aftermath of Covid. The pandemic has made the current environment unpredictable. The permanent changes in behavioural patterns need to be assessed correctly to make long-term gains," says Nirali Shah.

She believes it is safer to maintain a stock-specific approach and invest in quality companies with strong balance sheets, less leverage and good free cash flows. "If an investor needs still safer investments, then fixed deposit or sovereign funds can be a good substitute because sometimes no investment is the best investment," she says.

Bolinjkar says investors need to remain careful regarding consumer-centric sectors such as retail, non-essential FMCG, multiplexes, restaurants and aviation because a second Covid wave could scare off consumers, hurting revenues of these sectors. "We would recommend increasing the weight of IT, telecom, pharma, metals and essential FMCG in the portfolio. One can also accumulate engineering and infrastructure stock because they are expected to outperform during recovery," he says.

Yet, the most rational piece of advice is to diversify investments over various asset classes.

"Diversification is the key to insulate one's portfolio and having 30-35 per cent in equities, 40-45 per cent in bonds, 5-10 per cent in gold and 5-10 per cent in sovereign funds seems like a good start for an average investor in the current situation. Also, if there is a correction in equities, investors can increase their allocation by reducing debt," Nirali Shah suggests. After all, it's never a great idea to put all the eggs in one basket.

(Rashmi Pratap is Co-founder & Editor of