Global equity markets continued to decline between January and March 2009 amid renewed concerns about the deepening economic slowdown and the health of the financial sector. This forced the policymakers to intervene aggressively with rate cuts/quantitative easing, bail-outs, liquidity injections and fiscal stimulus packages. The treasury is under pressure due to worries about increased government borrowings to fund these measures. However, there has been a sharp rally in equity as well as debt markets in recent weeks thanks to the quantitative easing measures and efforts to absorb toxic assets.
The ongoing de-leveraging has triggered a negative feedback loop, as shrinking bank balance-sheets have impacted credit offtake, and spending cutbacks by corporates and consumers have led to a demand contraction. The ensuing fall in production and rise in unemployment is exacerbating the demand slowdown. The result has been a broad-based decline in economic activity and a particularly sharp drop in global trade and manufacturing. While there are some signs of stabilisation, it might take a few more quarters before we witness clear signs of a turnaround. The recent domestic economic data (exports, industrial production, tax collections, etc.) reflects the impact of near-term headwinds faced by the Indian economy—difficult credit conditions, demand slowdown and cyclical factors. The downturn is more dominant in the industrial segment. However, the threat to the Indian economic growth remains relatively limited due to the lower share of exports and high share of the services sector (about 55%) in the Indian economy.
This clearly sets the Indian economy apart from its peer group countries that rely on an export-driven economic model and are dependent on manufacturing. Typically, economies go through the manufacturing phase before services dominate. However, the Indian economy made this transition much faster than the other regional economies. In addition, the rural economy remains largely unaffected by the overall slowdown. From a structural point of view, factors such as high dependence on domestic consumption and investment mean that the economy is capable of generating strong growth over the medium-long term.
The high savings rate and a sustained rise in the per capita incomes over the past few years offer support to economic expansion. India's banking system is conservatively run, with a relatively low share of securitised debt. The monetary and fiscal stimulus is expected to provide a fillip to growth over the medium term.
The ongoing de-leveraging and shift in the macroeconomic environment have led to a deceleration in earnings growth in the current fiscal, with an increased possibility of negative year-on-year growth in the next few quarters. While the credit turmoil has made it increasingly difficult for Indian companies to refinance/raise fresh capital, corporate balance-sheets remain in good shape with a low leverage compared to that in the past. The Indian industry is also significantly less credit-reliant than its peers and the exposure to foreign debt seems manageable.
History clearly indicates that while sentiment can sway the short-term direction of the markets, fundamentals matter over the long run. The sharp decline over the past year or so has pushed leading indices to multi-year lows and the Indian equity markets appear to be attractively valued, keeping in mind the historical ranges and growth potential. Here are some measures that put the current market situation in perspective:
Bond and earnings yields: Research has shown that equity market upturns are often preceded by a rally in the bond markets. Over the past few months, monetary easing has helped Indian bond yields ease from the peaks touched in mid-2008.
Earnings-yield gap: The difference between the benchmark bond yields and trailing index earnings is at a historical high and also reflects the increase in equity risk premiums. Such broad pessimism typically presages an attractive long-term buying opportunity.
Price-to-earnings ratio: Between 1998 and 2007, the BSE Sensex moved between a PE (trailing) band of 9.83 times (Oct 1998) and 34.27 times (Apr 2000). Due to the decline over the past year or so, the PE ratio has moved significantly below the historical average (1998-current) of 17.8 times and is currently around 12.69 times.
Price-to-book value and return on equity: India has commanded premium valuations in the past owing to the ability of corporates to generate higher returns on equity. While RoE levels have declined from the recent highs, they still remain attractive compared with most countries and the comparative fall in price-to-book value indicates that from a historical perspective the price levels are lower.
Earnings per share: An index value is typically representative of the growth accrued and future earnings. At the current Sensex value (11,315 on 24 April), the index appears to suggest about 10% growth for EPS over the next 10 years (assuming a constant growth model). We expect earnings to grow by 12-18% over three-five years; the historical average for the index is 14%.
EV/EBITDA: This valuation multiple provides a glimpse of the market value of a business relative to its earnings and is a cash-flow measurement rather than earnings alone. The Indian equity markets have historically traded at an EV/EBITDA multiple of about 11x. Over the past one year, this multiple has fallen sharply and is trading close to historical lows.
The large fiscal and monetary stimulus measures are expected to aid an economic turnaround in the medium term. Markets are likely to stabilise once there is clarity over the future of Western banking and financial institutions. Despite the slowdown, the Indian economy remains one of the strongest across the world due to its inherent strengths, and is likely to be one of the fastest growing economies this year as well.
Sukumar Rajah is CIO, Franklin Templeton Investments (India)
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