If the Budget and Economic Survey are correct in their assumptions, the next fiscal should be excellent for the economy. GDP growth will bounce strongly through 2010-11 and should continue accelerating into 2011-12.
This doesn’t necessarily mean that equity investors will reap bumper returns in the next year. For that to occur, there must first be a strong correlation between GDP growth and corporate earnings. Second, there must be a strong correlation between earnings and share prices.
The first correlation exists. The linkage between macro-economic trends and corporate profits has grown stronger. Twenty years ago, a very small percentage of India’s GDP was generated by listed companies. Agriculture made a far higher percentage contribution to Indian GDP than it does now. Much of manufacturing was reserved for unlisted and inefficient PSUs.
Once manufacturing was opened up to the private sector, more companies came to the market to raise funding. Then the financial sector was opened up, along with other services, of course. As services and manufacturing took off, a much larger chunk of GDP became reflected in the balance-sheets of listed companies.
So we can reasonably expect that earnings will grow strongly if GDP does. We can make some further deductions. Growth in the next fiscal will be driven by retail consumption. This is in contrast to growth in 2008-09 and 2009-10, which was maintained by government stimulus, rather than consumption demand.
So a different set of industries are likely to be out-performers in 2010-11. The auto sector is bouncing back, for instance. The signs are evident in Q3 results where there’s been strong growth in car and bike sales.
Real estate and housing should start to recover in the coming fiscal and that will mean better volumes for the financial sector as well. Piggybacking on these industries, the offtake for steel, aluminium, cement and auto ancillaries should improve considerably. The recovery is likely to be disproportionately strong in smaller businesses that suffered more during the slowdown.
However, the second correlation is not guaranteed. Corporate earnings growth is not always reflected in rising valuations. For one thing, share prices have risen strongly through the past year, precisely because fundamental recovery was expected. Unless that recovery exceeds expectations, share prices may not rise through 2010 as much as one hopes.
There are other reasons to anticipate dampened valuation. For one, the government hopes to raise large sums through disinvestment. We’ve already seen FPOs of NTPC and REC. In both cases, a rescue was carried out by domestic financial institutions. Quite honestly, the issues devolved and only the GoI’s clout led to a bailout.
Perhaps the issues could have had better responses if they had been priced lower and certainly the government will have to consider that possibility in future attempts to tap the markets. But one way or another, the primary market will demand a larger chunk of financial resources. That could mean lower secondary valuations because there is only a limited amount of liquidity in the system and the GoI can arm-twist what’s available into PSU IPOs and FPOs, regardless of the objective value of those companies.
External sources of funding for Indian equity are difficult to gauge and cannot be relied upon. The FII attitude to India could change suddenly. While they appear positive on the Budget and on growth prospects in general, there are still very real fears of a “double-dip” in the global economy. Weakness in USA or Europe could create another liquidity crunch where FIIs retreat into hard-currency assets.
Another reason for possibly lower valuations is simply, higher domestic interest rates. Inflation continues to run high and it’s unlikely to come down significantly. At the same time, the demand for money in the system will rise. A lot of the consumption will be driven by hire-purchase or some other form of credit. Businesses will put their expansion plans back on track. All that means is less money for the secondary market.
Higher earnings coupled to lower valuations may mean that prices don’t move a great deal in 2010-11. A pause in the bull-run would be welcome in a situation where the fundamentals actually strengthen. Investors should start moving selectively and systematically into medium-cap and smaller stocks. Don’t be disappointed if there aren’t immediate capital gains. If the economy runs along expected lines, prices will eventually catch up.
This article was originally published on April 03, 2010.
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