Rates have been rising since '05 and the trend has pushed home loan rates over double-digits. That will pinch middle-class
01-Jan-2007 •Devangshu Datta
It's almost obligatory at this time of the year (late December) to try and project the likely direction of financial assets in 2007. Most people will be extremely optimistic given that we've seen over 40 per cent returns in the major indices over the past 12 months and a run of over 300 per cent in absolute Nifty returns over the past 42 months.
The sheer length of the bull run suggests that indeed, there has been a paradigm shift in the Indian economy. Indeed, that feeling is backed by the developments of the past four years. We've seen the evolution of a new consumer credit model after interest rates were freed and credit suppliers started concentrating on developing retail business. The resulting boom is real estate values and home-ownership caused a wealth effect. The mutual fund industry raised a record Rs 37,000 crore in 2006 and the longstanding record of Mastershare (1992) was beaten by Reliance Mutual's NFO that raised Rs 5,790 crore.
At the same time, the government embarked on a drive to build a better infrastructure and while the models are still imperfect, better roads and better telecommunications have definitely driven several years of excellent GDP growth and all round corporate performance. The first half performance of 2006-07 suggests that things are getting better.
The financial economy is turning full circle, however. Rates have been on the rise since 2005 and the trend has already pushed home loan rates over double-digits. That will pinch middle-class budgets and reduce the wealth effect considerably. Higher rates make institutions more reluctant to consider risky assets like equity. And it also reduces the rates of return for the financial industry at large.
We can use several basic metrics for valuing equity. Until quite recently, the stock market was a buy on most of these. It isn't any longer.
Take Book Value: According to the Tobin school of economics (which includes a large segment of FIIs), this is the best conservative measure of market valuations. The Nifty class of company is running at an average BV of 5-plus. That is incredibly high even if we adjust for the naturally high BVs of a rapidly growing market.
Take PE and PEG: The Nifty's price-earnings ratio is around 21, which is pretty much at the top of the sustainable range. That implies a yield of just under 5 per cent which isn't attractive in a market where debt is offering well over 8.
EPS growth expectations for 2006-07 are around that - perhaps 25 per cent. So the PEG is edging close to 1 though it is still okay.
My take is, if the EPS growth delivers with a comfortable margin, the market will stay buoyant. One quarter that's lower than expectations, will trigger a deep correction. On static valuation measures, the market is by any standards, stretched to full value.
Can the consumer deliver strong demand in the face of stronger inflation and rising taxes? Can industry supply higher demand given that manufacturing capacity is stretched and new capacity will take a year or three to come in? Can financial assets deliver decent returns?
The questions and answers are obviously linked and it's difficult to know if all of the answers will be yes. There are grounds for optimism but there are also equally logical reasons for pessimism. You could toss a coin and go with that as your view. One thing I do feel is that there will be higher asset volatility throughout calendar 2007. Another is that, it is ridiculous to suggest complete exits of either debt or equity assets. It isn't practicable and it isn't sensible. But you can try and be overweight in specific assets. In a high-volatility, rising interest rate scenario, I think floating debt funds will receive more than their fair share of attention. "Floaters" are immunised to a great extent. That is definitely an asset for the risk-averse.
The other thing will be a trend towards greater liquidity even in long-term assets. Exchange traded funds may gain in volumes as people catch onto their advantages in terms of smooth, intra-day exits. There are already derivative traders eyeing these as the ideal cash market underlyings. In theory, ETFs are as good as it gets as in terms offering spot market hedges for Index futures. If volumes build here, I suspect certain investors would pile in to these synthetic stocks.
Apart from specifics such as these, it's very difficult to take a view. But I suspect conventional debt funds will lose more ground than equity. Any fixed rate portfolio is likely to see value depreciation in 2007, some stocks will not, even if there's a bear market. So in a broader sense, equity should be favoured - even if it could offer overall negative returns.
Happy New Year, Anyway!