Shubh Deepavali and Best wishes for Vikram Samvat 2074. warmly sanjeev
Economy should bounce back strongly in next few quarters
By Prashant Jain 19/10/2017
The last few weeks have witnessed a lively debate about the prospects of Indian economy,
equity markets and earnings. The reasons for this debate have been a slowdown in
GDP growth in the last few quarters, weak
earnings and equity markets that have continued to do well. This divergence between weak economic and earnings growth on the one hand and strong equity markets on the other has raised concerns around two issues — one, whether the
economy is passing through challenging times and two, if markets are running ahead of earnings.
In my opinion, the observations on GDP and earnings growth are correct. But, the conclusion about equity markets is not. Sometimes what is visible is incorrect and what is invisible is correct. Let us deal with these issues one by one.
GDP growth has indeed slowed down in the last few quarters. However, it needs to be borne in mind, that the last one year has witnessed two important reforms — demonetisation and
GST. These, while being very beneficial over the medium to long term, have adversely impacted growth in the last few quarters. The slowdown in growth is temporary and should not be extrapolated into the future. In fact, there are reasons to believe that the economy should bounce back strongly in the next few quarters. Monthly data for July, August and September for several parameters (see first table) already points in that direction.
The outlook for the economy over the medium to long term is actually very promising. The last few years have witnessed a spate of reforms that have improved the macro economic fundamentals of the country and future growth prospects, results of which should soon be visible. This view is driven by a likely acceleration in infra capex, affordable housing and a revival in private capex. According to recent news flow, there are reasons to be optimistic about revival of private capex in the not too distant future, primarily led by the metals sector.
Moving to earnings, the first thing to note is that corporate profitability in general, and specifically for some sectors, is cyclical. The earnings disappointment in the recent past has been mainly due to a sharp fall in profits of sectors like steel, engineering & capex and corporate banks. This, however, is all set to change. With the sharp recovery in steel and other metal prices, with the peaking of provisioning costs in corporate banks, and with a slow but steady improvement in infra capex, earnings recovery is under way and it should become increasingly evident with each passing quarter.
Last quarter's results are already pointing in that direction. In fact, corporate banks and metals that witnessed a fall in profits in Q1FY17 have reported decent profit growth in the Q1FY18, albeit on a low base.
One more related issue is that expectations in financial markets move much faster than in the real world. In the real world, it typically takes two years to build a house, one year to renovate it. But we expect economy growth to surge,
NPAs to resolve, earnings to recover and much more in a few quarters. Unfortunately, to bring about changes in the real world — and more so in a large and complex country like India — takes longer.
That finally brings us to the most topical issue: Equity markets valuations.
It is commonly understood that over the long term, stock market indices in India are growing around the same rate as the nominal GDP (GDP growth + inflation) of the country. Also, it is well known that nominal GDP of India has been growing 12-16% per annum (4-9% real growth and 10-4% inflation) for several decades. This implies that when in any extended period of, say 10 years, indices grow less than nominal GDP, they tend to make up in the future by delivering higher returns.
The second table summarises the returns of the sensex in those 10-year periods (since its inception in 1979), when the returns were less than 7% compounded annual growth rate (CAGR) — approximately half of long-term nominal GDP growth rate of 12-16% — and the returns of sensex for the next 10 years. It is interesting to note that, thus far, every 10-year period of below 7% CAGR of returns by the sensex was followed by a period in which the index delivered 14-19% CAGR over the next 10 years.
Currently, we are at one such instance again as CAGR of sensex in last 10 years is just 6.1%. Equity markets have lagged nominal GDP by 8% CAGR over the last 10 years and are consequently at an attractive market cap-to-GDP ratio. At this juncture, to ignore this significant underperformance of market over last 10 years compared to nominal GDP growth and to conclude that the market is overvalued based on a slowdown in GDP data and weak earnings over last few quarters is not reasonable. Even in price-to-earning (P/E) ratio terms, markets are trading near 17x FY19(estimated, or e) and 15x FY20(e), which are reasonable, especially given the low interest rates. This suggests that equity markets are not excessively valued with a medium- to long-term view.
Successful investing needs more patience than intelligence. The track record of a few mutual fund schemes over decades and the experience of those investors who have stayed invested in these funds for long periods amply demonstrates this. Even in the future, patience should be well rewarded, given the strong fundamentals and growth prospects of the economy.
Let me end this note with a thought attributed to Gautam Buddha: "If the direction is right, all you need to do is to keep walking." Hopefully, even the most ardent critic of economy or of stock markets, will agree that the direction is indeed right.
To read detailed report by Prashant Jain, see attached PDF.
regards
