Tuesday, March 20, 2012

>INDIA STRATEGY: Risk-reward not favourable

Global liquidity and attractive valuations have driven a 15-17% rally in the Indian stock market from the start of 2012 to date. Will additional liquidity continue to benefit the market or hurt it? We believe the Indian market’s huge rally post QE-1 in the US and large underperformance post QE-2 provide a good basis for analysis. We find the current conditions similar to the post QE-2 period and, in our opinion, the market seems set to repeat the post QE-2 underperformance, owing to: i) expensive valuations relative to global peers, ii) high crude oil prices contributing to fiscal and current account deficits and inflation, iii) underwhelming preceding-period performance constraining policy action, iv)weak macro-economic fundamentals, and v) weak corporate earnings growth with risk on the downside. Likely political constraints to policy-making too could be added to the list. Market valuations are above their 10-year average, trading at 13.7-13.9x FY13 EPS. We expect Sensex to range between 16000-18600 based on 12.5-14.5x FY13 EPS corresponding to the Nifty range of 4975-5770. Though liquidity could stretch valuations, we expect markets to fall in the next few months to the lower end of the range.

Most expensive relative to peers: At 15.2x 12-month forward consensus earnings, the Indian market is the most expensive among its peers. It is also the second-best performing market YTD (CY12) in USD terms. These could constrain incremental FII inflow, global liquidity notwithstanding, triggering underperformance.

Crude oil at a high, impacting twin deficits and inflation: The India recovery story is largely based on lower inflation leading to interest rate cuts triggering investment. A forced sharp increase in retail oil product prices is likely to push inflation up by 300bps, derailing the recovery, in our view. Fiscal deficit and current account deficit too would be hugely impacted.

Weak macro-economic fundamentals: i) GDP growth recovery likely to be impacted by weak manufacturing sector growth due to lower investment (Q3FY12 loans for capex was down 77.5% YoY and 61.5 QoQ) and agri growth due to base effect and possibly poor rainfall, ii) inflation likely to flare up due to fuel price hike, iii) fiscal deficit set to remain above 5% in FY13 too, and iv) historic high current account deficit leaving the INR hugely vulnerable, are the factors that could trigger a domino effect once again.

Moderate earnings growth: We forecast FY13 Sensex EPS of 1,282 up 16.7% YoY and Nifty EPS of 398, up YoY 16.7%, with some downside risk on account of asset quality on banks, margin pressure on metals and possibly forex loan provisions, if the INR weakens.

Prefer Technology, Auto and Cement sectors: We recommend overweight on auto and cement despite our negative view on the market, as volume growth catches up. The technology sector is likely to achieve Nasscom’s 11-14% revenue growth guidance, with possible INR weakness adding to it.