Equity Markets – Correcting… What should you do??

·        Oil Prices
Oil prices have risen about 35-40% from the low levels seen in the recent past. Currently at 65 Dollars per Barrel.
India has benefited disproportionately from the sharp fundamental fall in crude prices. Crude price has fallen from ~110 in the FY 14 to ~65 now. India's crude import bill for FY 14 was 165 Billion USD. The sharp fall has helped the economy save nearly 50 Billion USD. The budgeted subsidy bill for petroleum has been reduced by Rs. 30K Crs. Further, with the fuel reforms, the pressure on Government from increasing crude prices is far lower. India will be easily able to manage the current oil prices (or even a marginally higher levels from now). In addition, the fundamental outlook for crude is for the prices to remain muted. Therefore, the recent hike in the prices is not a major concern.

·        Rupee
Rupee has depreciated to 64 levels against the Dollar - lowest in 20 Months
However, despite the recent depreciation, Rupee is one of the Best among EM currencies. Rupee has lost just 1.86% in the current year, as against Turkish Lira or Brazilian Real, which have fallen by about 14%. Over the medium term, sustained economic growth will attract capital flows, and help Rupee.

·        Bond Yields

10 Year G-Sec Yields inching closer to 8%

The movement in gilt yields is in line with sharp sell-off in the global bonds. US 10 year Yield went up to 2.24% before retracing to 2.19%, a sharp increase in the recent past, perhaps on the fear that oil prices could go up further. Our view is that India is one of the few countries in the world, which could afford to cut interest rates meaningfully - Current over-night rates are 250 bps above CPI inflation. Rates across the yield curve far higher. The Central Bank is targeting a real rate of 1.5-2%, leaving enough headroom to cut rates. Continuing fiscal prudence, disinflationary trends and benign liquidity scenario are expected to result in lowering of interest rates.

·        Fund Flows

FII outflow in the recent past.

FIIs have pulled out nearly Rs. 4000 Crs in May so far. However, FIIs have been consistently investing into India over the longer term. Since 2009, they have invested 120 Billion USD, an average of 20 Bn USD per year. They have been net sellers only in 2008-2009 during the global crisis when they had sold 10.4 Bn USD. With the fundamental outlook for India remaining strong, we expect FII flows to be robust. In addition to FII flows, Domestic Flows will also help. Mutual Funds, for instance, invested 6.6 Bn USD in 2014.

·        Flows to other countries

Countries like China, Korea, Taiwan and Japan have been attracting inflows in the recent past
Most investors were heavily underweight in countries like China because their economy was systemically slowing down. However, cheap valuations have started attracting fund flows recently. For instance, since the beginning of August 2014, their markets have gone up by nearly 85%. Some of the recent IPOs have also attracted flows into China. However, over the medium to long term, investors are likely to be guided by fundamentals, and hence we believe India is well-placed to receive flows. In Dollar Terms, Indian equity markets are at the same level as in May 2014, around elections, making it particularly attractive for FIIs

·        Sharp run-up in markets

Indian equities had gone up by 55% since Sep 2013 (since Mr. Modi was announced as BJP candidate), before the current correction of 8-10%.
There may be a bit of fatigue and profit-booking in some stocks. However, valuations of Indian equities very attractive. At 19x trailing P/E on low cyclical earnings, and 15x 2 Yr Fwd PE on expectations of decent turnaround in earnings, the valuations are quite attractive. Market Cap / GDP at 75% low in absolute and relative terms.

·        Concerns on MAT

Uncertainty around MAT may also be playing on the minds of investors
It has been clarified in the Budget that MAT will not be applicable from Apr 1, 2015. However, the claim from past transactions and the uncertainty about the applicability has spooked the FIIs. The amount involved is expected to be small - the amount that is being mentioned are anywhere between Rs. 500 - Rs. 5000 Crs. Stay has been granted to Aberdeen, one of the largest FII investors. Government is also setting up a committee to resolve the issue at the earliest. We believe the issue will be addressed very soon.

·        Earning Growth

Subdued earnings growth

Corporate India’s growth was subdued because no meaningful investment was made in the past – average capex from 2012-2014 has been 1.75%. In addition, the persistently high-interest rate scenario resulted in subdued earnings, despite a reasonably good sales growth (16% CAGR between 2008-2014). We expect this to turn around, and corporate earnings to grow meaningfully on the back of operating leverage and financial leverage.

·        Policy Issues

Reforms being implemented

Government is firmly committed to bringing about key reforms and implementing them. GST has been passed in the Lok Sabha, diesel price has been deregulated, gas price revision, targeted subsidy, hiking FDI limit in critical sectors of Railways, Defence and Insurance, etc., to name a few. We are confident that more such reforms will get implemented, benefiting the economy.

Bottom line: India is extremely well-placed for long-term economic growth and to generate attractive equity returns. The current market correction should be used as a good opportunity to increase allocation to equities

Is the India-story intact? Should investors invest into equities now?

Yes, very much!

·        The Fundamental Story

o Building blocks in place. Rapid growth round the corner.
§ Financial Inclusion – with almost ~100% of eligible India under UIDAI (Unique Identification Authority of India) to lead to Direct Benefit Transfer (DBT) of all social sector schemes, Banking & Insurance penetration
§ Project Monitoring Group – clearing high impact projects. Almost ~$100bn worth till Dec.’14
§ Goods & Services Tax : The most awaited and ambitious indirect tax reform
§ Power sector reforms : Coal mine auctions, Increase transmission network & substantially reduce distribution losses
§ Railways reforms : Proposes to spend over $100bn over next 5 years to expand & upgrade
§ Large infrastructure projects : Dedicated Freight corridors, River Linking project, Metros
§ Road Sector reforms : Efforts to fast track & execute almost $60bn+ of road projects
§ Make-in-India Initiative : with emphasize on Defence & Electronics manufacturing
§ All-round Business-easy reforms : Establishing National Institution for Transforming India (NITI) , single window clearances, online approval systems, e-tenders – leading to substantial reduction in bureaucracy
§ Digital India : To spend over $15bn over next 5 years; e-governance services across spectrum, in addition to complete urban digitization - to connect over 2.5 lac villages
§ Agriculture reforms : Restructuring Food Corporation of India (FCI), Apicultural Product Market Committee (APMC) reforms, Soil health cards, Farmer insurance, proposal for National Irrigation scheme, Easing supply side bottle necks
§ Housing for all : Aims for housing for all by 2022, Affordable housing mission
§ Ambitious foreign trade policy : to grow exports from $466bn in FY14 to $900bn in 2020

o Subsidy savings and innovative revenues give Government financial muscle to spend on the economy.
§ Coal and spectrum auctions have been highly successful (Auction and allotment of 67 blocks has unlocked over $55bn ( 335k crs ) for states / Telecom spectrum auctions raised $17.6bn - Over 1 lac cr )
§ Disinvestments : CY15 targeting to raise Rs. 55k crs i.e $9bn (Several other big ticket disinvestments in pipeline – Hind. Zinc, Specified Undertaking of The Unit Trust of India (SUUTI), Coal India, ONGC etc with cumulative potential of $20bn+ )
§ Banks allowed to raise funding for infrastructure with minimum SLR / CRR requirement
§ Fuel Reforms has reduced the budgeted fuel subsidy bill by Rs. 30,000 Crs, a drop of 50%
§ Rationalized subsidies and trimmed wasteful expenditure like Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA). LPG subsidy through Direct Transfer. In the long-term (>3 years), subsidy rationalization could result in savings of $5 Bn+
§ GST implementation will result in improved tax collection, and is expected to add to the GDP growth

o Huge investments totaling Rs. 24 Lakh Crs envisaged
§ Railways to invest over ~600,000 crores over next 5years on expansion & up gradation
§ Digital India - ~1,13,000 crores (Over next 5 yrs)
§ Roads ~5,00,000 crores (Over next 5 yrs)
§ Healthcare (National Health Assurance Mission): ~1,60,000 Crore (Over next 4 yrs)
§ Swacch Bharat Mission : ~2,00,000 crore (Over next 4 yrs)
§ National Rural Housing Mission: ~3,45,000 crores (by 2022, next 7 yrs)
§ Solar ( Renewable Energy ) : ~6,00,000 crore ( In next 7 yrs for 100,000 MW )

These initiatives envisage about Rs. 24 lac crores ($400bn ) of investment, entailing both Govt. & Private , Domestic & Foreign Investors

o Combination of low interest rate and economic recovery will lead to higher profit growth for Indian companies

§ India is one of the few countries in the world, which could afford to cut interest rates meaningfully
· Current over-night rates are 250 bps above CPI inflation. Rates across the yield curve far higher. The Central Bank is targeting a real rate of 1.5-2%, leaving enough headroom to cut rates
· Continuing fiscal prudence, disinflationary trends and benign liquidity scenario are expected to result in lowering of interest rates
§ Corporate India’s growth was subdued because no meaningful investment was made in the past – average capex from 2012-1014 has been 1.75%. In addition, the persistently high-interest rate scenario resulted in subdued earnings, despite a reasonably good sales growth (16% CAGR between 2008-2014)
§ We expect this to turn around, and corporate earnings to grow meaningfully on the back of operating leverage and financial leverage
We believe equity markets would capture the growth in earnings, to provide reasonable returns over the medium to long term.

·        The Valuations story

·        Reasonable Valuations – The market has risen ~55% in ~18 months, before this short-term correction. Market is nowhere close to bubble valuations. At 19.5x, based on cyclical low past earnings and given our expectations of structural high RoE & enormous growth potential, it is very reasonable.
o India’s market cap / GDP is ~70%. During the peak of 2008, it was over 100%
o In the previous growth cycle, Earnings became ~3 times in less than 6 years….. Sensex grew 6 times.
o If EPS could grow by 15% till FY 2020, and if we were to assign similar PEs as now, then Sensex would be at 55,000 levels! (~2 times) by 2020
o If EPS actually grows by 20%, Sensex would be nearly at 70,000 levels by 2020!! (~3 times)

·        The Sentiment story

Brand India has never been more vibrant and appealing than now, which will augur very well in attracting foreign flows, both FIIs and FDI.
o A total of 16 foreign trips made by the PM (5 of these for multi-lateral meetings like BRICS, G-20, SAARC )
o Barack Obama & China supports India's bid for permanent UNSC seat
o $35bn investment by Japan over 5 years & expertise in high speed trains
o Australia for supplying Nuclear Power fuel - ~500 tns of uranium
o Canada – First visit in 40 years by sitting PM. Agrees to supply 3,000mt of uranium to power Indian atomic reactors
o CXO’s of global corporations for investment in India: Satya Nadella (Microsoft), Indra Nooyi (Pepsico), Mark Zuckerberg & Sheryl Sandberg (Facebook), Jeff Bezos (Amazon)
o $20 billion investment from China

Summary – what should you do??....….

Simple: Add more equities!!

o The India story is strong and intact.

§ Building blocks in place. Rapid growth round the corner.
§ Subsidy savings and innovative revenues give Government financial muscle to spend on the economy.
§ Huge investments totaling Rs. 24 Lakh Crs envisaged.
§ Combination of low interest rate and economic recovery will lead to higher profit growth for Indian companies.

o Valuations are reasonable.

§ 19x on trailing basis and 15x on 2 year fwd basis
§ Market Cap to GDP ~75% low

o Short-term volatility not-withstanding, Indian equities could generate enormous wealth for investors.
§ Even reasonable earnings growth could result in Sensex growing by 2-3 times from the current levels in the next 4 years

o Corrections such as that happening now should be used as opportunities to add more equities.
§ Do not get swayed by short term volatility, nor attempt to time the markets. On the other hand, look at the direction in which we are headed, take confidence from the fact that things are already happening, and invest for the long-term into equities!