Revival in earnings is critical for rich valuations to sustain

After rising through most parts of 2017 and up until January 2018, global equity markets have turned jittery. Markets had become exceptionally calm but volatility is now back. A variety of crosscurrents is symptomatic with continued volatility going ahead. While fundamentals continue to support equities, the 2017 goldilocks situation of strong growth, but contained inflation is ebbing.

Growth in key economies is upping their long-term trend. Unemployment is at a multi-year low in developed world. Latest Purchasing Managers Index (PMI) and order inflows suggest continued expansion in business cycle and supports the earnings trajectory. Tax reforms and fiscal stimulus in the US point at further room to run, and consequently draws a line underneath the current equity market tailspin.

But any more good news on growth would imply faster monetary tightening. Concerns lurk over accelerating wage growth implying a tightening labour market, and capacity utilisation coming back. These, in turn, point to a build-up in the inflationary pressures, and possibility of more aggressive rate hikes.

Structurally, rising rates are good for equity market given that it reflects higher growth and restoration of pricing power to the corporates. But in a unique mix of events in last couple of years, global equity rally was also supported by easy liquidity (QE). US equities have benefited from aggressive buy-backs, at times funded by cheaper debt. Tighter monetary policy should lead to higher volatility and act as a headwind for valuations.

While remaining enthusiastic about the synchronised global economic growth, we also caution against the risk-loving behaviour and pressure on resources associated with it. As a result, subsequent economic and financial adjustments can be more aggressive and come sooner than expected.

US has imposed higher import tariffs on solar panels, washing machines, steel and aluminium. It’s not sure yet that it stops here or this is the opening salvo of a broader trade war. Other countries may retaliate. While the reduction in corporate tax is growth positive, the retaliatory import duties from other economies may adversely impact overall trade and growth.

India’s equity markets participated in the global rally, but the economy hasn’t participated fully in the global growth momentum. In line with the weak growth, earnings belied market expectations, yet again. FY18 is likely to see seventh straight year of earnings downgrades.

That said, after hitting the lows on the back of demonetisation and GST-related disruption, there has been a mild recovery in GDP growth. Interestingly, as opposed to the trend of last three years, investment seems to be driving the growth while consumption growth is moderating.

Order inflow for capital goods and infrastructure companies (particularly roads) has shown strong growth. Steel, Cement and auto-ancillaries depict improved capacity utilisation. These sectors can drive growth in private investment. However, low capacity utilisation in sectors with high capital requirement (power, textiles) could limit the pace of recovery. India needs an aggressive infrastructure push from the government. But this will be contingent on the tax-collection buoyancy.

The National Company Law Tribunal (NCLT) portrays serious commitment to resolve the non performing asset (NPA) cases. RBI guidelines are also suggestive of recognising the pains rather than stretching it any further. Along with the recent events, there could be negative repercussions on the corporate credit growth in the near term. A host of PSU banks are on the brink of being put under the RBI’s prompt corrective action (PCA) plan. This may force them to recall the AT-1 bonds and partially negate the impact of recapitalisation efforts. I believe, the recent reform measures and learning from the current NPA cycle will ultimately lead to a structural improvement in corporate lending space.

We would be keenly watching if India is finally able to participate in global growth recovery. Some of the large export sectors such as textiles, Gems & jewelleries, pharmaceuticals and IT services haven’t done as well due to industry specific challenges. From a broader perspective, India hasn’t invested enough in innovations and R&D, which requires considerable attention by the policymakers and industry.

Rising bond yields may have an impact on domestic equity flows while global liquidity tightening could challenge the Foreign institutional investors (FII) investment. To that extent, revival in earnings is critical for such rich valuations to sustain. After the stellar performance in 2018, particularly in the mid and small caps segment, it is very important to keep an eye on valuations. With little scope of valuation re-rating, bulk of the returns are likely to be guided by earnings growth. We continue to focus on bottom up stock picking, which we believe is the best way to generate alpha.