Market flirting with record highs! 5 big risks it faces in 2017

The Nifty50 is up 10 percent so far in the year 2017 and about 20 percent in the last 12 months; hence, a breakaway rally might not be on the cards for investors.

It will be best to remain invested in the markets via mutual funds if somebody does not want to take additional risks emanating from both local as well global factors.

“We have always advised retail investors to invest in equity mutual funds through SIP route to overcome volatile phases in the market. Even today, we advise the same, as we expect the next 2-3 years to be the earnings recovery phase for the market,” Harsha Upadhyaya, CIO, Equity, Kotak Mutual Fund told Moneycontrol.com.

“The recent State election results also provide a better platform for the government to take policy initiatives to spur growth in the economy. Though the market is reasonably valued at this point of time, strong gush liquidity could take market levels ahead of their fundamentals, if further rally from hereon is a sharp one,” he said.

Going by the buzz on D-Street we have shortlisted top 5 big risks which the India market has to brave in the year 2017:

US Federal Reserve turning hawkish:

The biggest risk from the international front could come from US Federal Reserve policy outcome. Although, a rate hike of 25 bps is already in the price but a hawkish Fed is something which might lead to excess volatility in markets across the globe including that of India.

This will be the third time when the US Fed will raise rates since the financial crash of 2008. The strength in the US economy is one major factor contributing to Fed’s optimism. Whenever the US raises interest rates, dollar gains strength which may lead to some volatility in currency markets.

Why it dollar matters? Well, businesses across the world borrow money in the dollar and a rise in interest rates would encourage an influx of funds into the US at higher interest rates. As per theory, higher interest rates in the US will prompt an increase in the value of the dollar and vice-versa in case interest rates are low.

The US Fed started its two-day monetary policy meeting on Tuesday, and the outcome if expected later today on Wednesday. The market is already pricing in a 95 percent chance of a US interest rate increase.

“What the US Fed is going to do about interest rates and how hawkish is going to be the tone especially in the context of the recent employment data which has come out of the US,” Nilesh Shah of Envision Capital said in an interview with CNBC-TV 18.

“I think that is going to be one important factor and two is basically the advance tax numbers, which come out on the 16th which will determine how good or bad the March quarter is going to be,” he said.

Monsoon, a local risk for India market:

Nomura India, which remains constructive on the Indian market, thinks that the rally could extend by another 10-11 percent by 2017 end, but there are global as well as local risks which investors have to deal with.

Another risk the market faces right now is monsoon. Most experts are counting on earnings recovery as well as economic recovery and monsoons play a very important role in that.

“Some challenges which the market is not factoring in currently are the uncertainties of monsoons which is a big driver of Indian markets,” Prashasta Seth, CEO & CIO, IIFL Asset Management told Moneycontrol.com.

“The current rally in the market is driven more by a confidence reassurance of the political landscape at the Centre beyond 2019, than by any change in the corporate earnings,” he said.

Rural demand has been dependent in a big way on monsoons and with forecasts of El-Nino this year, it could be tough to build optimism on the domestic consumption.

A bad monsoon could well turn tricky for India Inc and analyst estimates. Rainfall was normal in the year 2016 after two successive years of the deficit that curbed output of sugar cane, wheat and pulses.

“The risks to Indian story are more global. Talking about local risks, a bad monsoon could well translate into higher inflation and all the good macros we are seeing might get strained a bit,” Prabhat Awasthi, Head of Equity & MD, India, Nomura said in an interview with CNBC-TV 18.

"Other global risks which India market might have to deal with is a slowdown in China, trade tension ballooning up due to Trumponomics as well as any sharp rally in crude oil prices," he said.

Expensive frothy but in line with long-term avg:

After rallying nearly 10 percent so far in the year valuation does look stretched. All metrics – such as trailing multiples, the forward multiples, yield gap – all seem to indicate that the market is no longer cheap.

With markets trading at 22-23x P/E trailing and 19-20x forward P/E, the valuation comfort is missing and risk-reward is not favourable, suggest experts.

“At current prices, the market trades at 18.3x NTM EPS, and at 23.6x on P/7year trailing EPS, close to its LTA, and the risk-free less the earnings yield has risen from almost nil (an 8-year low) to 150bps now,” JMFinancial said in a report.

Some brokerage houses such as Religare Securities suggests that risk-reward does not look favourable, and investors should stay defensive. "We believe that the risk-reward is not favourable currently and advice investors to sell into this rally. We expect Nifty EPS to rise by ~15-16 percent in FY18, and see no triggers for an earnings upgrade at this juncture," it said.

"Rising domestic and US yields cap valuation upsides on a fundamental basis – implying that further upsides are only likely to come from positive earnings surprises. We have a December-end target of 8,650 for the Nifty50," said the report.

Earnings Momentum:

One of the biggest risks which the market faces in the wake of this massive rally is earnings which have not yet caught up with valuations. The March quarter was not as bad as some experts were anticipating but March quarter will be something which will reflect the true picture of demonetisation.

“Corporate earnings are yet to show any meaningful growth to suggest buying at these valuations. Barring a few select pockets, earnings are still not out of the woods for the majority of the sectors,” said Seth of IIFL Asset Management.

“We could see focus coming back on cyclicals as the government could speed up a lot of infrastructure projects seeing the political support across states,” he said.

For the market, the FY17 EPS is estimated to decline by 2 percent on a year-on-year (YoY) basis while the FY17-19E EPS CAGR stays at 21 percent. Sector-wise, the largest contributors to growth from a 2-year perspective are financials, consumer discretionary and materials while the laggards are telecom, energy and utilities, suggest experts.

JMFinancial in a report said that the rate of earnings cuts has been trending lower every quarter over the past 4 quarters (save the demonetisation effect) and hence, we assess the risks on earnings to be low.

Reforms process has to continue:

Now, it is time for the government to walk the talk. The resounding win for the BJP in the state elections pushed markets to record highs on hopes of the continuation of reform agenda.

The BJP-led NDA will likely reach 86 seats ( a simple majority is 123) in the Rajya Sabha by December 2019 and hence, this may not result in any immediate kicker for growth as much as increasing the chances of them coming back to power at the Centre in 2019.

But, for a rally to continue, reform process cannot stall now especially after attaining a majority in key state election results.

“For a real breakout scenario, I think what the markets would want are some of the big bang reforms so to say and the biggest of all of them -- we have been talking about the state of PSU banks, the banking system, asset quality and the fact that they need so much of capital,” said Shah of Envision Capital.

“The big step, which could prop up markets and is looked upon very positively is the government’s willingness to bring down its ownership below 51 percent mark. It is a very tough reform, it requires a lot of political capital to be able to do that. The time is right to do it,” he said.