As long as interest rates continue to remain in the lower band, market valuations will only get richer with time
Although equity valuations seem stretched at this point with Nifty trading at a price to earnings ratio of 24.6, today’s reality is different. Market valuations are a result of the underlying circumstances which are all conducive for further increase in valuations. All things are relative especially when it comes to financial performance.
Firstly, we are in a global bull market. If you look at the price to earnings ratio of some countries’ equity indices, it will reveal where things are heading. Valuations in the United Sates is around 23.8 and developed countries in Europe have a combined PE ratio of 22.9. The BRIC countries trade at a PE multiple of 12.7 due to the low valuation of Russia and China. Due to the ridiculously low interest rates around the world, valuations become more justified as there are fewer options to invest in financial assets to generate returns. Warren Buffett famously said, “Interest rates act on asset values like gravity acts on physical matter.”
As long as interest rates continue to remain in the lower band, market valuations will only get richer with time. This will hold true even if earnings growth is mediocre. Apart from that there are other factors which determine India’s valuations.
Some macro factors in India’s favour:
Low inflation – Since late 2013, inflation rate has been reducing consistently. From a high of 12 percent in 2013, in a space of 3 years, it has come down to as low as 2.18 percent as of May 2017. This is a huge positive for the economy. Stable prices are conducive for economic progress in more ways than one. It saves more money in the hands of the lower income group and gradually increases their savings rate. A low inflation rate is also essential for efficient allocation of capital as money will retain its purchasing power and cost of borrowing will be less as interest rates will not go up under such circumstances.
GDP growth rate - The world economy is in a recession with a growth rate of less than 2.5 percent. Among all the emerging and developed countries in the world, India is growing at the fastest rate of 6.8 percent this year. Although the rate of growth has declined in the last few years, it is higher than other countries..
Narrowing fiscal deficit – There has been a year on year decline in fiscal deficit since 2009 and this is great for the economy. In this year’s budget, finance ministry contained the deficit to 3.5 percent. Just 7 years ago, the fiscal deficit was double of what it is today. This indicates a strengthening financial position of the economy.
Narrowing current account deficit (CAD) – It has been a subject of headlines in the previous UPA government when the deficit widened to 4.8 percent of GDP. In 2017, current account deficit has been contained to around 0.6 percent of GDP. This puts the country’s balance sheet in a comfort zone. If the trade deficit improves, we could have a surplus account in the future.
Low oil prices – India being the third largest oil importer in the world and consuming more than 4 million barrels per day, the price of oil significantly impacts the economy. With oil in a downward trend below $50 per barrel, it is a significant positive for India. This downward trend is likely to stabilize at lower levels as the world supply of oil is on the higher trajectory.
Stable currency – In the past, an unstable rupee has been the cause of much distress among foreign investors because a depreciation in rupee deteriorates dollar denominated returns. This time around, a stable and in fact, strengthening currency will encourage foreign investors to take India more seriously. This can further elevate India in many ways by attracting foreign capital.
Demonetization proved to be less hazardous than analysts and foreign investors expected. Corporate earnings have not been damaged and it proves the resilience of Indian companies and the economy. Overall, due the above circumstances the Indian stock market can sustain current valuations and even expand if foreign investors participate more in equity markets rather than debt. Mutual fund flows have been robust from retail and can increase market valuations further in the future. It is more likely that the market will have a time correction than a price correction.
Author is Co-Founder of FYERSDisclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.