Market volatility can persist, focus on earnings visibility

Dhananjay SinhaRecent spurt in volatility comes as a rude shock for the market that was till recently, still busy extrapolating the benefits from the change of guards at the centre. Expectations for earnings growth for benchmark Nifty and Sensex for FY16-17 was pegged at 18—20% notwithstanding the fact that last year registered no growth at all and much lower than the previous 6 year average of 7%. The story has remained same even in FY16. So what has been the market psychology? Most market participants believe in the ability of the market to price in the future and hence, when the market sprung 45% in response to formation of BJP led government following the general elections in 2014, the general refrain was that the earnings trajectory catapult into a boom cycle. Conversely, the performance in FY15 was much worse than the scenario the markets was imagining 18 months back and even for FY16, the consensus earnings expectations has been scaled down to 10-13% from a high of 18-20% a quarter back. The consensus real GDP growth expectations for FY16 has also been scaled down to 7.2-7.3% from 7.6% following the less than expected print at 7% for the Q1FY16. Considering my scepticism on the new GDP series, which seem out of sync with things on the ground, the comparable growth on the earlier series would be much lower around 5%. The question is if the market indeed had a perfect foresight, would it have risen 45%? The fact that the past seven years the average earnings growth of 6% has been consistently been lower than the 16-20% anticipated 24-months ahead of the close of any financial year, challenges the efficacy of the market’s ability of price in the future. Experiences from the recent years indicate that there are lot of the other factors, like liquidity, portfolio flows and consensus psychology that can lead of enduring misalignment between market valuations and fundamentals. That seems to be a plausible explanation for the markets trading at 21x trailing four quarter earnings against a backdrop of a dismal earnings growth. Long term history, on the contrary, indicate that for such multiples earings should be growing consistently around 30-35%. Indeed these are some of the analysis that went behind our earlier judgement that the market valuation cycle was at least 4-5 years ahead of the actual business cycle, unseen in the past 20-30 years. These sentiments were captured in our earlier Strategy note: "Reparation for misaligned expectations", May 5th 2015.Aside from the above, global signals were also ignored. For instance, the collapse of global commodity prices in the second half of 2014 was seen as a factor that would compound the already robust anticipation of earnings expansion in India, proved to be misplaced. My research on global commodity prices challenged this consensus view in my article “Windfall from oil prices is overstated”, LiveMint Dec 9 2014. Conversely, earnings growth for the past three quarters has been negative. Decline in commodity prices in 2014 was a clear indication for lower global growth and was in contrast to the continued enthusiasm in global equities, including emerging markets (notably China which more than doubled during 2014) and developed markets.Seemingly, equity market interpreted decline in commodity prices as an indication of the lower inflation and continuation of the liquidity sops from central banks that would support valuation. Clearly, co-existence of opposite indications from multiple markets with equities on the one side and commodities, Fx and bonds on the other embodied the paradox that exits today, presaged relapse of volatility in the equity markets. So what does the future look like? The precursor for market fragility has been building up for a long time and I think there are a few triggers that will be pertinent here. First, what the Fed does following its mid Sept’15 FOMC meet will be very important in determining the future course of liquidity flows into EMs and the trajectory of US dollar. Second, the future course of Chinese development will also be keen watched. And third, the dilution of the conviction on the ability for the Modi government to get key reforms will be critically tested in the upcoming Bihar assembly elections. In view of the nervousness in global equity markets the market is now pricing in a lower 30-35% probability of Fed rate lift-off following FOMC’s Sep 15-16 meeting compared to 50-55% few months back. In my view, however, Fed’s decision will be solely guided by the strengths and weakness of the US economy. In my view, both the real growth numbers and improving labor market data have sustained despite the strengthening US dollar, indicating sufficient strength to move out of the zero interest rate regime. Hence, I see reasonable probability of Fed taking a stab at the lift-off in Sep’15; uncertainty will likely subside after the first move. Flows into EMs may remain a concern over a longer horizon, given the over-allocation that has happened over the past 5-6 years and also against the backdrop that US market are better placed in comparison on parameters like returns on equity and valuations. However, in the short horizon the ability to initiate a lift off in a smooth manner will be critical for the EM equities, including India. Chinese response to declining current account surplus, narrowing US current account deficit, impact of declining global commodity and generalised appreciation of US dollar against emerging and developed market currencies is a very critical factor for the world and emerging markets in particular. Given the context that the structural shift towards domestic demand driven economy from an export led economy has been much slower may call for more disruptive adjustment, including further depreciation in the Yuan, flooding of Chinese produce in large economies like India and protectionism. In particular, depreciation in yuan will also require INR to depreciate further, which we have projected to depreciate to 68-70 against the USD in the contest of overvalued REER. From domestic stand point, the lapse of the land acquisition amendment bill, postponement of implementation of GST have indications of weakening legislative strength of the central government, which markets believe had the strongest mandate following the 2014 elections. So in a way it is a sense of déjà vu when one compares similar expectations from the UPA II government which was formed without the support of the left parties. Hence, the outcome of the Bihar assembly elections in Oct-Nov’15 will be very critically watched. Victory for the NDA will have the strength to rebuild market confidence. Conversely, BJP’s loss can reinforce the decline of political strength following its loss in Delhi earlier this year. Overall, it is possible that market volatility can sustain some more time. In our base case, we continue to envisage only a partial capitulation in the visible future. We retain our focus on stocks that have: a) earnings visibility, b) No regulatory risk, c) beneficiary of INR/USD weakening, d) endowed with pricing power, e) focused more on urban rather than rural and f) maintain avoid for PSU banks. While lower inflation numbers in recent months has created some elbow room for rate easing by the RBI, weakening in INR and possible toughing out of inflation after Sep’15 will prevent RBI from easing substantially. In any case we do not expect rate to induce anything more than temporary fillip to market sentiment. Author is head of research, economist & strategist, Emkay Global Financial Services Limited