Are these market levels sustainable? Everyone is asking that question about the equities markets after the recent highs. Is it time to consider whether this is the start of another bull run? Or more importantly, should you now start selling?
A pertinent point here is that even though the markets have made new highs, valuations are not at a new high. While valuations are not absolutely cheap, they are lower than when they were at the previous peak in October 2021, which makes us believe that the market is not ‘euphoric’. That also makes us wonder about the underlying forces of these developments.
Encouraging earnings growth
One immediate factor that comes to mind is that earnings have been encouraging across the board. Since the market peak in October 2021, earnings have been on the uptick, and markets have rewarded those companies, from the top 500 by market capitalisation, that showed significant improvement in earnings as well as improvement in return on equity (ROE).
The markets have fairly rewarded companies that have achieved earnings growth, maintained reasonable valuations, and lastly, where an earnings upgrade actually materialised.
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How does this tie in with the macroeconomic reality of the day? Today’s macroeconomic situation gives us a lot of hope as India’s macroeconomic outlook is sanguine despite numerous challenges, globally. The lead actor in this success story is the earnings growth rate.
Regardless of whether we look at large-caps, mid-caps, or small-caps, the earnings growth rate in the last two years has been phenomenal and this is what is influencing today’s investment climate. Earnings have nearly doubled in the last 24 months, whereas markets have risen by 15-20%, which means that the PE multiples have corrected in the last 24 months. Therefore, we can term this a healthy rally and not merely a reflection of overenthusiasm or euphoria.
What’s more, earnings growth rates are broad-based, which provides comfort to the micro as well as the macro story. For instance, before 2020, Business-to-Consumer (B2C) companies were the main drivers of earnings growth rate. However, in the last three years, we have observed a phenomenon where Business-to-Business (B2B) companies are also driving earnings and are no longer struggling. This is a wonderful period when there is activity at the company level, at the sector level, and at the economy level.
In comparison to other major economies, India is now on a stronger wicket. This is caused by a few fundamental factors. One such significant force that has aided B2C and consumer-facing businesses over the past 20 years is the Indian demography. This is one major factor at work, of which everyone is mostly aware.
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The rise of India’s manufacturing sector
There is one more reason which has helped manufacturing and, by corollary, the corporate banking business, and that is the waning of China’s importance as the world's factory. Earlier, it produced everything from boilers to tiles, tyres, and safety pins. As a result, it was a challenging period for Indian producers after 2008. However, the recovery in the manufacturing sector now implies that corporate banks that lent money to these sectors are also reaping the rewards.
In the period after the pandemic, growth in "gross fixed capital formation" (GFCF) and higher-end discretionary consumption are propelling the post-pandemic recovery.
The government's capital expenditure is a major driver of GFCF growth, although businesses have started to experience strong growth from FY23. Empirical evidence reveals that manufacturing-related industries profit from the aforementioned environment, which is receiving further government assistance in terms of policy-making (PLI programmes and a general push for manufacturing in India).
Companies lower on the market cap curve are particularly well-positioned to benefit from the economic upcycle, given the current trend of economic growth.
Earlier, manufacturing and allied businesses had limited opportunity to take part in the cyclical rebound as large-caps were dominated by sectors like banks, oil & gas, IT, and FMCG.
Today, manufacturing-related businesses and industries have a higher weightage in the mid- and small-cap segment that can be seen profiting from the present demand climate brought on by the "capex cycle."
The manufacturing industry has also seen consolidation. Steel, cement and aviation are a case in point. In the small- and mid-cap space, ancillary businesses are also driving growth. The housing sector, on the retail side, is also a big driver of the economy.
Inflation is starting to decline rapidly (on a high base) and food prices are moderating. The declining current account deficit (CAD) is due to lower crude oil prices and strong growth in services sector exports, except the IT sector. There are no major negative surprises on the fiscal front although India’s fiscal deficit remains high.
With so many positives, we seem to be poised for a virtuous cycle of higher consumption and capex, eventually leading to job creation and higher incomes.
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