The first week of August saw, frontline equity indices touching a new lifetime high. Nifty and Sensex crossed the psychological level of 16,000 and 54,000 respectively. This has come after the market has remained in a very tight range of 15600 and 15900 for more than two months. Globally we are witnessing the equity market touching new highs including S&P 500 and Dow Jones Industrial Index.
Returns generated by the equity market globally have been phenomenal and the Indian equity market represented by Nifty 50 has been one of the best performing indices. For FY21, it moved up by 78 percent only three other indices have given returns better than Nifty 50. Even year-to-date return by Nifty 50 is one of the best-performing indices.
Many market experts are voicing concern about this rise in the equity market and are forecasting deep correction sometime in the future. So we will try to first understand what is making the equity market move ahead and then what are the events or triggers that can stop its march ahead.
The liquidity boom across the globe has remained one of the key reasons for a surge in the equity market. While liquidity surplus is undoubtedly likely to sustain for a couple of years more, the Federal Reserve has initiated discussions on tightening balance sheets and higher fed rates sometime in 2022-23. The ECB is also likely to end the pandemic emergency purchase program (PEPP) by March 2022. So the liquidity will remain abundant for a while globally.
While Fed officials are giving out mixed signals, higher inflation and buoyant growth are adding fuel to tightening expectations. US Fed Chairman Powell’s comments that discussions around taper and not rate hikes have started within the FOMC imply that as soon as the uncertainty around the pandemic is addressed, it might initiate tapering. ECB has also signaled easy monetary policy until inflation is durably above 2 percent, but its PEPP programme is likely to end by March 2022. These announcements from Fed and ECB are expected from September’21.
The RBI also took several measures in the wake of Covid-19 to provide necessary liquidity into the system. It reduced the policy rate by 115bps and CRR by 100bps. To support the economy, RBI injected liquidity worth Rs 17 lakh crore till now in the economy.
Therefore, next three to six months we do not see any major suction of liquidity out of the system that may impact the market adversely. The only caveat to this is if inflation does not remain transitory and becomes persistent. Even after rising in inflation, we believe that it will take some time to unwind the expansionary monetary cycle. There is a multiple-step process of unwinding in this cycle and we might be in the first or second step.
Quarterly Results
The Q1FY22 earnings to date can be considered a mixed bag with a few positive surprises as well as a couple of significant earnings misses. The IT sector performance was healthy overall with Infosys upping the guidance for the year. Tech Mahindra and Wipro, too, reported a good set of numbers while HCL Tech reported a marginal miss. The BFSI continued its mixed trend with the industry bellwether HDFC Bank reporting a sluggish growth and higher-than-expected NPAs. While the NPAs continue to remain manageable, concerns over growth have started to surface. ICICI Bank and SBI reported excellent growth and overall better numbers.
Maruti reported a miss on margins on account of rising input costs even though the revenue numbers were largely in line. Asian paints have impressed the street on the volume front. However, challenges on the margins persist due to sharp raw material inflation and lower price hikes during the quarter. Hindustan Unilever also reported lower-than-estimated margins. Though the Pharma sector was expected to report healthy numbers, the sectoral performance has been a mixed bag with Dr. Reddy missing the expectations while Sun Pharma beating the estimates. There has been margin pressure in the US business but the industry has been judiciously adapting with new product lines and specialty products. Overall, the quarter results have seen a mixed response but the trend is still constructive and earnings visibility continues to remain good.
The above table gives a glimpse of the current result season. Many companies were able to beat the street estimates when it comes to revenue, however, there was more miss at the earnings front due to the rise in commodity prices impacting many Nifty 50 companies.
After showing better than expected performance in FY21, earnings in FY22 began on a healthy note. Management commentaries, across the board, suggest an improved demand environment post-Jun ’21, led by an easing of restrictions, fewer COVID-19 cases, and a pick-up in vaccinations. However, the impact of rising commodity prices and in general higher inflation is felt on the bottom line of the companies. We expect the recovery in corporate earnings to continue as the economy opens up with progressively higher vaccinations. Therefore, the financial performance of the companies is likely to gather further pace from hereon as we see commodity price stabilising and supply-side constraints are adequately addressed. Hence earnings of companies are also likely to improve from hereon.
Valuation
The Indian equity market represented by Nifty is currently trading at a price to earnings (PE) ratio of 26.51x, which is almost 30 percent higher than its long-term average of 20.63x and is trading at little more than one standard deviation above its last 22 year mean. Purely looking at this valuation it looks expensive.
Even if we take the valuation of MSCI India, it is looking stretched compared to MSCI Emerging Market. MSCI India is currently trading at a PE of 30x. If we take a historical average of the index since 2002, it has traded at a premium of 40 percent, however, at the end of June, it was trading at a premium of 63 percent. Therefore, in terms of relative valuation with other emerging markets also the Indian market looks expensive. The Indian market is not only expensive on an absolute basis but also on a relative basis.
Companies and Sector
Now let’s dig deeper into company wise to understand the companies and sectors that are leading to a much higher valuation. On average little, more than 50 percent of the constituents of the sector are trading at a premium to their historical average. Companies trading at a significant premium to their historical averages are HCL Technologies (+82%), Divi’s Labs. (+80%), Wipro (+76%), Asian Paints (+65%), and Infosys (+65%). There is almost 45 percent of the companies that are trading at a significant discount to their historical averages: Tata Steel (-60%), Coal India (-56%), ONGC (-52%), NTPC (-38%), and ITC (- 38%).
Therefore, there is a balance between companies trading at a premium as well as companies trading at discount to their long-term average valuation. Companies that are trading at a premium are also those companies or sectors that have demonstrated better growth potential.
In Terms of Sector, 67 percent of sectors are trading at a premium to their averages. One of the sectors that is trading at a premium is technology. The Technology sector is trading at a P/E of 26.5x, at a 52% premium to its historical average of 17.4x. The top four IT companies reported a robust growth of 4% sequential and 21% yearly in 1QFY22, indicating continued strength in the tech spending environment. Management commentaries on enterprise demand, especially Cloud, imply a positive outlook for the Indian IT industry.
NBFC is trading at a P/B of 3.2x, above its historical average of 2.6x (at a 20% premium). The demand for Home loans/LAP products has been strong in Jul’21. Housing Finance Companies (HFC) are expecting business volumes in 2QFY22 to be similar to 4QFY21. Gold loan demand has been strong in the North and has picked up in the South (post lifting of the lockdowns) in July 21.
The Metals Sector is still trading at discount to its long-term average. At an EV/EBITDA of 4.7x, it is below its 10-year historical average of 6.7x. Improving demand across the globe has helped base metal prices sustain at higher levels. Aluminum rose 3% MoM to touch a decadal high of $2,624/t, whereas zinc rose 3% MoM to $3,039/t. We expect domestic steel demand to improve in August 21 as local restrictions ease off. Higher exports should normalize inventory levels, which, coupled with improving demand, would support prices.
Our Take
Hence, we believe that despite higher valuation, there are pockets where companies are under-valued. Moreover, corporate profit growth is at an inflection point and we will see an improvement in earnings trends in FY22 and FY23 that will normalise the overall valuation. Besides, a lower interest rate is also helping equity to command such valuation. The chart, MSCI India Index EPS Growth Trend – 2011-23, shows the earnings trend of the MSCI India Index. This clearly shows that next two years we will see better growth for Indian companies and hence the elevated valuation may not be a worrying factor.
The chart that shows the Bull and Bear market of Sensex since its inception in 1979 also justifies our argument.
Therefore, in short term we may see a little volatility in the market; however, we do not see any serious downturn in the market till October. Even if we face the third round of Coronavirus cases, it will have a minimal impact on the market.
