Over the last few days this has been the question which I have been asked the most and a vast majority of market participants seem to believe that there is no trigger for the markets to move up from where they are today. I believe that the triggers for a market upmove are far greater than those for a downmove today. The factors which will lead the markets up (from wherever they end up over the next 2-3 weeks) are as follows –
Improving economic growth prospects – I believe that the biggest positive for India today is that the economic recovery has become self sustaining and the growth rate seems to be stabilizing at a higher plane. Despite the start of the tightening process by the RBI in which a significant amount of liquidity has been sucked out of the system over the last six months and policy rates have also moved up & also the partial withdrawal of stimulus by the government by increasing Fuel prices and increasing Excise duties in the last budget the consumer demand has held up quite well and in fact the demand for consumer durables, automobiles, cement etc. have not only held up but accelerated. For the month of May auto sales are up around 30%, cement by 13-14% and our interaction with consumer durable companies reflects a growth rate of 25-30%.
The investment demand is also picking up strongly now with most companies in the construction space indicating a growth rate of 30% for the current month. Services sector growth rate which had seen a decline last year is also likely to pick up and show a 9% plus growth in the current year.
The only joker in the pack seems to be agricultural sector growth where the monsoons will play an important role. As per the current forecasts there are expectations of a normal monsoon. In case that fructifies we should have a 5% plus growth in Agriculture which is typical of an year following a drought year.
A much lower fiscal deficit – The governments Fiscal deficit for the current year is likely to be much lower than forecast driven by stronger revenue growth due to the pick up in economic activity as well as higher non tax revenues from segments like 3G auctions (Rs 68000 crores), Broadband auctions, Disinvestment etc. I believe that the revenue pickup for the government is generally underestimated. In the current financial year the nominal GDP growth will be around 14% and with the increase in tax rates in the Union Budget the tax revenue ramp up should be over 20%. This combined with the fact the the employment situation has picked up substantially and wage increases are back should support government tax revenues.
The GDP growth will also be stronger than projections, thus increasing the denominator more than initially expected. With the increase in Natural Gas prices and expectations of partial decontrol of Auto fuels combined with the increase in prices of Gas for household use and Kerosene the fuel subsidies should also be well in control.
The other big subsidy element i.e. fertilizer subsidies should also be under control with higher gas availability for domestic fertilizer plants and lower fertilizer prices globally. For example Urea that peaked out at USD 875 per tonne in 2008 trades at around USD 280 PT today. With the expectations of natural gas prices remaining rangebound over the next couple of years due to higher availability and production globally there is unlikely to be a substantial increase in fertilizer subsidy. Also with the partial decontrol of this sector over a period of time the subsidies will reduce further.
Thus on an overall basis Fiscal Deficit could be one full percentage point lower than projected.
Reducing inflation & low interest rates – Inflation is likely to fall off sharply over the next 3-4 months. This will be due to two factors, the first that the base effect will playout over the next three months which was the time last year when commodity prices globally shot up sharply. The base effect will also play out in domestic food prices which also shot up during this time period due to the failure of the monsoon last year. The second and more important factor is that given the growth outlook in Europe, Japan and other Western economies combined with efforts by the Chinese government to cool down the economy on an overall basis commodity prices should remain subdued in the near term.
Lower inflation and lowering of inflationary expectations combined with extremely low short term rates globally will keep the liquidity flowing and keep interest rates low. The current increase in spreads due to the European Sovereign fears should also cool off over this time period. Improving growth prospects in the US should also bring some confidence back as Eurozone goes through a prolonged downturn.
Reasonable valuations – At the current price levels Indian markets are trading at 13-13.5X one year forward earnings depending on what growth one takes for the next financial year. For an economy growth at 8% plus and earnings growth of 20% plus these are extremely attractive valuations. In case due to the global issues the markets sell off 5-8% more (which is a realistic possibility) if the fear factor picks up then valuations will become even more attractive.
Investor Psychology – I believe that this is the biggest factor which will drive markets higher. Most investors have still not got over what they saw in 2008 and as such the predominant psychology is of fear not greed. This is the reason why we saw VIX shoot up so sharply when the markets fell just around 10%. Most investors would still shoot (sell) first and ask questions later. This is not the market psychology which leads to big market falls as such the possibility of a severe sell off remains low.
Imminent correction in the US Dollar – The US Dollar Index is showing a clear toppish pattern formation where it should now give up some of the gains made over the last 7 months. From the current levels of around 87 we should see a correction to the 80-82 range. Whether there will be a spike up before the correction sets is in something to be seen but I would not bet on any significant move up from the current levels. As the USD corrects we should see increased money flow to risky assets.
In terms of concerns, The Eurozone Sovereign issue has been discussed at length across various mediums and as such there is little to add here except for the fact that we could see the newsflow create short term volatility. The Budget cuts and tax increases announced by various European countries should reduce some concerns if investors believe them to be credible and something that will have an actual impact on reducing fiscal imbalances.
I believe China will have lesser international pressure in the near term as Western economies bet on increasing Chinese consumption to take care of the slack in their own economies and also support their exports. As such the China overheating issue which was of a greater concern to me till a few weeks back seems to have been postponed by at least a year if not more.
Thus on an overall basis the markets are positioned in a manner where the downside risk is 5-6% and the upside potential 20-22% by the end of this year.