2019 A YEAR OF DICHOTOMIES
As I think about the year 2019 ( I also wonder why all forecasts are made at the end of December only) there are a large number of moving parts that will influence the markets. Global Central bank positioning is varied as compared to normal tightening and loosening cycles which have traditionally been synchronized. Politics influence on Economic Performance and market volatility is the greatest in several decades & specific to India we have the General Elections in the middle of 2019.
As I sit down to write we have seen an unprecedented sell off in the US Markets which is very rare for the month of December and a relative calm in Emerging Markets. So could decoupling be a theme for the year 2019. As history has shown, if there is a big crisis then there is no decoupling and financial market meltdown is global. However if a crisis is avoided then decoupling does play out. US Markets continued to rally for a long time while other markets did not do well driven by the tax cut driven earnings revival as well as disproportionate flows into FAANG stocks. This has now ended and we have seen relative outperformance from markets like India, Brazil etc in the short run.
Before going to anything else we first need to address what’s happening in the US Markets. On the question of whether the selloff was justified, it was justified. The reason being that there has been unprecedented tightening by the US Federal reserve where they have reduced the balance sheet size by nearly $ 400 billion while increasing rates four times. This is a huge amount of tightening in a short period of time. If we go back into history the Fed Funds rate was first cut to zero and then QE took place in a step by step manner. Here both have happened simultaneously. The impact should be a decent slowdown in the US Economy next year contrary to what is currently believed and the markets are factoring that in.
The other part of that story is whether we were at bubble valuations like in 2000 and 2008 and will we get a similar sell off. The answer to that is no as investors have been sceptical in general and equity flows in most other parts of the world have been negative even as US Equities saw inflows. Unlike in 2007 EM’s are not at a premium to US Valuations and neither have there been Euphoric inflows. Infact we have seen outflows. Japanese Equities have lost a huge $ 48 billion this year. Under the circumstances it will be a normal corrective wave 0f 20-25%.
Now lets look at the valuations
| S&P Earnings Per Share | Index Level Before Fall | P/E Ratio | Current P/E Ratio | |
| 1999 | 48 | 1550 | 32.3 | |
| 2007 | 66 | 1550 | 23.5 | |
| 2018 | 160 | 2950 | 18.4 | 15.1 |
A P/E ratio of 15X on current year earnings and around 14X on next year earnings is not exactly bubble valuation. Moreover Emerging Market Equities are trading at a P/E of just around 8-9 times as against 25X at the end of 2007. Overall the valuations argument is constructive.
Global growth should continue to soften next year as US, Europe, China etc all continue to slowdown. So should equities do something great when growth is slowing down. Normally equity returns will be subdued in such a situation unless the future outlook turns around. As such the dichotomy of low valuations but slower growth should keep overall returns subdued to start with. However given the fact that we will see the tightening bias reduce in a few months we should overall see positive returns from equities.
I have pointed out several times that the risk in the markets is not the same as perceived risk. When markets are falling, INR is under pressure and there is a possibility of interest rate hikes we normally see panic being spread all around. These times are typically the best times to invest. The following data reflects this so well
Nifty performance in the years following major #INR declines
2008- INR fell 20%, 2009- Markets rose 75%
2011- INR fell 19%, 2012- Markets rose 28%
2013- INR fell 12%, 2014 Markets rose 31%
2018 INR is down 10%, 2019 Markets ?, Markets should do very well next year.
The other big fear that is playing out is related to the “Fear of Elections”. However in my view this should not be a fear as markets do not like uncertainty and once uncertainty goes away markets do well as is reflected in the following data.
| YEAR | RETURNS
JUNE TO DECEMBER |
| 2004 | 40.1% |
| 2009 | 16.0% |
| 2014 | 14.6% |
| 2019 | ? |
Purely from the context of the Indian Economy the macro factors have turned extremely positive with the decline in crude prices, fall in bond yields and a recognition by the Central Bank that they need to improve liquidity. Inflation is at multiyear lows and positive to boost consumption. The order books of Infrastructure companies is strong, bank balance sheets have been cleaned up and corporate leverage is at multiyear lows contrary to many other economies where the leverage is very high. Corporate profitability remained under pressure this year due to the sharp increase in commodity prices in a very short period of time as well as increase in interest rates. Both these factors are likely to reverse next year.
The only negative in a manner of speaking is that Indian Valuations of large cap indices is at a substantial premium to other Emerging Markets and as such Index performance might not be as great until the earnings growth picture becomes clearer and stronger. However the broader market valuations are very cheap and there are likely to be great stock specific opportunities contrary to 2018.
Some themes that can be played next year will be
- Building Material stocks have become cheap and provide good growth opportunities
- Sugar is starting a new upcycle
- Ethanol presents a strong opportunity
- Capital expenditure cycle revival will present opportunities in capital good stocks especially mid cap
- Infrastructure stocks are very cheap and will do well as rate hike cycle seems to have peaked
- Cement sector could be starting a strong upcycle
- Automobile stocks have become cheap relative to long term potential
- Consumer Goods stocks will become interesting on some correction
- Sectors to be avoid will be Technology i.e. IT Services as we are likely to see a significant slowdown in order flows as the US Economy slows plus they lose the advantage of INR Depreciation. Commodities in general should be avoided as prices will remain subdued as demand growth falters.
- Market tops are mostly made at market PE’s of around 30+, huge outperformance from Small Caps and Euphoria with no fear
- None of these things exist as of now.
Post May 2019 will be more of a Buy and Hold market as specific sectors and industries will have a secular run
SO How does 2019 look in conclusion
The year 2019 will have several pulls and pushes. While many economies will slow and potentially also go into recession India with its relatively insulated economy and domestic growth drivers should hold on.
As we end the year on high volatility there is a general consensus that this will continue. However history does not justify this assertion. Periods of high volatility do not last very long.
Broader Market opportunities are huge when inflation is low, interest rates stabilize and input cost pressures are low. All of these ingredients are present as we go into 2019.
The significant improvement in the Ease of Doing Business ranking of India, the digital economy and GST are improving efficiencies and creating possibilities of a higher growth with lower inflation. Lot of good work has been done by the Government on the bank clean up, transparency in bidding for projects, reducing the cost of doing business etc. This will hold stead irrespective of who wins in the next elections. Any improvement in the trade tensions between the US and China will be an added positive but cannot be forecast at this stage.
Overall India is well placed in the global context and the next 2-3 years will show that. Markets will be higher the same time next year and much higher beyond that.