Indian equity market: Down and out- atleast for now!!!
I am not from the bear camp, but generally everyone is more cautious theoretically, than what he does practically. So here it goes…my cautious view on the market, though personally I am net long- quite contrary to my theoretical approach of thinking!!!
There was a report from a leading global investment bank that CY08E/ FY09E earnings growth for MSCI Asia ex Japan would increase by 4% YoY. The same was expected at around 12% at the beginning of 2008. They added they won’t be surprised if their estimate falls down to 0% growth later during the year. This is the kind of earning risk prevailing across the emerging markets in Asia.
India is also observing similar earnings downgrade threat. I believe the consensus expectation for FY09E is still of around 12-14%, though is down from 18% at the start of 2008. And I would not be surprised if the consensus growth number goes below 10% and then analysts start revising down their FY10 estimate too which currently stands at early 20s% (and increasing as FY09E numbers change and FY10 EPS remaining the same).
Better than expected Q1 FY09 numbers, the UPA No Confidence win in the Parliament, global stock rally (esp financials) in later July/ early August helped Sensex reach around 15500 by mid August. Decline in commodities and actual inflation numbers below expected for 2-3 weeks also helped the market. The credit market suddenly had a very good time, and CDS on Indian corporate debts reduced during July.
However globally Hedge Funds made substantial loss and Hedge Fund Index was down by 2.8% in July as they were long commodities and short financials-which panned out opposite during August. During August also, they are not doing good as they are short USD!!!
Commodities decline also helped the markets as India is net importer. Sensex of late has been showing a near perfect negative correlation with commodities, though during 2003-2006 both were trending north, but it requires a turmoil in the market which actually tests the correlation.
Sensex (White) and Goldman Sachs Commodity Index (Orange)
Source: Bloomberg
While other emerging commodities driven markets (Brazil, Russia) faltered during July.
Brazil Bovespa (White) and Goldman Sachs Commodity Index (Orange)
Source: Bloomberg
Russia RTS (White) and Goldman Sachs Commodity Index (Orange)
Source: Bloomberg
So, what lies ahead…is not so good picture…
Recession blues…and European banks’ worries
With more than 50% of global economy facing threat of recession or severe slowdown (likes of the US, Japan, Germany, UK, Spain etc), the global macro picture remains very bleak. The menace happened in the US, is waiting to happen in Europe. European banks, so far took hit on only their US centric investments, now that their home markets are under threat, another blow of domestic write down is on the anvil, so it might give another blow of negative sentiments to the investors.
Inflation worries
Coming to India, the 10 year Govt Bond Yield that retreated below 9% during early August, is again hovering at around 9.2% due to inflationary concern, as against Sensex current earning yield of around 7.2%. The inflation surged to 12.63% from around 11.8% during July.
Source: Bloomberg
Infact inflation now lies beyond 4x Standard Deviation from its 12 years mean of 5.05% and Std Dev of 1.8% (and 5 year mean of 5.6% and 1.8%). The observation till May end numbers had a normal distribution and all the observations lie within 2.5x Std Dev around the long term mean. However come June and we had a oil price hike led inflation spike, which surged past 11.5% and now at 12.63%. It threw the inflation numbers beyond 3.5x Std Dev. Till the inflation does not come within 2x SD (i.e. 8.5-9.0%)-within 95% confidence interval, market will remain jittery on the concern.
It will further increase the socio-economic divide. Poor people as it is did not participate in the India story so far, but they are being penalised as their only expense was towards non-discretionary expenses like food, depleting their savings potential, if at all they save.
Source: Bloomberg
Source: Bloomberg
Tight credit market and rising funding cost…
Rising inflation prompted RBI to increase interest rates and the reference prime lending rates (charged from most favored clients by banks) are at around 14%. Much deteriorated capital markets and increased interest rates are making funding very very tight. All exotic external funding sources are of no respite, as many of the previously issued FCCBs (convertible in equities) are deep out of the money, so now the global investor having risk appetite would demand much lower conversion price for further funding…which would lead to imminent dilution. ECBs are also not favoured currently as global lenders see deterioration in the Indian macro picture further spiked by downgrade rhetoric by credit ratings firms (infact Fitch has recently downgraded its ratings for India’s LT Currency Issuer Default Rating). Blue Chips like Tata Motors has recently shed out plan to issue convertible preferred shares and selling its assets and is issuing rights issue for the remainder instead.
Interbank rates are tightening in the Middle East, ME banks are also resorting to wholesale funding from global financial institutions. There is a lot of Tier II and Subordinate Debt issue happening in USD and Euro by ME banks. ME corporates are also raising funds from abroad. So, Indian corporates have to compete against their ME counterparts to get funding, and I believe on the sound macro footings, ME companies would win the battle if not the war.
And CDS again rising high…
Credit Default Swaps (CDS) on investment grade bonds issued by Indian corporates like Reliance Industries (230bps), Tata Motors (500bps), ICICI Bank (330bos), Reliance Communication (370bps) is again rising after falling from their March and Mid July highs. ICICI Bank followed by SBI and BOI has the highest CDS among the Asian banks’ investment grade bonds. It takes 3.3% (330bps) to insure ICICI Bank bonds against any default. So, if your cost of funding is let say 5% (lowest possible cost of funding), you need to pay 3.3% to insure yourself against any default. So 8.3% is you total cost. An investor would need atleast 2-3% net spread…hence you would demand 11-12% yield from their bond. Imagine, this is the cost of Senior Debt for ICICI Bank, and if they issue subordinated debt the cost would further rise as investors would demand even higher yield for the subordination.
CDS on Indian banks’ Investment Grade bonds
Source: Bloomberg
Trickling down effect of rising funding cost…
If this is the plight of big banks, imagine corporates who borrow from these banks. Let say a Construction Company A, who bids for a project for a margin of 3-5% over its cost of funds. Earlier, thanks to the benign capital market, their explicit weighted cost of funding were cheap (around 8-9%) as they used equity/ quasi equity routes (at huge conversion premium, so existing shareholders were also happy as dilution happened at higher price). Now equity capital market is fully dried up, Co A has to borrow locally. If ICICI banks’ marginal cost of fund is 11% it will keep a net spread of 2-2.5% and would lend to A at 13-14%. Hence the asking IRR climbs to atleast 17% to bid for any project A bids for. Earlier A was bidding at of IRR of 12-13%. Hence, either A has to bid at a very low IRR reducing its margin further or master project becomes extremely costly. And the cost trickles down to end user by way of higher toll/ utility charges.
Hence tightened market today for 2-3 quarters can have a long lasting impact on inflation. This is just one small example. Higher interest cost seeps into all forms of cost components, as for everything you do, you need money…to create money…
Global gloom…
Now with more than 50% of world economies flirting with recession (namely USA-25% of world’s GDP, Japan- 8%, Germany- 6%, UK- 5%, Spain- 3% etc.), and given so much of global financial sea-saw (Freddie-Fannie’s CDS at 350bps), writeoff scare on European banks and so much of earning risks for 2008 and 2009, Indian market Forward PE of 15x looks high. True currently Indian market PE is now at a premium of only 1% over Asian ex-Japan, as against an average premium of 10% during 2006 & 07, but that period was characterised by positive surprise in earnings numbers and lower interest rate/ inflation regime.
Things have turned upside-down as of now and expected to remain the same for next 1-2 quarters. Multiple measures of monetary tightening…multiple times…would start affecting the bottom line and balance sheet of Indian corporates expected from September quarter result, plus we can see some contraction in the capex plan or trimming of order book. And this time around we still have hidden earning risk…so even if markets remain at the same point, PE can actually increase.
Pundits say that credit crunch and slump will take half or whole of 2009 to get stabilise. And when any financial turmoil happens in developed market, correlation among global markets increases and the sentimental negative contagion spreads around the world. Middle East markets are largely negatively correlated with global markets, but during any sharp movement in S&P 500 Index, the ME markets react accordingly in the same direction.
Lagging foreign demand for Indian equities…
And in this global gloom, its very difficult to expect foreign investors to come back hugely, after USD 7bn YTD 08, and ticking, sell off. Domestic funds have been net buyer YTD but of no respite to the markets. Hence, thinking that Indian MFs will rescue the market will not help this time. We need foreigners…and now they need additional risk premium (remember rising bond yield will add risk free rate too!) and hence very cheap valuations. Middle East markets are trading at 11-17x CY08E earnings with ROE of around 23%. 1H 08 result has been stupendous. And this market is also attracting lot of global investors, primarily hedge funds. Now the biggest market Saudi Arabia is gradually opening for foreign investors. This region puts a threat to emerging Asia (incl India) in competition for foreign funds.
Conclusion
There could be an argument that now commodity prices are coming down, and thus is a good sign for inflation. Yes its good for short term, but if we see the reason for the decline…(and I believe it is more because of recession fear than a technical correction)…the story does not look favourable on a medium term basis. India is in Bear Market grip for the time being. Long run, everybody is dead that’s why we don’t bother to say…long term India is a Buy!!!
The reason I compared Indian market with Middle East market, because both are considered emerging markets. One side you have poor emerging economy (PCI $1000), other side you have ultra rich emerging economy (PCI $25000). Though these markets are still considered as frontier markets, it’s a matter of time, couple of these markets (UAE and Kuwait to start with) would get added in MSCI Emerging Market Indices-hence they would come in more limelight for global big players and would compete with established emerging market like India for FII inflows.
There was a report from a leading global investment bank that CY08E/ FY09E earnings growth for MSCI Asia ex Japan would increase by 4% YoY. The same was expected at around 12% at the beginning of 2008. They added they won’t be surprised if their estimate falls down to 0% growth later during the year. This is the kind of earning risk prevailing across the emerging markets in Asia.
India is also observing similar earnings downgrade threat. I believe the consensus expectation for FY09E is still of around 12-14%, though is down from 18% at the start of 2008. And I would not be surprised if the consensus growth number goes below 10% and then analysts start revising down their FY10 estimate too which currently stands at early 20s% (and increasing as FY09E numbers change and FY10 EPS remaining the same).
Better than expected Q1 FY09 numbers, the UPA No Confidence win in the Parliament, global stock rally (esp financials) in later July/ early August helped Sensex reach around 15500 by mid August. Decline in commodities and actual inflation numbers below expected for 2-3 weeks also helped the market. The credit market suddenly had a very good time, and CDS on Indian corporate debts reduced during July.
However globally Hedge Funds made substantial loss and Hedge Fund Index was down by 2.8% in July as they were long commodities and short financials-which panned out opposite during August. During August also, they are not doing good as they are short USD!!!
Commodities decline also helped the markets as India is net importer. Sensex of late has been showing a near perfect negative correlation with commodities, though during 2003-2006 both were trending north, but it requires a turmoil in the market which actually tests the correlation.
Sensex (White) and Goldman Sachs Commodity Index (Orange)
Source: Bloomberg
While other emerging commodities driven markets (Brazil, Russia) faltered during July.
Brazil Bovespa (White) and Goldman Sachs Commodity Index (Orange)
Source: Bloomberg
Russia RTS (White) and Goldman Sachs Commodity Index (Orange)
Source: Bloomberg
So, what lies ahead…is not so good picture…
Recession blues…and European banks’ worries
With more than 50% of global economy facing threat of recession or severe slowdown (likes of the US, Japan, Germany, UK, Spain etc), the global macro picture remains very bleak. The menace happened in the US, is waiting to happen in Europe. European banks, so far took hit on only their US centric investments, now that their home markets are under threat, another blow of domestic write down is on the anvil, so it might give another blow of negative sentiments to the investors.
Inflation worries
Coming to India, the 10 year Govt Bond Yield that retreated below 9% during early August, is again hovering at around 9.2% due to inflationary concern, as against Sensex current earning yield of around 7.2%. The inflation surged to 12.63% from around 11.8% during July.
Source: Bloomberg
Infact inflation now lies beyond 4x Standard Deviation from its 12 years mean of 5.05% and Std Dev of 1.8% (and 5 year mean of 5.6% and 1.8%). The observation till May end numbers had a normal distribution and all the observations lie within 2.5x Std Dev around the long term mean. However come June and we had a oil price hike led inflation spike, which surged past 11.5% and now at 12.63%. It threw the inflation numbers beyond 3.5x Std Dev. Till the inflation does not come within 2x SD (i.e. 8.5-9.0%)-within 95% confidence interval, market will remain jittery on the concern.
It will further increase the socio-economic divide. Poor people as it is did not participate in the India story so far, but they are being penalised as their only expense was towards non-discretionary expenses like food, depleting their savings potential, if at all they save.
Source: Bloomberg
Source: Bloomberg
Tight credit market and rising funding cost…
Rising inflation prompted RBI to increase interest rates and the reference prime lending rates (charged from most favored clients by banks) are at around 14%. Much deteriorated capital markets and increased interest rates are making funding very very tight. All exotic external funding sources are of no respite, as many of the previously issued FCCBs (convertible in equities) are deep out of the money, so now the global investor having risk appetite would demand much lower conversion price for further funding…which would lead to imminent dilution. ECBs are also not favoured currently as global lenders see deterioration in the Indian macro picture further spiked by downgrade rhetoric by credit ratings firms (infact Fitch has recently downgraded its ratings for India’s LT Currency Issuer Default Rating). Blue Chips like Tata Motors has recently shed out plan to issue convertible preferred shares and selling its assets and is issuing rights issue for the remainder instead.
Interbank rates are tightening in the Middle East, ME banks are also resorting to wholesale funding from global financial institutions. There is a lot of Tier II and Subordinate Debt issue happening in USD and Euro by ME banks. ME corporates are also raising funds from abroad. So, Indian corporates have to compete against their ME counterparts to get funding, and I believe on the sound macro footings, ME companies would win the battle if not the war.
And CDS again rising high…
Credit Default Swaps (CDS) on investment grade bonds issued by Indian corporates like Reliance Industries (230bps), Tata Motors (500bps), ICICI Bank (330bos), Reliance Communication (370bps) is again rising after falling from their March and Mid July highs. ICICI Bank followed by SBI and BOI has the highest CDS among the Asian banks’ investment grade bonds. It takes 3.3% (330bps) to insure ICICI Bank bonds against any default. So, if your cost of funding is let say 5% (lowest possible cost of funding), you need to pay 3.3% to insure yourself against any default. So 8.3% is you total cost. An investor would need atleast 2-3% net spread…hence you would demand 11-12% yield from their bond. Imagine, this is the cost of Senior Debt for ICICI Bank, and if they issue subordinated debt the cost would further rise as investors would demand even higher yield for the subordination.
CDS on Indian banks’ Investment Grade bonds
Source: Bloomberg
Trickling down effect of rising funding cost…
If this is the plight of big banks, imagine corporates who borrow from these banks. Let say a Construction Company A, who bids for a project for a margin of 3-5% over its cost of funds. Earlier, thanks to the benign capital market, their explicit weighted cost of funding were cheap (around 8-9%) as they used equity/ quasi equity routes (at huge conversion premium, so existing shareholders were also happy as dilution happened at higher price). Now equity capital market is fully dried up, Co A has to borrow locally. If ICICI banks’ marginal cost of fund is 11% it will keep a net spread of 2-2.5% and would lend to A at 13-14%. Hence the asking IRR climbs to atleast 17% to bid for any project A bids for. Earlier A was bidding at of IRR of 12-13%. Hence, either A has to bid at a very low IRR reducing its margin further or master project becomes extremely costly. And the cost trickles down to end user by way of higher toll/ utility charges.
Hence tightened market today for 2-3 quarters can have a long lasting impact on inflation. This is just one small example. Higher interest cost seeps into all forms of cost components, as for everything you do, you need money…to create money…
Global gloom…
Now with more than 50% of world economies flirting with recession (namely USA-25% of world’s GDP, Japan- 8%, Germany- 6%, UK- 5%, Spain- 3% etc.), and given so much of global financial sea-saw (Freddie-Fannie’s CDS at 350bps), writeoff scare on European banks and so much of earning risks for 2008 and 2009, Indian market Forward PE of 15x looks high. True currently Indian market PE is now at a premium of only 1% over Asian ex-Japan, as against an average premium of 10% during 2006 & 07, but that period was characterised by positive surprise in earnings numbers and lower interest rate/ inflation regime.
Things have turned upside-down as of now and expected to remain the same for next 1-2 quarters. Multiple measures of monetary tightening…multiple times…would start affecting the bottom line and balance sheet of Indian corporates expected from September quarter result, plus we can see some contraction in the capex plan or trimming of order book. And this time around we still have hidden earning risk…so even if markets remain at the same point, PE can actually increase.
Pundits say that credit crunch and slump will take half or whole of 2009 to get stabilise. And when any financial turmoil happens in developed market, correlation among global markets increases and the sentimental negative contagion spreads around the world. Middle East markets are largely negatively correlated with global markets, but during any sharp movement in S&P 500 Index, the ME markets react accordingly in the same direction.
Lagging foreign demand for Indian equities…
And in this global gloom, its very difficult to expect foreign investors to come back hugely, after USD 7bn YTD 08, and ticking, sell off. Domestic funds have been net buyer YTD but of no respite to the markets. Hence, thinking that Indian MFs will rescue the market will not help this time. We need foreigners…and now they need additional risk premium (remember rising bond yield will add risk free rate too!) and hence very cheap valuations. Middle East markets are trading at 11-17x CY08E earnings with ROE of around 23%. 1H 08 result has been stupendous. And this market is also attracting lot of global investors, primarily hedge funds. Now the biggest market Saudi Arabia is gradually opening for foreign investors. This region puts a threat to emerging Asia (incl India) in competition for foreign funds.
Conclusion
There could be an argument that now commodity prices are coming down, and thus is a good sign for inflation. Yes its good for short term, but if we see the reason for the decline…(and I believe it is more because of recession fear than a technical correction)…the story does not look favourable on a medium term basis. India is in Bear Market grip for the time being. Long run, everybody is dead that’s why we don’t bother to say…long term India is a Buy!!!
The reason I compared Indian market with Middle East market, because both are considered emerging markets. One side you have poor emerging economy (PCI $1000), other side you have ultra rich emerging economy (PCI $25000). Though these markets are still considered as frontier markets, it’s a matter of time, couple of these markets (UAE and Kuwait to start with) would get added in MSCI Emerging Market Indices-hence they would come in more limelight for global big players and would compete with established emerging market like India for FII inflows.
posted by Vikas Maheshwari, CFA at 7:08 PM
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