Equity Market Outlook - December, 2011

The Indian equity market continued its downward trend in December 2011, with the Sensex losing another 4%. The year ended with investor sentiments moving from one of hope at the beginning of the year to one of gloom and doom as the year went by. Unlike 2008, it has been a slow downward grind for the equity markets. The benchmark indices declined by around 25% in 2011 but the carnage was quite severe in the mid-cap space and the broader market. The value erosion in some of the mid-cap stocks and sectors is as bad as what was seen in the 2008 crash. The Indian Rupee and equity indices were among the worst performers globally. Much of this was self-inflicted. The domestic macro-economic environment deteriorated sharply due to continued monetary tightening by the central bank. There was also a lack of resolute policy response from the government. Global conditions are tough and the European problems worsened the global macro environment, pushing most economies into a somewhat distressing low-growth cycle, which is now in its third year. One big solace for the global economy, however, is the recovery of the US economy which has surprised positively with its improving PMI, retail sales and employment generation.

At home, due to the political logjam, policy decisions have been derailed and the slowdown is quite evident. Recent GDP and IIP data indicates a more subdued FY12. GDP growth is expected to be around 7.25%-7.5%. The growth slowdown has been led by a fall in corporate and government investment. Industrial production has slowed with capital goods registering a 25% de-growth. Business confidence is low and many big Indian Corporates have raised concerns on the government's policy paralysis, regulatory hurdles and lack of reforms. We are witnessing many deferments of the existing projects and delays in capex plans. If the investment rate, which is now at a 5-year low, is to see a revival, regulatory approvals have to be speeded in 2012 and the government needs to act together and fast track the approval process for project clearances. The consensus earnings estimates for FY2012-13 has been revised downwards by 9-10% and the CAGR growth estimate for FY2012-13 now stands at 12%-13%. Any meaningful revival in the equity market can only be led by a reversal in policy rates. With growth slowing down considerably, a cut in policy rates seems inevitable. Headline inflation remained high mainly on account of imported inflationary pressures led by the rupee's depreciation. A complete breakdown in the rupee was arrested, thanks to the increase in FDI and FII investment in debt. This kept the current account deficit at manageable levels and the BoP positive.

Equity Outlook

In 2011, emerging market equity, India Included, did not find favour with foreign investors. 2012, however, could be different and surprise us positively. How Indian equity will perform in 2012 will depend greatly on how the government and policymakers respond and provide solutions to the stasis in the economy. As the saying goes, in every large problem there lies an opportunity. What could support a revival is the attractive equity valuations, which are near historic lows. Current valuations appear to be discounting all the negatives. The BSE Market Cap to GDP at around 0.6 times is very close to the 2008 panic bottom level of 0.55 times. The equity earnings yield is at 8%, equivalent to the 10 year G-Sec yield. The one year forward P/E multiple is at 12x, significantly lower than the 15 year average of 15x. In this scenario, any resolution to the growth and investment slowdown, could lead to a spectacular rally in the equity market in 2012. Even if the current inaction persists, the downside for the equity market is limited. RBI has been doing Open Market Operations to infuse liquidity and attempting to attract higher debt capital flows through changes in the regulatory regime. With inflation expected to come down to 7% by March 2012, RBI is expected to focus on growth rather than inflation resulting in substantial monetary easing in 2012. Investor sentiments have already turned positive at the start of the New Year 2012 and we believe that all Indian investors would have a happy and prosperous year ahead.