5 reasons Dalal Street will see consolidation, even correction for 6 months

Indian equities have been a big outperformer over the last two years, rewarding investors with sizzling returns.

But after rising approximately 2.5 times in the last two years, the market has started showing signs of consolidation.

The last two years of economic recovery, high equity returns, fiscal stimulus and increased allocation to rural-focused government sponsored schemes have rightly brought the economy back to its pre-crisis growth trajectory, but have also been accompanied by many undesired results such as sticky inflation, high interest rates, capacity constraints and very high purchasing power.

In my view, Indian equity market is heading for at least six months of consolidation and may even undergo a short spell of correction.

Return from equities in the immediate future is likely to be influenced by domestic macroeconomic environment, punctuated by slowing growth momentum, return of inflationary pressures led by rising commodity prices and wages, tight liquidity (tillmid-2011), hesitant recovery in the investment cycle, below-average corporate earnings growth, high cost of funds, tight monetary policy and somewhat muted government expenditure.

There are five key risks which can dampen short-term market sentiments:

1) Overdependence on FII inflows: Over the last 11 months, one of the key contributors to the Indian equity market’s outperformance to other global markets was the receipt of highest-ever FII equity flows worth over $28 billion, over 50% of total flows to Asia ex-Japan & China. Along with the equity rally, it also expanded India’s premium to its Asian peers. Going forward, this, coupled with the economic headwinds and chances of marginal downgrade of FY12 corporate earnings estimates, may lead to a reversal of FII inflows. There are also chances of FII’s tactically shifting their focus towards US equities, which have started looking attractive after many years of flat returns, backed by chances of higher than expected economic growth, strong corporate fundamentals and extremely cheap valuations.

FII inflows in the last six months may also have a significant chunk of ETF (exchange traded fund) and arbitrage flows along with hedge fund money, which is very opportunistic and swiftly moves from one country to another. In 2008, such outflows had done havoc in the Indian markets.

2) Tight domestic liquidity situation resulting in high cost of funding: It is valid to get concerned over domestic liquidity situation when you see banks borrowing one-year money at 9.5% in the wholesale deposit market, marking a jump of 300 basis points (bps) year on year.

Further, many mid-tier companies in infrastructure, realty and commodity sector are seen borrowing at rates as high as 10.5-11% for a year. Such high cost of funds can adversely impact corporate profits and ultimately their valuation.

Even though the demand for credit remains somewhat sluggish, liquidity tightness persist in the last six months, partly engineered by RBI on the back of very high inflation, and is hurting India Inc. If the credit growth picks up in next quarter, short-term rates are likely to remain under pressure, thereby impacting FY12 earnings.

3) Higher crude and commodity prices building inflationary pressures: Unlike the first round of Quantitative Easing (QE-I) in the West, which resulted in a rally in emerging market equities, QE II saw heightened interest in commodities.

Many commodities, including crude oil, are at their two-year highs.
Chances of higher-than-expected growth in the US, Japan and core Europe are also driving speculative investments in commodities.

Liquidity and momentum-driven rally in crude oil can take its price to $100/barrel in the immediate future, queering India’s fiscal arithmetic, current account deficit and corporate earnings along with flaring inflationary pressures.

For instance, since India imports ~70% of its crude oil requirements, a rise in crude oil prices to $120/bbl can take the CAD to its highest even levels of over 4.5% of GDP. This will hurt the economy even more in an environment of slowing growth momentum on the back of high base effect.

4) Surge in corporate wage bill coupled with lower productivity: Indian corporates are facing two key challenges on the human capital front, namely shortage of both skilled and unskilled labour as well as stagnant productivity.

After a two-year hot streak, it’s consolidation time for equities
The NREGA transmission and inter-state political conflicts are leading to shortage of unskilled labour whose supply has reduced by 40% in the last 18-24 months. Shortage of skilled labour is well manifested in the rising wage bills. In Q2FY11, manpower expenses of BSE-500 companies, on an aggregate basis, have risen dramatically by 25% yoy.

5) Stress on fiscal consolidation going forward: At present, government balance sheet is looking relatively strong on the back of buoyancy in tax collections, unaccounted oil, food & fertiliser subsidies, successful disinvestment proceeds and one-time bonanza from the sale of 3G spectrum. The confluence of multiple headwinds will make achieving FRBM targets difficult next year.
Assuming that one-third to half of the oil under-recoveries is absorbed by the government, every $10/bbl increase in the crude oil price will increase fiscal deficit by ~0.2% of GDP. Further, moderation in growth impacting tax receipts and absence of one-time 3G revenues will also take a toll on the government balance sheet. If the equity markets undergo a correction, then success of disinvestment programme will also be difficult to achieve.

Along with the above concerns, the recently unearthed 2G spectrum allocation scam and housing finance bribery scam has negatively impacted risk perception for India. In my opinion, this may also lead to some compression of premium between India and Asian peers. Over and above these domestic issues, the economy will continue to be vulnerable to any negative global development such as Chinese monetary tightening to combat inflation, Korea’s war tensions and continued stress in peripheral Europe.

In a nutshell, the risks enumerated above have started hitting Indian corporate earnings from the last quarter and are likely to intensify going forward. These will necessitate further hikes in policy rates next year, making the RBI’s job tougher. While lesser than warranted tightening may flare already high inflation, excessive tightening may falter the growth process and snap the very economic advantages the country enjoys.

The confluence of these factors, coupled with relatively high valuations, calls for a near-term breather in Indian equities. The next market and economic cycle will be led by benign global outlook, lower interest rates and much cheaper valuations. In the interim, before the next cycle picks up steam, we are most likely in for a lack-luster stock market performance with a downward bias of 15-20%.

The writer is chief investment officer, Birla Sun Life Insurance. Views are personal