Investment Demand – Surging Sentiments to drive the recovery …
Much of India’s growth problems over last few years is rooted in the steep slump in investment demand ( capital investment ) . Industrial Capex which fuelled the boom in 2004-07 cycle crashed from 17% of GDP in 2007-08 to 10-12% level in the last year .This fall from grace explains the reasons for deep cut in GDP numbers over the last few years . While high inflation and elevated interest rates have punctured a deep hole in India’s capex story , what caused such a prolonged sleaze in capex demand goes beyond usual macro suspects . Collapse in business confidence (sentiment) stemming from rotten retrospective tax regimes and woeful drift in policy making ( not to mention the toxic graft ) had a much larger role to play than usually credited for in deepening the woes in the investment demand . Power of sentiments can rarely be underestimated , in either direction .
The surge in optimism with the new business friendly govt. at the centre can equally be a powerful sentimental force to set the ball rolling in the opposite direction now , though the esoteric macro metrics like inflation and interest rates may take longer to revert to mean . Soaring animal spirits can sometimes cause spectacular turn in murky macro by feeding on itself and thus triggering a sharp rebound , more so in capex demand given its close correlation to sentimental swings . One doesn’t need to look too far to fathom this.
Let us look at what ails the capital goods sector and how surging spirits can change those magically on the ground . Stretched balance sheets ( high leverage) , high cost of external debt ( on weaker rupee) , challenges in capital raising ( on bank’s NPA issues and weak capital market ) and weak demand etc are some of the well entrenched problems in the capital goods space . But the rising mercury in stock indices is scripting the much needed relief to these problems thro’ its sentimental effects . Spurt in Sensex in no small measure leading to (1) easing access to capital with confidence and visibility for IPO / FPO building up (2) rising stock prices reducing dilution risk and hence more cushion for capital injunction (3) firm rupee softening the cost of external debt (4) NPAs turning miraculously into write-backs , thus boosting banks profits and thus enhancing their ability to lend and so on . Economic cycles are as much about macro metrics as about confidence ( sentiments) , ephemeral though it may be . When confidence gathers momentum , lot of macro mess gets melted away mesmerizingly in a self-fulfilling manner . Such is the power of surging optimism .
It goes without saying that the sector which faced the brunt of above issues will also be the biggest beneficiary of this changing tide . Industrial Capex is set to benefit the most from this changing prospects . Add to this the lack of capacity addition for past few years ( no capex spending and hence the rush to add capacity to meet the new demand ) and the low base effect , one has a compelling case for a sharp rebound in investment cycle . No surprise that no one wants to miss out the rally in hi-beta capex stocks .
This is not to argue that all structural problems such as elevated food inflation , archaic labor laws , wasteful subsidies ( high fiscal deficit) , Infra woes etc can be pushed under the carpet . Reforms in these are key to sustaining the rebound . But the cyclical turn fuelled by the animal spirits can buy the much needed time to work on these structural reforms for the new govt. Else , this much needed rebound can easily trip into lower gears hitting those speed breakers if reforms are not unleashed quickly . Watch out for interesting times …
Market Outlook :
The debate is no longer about whether the stage is set for a new secular bull market or not . The views on this can’t more convergent . The debate is more on the timing of such an event . While there is a growing consensus that the policy actions that will be unleashed by the new pro-reformist govt. will act as a catalyst for the new bull market to kick-start , the concern is whether the market is racing far ahead of immediate fundamentals . Since the ‘hope rally’ began in Feb, the Sensex has zoomed 20%+ and market’s multiple has surged to new high . The Sensex is currently trading at 16x+ its FY15 earnings, which is higher than the 10-year average of 14.2x. India is trading at a 35%+ premium to the MSCI Asia-ex-Japan Index.
Historically , when market starts discounting beyond the next immediate year’s prospects , that too turning blind eyes to short-term headwinds , the risks of it tripping grow larger and consequently ,the rally can become unsustainable . Market is caught up on its post election binge and is yet to recover from its hang-over . Earning upgrades are critical for premium valuations to sustain . Since macro challenges such as entrenched food inflation and hence elevated interest rates can impact negatively the earning upgrade cycle , more so if El Nino takes effect ( bad monsoon) , current valuations do seem stretched on short-term basis .
This is not to argue that the market is not attractive from longer-term perspective given India’s long-term re-rating potential from global investors . But it is more likely to be interspersed with short-term corrections as the earning upgrade cycle navigates thro’ difficult terrain of elevated yield and inflationary pressures in the medium term . Investors are advised to use such short-term corrections to build a sound portfolio to gain from this new bull market cycle than taking positions one-shot in this over-heated market.