The Indian market may stay range-bound over the next few months given the lack of any meaningful catalysts—(1) fair valuations overall with expensive valuations in certain sectors, (2) limited scope for earnings upgrades, (3) low space for inflation and monetary policy surprises and (4) sluggish legislative reforms. Executive reforms over the next 2-3 months will be important to sustain valuations, especially if monsoons disappoint.
Valuations are fair—market is down in the past three months but in line with earnings cut.
The Indian market’s valuation appears fair at around 17.4X FY2016E ‘EPS’ (see Exhibits 1-5). The 12-month rolling-forward P/E of the BSE-30 Index at 17X is at the top-end of the ‘normal’ historical trading band. Of course, low global yields and resultant cost of equity suggest that valuations will be higher versus historical levels. Nonetheless, valuations are terribly expensive for high-growth quality stocks (see Exhibit 6) even after factoring in a strong growth in earnings. Our FY2016E ‘EPS’ (free-float basis) for the BSE-30 Index is down to Rs1,585 from a high of Rs1,755 in October 2014. Valuations look more reasonable on FY2017E basis but that is predicated on our earnings forecasts being met or exceeded.
Earnings bottoming out in certain sectors but large risks exist in others
4QFY15 net profits of BSE-30/Nifty-50 companies that have already reported were well below expectations (see Exhibit 7) with PSU banks and cement companies reporting very disappointing results. We see high risks to our estimates in the consumer and infrastructure-related sectors. We had already cut earnings for a few sectors (see Exhibit 8) due to a variety of reasons—(1) unfavorable currency movements (IT), (2) lower crude oil prices (upstream energy) and (3) weak rural consumption (2-Ws, 4-Ws, tractors). The first two factors have largely played out. However, we do not see any meaningful scope for earnings upgrades as we model reasonably strong growth across most sectors. On current form, both consumption and investment will likely disappoint and so will earnings (see Exhibits 9-10). It looks like Street estimates have simply been pulled up to reflect rising stock prices, a case of the tail wagging the dog. Investors may want to scrutinize analysts’ estimates more closely given how badly the final FY2015 earnings numbers missed initial estimates.
Not much support from the monetary side
We do not see much scope for RBI to cut policy rates beyond 25-50 bps given (1) the projected inflation trajectory and CPI inflation reaching almost 6% by end-FY2016 and (2) RBI’s stated policy to keep real interest rates positive (150-200 bps). We see scope for a further 25 bps cut (June 2, 2015) and another 25 bps at a stretch if CPI inflation stays below 5.5% in 1QCY16. Anyway, 25-50 bps rate cut may not be sufficient to revive the flagging investment cycle. Government reforms and government spending will be more material, in our view.
Pray for some rains (and some reforms)
With El Nino emerging as a factor once again for 2015 monsoons, India’s inflation targets may go awry. The government will have to manage food prices well if monsoons turn out to be below normal or deficient in order to prevent inflation overshooting the projected trajectory of the central bank and the private forecasters. More important, the fact that monsoons remain relevant for Indian agriculture almost 70 years after India’s independence and is an annual ritual for the market (along with the union budget) shows the extent of reforms required in India.
The next stage of reforms
Government reforms and government spending may be two important factors for the market over the next few months. Government reforms may provide further affirmation of India’s medium-term story while government spending may lift investment and catalyze follow-up investment by the private sector.
A. Government reforms. With two of the government’s important legislative efforts (GST and land acquisition bills) stuck in the parliament, we hope that the government can unleash certain other reforms that do not require legislative approval. Exhibit 11 shows the status of pending economic bills as also recent important legislation. We expect the GST bill to be passed by the upper house of parliament in the monsoon session of the parliament but are less hopeful about the land acquisition bill being approved in its current form.
Nonetheless, we note that several reforms can be implemented through the executive route. We present a list of important pending and ongoing reforms in Exhibit 12; we have included legislative reforms also for the sake of completion. Among key executive reforms, we would like to see progress on a few, which we discuss below.
1. Auction of mineral ore mines. We note that the government has put in place the necessary legislation for state governments to auction mineral ore mines (other than coal) with the passage of The Mines and Minerals (Development and Regulation) Bill, 2015 in the budget session of the parliament. This will help increase supply of bauxite for several aluminum downstream units (Hindalco, Vedanta) and iron ore for upcoming steel plants. It is imperative that the governments address the challenges of the steel sector in order to avoid further defaults on loans by the steel sector. The sector is under tremendous stress (see Exhibit 13).
2. Auction of coal mines for private sector commercial mining. In our view, the government should move rapidly to auction new coal blocks for commercial mining by the private sector. Coal India has done a good job in stepping up production over the past year or so but India would require private sector mining. The auction of coal blocks post the first round in February 2015 seems to have inexplicably come to a standstill. The government has so far auctioned 31 blocks only, out of the 204 cancelled by the Supreme Court in August 2014.
3. Extension of DBT (Direct Benefit Transfer) schemes to food and kerosene. The success of DBT scheme for LPG should encourage the government to look at extending DBT to food and kerosene. The government has already put in the framework for direct payment of cash subsidies to target households with issuance of more than 800 mn UID cards (see Exhibit 14) and opening up of new bank accounts (see Exhibit 15) for the unbanked section of the population as part of its financial inclusion thrust.
4. Resolution of problems in the power sector. We believe the government’s focus should include the power distribution segment also. It has focused its efforts on the generation side hitherto; we note its efforts to increase availability of coal and gas for power plants. However, any permanent solution to the problems in the power sector would require a joint effort between the central and state governments to fix the financial challenges of the state-owned distribution entities.
We would recommend a one-time settlement of accumulated losses with the central and state governments ‘accepting’ a portion of the accumulated loans. However, any such settlement should entail strict conditions regarding the distribution entities achieving financial viability within a stipulated timeframe. The central government can withhold part of the central transfers (share of states of central taxes) to states if their SEBs fail to meet the agreed targets.
5. Resolution of NPL problems in the banking sector. The government’s macro reforms will undoubtedly help reduce NPLs in the banking system over a period of time. However, as discussed several times in the past 12 months, we believe the creation of a bad bank will help avoid a banking-system crisis and stop the current ‘extend-and-pretend’ practice in the banking system. This helps achieve little other than perpetuate bad habits and lending practices for a long time.
We believe the transfer of assets from ‘bankrupt’ companies to healthier companies is imperative to ensure that the assets are properly utilized. This is unlikely to take place until the banks’ balance sheets improve sufficiently for them to be in a position to write down a portion of their loans (other than equity, which needs to go to zero for the defaulting companies). The government has announced its intention to introduce bankruptcy laws but we are not sure about its timing. As an aside, India does not need more power and steel plants; it needs the extant ones to work properly.
6. Further deregulation of the energy sector. The finalization of a fair subsidy-sharing formula for the government-owned companies should be a straightforward exercise given the current ‘low’ levels of crude oil prices. This will also help the government divest its stakes in the oil PSUs in order to meet its ambitious divestment target of Rs695 bn for FY2016. Also, the government should start the process of alignment of LPG prices to market levels. A reduction in the number of subsidized cylinders by one or two or small increases in prices are unlikely to create a political or social furor. Finally, the government should also review its gas pricing policy since the policy is unlikely to encourage domestic E&P activity and will make India more dependent on LNG imports.
B. Government spending. We expect government spending to pick up over the next few weeks, which should alleviate the current feeling of ‘gloom and doom’ in the economy. The government has increased allocation for capital expenditure for roads and railways. This will be important to kick-start the investment cycle, which appears very weak currently. We note that awarding activity has picked up in the road sector (see Exhibit 16) although execution is still slow (see Exhibit 17). The government has patiently resolved several pending issues in the road sector and we are hopeful about execution picking up over the next few months.
We attribute the sharp decline in rural consumption and increase in defaults in the construction equipment finance partly to the government’s decision to reduce capital expenditure in FY2015 (see Exhibit 18). The central government’s capital expenditure declined 0.5% in FY2015 as it sought to meet its gross fiscal deficit target of 4.1% of GDP (final figure was 4%). The government seems to have increased capital expenditure significantly in March 2015 since 11MFY15 capital expenditure was down 12% yoy. We are not sure about the flurry of expenditure in the last month of the last fiscal (it could just be certain ministries meeting their targets for FY2015 as plan expenditure is up 72%) but it may be a sign that the government has finally started to spend after months of parsimony. However, a portion of the growth may reflect expenditure on defense since non-plan capital expenditure has also shown a strong growth in March 2015.