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May 08, 2013

Small could be better now

Widened valuation gap offers opportunity in the mid-cap space RBI delivers rate cut of 25 basis points but its commentary turns distinctly hawkish: The macroeconomic variables have shown a mild recovery with moderation in inflation and narrowing of the trade deficit for March 2013. The softening of the commodity prices (especially crude oil and gold) is like manna from heaven for the import dependent Indian economy. Despite this, one cannot neglect the challenges facing the economy. For FY2014 the Reserve Bank of India (RBI) has projected a growth rate of about 5.7%, which is marginally higher than the FY2013 growth rate. The central bank has obliged by cutting policy rates by 25 basis points but expressed concerns related to the unsustainable level of current account deficit (CAD) and persistent inflationary pressures. The tone has distinctly turned hawkish and the pace of monetary easing is likely to turn subdued going ahead. Political crisis deepens, economic reforms in limbo: The ongoing political crisis over the leak of the coal scam report and a slew of other scams (railgate being the latest in the list of scams) leaves limited room for the government to push through important pending legislative bills (such as the land reforms bill, the insurance bill and the GST bill) that require parliamentary nod. The RBI in its recent policy statement articulated that governance issues were dragging the economys growth rather than the monetary policy. Moreover, the decisive victory in Karnataka state election could increase the governments assertiveness on reforms and/or prompt the ruling party to call for early national election. Q4 earnings meet expectations; margin expansion is an encouraging sign: The corporate earnings growth for Q4FY2014 trended largely in line with the estimates though the estimates themselves were quite conservative. In terms of the Sensex companies, the earnings growth was largely in line with expectations (automobile and metal companies delivered a surprise) though the revenue growth fell short of estimates. In the near term, the corporate earnings growth will remain subdued and may pick up towards H2FY2014, led by improved macro-economic conditions and the accumulated effect of some of the measures announced earlier. Global economyconsolidation in progress: The US economy is showing firm signs of recovery as indicated by the falling unemployment numbers and the recovery in the housing sector. The fiscal stimulus announced by the US government and the other governments (of China, Japan etc) is likely to support the cyclical upturn in the global economy. However, the European economies remain in shambles and could continue to trigger bouts of risk aversion. Outlookpositive stance v indicated; expect outperformance in the mid-cap space: We had been constructive on equities in our last Market Outlook report (Policy push dated March 6, 2013) and had expected the budget hangover to recede and the global environment to be supportive. The benchmark indices have performed ahead of the consensus expectation and the crash in the commodity complex has provided the trigger for a sharp bounce. For the next two months, we see limited scope for re-rating and the benchmark indices would do well to consolidate in a range in the seasonally weak period of May and June. However, we expect quality stocks in the mid-cap space to outperform the broader market due to the widened valuation gap and the expected improvement in corporate earnings in the next few quarters.
Sensex one-year forward P/E band
27.0 22.0 17.0 12.0 7.0 Apr-01 Apr-03 Apr-05 Apr-07 Apr-09 Apr-11 Apr-13

+1 Avg PE -1

Source: Bloomberg, Sharekhan Research

market outlook

Small could be better now

Macro variables show mild improvement The decline in the inflation rate to a three-year low (5.96% in March 2013), a moderate pick-up in the Index of Industrial Production (IIP) and contraction in the trade deficit (in March 2013) are the variables that point to the easing of concerns pertaining to the economy. The manufacturing inflation has declined to 4.1%, though high food inflation remains a concern. The improvement in the trade deficit was aided by moderation in imports and a slight pick-up in exports. The economy seems to be heading for a cyclical pick-up though the recovery will be modest, given the multiple challenges the economy is facing right now. Apart from policy action the economy needs to be supported by sustained softness in the commodity prices and monetary easing which seem a bit uncertain at this point of time.
GDP, inflation growth
12.0 10.0 8.0 6.0 4.0 2.0 (2.0) Mar-09 Mar-10 Mar-11 Mar-12 Mar-13

But RBI turns hawkish after reducing rates by 75 basis points in CY2013 Including the recent reduction in the repo rates the RBI has reduced the repo rates by 75 basis points in the year till date (YTD; CY2013) against the expectation of a 100basis-point reduction for CY2013. In view of the macroeconomic challenges (especially inflation and the twin deficits), the RBI will be constrained to ease the rates further. Since the transmission of monetary policy has not been very active due to the tight liquidity and higher cost of deposits, the rates are unlikely to decline any further significantly.
10-year G-Sec bond yields
8.7 8.5 8.3 8.1 7.9 7.7 May-12 Feb-13 May-13
Source: Bloomberg

GDP (%)

WPI (%)
Source: Bloomberg

Reform momentum to be affected by political crisis Due to the face-off with the opposition over several issues ranging from the coal scam investigations to the institutional integrity of the Central Bureau of Investigation the governments reform agenda has come under cloud. Several key bills, such as the land reform bill, insurance bill, direct tax code bill and the bill for deregulation of sugar, are likely to be stuck indefinitely. In addition, the government has entered into election mode with election in Karnataka and four other major states which will shift focus towards populist bills such as the food security bill. As rightly pointed by the RBI, the governance issues have largely affected the pick-up in investments and need to be focused upon. Going ahead, the decisive victory in Karnataka could increase the governments ability to push reforms. Corporate earnings; revenue growth concerns remain, margins rebound Amid conservative estimates, the corporate earnings growth is largely in line with estimates. However, the pressure on revenue growth is clearly visible due to the slowdown in the economy. On the positive side, the margins have come in better than expected and are driving the earnings. In the given circumstances, the corporate earnings are likely to remain subdued in the near term and follow the revival in the economy, which is expected to recover gradually,
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May 08, 2013

Easing of commodity prices provides relief Driven by global factors the commodity prices have declined significantly over the past several weeks. Gold and crude oil prices have declined by 8-10%; together these two constitute about 40-45% of the imports and a drop in their prices has reduced the current account deficit. The exports have shown a marginal recovery and a meaningful pick-up will happen once the global economy starts improving. Going ahead, the outlook on the key commodities will shape the recovery trend for the domestic economy.
Crude and gold prices
115.0 110.0 105.0 100.0 95.0 90.0 85.0 80.0 75.0 Nov-12 Dec-12 Mar-13 Feb-13 Jan-13 Apr-13

Brent crude

Gold spot
Source: Bloomberg

Sharekhan

Aug-12

Nov-12

market outlook

Small could be better now

possibly towards the second half of FY2014. Given the expectation of ~14% earnings growth in FY2014, there could be some downward revisions, as had happened in FY2013. Cyclical recovery in global economy underway As mentioned in our previous reports, the global economy is heading for a cyclical recovery in 2013 and may pick up momentum in 2014. The advanced economies like the USA are showing firm signs of recovery while stimulus offered by several other countries (Japan, euro zone) will facilitate the global recovery. The emerging markets continue to witness healthy consumption and investments in infrastructure which will support the global growth. In case of the euro zone, the major achievement has been that the region has averted major crises which could have destabilised the global economy.
Global GDP growth (IMF)
6.0 5.0 4.0 3.0 2.0 1.0 (1.0) 2007 2008 2009 2010 2011 2012 2013 2014 2015 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Outlookpositive stance v indicated; expect outperformance in the mid-cap space: We had been constructive on equities in our last Market Outlook report (Policy push dated March 6, 2013) and had expected the budget hangover to recede and the global environment to be supportive. The benchmark indices have performed ahead of the consensus expectation and the crash in the commodity complex has provided the trigger for a sharp bounce. For the next two months, we see limited scope for re-rating and the benchmark indices would do well to consolidate in a range in the seasonally weak period of May and June. However, we expect quality stocks in the mid-cap space to outperform the broader market due to the widened valuation gap and the expected improvement in corporate earnings in the next few quarters.
Sensex one-year forward P/E band
27.0 22.0 17.0 12.0 7.0 Apr-01 Apr-03 Apr-05 Apr-07 Apr-09 Apr-11 Apr-13

+1 Avg PE -1

World GDP (LHS, %) Inflation, average consumer prices (%)

Source: IMF

Source: Bloomberg, Sharekhan Research

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