* Indian equities catching up on the underperformance since demonetisation:
Significant outperformance of US equities and other DMs vs. Indian equities since Trump victory is due to a combination of (a) the pro-growth narrative for the US economy; (b) growth uncertainty in India due to demonetisation and weakening investment cycle and (c) declining spread between India and US bonds resulting in massive FPI outflows especially from Indian bonds. Nifty has been amongst the worst performing equity market globally till end of Dec 2016 but it is playing catch up currently and has become the best performing equity market globally YTD as the impact of demonetisation was below expectations and the budget focussed on growth and fiscal prudence.
* Valuations are not stretched:
As it is erroneous to base valuations on one point earnings during the peak of an earnings up-cycle (for example FY08 earnings), similar is the case of relying on one point earnings towards the fag end of an earnings down-cycle (real earnings growth are flat since 2008 for the Nifty) and therefore trailing and one year forward based P/E multiple which are showing above average valuations may not be the best indicators of overvaluation. On the other hand market appears to be trading below average valuations using alternate methodologies such as market cap to GDP (74.9%), CAPE (cyclically adjusted PE ratio – 19x) and Bond to earnings yield spread.
* No negative surprise in corporate earnings due to demonetisation…:
Impact of demonetisation is clearly visible in consumer stocks such as staples and discretionary consumption in terms of weaker volumes but the silver lining is that it is not worse than expected. Retail finance focussed private sector banks have seen very little impact of demonetisation. Q3 results for Nifty stocks declared so far indicate neutral results vs. expectations (Out of the 28 stocks which have declared results, 13 are neutral while the earnings beat and miss are equally distributed at 7 and 8 respectively).
* …but MSME and informal sector could have been impacted severely:
Marginal impact of demonetisation on large Nifty stocks is largely due to the shift in economic activity from unorganised to organised sector during the cash crunch (Clearly evident in organised retail channels and consumer products) although the advance estimates released by CSO peg economic growth for FY17 at 7.1% y/y, significantly down from 7.6% in FY16 implying that the brunt of the slowdown fell on the SME segment. Also recorded GDP growth for H2 FY17 will overstate the overall impact because informal and cash based economy are either not captured in the national income accounts or to the extent they are, it is limited to formal sector indicators.
* Union budget 2018 pass muster of investors:
Staying the course of fiscal consolidation amidst moderating revenue growth, the FM (a) laid emphasis on rural and social sectors; (b) made significant allocation for productive capital expenditure ; and (c) granted tax exemptions to spur private consumption. On the other hand, the FM dispelled fears by (a) not imposing long term capital gains for equity investors; and (b) refraining from populist moves involving fiscal largesse. Despite the marginally expansionary FY18 fiscal deficit target of 3.2%, the moderate expected net borrowing of INR 3.48 tn (including buybacks) in FY18 can have a positive impact on borrowing rates.
* Macro indicators stable:
While retail inflation dipped to its 25-month low of 3.4% in Dec ’16 although core inflation remained sticky at 4.8%, industrial production growth rose to its 13-month high of 5.7% in Nov ’16 albeit on a low base. Core sector output, which accounts for 37% of IIP, rose 5.6% in Dec ’16 on the back of robust production of steel, electricity, petroleum refinery and coal. Trade deficit narrowed to $10.37 bn as rising exports provided comfort. Liquidity surplus and low credit growth post demonetization has resulted in MCLRs dipping by as much as 90 bps for banks making credit cheaper in the system.
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