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Normalisation of ‘excess liquidity’ and ‘risk free rate’ to act as gravity on elevated equity valuations while continued uptrend in ‘profit/CFO cycle’ and rising ‘investment rate’ will be the counterbalancing force!

Excessive liquidity and interest rate cut cycle to reverse in 2022 and will weigh on equity valuations...: Two factors which will be the hallmark of 2022 are the reversal of the QE programme of the US FED and the expected initiation of the rate increase cycle in the US. While these events will weigh on equity valuations in general, the impact will be high for extremely low earnings yield or negative yield stocks (loss makers) with growth uncertainty.

however, in 2022 we will still be in the early stages of interest rate normalisation and the transition from excessive liquidity to adequate liquidity will continue to offer relatively low interest rates with inflation trajectory expected to moderate in 2022. Also, other major central banks have not yet stopped QE with the PBOC moving in the opposite direction by initiating liquidity injections while the ECB remains accommodative. Despite the expectations of liquidity reversal and rate hikes by the US Federal Reserve, the average yield offered by the US 10-year bond and India 10-year bond remains relatively low at around 4%. The above indicates ample liquidity in the system and expectations that the inflation spike is transitory thereby, making us constructive on Indian stocks which are offering around 5% forward earnings yield in an earnings upgrade cycle environment.

* Our Dec’22 target for the NIFTY50 is 19,500 and is based on a 5% one-year forward earnings yield or 20x PE.

* Outperformance zone and top picks – Stocks with robust growth visibility (> nominal GDP growth) and relatively attractive earnings yield (> 4-5%) related to the following economic activities to outperform -

Rising ‘investment rate’ including digital infra – L&T, NTPC, Power grid, NHPC, Ultratech cement, Ashok Leyland, Bharti Airtel, Tata communications.

Channelising savings, insurance and credit growth – SBI, HDFC Bank, HDFC, SBI Life, ICICI Lombard general insurance.

Pent-up demand (including real estate)– Tata Motors, TVS motors, Phoenix Mills, Greenpanel Industries.

Exports & staples – Alkem, Dr. Reddy’s, Gujarat Fluorochemicals, Infosys, Dabur and Godrej consumer.

* Covid showing signs of losing its severity as evidenced by the disconnect between sharply rising new cases and moderating deaths worldwide.

Mid and small caps will play a dominant role in the ‘opening up trade’ and could eke out marginal outperformance over large caps in 2022.

FPI outflows waning while the risk of volatile FPI equity flows on external sector mitigated by rising FDI, primary flows and relatively low vulnerability on 'current account balance'; structural rise in household savings into equities is emerging as another counterbalancing force. We expect INR to trade in the 74-76 range.

Profit cycle uptrend appears structural and is in its first phase of normalisation from depressed earnings –

‘operating and financial leverage’ effects yet to kick in. PAT to GDP reached a decade high level of 4.2% on a TTM basis and this uptrend appears structural with the deep impact of demand and supply shock due to covid pandemic unable to break it. In our view, this is the first phase of the profit cycle where depressed profits and loss pools are normalising while the next leg of the profit cycle will be driven by improving ‘operating leverage’ as capacity utilisation improves from 60-70% levels and later by ‘financial leverage’ as credit growth picks up in a relatively low interest rate environment. NIFTY50 earnings to have a CAGR of around 24% over FY21-24.

Investment cycle – key signals indicating a revival. Key signals which indicate we are nearing the revival in the private capex cycle are:

* Ample availability of internal and external financial resources in terms of highest ‘CFO/capex’ ratio of 2.2x in FY21 over the past two decades for India Inc., excess banking system liquidity, low interest rates and easy access to liquidity from capital markets (bond & equity markets).

* Rising investment demand as well as ‘animal spirits’: Bulk of the economic recovery is being led by the growth in GFCF (gross fixed capital formation) which incidentally is above the level seen in the pre-covid period while the PFCE (private final consumption expenditure) is lagging and yet to reach the pre-covid levels. Despite the covid impact, the listed space private capex maintained the run rate of around Rs5.6trn seen in FY21. Animal spirits in terms of significant capex announcements by large private players in capitalintensive sectors such as energy and metals is a key positive

* Improving tax buoyancy and waning expenditure for covid-related programmes could channelise higher spending towards development expenditure such as infrastructure spending going forward.

* Revival of housing sector: Absorption of housing units is improving as a result of rising income in key white collar jobs related to technology space and low interest rates.

* Improving external sector: Robust exports sector and improving FDI to boost investments.

* Strong investment demand from digital economy including digital infrastructure.

* Credit cycle showing signs of bottoming out in FY21 as credit growth inches above the 7% mark.

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