Optimistic valuations

Markets continue to run ahead of fundamentals

Adovish speech by Federal Reserve Chairman Jerome Powell has given a new impetus to the market rally. At the Jackson Hole conference on Friday last week, Mr Powell said the Fed believed inflation, currently running over twice the US target rate of 2 per cent, was “transitory”, and “temporary”. The Federal Open Market Committee may discuss the possibility of tapering its monthly bond-buying programme of $120 billion but a taper is not expected until 2022. Hence, fears of monetary tightening have been allayed. A higher headline gross domestic product (GDP) growth number in the first quarter of this fiscal year may add to the momentum. Though the numbers were broadly in line with expectations, given the catastrophic fall in April-june 2020, which created a low base, the data gives hope that the economy is heading back towards normal.

The stock market continues to be bullish for a few other reasons. One is the willingness of foreign portfolio investors (FPIS) to increase exposure in risky emerging market assets, given the assurance that the US will continue its liberal monetary policy. The FPIS have been net sellers of rupee-equity in the 2021-22 fiscal but the expectation is that they will reverse their stance. Indeed, FPIS were enthusiastic buyers on Tuesday. Another reason for the bull run is a narrow focus on earnings. Starting with the second-half of 2020-21, many corporations have generated higher profits on low revenue growth. This is because of drastic costcutting measures, coupled with lower corporate tax rates, and a monetary policy that has helped cut financing costs. Commodity stocks have also benefited from the global rise in metal prices as the world economy has expanded. The GDP data also implies the second wave did not have a huge impact on companies. Hence, the second quarter results, which will start flowing soon, are expected to “beat the street”, evident from the upgrading of consensus expectations about corporate earnings growth.

There are some negative factors as well. Unemployment is high, so is inflation, and most of the unorganised sector workforce has suffered income reduction. As a result, consumer confidence is low, according to the Reserve Bank of India surveys. Many are watchful of a third wave. That implies private consumption, which contributes over 50 per cent of GDP, will grow slowly. Some estimates suggest private consumption will exceed that of 2019-20 (the last normal fiscal) only by the middle of 2022-23. The economy is also running well below capacity and firms are not looking for big-ticket capital expenditure at this stage. Bank credit expansion has been low as a result. There is a point beyond which companies cannot squeeze out excess profits if there is no revenue growth. The base effects will also moderate in the second half of 2021-22. Valuations are another concern. According to Bloomberg data, valuation premium of Indian equities compared with those in emerging market has risen to a decade-high. For example, the MSCI India index trades at 80 per cent premium to the MSCI EM index. Traders and investors should exercise caution, given the runaway stock prices.