Assessing key trends in 2012
2011 has turned out to be at best a forgettable year for the Indian equity markets. India has been the worst performing markets globally with 25% negative returns; Given the sharp currency depreciation, performance in USD terms has been even worse at -37%, making India by-far the worst performing global market. Also, the Sensex returns in each quarter of 2011 have been negative, indicating a gradual build-up of the headwinds.
Besides the global headwinds, everything that could have gone wrong domestically has gone wrong. Policy paralysis, stubbornly high inflation, high interest rate scenario and ending the year with an unfavorable currency movement. All these had an impact in GDP growth, fiscal deficit and corporate profitability. While some of the domestic issues are cyclical (like interest rates, currency, etc) and will get corrected over a period of time; several of them are more structural like lack of reforms, fuel linkages and subsidy issues. And finally, the biggest issue at this point: When will the Policy engine start cranking?
Trend #1: GDP growth hard lands; finds its base at 6-7%
After six consecutive quarters of slowdown, India is staring at sub-7% growth for FY12 (8.6% in FY11), which could dip further to 6-6.5% levels in FY13. During the course of the year the several downgrades of high magnitude were effected giving it a semblance of ‘hard landing’. So far the agriculture and services have continued to perform with service sector displaying only moderate slowdown. Of much bigger concern, is the industrial downturn that crashed to -5.1% in Oct-11 from 7.5% in Jan-11.
In the last 15 years service sector has fallen below 8% only in four occasions. Given the strong resilience of the service sector, it is fair to assume 8-9% service sector growth going forward. In view of the continued weakness in the industrial sector we have cut our FY12 growth estimate to 6.8% from 7.2% estimated earlier. However, if industrial slowdown further aggravates affecting the service sector as well, it may take GDP growth closer to 6.5% level or even to 6% in the worst case. We think large part of FY13 would be spent in spillover effects of downturn in FY12. However, we expect things to improve in 2HFY13. Industrial growth may perform a notch higher on lower base while service sector might be affected over longer period of industrial downturn.
Trend #2: Monetary policy - from tight to loose
The biggest positive surprise may emanate from rapid decline in inflation in 4QFY12. Inflation is expected to come down within 7% by end-March 2012. However, because of an interplay of several factors including i) rather sharp decline in food prices, ii) expectation of oil price moderation, iii) international commodity prices remaining under pressure and iv) the base effect, inflation is expected to remain range-bound within 4.5-5.5% for large part of FY12. Thus there is every chance that inflation might surprise on the positive.
This gives enormous policy space to RBI to effect rate cuts in the backdrop of rapid slowdown of growth. Surely the growth inflation mix is changing in favor of growth and RBI may effect larger rate cuts than expected at present. We hold that the rate cut cycle would begin as early as Jan-12 now. We also expect RBI to continue with its series of open market operations (OMOs) aggregating INR860b for FY12, especially in the backdrop of currency intervention draining out liquidity. However, depending upon the prevailing liquidity situation a CRR cut may be effected too coinciding with rate cuts. In aggregate we expect RBI to ease rates at least by 150bp in FY13.
Trend #3: Fiscal policy - from loose to tight
In FY12 government the fiscal situation has slipped considerably and expected to clock a full 1% higher at 5.6% vs. 4.6% placed in the Union Budget FY12. Hence, market borrowing targets have already been announced to exceed by a steep INR930b, also reflecting unavailability of some alternate source of borrowing i.e. implying a reversal on the path of fiscal rectitude.
Any meaningful fiscal correction would remain a challenge in FY13 as well. Revenues would be affected by growth slowdown. With deferment of major tax reforms no major improvement in revenue buoyancy is expected in the near term either. On the other hand an expanding welfare net on account of possible implementation of the food securities bill would weigh on the expenditure. Thus there is no headroom left on fiscal front to come up with a counter-cyclical policy response. Given the sensitivity of sovereign debt crisis and its implications for financial market as also from reprioritization of domestic demand, a fiscal course correction seems imperative. However, a significant part of it may come from cutback on planned expenditure. Given that a FY12 fiscal slippage was partly on account of unanticipated growth slowdown, the FY13 budget calculations are expected to be conducted on more realistic assumption. While fiscal consolidation would still be a challenge, we expect government to announce a fiscal deficit ~5.0% of GDP in the Union Budget for FY13.
FY12 earnings muted; mild recovery in FY13; earnings downgrade risks persist given high uncertainty For full year FY12, we expect MOSL Universe (ex RMs) to report aggregate sales growth of 10% YoY and PAT growth of 9% YoY. In YTDFY12 (i.e. trailing three quarters), aggregate sales growth of 22% and PAT growth of 10% has already been achieved. Thus, the residual growth required in 4QFY12 is ~9%, which we believe, is achievable.
Likewise, YTDFY12, Sensex companies clocked sales growth of 23%, EBITDA growth of 13% and PAT growth of 12%. Residual 4Q PAT growth required is ~15%, which is expected to be led by SBI given its washout 4QFY11.
We expect FY13 Sensex EPS of 1,266, up a 15% over FY12, despite a 15% downgrade from 1,492 expected a year ago (i.e. in Dec-2010). This is because, over the same time, base FY12 EPS itself has seen an 18% downgrade from 1,263 expected in Dec-2010 to currently expected 1,105. In effect, FY11-13E EPS CAGR for the Sensex has gone down sharply from 19% to 11%. Interestingly, after a growth holiday of FY08-10, FY10-13E EPS CAGR works out to 15%, which is in line with Sensex’s long period EPS CAGR.
3QFY12: Lowest growth in last 23 quarters ex global crisis
We expect MOSL Universe (ex RMs, oil refining and marketing companies) to report PAT growth of 7% YoY in 3QFY12. This would be the lowest PAT growth in the last 23 quarters, excluding four quarters of global crisis (3QFY09-2QFY10), when YoY PAT growth was negative. The results would clearly reflect the macroeconomic backdrop of persistent high inflation, high interest rates, and weak currency.
- We expect 51 out of 136 companies ex RMs (i.e. 38%) to report PAT de-growth YoY. This is the highest ever in any quarter excluding the four global crisis quarters. At the same time, the number of companies with expected PAT growth of over 30% is the lowest ever at 24 (18% of Universe).
- Aggregate EBITDA margin (ex Financials) would be 14% - 200bp lower than FY05-12 average of quarterly margin, and 150bp lower than FY05-12 average of 3Q margin. Aggregate PAT margin (ex Financials) would be 7.3%, the lowest ever 3Q margin over FY05-12. It would be 220bp lower than the average quarterly margin and 170bp lower than the average 3Q margin.
- Only four sectors are likely to see meaningful expansion in margins - Cement (230bp), Telecom (160bp), Technology (6bbp) and Healthcare (60bp). The worst margin hit would be seen in Oil & Gas ex RMs (-530bp), Real Estate (-470bp), Metals (-280bp), Infrastructure (-250bp) and Capital Goods (-250bp).
- Top-5 PAT growth sectors would be: Cement (38% YoY), Utilities (29%), Private Banks (20%), Consumer (17%) and Technology (17%). The top-5 PAT de-growth sectors would be: Infrastructure (-64% YoY), Real Estate (-23%), Telecom (-17%), Metals (-13%) and Capital Goods (-8%).
- Private Banks is the only sector where all companies are expected to report positive YoY PAT growth. In sharp contrast, Infrastructure is the only sector where all companies are expected to report YoY PAT de-growth.
- Sensex PAT is expected to grow 9% YoY. The last 4-quarter average growth in Sensex PAT is 9%. This is the lowest ever 4-quarter average growth ex global crisis quarters.
Investment strategy
Post a dismal performance of 2011, Indian market valuations have slipped to below historical averages (rolling 12-month forward PE of 12.6x v/s 10-year average of 14.6x). We believe that a bulk of the earnings downgrades (15% downgrade in FY13 earnings) and the entire rate tightening (425bps rate hikes) is now behind. However, there is poor visibility of Implementation of key reforms. While the monetary cycle is expected to ease hereon, any meaningful re-rating of the Indian markets will have to be preceded either by confidence in implementation of key reforms or a turnaround in the cycle in earnings downgrades. The outcome of UP state elections and the Budget for 2012-13 will be two very significant events for the markets.
