According to a well-known proverb, once a pigeon spots a cat, it immediately shuts its eyes and relaxes, thinking that it is no longer in danger. The Indian equity markets are behaving exactly like that pigeon by disregarding the risks and ignoring the realities. Investors are ignoring the economic and financial risks that are a direct result of the disruption caused by the second surge of coronavirus, despite the fact that reality is staring them in the face. Even as the number of daily official deaths hit an all-time high of 4,329 on May 18 and state after state announced lockdowns to slow the spread of the virus, the benchmark BSE Sensex reclaimed mount 50K, defying the increasing death count, case load, and sluggish pace of vaccination. This occurred even as the BSE Sensex reclaimed mount 50K.
As a result of this, the Sensex has increased by 5.1% since the start of the calendar year and is currently trading at a price to earnings (P/E) multiple of 32 times, making it one of the most expensive equity indices in the entire globe. When compared to the 25.5 times that the Dow Jones Industrial Average, the most important equity indicator in the world, is currently trading at, the Sensex is nearly 25 percent higher. The Sensex is nearly twice as expensive as the Shanghai Stock Exchange Composite Index, making it one of the most expensive stock markets in Asia. It is also among the most expensive in Asia. (see The Risks).
The surge in value of second- and third-tier equities has been even more ferocious than initially anticipated. The BSE Mid-Cap Index has seen growth of 18.3 percent so far this year. (YTD). The current price is close to 55 times the company’s trailing revenues per share. The BSE Small Index has seen a year-to-date increase of 26% and has a P/E multiple of 62.
There are indications that domestic investors have been significantly more optimistic about the future of India Inc. than foreign investors have been. This is due to the fact that domestic investors primarily bet on small- and mid-cap stocks, whereas foreign portfolio investors (FPI) concentrate more on large-cap and index stocks. They are so optimistic that they are ignoring a number of significant threats that are right in front of them.
A 2020-like Rally? It’s Not Easy
The anticipation of a V-shaped recovery in corporate earnings and India’s economic growth in the second half of FY21 and FY22 fueled the rally in 2020. This was the expectation following a washout in the first half of FY21 as a result of the Covid-19 lockdown. The sharp decline in commodity and energy prices in the first half of FY21, which was primarily caused by the sharp fall in demand, as well as the similarly sharp decline in interest rates that had continued throughout most of FY20, contributed to an increase in the optimism surrounding corporate earnings.
As a result of this combination of reduced finance and input costs, margins were improved, which led to a growth in net profits by double digits despite a decline in revenues. Corporate profits increased 27.3 per cent in FY21 despite 2 per cent decline in net sales. The prices of raw materials for manufacturers decreased by approximately 7 percent in FY21. As a result of the epidemic and the growing popularity of working from home, many businesses were able to reduce their expenses for labor, sales and marketing, and other overhead costs in FY21, resulting in additional profits.
These tailwinds are gradually becoming headwinds as the prices of commodities and energy sharply rise, which increases the costs of inputs, even as the second wave of Covid-19 lowers the development potential of corporate India. If the number of infections does not begin to drop to more manageable levels, the breadth of the lockdowns may expand, which will have a more severe effect on the earnings recovery. According to an analyst from Moody’s Investors Service named Sweta Patodia, who was quoted in a report published on May 18, “This will weaken the earnings of rated companies and derail the recovery seen over the last six months.” Additionally, interest rates all over the world are getting up. The unbridled confidence that exists among equity investors is called into question as a result of all of this.
The consistent ascent in the prices of commodities and energy also represents a threat to the revenues of corporations. In the past year, the price of a gallon of Brent crude oil has more than doubled, reaching $70. During this time period, the price of industrial metals such as aluminum, steel, copper, and zinc increased by between 80 and 100 percent. In FY22, higher prices for commodities and energy will translate into higher expenses for manufacturers, who will also see lower margins as a result. According to Dharmakirti Joshi, Chief Economist at Crisil, “rising costs could pose headwinds to companies as they recover,” which is a quote from Joshi.
Because of the Covid-19 lockdown or the redirection of industrial oxygen for medical purposes, the majority of manufacturing activities and services that are not absolutely necessary have come to a stop across the majority of the country. It is anticipated that this will have an impact on the revenues and profits of the corporation during the first part of fiscal year 2022. According to Patodia of Moody’s, “Production will decline in industries such as steel that use oxygen.” [Citation needed]
a lowering of the GDP
Additionally, stock markets are ignoring predictions for a decrease in GDP, which indicates that corporate performance will suffer as a result. According to Shankar Sharma, who is the co-founder and chief global strategist at First Global, there are significant dangers due to the fact that it is unclear how long the second Covid wave will last. Close to ninety percent of the nation is currently under quarantine. “There are not enough immunizations, and it will take a significant amount of time to immunize the entire population. “There is no question in my mind that this year will be a washout,” he adds. Sharma predicts that the ten to eleven percent GDP growth predictions for fiscal year 22 will be reduced. “You will have more like mid-single digit growth of 5-7 per cent,” he adds, which indicates that on a two-year basis, the economy is still in a negative position.
According to Moody’s Investors Service, the second wave of coronavirus will make it more difficult for the economy to recover, so on May 11 they lowered their estimate for GDP growth to 9.3 percent, down from 13.7 percent in February of this year. If the peak of the Covid outbreak occurs in late June, as S&P has predicted, India’s growth rate could drop to 9.8 percent under the “moderate” scenario and 8.2 percent under the “severe” scenario. Previously, it had projected 11 percent growth. According to Joshi, the second phase presents a challenge for both the healthcare and economic systems.
Overvaluation Risk
There has been no letup in the pace of the rally that has been taking place on Dalal Street despite the worsening of socioeconomic indicators. The fact that the majority of leading index businesses are currently more expensive than they were before the pandemic is one of the factors that is exacerbating the risk. P/E multiples are currently at a level that is fifty percent higher than they were previously in the information technology (IT) sector, which accounts for roughly one-fifth of the market cap of the index. As an illustration, Tata Consultancy Services (TCS) is currently trading at a P/E multiple of 36 times, which is significantly higher than the 24 times that it was trading at at the end of January 2020. During the time period in question, the P/E ratio of Infosys increased from 21.6 times to 31.4 times. The long-term average P/E multiple for Infosys is 20.4 times, while the P/E multiple for TCS is 22 times over the course of 15 years.
Another heavyweight, Reliance Industries, is currently valued at 44 times earnings, which is significantly higher than its previous valuation of 25.4 times earnings. During this time period, P/E multiples in the pharmaceutical industry have increased. This indicates that investors are disregarding the downside risks posed by the second wave of Covid in favor of anticipating a dramatic rise in the earnings of pharmaceutical companies in FY22. “One-year forward Nifty valuation stands at 21.4 times earnings, which is at the higher end of the historic range, posing a downside risk if earnings disappoint in FY22,” says a fund manager at a leading mutual fund. “This puts the market at risk of a decline if earnings fail to meet expectations in FY22,” the fund manager added.
The Indian stock market is still consistently ranked among the most expensive on a worldwide scale. For instance, the price-to-earnings multiple of the Shanghai Composite is currently selling at 15.7 times, which is half that of the Sensex, while the multiple of the Kospi is currently at 19 times. In India, the index P/E is currently at roughly 65 percent higher than its valuation at the end of April of the previous year, which was 28 times. This figure is 11 percent higher than the pre-Covid peak of 28 times.
Fund managers recommend that investors adopt a strategy that is tailored to each individual company in light of the risks involved. According to Saurabh Mukherjea, Founder & CIO of Marcellus Investment Managers, “There are companies that make you money every year regardless of the macro outlook, and there are those that rarely make you money regardless of the external environment.” “There are companies that make you money every year regardless of the macro outlook,”
Therefore, at any given moment in time, there will be a small number of stocks in which you have a good chance of making a profit.
The Return of Inflation with a Vengeance
Retail inflation is also feeling the effects of rising commodity and energy prices, which is placing pressure on it. Because of a low base impact and rising food and commodity prices, wholesale price index-based inflation skyrocketed to an all-time high of 10.49 percent in April. This marks a new record for the month. “Inflation at the wholesale level skyrocketed to 10.5 percent in April 2021, compared to 7.4 percent in March 2021 and -1.6 percent in April 2020. According to Madan Sabnavis, Chief Economist of CARE Ratings, “This growth is the highest it has been since 2012.”
The rising rate of inflation has already begun to have an effect on the operating expenses of India Inc. “An increase in the price of crude oil not only has the effect of driving up the cost of fuel, but it also has the potential to maintain overall inflation at a high level by driving up the cost of transportation. The values of metals and oils used in cooking have also seen significant increases on the global market. According to Joshi of Crisil, “this is causing an increase in the cost of manufacturing.” A higher inflation rate results in decreased purchasing power, decreased desire for goods and services, and consequently increased pressure on the earnings of corporations. It is also possible that this will result in a depreciation of the currency and an increase in bond yields, both of which are considered to be bad for financial markets.
Inflation at the retail level is also on the rise. Inflation as measured by the Consumer Price Index increased to 5.03 percent in February after reaching a 16-month low of 4.06 percent in the previous month.
FII Outflows
It should come as no surprise that overseas investors are becoming more wary of the Indian market. After being net purchasers through the first three months of 2021, FIIs became net sellers during the months of April and May. According to statistics provided by National Securities Depository Ltd., FIIs sold shares with a net value of Rs. 8,836 crore in the month of April, and they have sold shares with a net value of Rs. 6,144 crore so far in the month of May. It is possible that this will keep markets under pressure because FIIs own nearly half of all free-floating shares (measured in terms of worth). The activities of FIIs are typically a significant contributor to the movements of the market in India.
A jolt could also be given to Dalal Street by a combination of high valuations and poor corporate earnings in FY22, particularly if the Federal Reserve starts to tighten its monetary policy in response to the surge in inflation in the United States.
After one year of results that were higher than average, equity investors in India should begin to exercise more caution. In contrast to the situation in March of the previous year, when valuations had dropped to their lowest point since 2014, the risk-reward ratio is currently not in the bears’ favor.
