The birth of a new bull market

The significance of the 2014 rally was that it heralded the birth of a new bull market in India says Pankaj Murarka, Head Equity and Fund Manager at Axis Mutual. In an interview with FundsIndia.com Murarka explains how the focus will now shift from returns dominated by P/E re-rating to returns supported by earnings growth.

2014 ended on a positive note for equity markets but corporate earnings have not seen much of a pick up. Can valuations stretch any further without earnings growth?

The Nifty went up by close to 30% in 2014 which looks like a great one year return until you put it in context –despite the 2014 rally, market returns have been modest for the period 2008-2014.
The significance of the 2014 rally was that it heralded the birth of a new bull market in India.
The bull market was born out of 3 factors – cheap starting valuation, turnaround in economic cycle and change in political leadership. The initial period of the bull market has seen the returns dominated by P/E re-rating rather than earnings growth. We think that as this market matures in 2015, the contribution to market returns should shift in favour of earnings growth.

 What could be the levers for an earnings growth pick up?

Corporate profits have trailed nominal GDP growth over the last few years. The pressure on profitability has come from a number of factors – weak economy, large capex projects in progress (many of which have got stuck or delayed), high interest rates and high input cost inflation. As most of these issues get sorted, we should be entering a period where earnings growth can outpace nominal GDP growth over the next few years.

The high capex work-in-progress should start coming off as delayed projects get back on track. The new government has sharply fast-tracked project approval process and is also untangling other roadblocks – such as coal availability, fuel linkages for power plants.
Further, a number of leveraged corporates are exiting projects that they do not have the capacity to finish. These projects are being acquired by companies/funds with plans to get them commissioned as soon as possible. This process is being facilitated by banks that are under pressure from RBI on restructured loans and NPAs.

For example, companies have announced initiatives to acquire troubled power plants. Similar initiatives are underway in other infrastructure sectors such as highways and ports. Buoyant equity markets will allow companies and PE funds to raise equity capital to invest into such projects.

Input cost inflation for the manufacturing sector has been high in recent years on account of high global commodity prices and weak currency. The sharp fall in commodity prices (especially crude oil) and the stability in Rupee (on account of improved macro fundamentals) should bode well for bringing down input costs and hence improve margins. The fall in commodity prices is also supporting the process of disinflation in the economy. This fall in inflation is creating the headroom for lower interest rates which should bring down finance costs for companies.

The most significant lever for earnings growth over the medium term is operating leverage. Current low capacity utilization levels will allow companies to take advantage of any demand revival through existing capacity, thus providing high marginal profitability of incremental demand. As the economic growth picks up, a meaningful demand revival is expected towards the end of 2015. Once demand picks up it will give a further large boost to earnings.

What is your house view on where we are headed in 2015-16?

The initial period of the bull market has seen the returns dominated by P/E re-rating rather than earnings growth. We think that as this market matures in 2015, the contribution to market returns should shift in favour of earnings growth.

The market has gone through the entire year in 2014 without seeing a correction of over 10%. Historically, any bull market experiences corrections – with the 2003-2007 market seeing a number of 10% falls as well as some that were over 20%.

So a correction can reasonably be expected to take place going forward as the current bull market becomes mature. Investors should not fret too much on short term ups and downs of the market and instead take advantage of the maturing bull market which still has long legs left.

What is the kind of opportunity investors should seek in debt now?

The bond markets had a great run in the second half of 2014. Markets spent the first half of the year worrying about El Nino, monsoon and food inflation and potential for further rate hikes from RBI.

However, our reading right through the year was that inflation momentum was waning and would be reflected in the headline numbers shortly. The confidence on the disinflationary trend was on account of muted MSP hikes, weak growth and low pricing power, and large output gap in the economy.

As these forces played out in the second half of the year and were supported by the sharp fall in global commodity prices, the bond rally started in earnest.

We have however been a bit surprised at the pace at which yields have dropped – as market has gone from being fearful to greedy in 12 months.

While 2015 should continue to see rates moving lower, the extent and the rate at which they fall will depend largely on RBI policy. Ultimately this will depend on the inflation trajectory in the second half of 2015.

We expect RBI in 2015 to increasingly shift its focus from the current inflation prints to the medium term outlook. The RBI glide path for CPI inflation in Jan 2016 is at 6% and we do not expect aggressive rate cuts until they have a high degree of comfort of it getting met.

Further, in case the monetary policy framework and the CPI target of 4% gets adopted (as is expected) in 2015, then RBI will also start looking at how inflation is likely to trend in 2016 and beyond.

In order to attain a sustained lower inflation trajectory, the government will have to play its part by keeping the discipline on food prices and also keeping a tight lid on government wage revisions (including DA), monitor rural wages and MGNREGA spends as well as carrying out supply side reforms.

It will also require reasonable stability in currency such that benefits of lower commodity prices can be sustained locally. As per its current estimates, RBI expects inflation to meet its 6% target in January 2016.

Once some of these conditions are met, and the inflation trajectory plays out as expected by the RBI, the odds of lower inflation getting entrenched go up substantially. RBI has said repeatedly that they do not want to be seen as flip-flopping on policy rates.

We think that this would mean that they would cut aggressively only when they get comfort on the medium term inflation outlook. However once this comfort is achieved, we expect the RBI will surprise the markets by the extent to which it can cut policy rates in the medium term.

In summary, we expect the fall in yields to be spaced through the year and don’t expect it to happen in a front-loaded manner in early 2015. From a bond market perspective, the above is actually setting a stage for a much healthier longer term rally.

Investors should continue to look at duration products from a medium-term perspective. Investors with a lower risk appetite can look at short-term funds.

What if a rate cut does not happen as forecasted even by mid 2015? Would that hurt yields?

RBI has said repeatedly that they do not want to be seen as flip-flopping on policy rates. We think that this would mean that they would cut aggressively only when they get comfort on the medium term inflation outlook. However once this comfort is achieved, we expect the RBI will surprise the markets by the extent to which it can cut policy rates in the medium term.

In summary, we expect the fall in yields to be spaced through the year and don’t expect it to happen in a front-loaded manner in early 2015. From a bond market perspective, the above is actually setting a stage for a much healthier longer term rally. Investors should continue to look at duration products from a medium term perspective. Investors with a lower risk appetite can look at short term funds.

The views expressed are that of the Fund Manager. Mutual funds are subject to market risks. Please read the scheme information document before investing. Past returns are not indicative of future performance.