Big Story

Outlook for 2019

BL Research Bureau | Updated on January 06, 2019 Published on January 06, 2019

With general elections around the corner, a trade war that threatens to derail global growth and tightening monetary conditions, investors in equity and debt are likely to face a rocky time this year. Gold could, however, gain some sheen as the dollar weakens

Look for value buys in equity

Lokeshwarri SK

Nothing much changes at the dawn of every year; the prevailing trends tend to continue into the New Year. But there is no harm in reviewing the prospects of the investments we hold and plan the strategy for the year ahead at the beginning of each year.

As we step in to 2019, it is important to understand where we stand. 2018 was an extremely tumultuous year for equity investors, with eight out of every 10 listed stocks registering declines. Almost 60 per cent have lost over 25 per cent in value.

But the market correction last year was not entirely unexpected. Mid and small-cap stocks had been on a tear since 2014 and a deeper correction was warranted, as pointed out in our Big Story (December 30, 2017).

Large-caps appear safer

An important question that needs to be asked at this point is, has the deep gash in stock prices made stock valuation attractive? According to Bloomberg, the Nifty 50 trades at a price-earning multiple of 22.1 times its trailing 12-month earnings, above its five-year average of 20.8 times.

But the valuation in large-caps appears less pricey, when compared to the mid- and small-cap indices. The Nifty mid-cap index trades at PE multiple of 43.9 times currently, while the Nifty small-cap index trades at 73.1 times.

 

 

 

Market participants are also being more moderate when projecting earnings growth for large-caps, compared to the projections for smaller stocks. Bloomberg estimates project 13 per cent earnings growth for Nifty 50 in 2019, which appears achievable. But the earnings growth for Nifty mid-cap index is being forecast at 117 per cent and Nifty small-cap index at 382 per cent for 2019.

Earnings under duress

There are worries on the corporate earnings front. September quarter earnings showed that revenue growth was stable but profit growth was flat. Spike in prices of imports such as crude oil and metals and rising interest cost had impacted margins. As the favourable base effect — due to the GST effect depressing earnings in 2017 – wears out, profitability could be further impacted.

The declining trend in WPI and CPI could have an impact on revenue growth as well in the coming quarters. WPI slipping into the negative in 2015 had pulled down India Inc’s revenue growth in that period. Two, there is also the threat to realisations of producers of commodities from the ongoing trade war and slowdown in China. As the new tariffs and slowing demand from China increase global surplus, dumping into India can gain force, impacting these companies.

The lowering of earnings guidance by Apple last week portends slowing orders for some of the IT companies. The other pain-point in earnings is likely to be from the PSU banks that could continue to bleed as the large bad loan book is written off.

Drivers of 2019

The 2019 general elections is the most important domestic factor that will guide the Indian market in the first half of the New Year.

As the D-day nears and voting trends emerge, nervousness will grow, impeding any possible rally.

The rhetoric of the ruling party and populist measures ahead of the elections will add to the pressure. However, if a stable government is formed, there could be a reprieve.

Besides the domestic factors, if there is a global sell-off in equities, Indian stocks will not be able to escape unscathed.

Global slowdown due to the trade-war and a messy BREXIT are already beginning to cause a steep fall in stocks. As the impetus provided by Trump’s tax cut fades, US growth is also expected to slow. This will impact sectors dependent on overseas revenue such as IT.

Is value emerging?

The positive factor among all this gloom is that value is definitely emerging in many pockets in the listed universe due to the sharp correction in 2018. Many stocks are trading at lower PE multiples when compared to their valuation multiple six years ago (before the breathless rally in smaller stocks began), despite decent growth in earnings.

Investors can look at fundamentally-sound stocks with strong parent in sectors that were bruised due to investor aversion such as NBFCs.

Then there are stocks that are languishing due to investor ennui — investors are bored with these dull stocks that fail to budge, despite steady growth — PSU stocks in power generation and distribution and mining space are examples.

Many stocks such as oil and gas companies are languishing due to regulatory uncertainties; these could pay off over the long-term.

Besides this, a market correction due to global or domestic factors could throw up other buying opportunities in blue-chips too. Investors with a perspective of over two years should stay alert to cherry-pick stocks over the year.

Those who look for quick returns will, however, find the next year an ordeal.

Volatility to haunt bonds

It was a rocky 2018 for the bond market, with yields swinging wildly through the year. While the year began on a sanguine note, concerns over tightening global liquidity, the RBI’s rate hikes and inflation risks quickly took centre-stage and led to sharp rise in yields. But after peaking to 8.1 per cent levels in September, yields began to soften, thanks to the central bank’s measures to ease liquidity, coupled with several open market operations (buying of government bonds). The sudden change of guard at the RBI, re-kindling hopes of a softer monetary policy, led to a sharper fall in yields (to 7.2 per cent) by the end of 2018.

 

 

 

While the RBI opening up the liquidity tap by ramping up the pace of open market operations recently is a positive, last week’s announcement of larger-than-expected market borrowings by State governments for the Jan-March 2019 quarter spooked markets once again. The Centre’s fiscal position, unfavourable inflation dynamics in view of possible reversal in food prices and sticky core inflation, persisting uncertainty over crude prices and 2019 elections, make it difficult to predict the road ahead. The New Year is likely to ring in more volatility for the bond market.

Inflation saga

The strongest argument in favour of an easing monetary policy is the consistent fall in CPI inflation through 2018, thanks to the sharp slide in food prices. The RBI, in its December policy substantially lowered its inflation projection for the second half of the fiscal, indicating a long pause in rate action (rate cuts for optimists). However, a peek into the components of CPI suggests that there could be several risks to this optimism.

The CPI inflation fell unexpectedly to a low of 2.3 per cent in November, led by food inflation that was a negative 1.7 per cent. A look at the retail prices put out by the Department of Consumer Affairs, suggests that vegetable inflation has been very sedate in 2018 owing to a high base of vegetable prices in 2017 (though excess production has also been a factor). Whether such sharp fall in food prices will sustain, remains to be seen. However, as the base effect wears out, the fall in food inflation should taper off.

In any case, the sticky core inflation (excluding food and fuel) over the past year remains a concern. The general elections in 2019, leading to populist spending, particularly in the rural economy, could keep core inflation elevated. Global crude prices could also move the needle on inflation in either direction. Hence, uncertainty around CPI’s trajectory suggests that rate cuts will not happen in a hurry.

Fiscal worries

With only three months left for the close of the financial year, meeting the 3.3 per cent fiscal deficit target appears tough, as shortfall in GST collections could play spoilsport. Fiscal deficit has already reached 114 per cent of the target up to November. While the Centre’s last ditch efforts to meet the disinvestment target may pay off, the shortfall in indirect tax collection is a concern. For FY19, the Centre had pegged gross borrowing of about ₹6.05 lakh crore (cut back by ₹70,000 crore subsequently). About ₹3.91 lakh crore has been raised so far (until December 21). The Centre has already spent 66 per cent of budgeted expenditure between April-November. How far it is able to stick to its borrowing programme remains to be seen (pruning budgeted expenditure is unlikely in an election year).

Also, several States announcing farm debt waivers have ramifications for the fiscal burden of States. Last week, the RBI announced the calendar of market borrowings by the State government for the January-March 2019 quarter in the ₹2.19-2.25 lakh crore range — significantly up from about ₹1.2 lakh crore in the same period last year.

Besides inflation and fiscal risks, global concerns on trade wars, change in expectations on rate actions by various central banks will have a bearing on the bond market. Even if the economy grows as expected, the bond market will be impacted from foreign flows; foreign investors pulled out $6.9 billion in 2018 from the debt market.

Bottomline

Given the uncertainty around various factors impacting bond yields, investors must tread with caution. The yield on the 10-year G-Sec is likely to hover in the 7.25-7.4 per cent range in the near term. A sharp fall in yield hereon is unlikely. In fact, sudden reversal in inflation trends and fiscal slippages remain a key overhang.

Hence, investors should avoid duration and credit risk in their portfolio. A chunk of your debt fund investments should be in short-term debt funds that carry less volatility in returns. Short- and medium debt funds with duration of up to three to four years are ideal for investors with a medium-risk appetite. Opt for corporate bond funds that invest a chunk of assets in high-rated debt instruments.

Gold to glitter as dollar descends

Weighed down by the US-China trade war, recovery of the greenback on Donald Trump’s tax cuts and higher US treasury yields, gold lost its lustre in 2018. Further, concerns over China’s economic growth and a weak rupee, which makes the metal expensive for Indian consumers, disturbed the fundamental arguments in favour of gold.

In 2017, while the net inflow into gold-backed ETFs averaged about 50 tonnes a quarter, in 2018, it was 27 tonnes in the first quarter (January-March), 33.8 tonnes in the second and a net outflow of 103 tonnes in the third quarter. Gold closed the year with a negative return of 1.5 per cent. The year 2019, however, looks promising for the metal. The US economic growth is expected to slow down on tighter financial conditions as impact of the tax cuts fade.

 

 

Investors in the bond market have actually factored-in a recession in the US. Experts say that the narrowing of the spread between the short-term and long-term bonds is nothing but a signal of an impending economic slump. The weakness in Europe may also ripple over to impact growth in the US and see businesses cut spending.

Further, with the Federal Reserve expected to pause after one/two rate hikes in 2019, the US dollar is also likely to set-off on a downward descent — a positive for gold. So, as investors diversify into non-dollar assets in search for better returns, gold will regain its lost charm. Inflows may make a comeback in gold-ETFs.

Consumer demand for jewellery, which was flat in 2018 (1,569 tonnes in the first nine months), may spring-back if China is able to handle economic pressures from US tariffs. What also looks promising is central bank buying. In the first nine months of 2018, central banks across the globe bought a total of 351.5 tonnes of gold, which is 50 tonnes more than what they purchased in the same period last year. The appetite for the yellow metal from central banks is likely to continue with new buyers coming in, predicts WGC.

On the supply front, data shows a sustained increase in mine production over the last six quarters, supported by growth from Russia and Canada — the two large gold-producing countries. In the nine months of 2018, the total mine output was 2,499.5 tonnes versus 2,441 tonnes in the same period last year, up 2 per cent. Though some of the largest gold producing nations saw sharp declines during the September quarter, it was offset by gains in Mali (output increase by 34 per cent) and Papua New Guinea (up 25 per cent), claims WGC.

Gold mine output in the US was higher by 9 per cent, Y-o-Y. Among those that reported sharp drop in output were China, where environmental regulations impacted mining, and national gold output fell in the September 2018 quarter by 6 per cent Y-o-Y. South Africa’s production dropped by 10 per cent Y-o-Y due to shutdown of loss-making mines.

Investors, however, can expect good prospects for the yellow metal in the current year with demand outpacing supply.

As of September 2018, the cost of producing an ounce of gold for a miner was about $1,000/ounce (all-in sustaining cost that includes mining and ore processing costs, maintenance/ongoing capital costs, an allocation for corporate overhead charges plus reclamation expenses). This would serve as the bottom for gold price.

What you should do

For Indian investors, the rupee/dollar exchange rate will decide the returns on gold. In 2018, while gold prices dropped internationally, in rupee terms, it was up 8 per cent. The outlook for the rupee is difficult to predict at this point, with a host of uncertain factors, including oil prices.

The volatility in rupee could increase ahead of the vote-on-account in February and the general elections subsequently. Direction of the policy rate and inflation will also influence the rupee.

But if you are a long-term investor, the short-term price volatility should not hinder you. You can invest 10-15 per cent of the portfolio in gold to diversify risks from equity investments. Sovereign gold bonds are the best route to invest in the metal.

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