Technical Analysis

It is always darkest before dawn

Prashant Jain | Updated on August 13, 2011 Published on August 13, 2011


Initially, I wrote a long note on equity markets and on why it is time to press the accelerator on equity investments, but then I was reminded of the saying that a picture is worth a 1000 words. So here is the picture and the abridged note follows.

The message is so simple that one does not have to be an expert to grasp the implications.

Good returns materialise over time on investments made at cheap valuations (meaning low PEs) and PEs are more likely to be low when the news flow is adverse.

Simple, isn't it! To be successful in investing, one should focus more on value and less on news flow. Ironically, today, apart from the low PEs, even the news flow is getting better. The issue however is, with the US downgrade, with slow growth in the West despite low interest rates/large stimulus, with countries on the verge of default, with rising interest rates and high and persistent inflation in India, with the coming to light of corruption scandals in India with alarming regularity, etc how can the news flow be getting better?

The not-so appealing news items mentioned above miss one important happening and that is falling crude prices. The positive impact of falling crude prices can negate the impact of all the factors listed above.

Why so? - The structure of the Indian economy

India is one of the few emerging economies that's net importer of commodities and oil.

Thus every $20 fall saves the country $18 billion p.a., equivalent to 1.1 per cent of GDP. Lower oil prices mean lower fiscal deficit, lower inflation, lower interest rates etc. over time.

Indian exports to US/ Europe are only 6 per cent of the GDP. In my opinion, these exports are not materially linked to how these economies perform. Consider this: Indian IT exports over the last 10 years have grown at a CAGR of 25 per cent in USD terms compared with 6 per cent growth in the US/European economies in USD terms. Thus, bulk of the growth (nearly 75 per cent) has come from gains in market share, which is driven by competitiveness and nothing else.

Given the miniscule share of 1.6 per cent of Indian exports in the total world trade and improving competitiveness of Indian exports, there should not be a material impact of slowdown in West on Indian exports. Exports were materially impacted in 2009 after the Lehman bankruptcy as the crisis was unanticipated, due to a paralysis in bank lending and a consequent sharp inventory de-stocking. This is clearly not the situation today.

Downgrade of the US and problems in Europe point to the fact that these economies have lived beyond their means for too long and it is now payback time – growth rates should continue to be low for many years. These also point to the shifting centre of gravity of growth in the world economy – contrast the unsuccessful attempts to improve the growth rates in the West with the attempts to slow economic growth in the countries such as India/China.

Scandals were already there, that was the bad news. Their coming in the open is good news. In a democracy with coalition governments, change takes place mainly in a crisis. Right from the opening up of the economy in 1992 driven by a balance of payments crisis, to improving the security set up after the terrorist attacks in Mumbai, to increasing diesel prices when the subsidy burden was unbearable, to the likely reforms in power distribution driven by mounting losses of distribution companies, all have been triggered by a crisis. Some of the welcome changes that are already under way are improving transparency in land acquisition, in allocation of natural resources through a bidding process, better targeting of subsidies though cash transfer to the needy etc.

Growth prospects

The growth rates of the Indian economy have been accelerating at 0.5-1 per cent p.a. every decade. This is in spite of everything or despite so many things!

The reasons for this growth are well known- a young and growing population, reducing size of families, increasing incomes and affordability, rising aspirations, improving availability of credit and so on.

Apart from the above mentioned factors that lead to a secular growth in consumption, capital spending should accelerate as and when interest rates come down. Lower prices of crude in particular and other commodities in general could trigger a reversal in the trend of rising interest rates. Indian exports are also gaining in competitiveness against China because of the depreciation in INR vs the yuan and the higher wage inflation in China. These are the two key reasons that could lead to a further acceleration in growth rates in the current decade.

A point worth noting here is that despite the impediments, delays, scandals and several rounds of changes in regulation, infrastructure is improving significantly. Apart from the telecom story which is a clear success, India has a rapidly rising number of privately owned world-class airports and ports, fast improving inter-city roads, sharply reducing power deficits etc.

There are thus several reasons to be optimistic about the growth prospects and about improvement in governance and infrastructure in India. If growth persists and if PEs are low, then equity returns can't be far, at least not too far.

Happy investing!

(This is a note written by Mr Prashant Jain, Executive Director & CIO HDFC AMC to investors. The author's view should not be construed as investment advice to any party).

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