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Outlook 2018: Year of Micro Improvements & Macro Risks
January 2, 2018
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2017: The year of structural strengthening and buoyant markets

Unpredictability is the second nature of markets. 2017 kicked off against the backdrop of sudden uncertainty triggered by demonetisation and Donald Trump’s unexpected victory. No surprise, therefore, that most expected modest returns from equities globally. Yet, what we ended up with is significantly divergent. It’s a well acknowledged fact that Bull markets are built on the wall of worries and this was so true in 2017. We saw a global rally in equities.

Back home, just as we were recovering from the demonetisation impact, two more structural reforms—GST and RERA—took a toll on growth for a quarter, creating wide-spread scepticism around the much elusive earnings growth. A bit of cheer did come in from sovereign rating upgrade of India by Moody’s—its first upgrade in past 14 years.

Though the rally in the Indian market was attributed to local tailwinds, the realty is perhaps more nuanced. Nifty crossed the 10,000 mark, delivering 28% return, so did most EMs. Indian MFs received unprecedented local flows into markets, thanks to TINA factor for investors and an expanding SIP cult. However, despite the strong domestic flows, India outperformed other EMs by mere 1% in local currency terms. This is rather insignificant in light of robust structural reforms that are underway in the country. Hence, it is reasonable to say that India was very much part of the global rally; but, this also sets base for the future.

So, what’s in store as we move into 2018?

2018: A year of strengthening infrastructure capex, mending rural economy, global tailwinds and broad-based earnings growth

Fundamentally, I believe, 2018 is commencing on a strong foundation. As we move into the year, 4 broad themes will be at play—robust spending on infrastructure, uptick in private capex, significant mend in rural economy and sustained global recovery. All these are bound to reflect in broad-based earnings improvement.

  • Strong thrust on infrastructure capex and Affordable Housing: Grey Revolution in the making
    India is going through its second Grey Revolution—an era of massive infrastructure capacity creation, with vast planned expenditure on a wide spectrum of infrastructure activities encompassing roads, railways, urban transportation (especially Metros), ports and Affordable Housing. According to estimates, India will spend ~INR50lakh crore on infrastructure till 2022. Spending of such magnitude entails humungous economic impact as it touches almost every industry—Steel, Cement, Construction, Financials— and the job market as well.
    With the government sharpening focus on Housing For All by 2022 and major initiatives on Affordable Housing, this space continues to be a multi-year growth driver, including in 2018. Given politicians’ proclivity to these themes, especially closer to elections, and 2019 being a general election year, I believe these will gain prominence in the coming year. This bodes well for all players in this space.
  • Rural economy on serious mend; post Gujarat results, love for the rural sector is overflowing
    One thing I have written about in the past is the government’s serious intent to mend the rural economy structurally. This has been manifested in crop insurance and productivity improvement initiatives like soil health cards, fertilizer reforms, and huge investments in irrigation, among others. Most importantly, the government, post Gujarat election, is likely to get aggressive on MSP hikes and import duty protection. These augur well for rural consumption and agri-focused & rural infrastructure businesses.
  • Private capex to gain momentum gradually
    Corporate India’s perception of growth prospects has undergone significant transformation over the past 12 months. Most corporates across sectors have started equipping themselves for growth as their capacity utilisation is rising. Green shoots are visible and are likely to accelerate in 2018. Agreed, massive capex, a la 2003-07 with lax underwriting by the banking system, is unlikely. However, I am not complaining; rather, I am happy as, it will be slow, but sustainable.
  • Strong global growth
    Global economies, especially developed markets, are doing well. US, the fount of global growth, seems to be set to clock yet another spectacular year. Though, this could create a bit of risk for EMs (which I have discussed in the risk section ahead), it will be beneficial for Indian IT companies. US tax cuts will also spur discretionary spending in IT. I believe, depreciating INR outlook with increased IT spending augurs well for Indian IT and the job market.
  • Broad-based earnings growth
    On the earnings front, I believe, the worst is over and disruptions due to painful, but much-needed reforms, (demonetisation, GST, RERA) are starting to fade. Thus, base for a broad-based earnings growth has been built. Last year, several distressed sectors like Pharma, Telecom and Banks had taken a toll on earnings growth; excluding these, earnings grew approximately 15%. I believe, this negative contribution will now turn positive and a broad-based earnings growth is anticipated. FY19 Nifty EPS is likely to be in the INR590-610 range, which, in my view, is impressive.
  • Market outlook: Year of earnings growth, not rerating
    So what does this imply for the market? 2017 delivered 28% returns, almost two-thirds of which were due to rerating and only one-third due to earnings growth. This is likely to reverse in 2018. I predict 18-20% returns, largely spurred by earnings growth. There is widespread scepticism on earnings growth. The market always under estimates operating leverage impact. However, I remain a firm believer in its pick up in 2018 and an even more sharp uptick in 2019.

Potential risks – Expect macro induced volatility
Under the risks category I reiterate the usual suspects bandied around—geo political, political and Key-Men. They will be relevant, but more unusual risks to watch out for are as follows:

  • US is growing spectacularly and the momentum is likely to sustain. In cognizance of this, Fed is normalising its ultra-loose monetary conditions. At the same time, the US current account deficit (CAD) could be a potential blind spot. It’s pertinent to note that US CAD is the fount of USD flows to the rest of the world, especially EMs.
  • Historically, Fed easing has been able to widen US CAD, thus driving global liquidity. However, this time, Fed is normalising the monetary policy when the US CAD is either stable or may even narrow further given sustained weakness in USD in the past 2 years. And, this stable/narrowing US CAD and tightening monetary conditions in the US are unfolding at a juncture when leverage of EMs is at an all-time high, led by China. US tax cuts leading to reverse flow can only accentuate it further. USD getting stronger also has huge implications for the already leveraged EMs in terms of cost of capital as well as capital availability. Predicting the timing & its impact on the market is almost impossible, but this risk is worth bearing in mind.
  • Locally, risks worth noting are humungous leverage (close to USD30bn) and high optimism in the market. Both are dangerous even in a structural bull market. Any minuscule change in liquidity can send markets in a tizzy. This has happened in every bull cycle and one has to be mindful of it. I am almost certain we will see this during 2018 as well in some magnitude.
  • While domestic flows seem to be quite strong, one should not underestimate paper supply planned in 2018, despite the record fund raise of approx USD 20bn in 2017. There is similar and more planned; while these issuances offer great opportunities, it worth bearing in mind the risks associated.
  • Lastly, several important state legislative assembly elections are lined up in 2018. And, it being the penultimate year in the run up to General Elections, the government could be compelled to take a few populist measures such as loosening fiscal deficit, which could be bad for interest rates. More dangerous in rising global rates environment.

INR outlook
While domestic fundamentals are strong, global concerns with regards liquidity and balance sheet tightening of the Fed & ECB may be areas of concern. However, these risks notwithstanding, I anticipate a slight depreciative bias—INR hovering around 65-67 level; but, a lot depends on what happens in China.

In Summary,

I continue to remain very bullish on India’s prospect of being a story of the decade and the opportunity it offers to create significant wealth, despite all challenges & risks. 2018 will be year of improving Micros and somewhat risky Macros. So Finally, how do we play?

• Stay invested, be careful of leverage. Embrace for volatility. Businesses and companies will do well but we will see macro induced volatility. Better Micros but somewhat risky Macro
• Play the Grey Revolution, Rural Mend and operating leverage themes
• Financial Services and Unorganised to Organised themes continues to be multi-year opportunity
• Buy Indian IT, Pharma & Telecom services as contra plays. IT offers good hedge as well against Macro risks
• Buy Real Estate stocks, not real estate

I would like to end by quoting celebrated American investment consultant Charles Ellis:

‘Market timing’ is unappealing to long-term investors. As in hunting deer or fishing for rainbow trout, investors have learned the importance of‘being there’ and using patient persistence—so they are there when opportunity knocks.

Hence, I reiterate my faith in the virtue of patience and importance of stock selection rather than trying to time the market. Volatility is risk but can be a friend to the prepared.

With this, wishing you a happy and prosperous 2018. Happy investing. 

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Vikas Khemani

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