What could derail this rally?

By Rex Mathew | 15 Nov 2006


Stock markets are under a firm bull grip and indices are scaling new lifetime highs almost everyday. What are the factors, which could upset market momentum?

After moving past their earlier lifetime highs in October, domestic stock indices have not even bothered to pause before surging ahead this month as well. Helped by strong inflows from both domestic and overseas investors, the Sensex and the Nifty have been scaling new lifetime highs almost on a daily basis for the last couple of weeks.

Once again seasoned analysts are surprised by the strength of the up trend. Not many had expected the indices to rally past their previous highs as early as October. Some were predicting a steep correction towards the end of the year, which would take the indices back to their June, lows. Even the most optimistic analysts had not predicted so much, so soon.

What helped the markets to break down this wall of scepticism were the strong second quarter earnings reported by listed companies. Results from frontline companies, which set the market sentiment, were above expectations and they were even more bullish in their guidance for coming quarters. The performance of some of these companies was so strong that others whose results were in line with market expectations were considered laggards and their stocks have remained subdued.

Other factors, which have supported this rally, are domestic growth momentum, firm global markets and subdued oil prices. Domestic economic momentum is probably at its strongest in history and may push growth rate for current financial year to closer to, if not, 9 per cent. Oil prices have remained subdued for more than a month now, after declining over 25 per cent from record highs. Helped by lower oil prices and steady interest rates, other global markets have also sustained the up trend in recent months and major indices like the Dow are at historic highs.

Even as everything looks very rosy and sustainable, it maybe worthwhile to analyse the biggest threats, which may derail this bull-run. Though these risks may appear manageable at this point, they can worsen in the coming quarters. If market momentum ebbs next year, such risks may look all the more threatening.

Corporate earnings growth
Strong corporate earnings growth is the single most important factor driving this rally. Investors are comfortable with the relatively higher valuations for Indian companies as they have much better earnings visibility. Besides, Indian companies are less dependent on global growth and commodity price cycles for sustaining their earnings growth.

Can the frontline Indian companies sustain their current growth rates next year as well? Even if they can, markets may be disappointed if they cannot exceed expectations on a sustained basis. Maybe an Infosys or a Bharti would be able to consistently exceed expectations, but others are bound to disappoint when expectations continue to rise.

Operating margins have been under pressure for most sectors for many quarters now. So far, bottom line growth remains unaffected because of strong volume growth. Even if companies can protect their current margins, exceeding market expectations would become increasingly tougher. The high base effect, after many years of sustained bottom line growth, itself would make it difficult to sustain growth rates.

Costs would continue to rise in the coming quarters, squeezing margins further. Shortage of skilled manpower has led to spiralling wage costs for most fast growing sectors. Domestic salary levels for middle and senior management personnel have started touching global levels; with many senior executives getting million-dollar pay packages.

Companies have also stepped up their capital spending to overcome capacity constraints and meet rising demand. Incremental volume growth may come at lower margins because of higher capital and other costs. Borrowings to finance capital expenditure may lead to an increase in interest costs, even if interest rates do not increase further.

Most of the leading investment banks expect earnings growth to decline next year, even if the economy continues to expand at above 8 per cent. Yes, they have been sceptical in the past too and were proved wrong many times. But this time around, the weight of expectations is very high and even a modest disappointment can look disastrous.

Inflation and interest rates
Inflation is another important factor, second only to corporate earnings growth, which could derail market sentiment next year. Despite very strong economic growth momentum, domestic inflation has remained within the 5 to 5.5 per cent target range over the last year and has prompted the RBI to hold interest rates steady at its quarterly review meeting last month.

But inflation has been on a sustained upswing for the last many weeks and went very close to 5.5 per cent by the middle of October. Worryingly, costlier primary articles – including food - are driving inflation when crude oil prices have remained subdued. Prices of manufactured goods have also maintained a steady up trend. Higher income levels of consumers and stagnant output levels are behind the rising prices of primary articles while higher input costs have led to costlier manufactured goods. These factors won't disappear easily and inflation expectations would remain high next year as well.

The decline in crude oil prices would not have much of an impact on inflation expectations. Government has made it clear that it would consider a cut in retail fuel prices only if crude prices drop to $52 per barrel and that is still some way off.

If inflation remains close to the upper end of RBI's target range, the central bank would be forced to hike interest rates by January – especially since economic growth momentum is so strong. Most economists now expect a rate hike in January and some expect the increase to be as high as 50 basis points. Apart from the obvious impact on consumer demand growth, higher interest rates would be an added pressure on corporate margins when companies are expected to step up their borrowings.

Global economic growth
Though India is relatively insulated from a global economic slowdown because of less reliance on international trade to sustain growth rates, we are not completely immune to it either. Slower growth in some of the larger economies can impact the earnings growth of some of our frontline technology companies and emerging mid-caps, which rely on exports.

Most economists now expect US economic growth for 2007 to decline below 2 per cent from over 3 per cent forecast for the current year. Growth rate may even be worse if the US housing market continues to decline, which, though unlikely, is still possible. US corporate spending, which determines the volume growth for Indian tech companies, has so far remained strong despite clear signs of economic slowdown. But that may change, if US consumer spending declines.

The US Fed may bring down interest rates next year, but that is expected only towards the second half. Even if interest rates come down, it would take some time to revive consumer sentiment and in turn the housing market.

Other major economies like the EU and Japan are expected to do well next year. But Indian companies derive a much smaller portion of their revenues from these markets. Overall global growth rate for next year is expected to decline modestly from around 5 per cent forecast for the current year.

Fund flows
Domestic markets look to inflows from foreign investors for setting the direction. Even if the inflows were not very large, as in the current rally, markets would be all right as long as modest inflows are sustained. But they still don't have enough depth to absorb any selling pressure from overseas investors.

In the event of any major global sell-off, it is quite likely that the domestic markets would also go into a tailspin and lose substantial ground. But as happened post-June, the markets would climb back as long as corporate performance does not disappoint in a big way.

Even if fund flows remain robust, some analysts are worried that increased supply of fresh paper would suck out liquidity from the system and halt the rally. It is expected that Indian companies would raise around $12 billion from the primary market over the next year.

Historically, primary market issues from strong companies have benefited the markets even when they absorbed some liquidity. It was the Maruti disinvestment through an offer for sale by the government, which kicked off this bull-run. When the TCS IPO was launched, sceptical analysts even blamed the Tata group for launching such a large issue when the markets were struggling to sustain an up trend. But the stock went on to support the rally in a big way and TCS became the fifth most valuable company.

It is largely a misconception that large primary issues dampen market rallies by sucking out liquidity. On the contrary, such high profile issues often attract additional inflows into the markets. Primary issues also bring other stocks in the same sector into the limelight and help sustain market momentum. But hyped-up and over-priced issues can flop and dampen sentiment considerably.

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