Cheap index valuation isn't inspiring

The Reserve Bank of India (RBI) has just announced extraordinary measures to help maintain economic activity during the pandemic. The central bank has cut policy rates by 75 basis points, alongside a moratorium on various loans, and a sequence of other measures designed to improve liquidity and transmission of rate cuts to commercial rates. It has also cut the cash reserve ratio, which frees more bank resources for commercial credit. 

The RBI refrained from concrete projections. It believes, probably correctly, that inflation will fall due to low demand. It sees a high risk (guaranteed really) that the global economy, or several global regions, could slip into recession. There is an economic crunch both from the demand and supply side. 

How long this situation could last and the eventual costs depends on imponderables such as eventual impact of the virus, the duration of lockdown, etc. For sure, economic growth in India will be lower for at least two quarters, with likely negative GDP prints. 

Headline inflation, which includes food and energy, could go anywhere. The food basket has a 45 per cent weight in the India consumer basket. Headline inflation is currently well above the target “upper circuit” of 6 per cent due to high food costs. 

It’s hard to know where food prices will trend. They could spike due to unavailability, or food prices could collapse, due to an inability to buy, given large populations suffering loss of income. Both situations may occur in the next six months, at various stages. 

But core inflation and energy will trend down. After the RBI cut, policy rates are well below headline inflation. A real negative policy rate, coupled with other liquidity-enhancement measures, should ensure money is available for anybody who is interested in borrowing it. 

The lockdown could well lead to civil unrest if there are shortages of food and other essential items. The healthcare system may also not be able to cope if serious cases (not only COVID-related ones) spike. These are obvious downside risks. On the upside, cheap commodities, including cheap energy, reduce pressure on imports. 

Investors may recall that the Nifty traded at 7,500 in May 2014, when Narendra Modi led the BJP to victory in the General Election. Last week, it hit 7,500 again, before rebounding to 8,600-plus. The rupee traded at Rs 58-59 per US dollar during May 2014. It is now below Rs 76 per US dollar.  

This means that a foreign portfolio investor (FPI) who entered in May 2014 during that first rush of enthusiasm for the BJP has lost a considerable amount in dollar terms over the past six years, even if we ignore the opportunity cost of capital. A domestic index investor has a 14-15 per cent absolute return in rupee terms – that’s below the rate of interest paid in a savings account. 

Beyond all the rationale about the damage done by the black swan of the virus, take a long, hard look at the long-term trend of the economy. India is doing a lot worse on most counts than in 2014. There’s far higher unemployment, consistently lower GDP growth, higher NPAs across banks and non-banking financial companies, lower exports and more public unrest. All these problems were already highly visible before the virus surfaced. The economy is still struggling to recover from the madcap demonetisation scheme. And a poorly designed and implemented Goods and Services Tax regime has not stabilised yet.  

The lockdown has just made things a lot worse. The pandemic triggered a big exit by FPIs who pulled out a net Rs 1.16 trillion worth of rupee debt (net sales of Rs 57,003 crore) and equity (net sales Rs 59,377 crore) in March. 

Some of the RBI-driven liquidity will flow into the stock market simply because there are no more productive channels. But this could be a dead cat bounce. Investors, already tired of holding through seven successive quarters of lacklustre returns, may not be happy to hold for at least two more poor quarters. Any further bad news, such as a spike in COVID cases, or food riots, could trigger more flight of capital. 

At 8,600 Nifty, the official price-to-earnings (P/E) ratio for the index (four trailing quarters of standalone EPS weighted by free-float market cap) is about 19.5. At 7,500 Nifty, it’s about 17. Historically, the index has been a buy at 17 P/E, but these are extraordinary circumstances due to the cloudy earnings outlook.

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