Dichotomy between markets & economy? Just live with it
The economy seems to be at a low while the market appears to be on a high.
The market and the quality part of it are largely factoring in a reasonable recovery in the economy and earnings. However, given the structural issues faced by the economy, a quick recovery seems improbable. Earnings may, however, recover faster due to lower corporate tax rates and lower-than-anticipated loan loss provisions for banks.
The economy seems to be at a low while the market appears to be on a high. Nifty is trading at 22.5 times FY20 earnings on a free-float basis and seems to be factoring in economic recovery and an improvement in earnings. The economic recovery, however, seems challenging in the near term due to several structural issues, very limited space available on the fiscal front to support either consumption or investment demand and inefficacy of policy rates given the high level of government borrowing, leading to crowding out of the private sector.
Rich valuations of consumption stocks may continue to be supported by low global bond yields. However, valuations of certain discretionary stocks like auto and construction material may get de-rated without a significant recovery in demand. A few value stocks may get re-rated based on company or sector specific issues, such as revival of global sentiment based on the extent of the US-China trade agreement, improvement in domestic credit conditions or privatisation of central PSUs.
A convergence between the economy and market and between growth and value stocks would be difficult to call, however, a few conditions could be identified.
On the economy-market divide, an extended slowdown could result in the market losing hope for an imminent revival in demand supported by government action. On the growth-value divide, sector- and company-specific developments may result in some re-rating of the ‘value’ stocks, which have languished at low levels. For growth stocks, it would be a stretched expectations for investors to worry about the rich valuations.
Earnings have limited scope for upward surprises. Q2FY20 net profits declined 3 per cent year on year for Nifty stocks, led by a sharp drop in volumes of auto companies and lower profitability in case of metals and oil & gas companies. The YoY decline in profit was despite lower corporate taxes, which resulted in a reversal of higher tax provided for in Q1FY20. Some PSU companies have still not given effect of the lower tax rate in their respective financials.
Based on the numbers for the first two quarters, 10-11% is the best earnings growth that can be expected in FY20. We may have to live with the dichotomy observed between the economy and markets as well as the in valuations between growth and value stocks for a while.