Approaching the point of maximum uncertainty

The world is going through a crisis the likes of which most of us have never seen before. The excessive gearing of the past 25 years had taken gross debt in the US to over 300 per cent of GDP and a breakdown of this debt super cycle will likely slow global growth, dragging the world into a recession. It may take several years to restore the confidence of the system. India has been affected adversely by this, although this conclusion may appear surprising to the lay observer. After all, India derives less than 14 per cent of its GDP from exports, runs a relatively closed capital account and does not seem overly dependent on global growth. However, India was a big beneficiary of the very high global risk appetite over the past five years and is dependent on capital to fund its current account deficit. The bulk of this capital comes from financial markets and not foreign direct investment (FDI), unlike in other large emerging markets. This makes India a relatively high beta equity market despite the low share of exports in GDP.

India received $108 billion (Rs 5.18 lakh crore) in capital flows in the financial year ended March 31, 2008, and a cumulative inflow of $224 billion (Rs 10.75 lakh crore) over the past five years. This serviced India’s biggest-ever credit and capital expenditure cycle. India’s outstanding credit grew from $189 billion (Rs 9.72 lakh crore) in March 2003 to $643 billion (Rs 30.86 lakh crore) by March 2008. Over the past five years, the country spent $1.4 trillion (Rs 67.2 lakh crore) on investments, powering growth to an average of 9 per cent. However, India’s infrastructure was not ready for this growth, and this, together with the surge in global commodity prices, pushed up inflation in a classic case of overheating. Of course, we got prompt action from the central bank but it has left us with a cyclical slowdown in growth. If capital flows recede— a natural outcome of the current global crisis—India’s growth will hurt further.

Consequently, earnings will suffer. Taken together, the constituents of the 30-share BSE Sensex have reported a five-fold growth in earnings over the past five years from Rs 24,700 crore to Rs 1,21,500 crore, creating what can be called an earnings bubble. Corporate India is sitting on record margins, record financial income and a high base of earnings. If earnings fall in the coming quarters, it should surprise nobody.

Share prices look into the future and are reacting violently to this flux. At the beginning of 2008, Indian equities were trading at over 30 times earnings and pricing in high long-term growth relative to India’s potential growth rate. The events of the past few months leave a question mark over India’s medium-term growth prospects and, thus, equity valuations have been shattered. The near-term looks uncertain and it is quite likely that share prices will fall further in the coming weeks. For investors with a short-term horizon, cash is king. For those looking at long-term investments, this may soon become an opportunity of a lifetime as India is still poised to grow strongly over the next 3-4 decades.

However, even long-term investors ought to remember that patience pays in bear markets as they travel through the most vicious bear market in India’s history (the market has lost nearly 60 per cent in 42 weeks). Of course, it comes as no surprise that it follows the best bull run in Indian history.