Tuesday, March 08, 2011 10:03 Hrs IST

With the expected corporate earnings growth in the vicinity of 22% for FY11 and 18% for FY12, the valuations look very reasonable

DSP BlackRock Investment Managers-Indian Equity Market

Global Update

MSCI India underperformed the global indices for the second consecutive month, being the second worst performing emerging market after Egypt. Unlike 2010, the MSCI India Index no longer outperforms MSCI EM Index on a 3-m, 6- m and 12-m basis. On a YTD basis, the MSCI India Index is down 14.7%, while being up 6.2% on a trailing 12 month basis.

Domestic market review

Sensex/Sectors: The BSE Sensex Index touched a 7-month low in February, falling 2.2% m-o-m and 13.1% YTD. On a 1-month basis, FMCG was the best performing sector with 0.4% contribution, while Capital Goods was the worst performing sector with a negative contribution of 0.7%. On a 1-year trailing basis, Sensex is up 8.5% with the Financials contributing 4.7% of this and Capital Goods sector being the worst performer contributing (-)1.1% on an absolute basis (refer to charts on the next page).

Large/Mid/Small Cap: On a relative basis, the large cap index (BSE 100) outperformed the mid-cap and small cap indices by approx. 4% during February. On a 1-year basis as well, the large cap index has outperformed the other two indices by a significant margin.

Flows: FII inflows in the cash market were negative for the second consecutive month, with FIIs selling in excess of USD 800mn. In the futures market, however, FIIs were net buyers to the tune of USD 1bn. Domestic mutual funds were positive for the third consecutive month after being negative through most of 2010, while domestic insurance companies bought stocks worth more than USD 700mn in February.

Equity market activity: Market activity remained weak. Cash volumes and turnover were flat. Cash turnover is at a 12-month low. Derivatives turnover, however, rose further this month. Average open interest was flat for the month.

Earnings expectations: The consensus expects Sensex EPS growth of 23.5% and 18.8% in FY11 and FY12 respectively.

Corporate activity: 3-month rolling equity issuances show a downward trend as does the 3-month rolling trend for debt issuances. M&A activity, however, showed a pickup.

Valuation: MSCI India's absolute valuations fell to a 16-month low. Relative to emerging markets, the India's valuations are currently at a 50% premium to the MSCI EM valuations. The Sensex Index is trading at 14.2(x) 1-year forward earnings (refer chart alongside).

Macroeconomic Review

The Industrial Production (IP) growth for December moderated further to 1.6% y-o-y compared to 3.66% (revised upwards from 2.7% y-o-y) in the previous month. On a seasonally adjusted basis, the IP index was up 1.0% m-o-m in December compared to (-) 2.9% m-o-m decrease in November. On a quarterly basis, IP growth decelerated to an average of 5.5% y-o-y during the quarter ended December 2010 from 9.1% during the previous quarter. Growth in the manufacturing as well as mining segments moderated to 1% y-o-y and 3.8% y- o-y (compared to 3.2% y-o-y and 7.4% y-o-y in the previous month) while growth in the electricity segment accelerated to 6% y-o-y (compared to 4.6% y-o-y in November).

The WPI headline inflation decelerated marginally to 8.2% y-o-y in January 2011, compared to 8.4% in the previous month. The seasonally adjusted WPI Index was up 1.1% m-o-m. Food inflation (primary and manufactured) accelerated further to 9.5% in December against 8.9% in the previous month while non-food inflation decelerated to 7.7% this month from 8.2% in December.

India's GDP grew by 8.2% y-o-y in the quarter ended December 2010, which was slightly lower than market expectations of 8.8%. The strong GDP growth was on account of agriculture and services segments. The agriculture output grew 8.9% y-o-y which was significantly stronger than the 2.5% and 4.4% growth seen in the previous two quarters. The industry segment growth was 5.7% y-o-y which was substantially lower than 11.7% and 8.9% growth seen in the previous two quarters. The services sector saw a growth of 8.7% y-o- y, compared to an average growth of 9.5% in the last two quarters.

Non-Equity Market Update

Fixed Income: During February, the treasury yield curve (between 10-yr and 1-yr Government Bonds) narrowed by 7 basis points (bps) m-o-m to 50 bps. The 10-year bond yield moved from 8.16% pa to 8.02% pa during the month while the 1-year bond yield moved from 7.59% pa to 7.52% pa during the same period.

Currency: In February, the Indian Rupee appreciated 1.38% against the US Dollar and by 0.16% against the EURO. The USD/INR FX rate closed the month at 45.27 against 45.91 as at previous month end. The EURO/INR FX rate closed the month at 62.65 against 62.75 as at the previous month end.

Gold: Gold price moved up 5.9% in February to close the month at USD 1411.5/ounce.

Oil: WTI crude moved up 5.2% to close the month at USD 97/barrel. Brent crude was significantly higher at 111.8/barrel as on February 28, 2011.

Equity Market Outlook

The Indian equity markets have had a rough start to 2011, with the BSE Sensex Index falling 13.1% YTD. While the correction cannot be attributed to one single reason, the heavy FII selling that we have witnessed has been a major contributor. YTD FIIs have sold $2.2bn in the Indian equity markets. The other factors that have contributed to this correction include the news flow that we have seen on the 2G scam. Further, the concerns over domestic inflation and its impact on consumption and the resulting RBI policy action have continued to be an overhang for the Indian stock market. The geo-political tension in the recent past has further impacted the market sentiment.

The domestic macro economic news flow continues to be negative. High oil prices are continuing to exert upward pressure on inflation and could eventually pose a threat to the fiscal deficit. Industrial production as well has been declining. The tightness in money market continues, and the slight negativity towards emerging markets during the current year could result in FII flows slowing down.

From a valuation perspective, however, the Sensex is currently trading below its long term average 1-year forward PE multiple of 14.5x. Keeping in mind the expected corporate earnings growth in the vicinity of 22% for FY11 and 18% for FY12, the valuations look very reasonable.

The domestic engines of growth – consumption, infrastructure and outsourcing - remain intact, and while not all cylinders will fire at the same time, the economy should continue to deliver 8% GDP growth over the next few years.