Volatile times ahead
- We have seen a sustained one-way rise in the Sensex since early April with the easing of the domestic concern over hardening interest rates. However, globally the uncertainty over interest rates (particularly in the USA) persists which could give rise to volatility in the emerging markets. Some other factors like mega initial public offerings (IPOs), earnings downgrades (possible in sectors such as automobiles, information technology [IT] and cement) and the availability of liquidity would dictate the market direction, at least in the near term.
- Our first base case assumption that domestic inflation would moderate by mid May—highlighted in our previous Market Outlook report, "Markets dance to local tunes", dated April 9, 2007—has come true. The latest inflation number of 4.85% for the week ended May 26 is a welcome relief for the equity markets, as it has reduced the upward pressure on interest rates and also provided the Reserve Bank of India (RBI) with that extra elbow room to go slow on the inflation control exercise via exchange rate management.
- Our second base case assumption of a slowdown (but not a recession) in the USA has held steady. In the first quarter of CY2007 the US gross domestic product (GDP) grew at 0.6% compared with an average 2.5% growth in the previous fiscal. Economic growth is expected to pick up going forward but the same will remain sluggish.
- On the global front, we need to be cognisant of certain risks, such as a possible interest rate hike in the USA due to firm inflation numbers. However, this will take another two to three months to come about, as the market would wait for more data before taking a view on interest rate hikes.
- Some leading indicators continue to point towards a slowdown in certain domestic sectors (viz automobiles, retail home loan disbursements, cement dispatches and exports). The earnings growth is expected to slow down in FY2008 and FY2009. We feel the FY2008 earnings expectations in certain sectors like automobiles, IT and cement remain too high. Hence there's a possibility of an earnings downgrade in these sectors, which is likely to put pressure on the market in the short term, ie in the run-up to the Q1FY2008 earnings season.
- The Sensex' valuation at 16.3x FY2008E earnings is not cheap and we have seen that at these levels the markets are prone to some sort of correction. After the sharp run-up in the Sensex (the benchmark index has gained 16.8% in the last two months), the valuation gap between the large-cap companies and the mid-cap companies looks attractive despite the fact that the CNX Mid-cap Index has clocked a gain of 20.4% in the same period. We continue to like sectors where the earnings visibility is strong, eg infrastructure, capital goods and engineering sectors and the leading private sector banks. Quality mid-cap companies from these sectors could outperform their larger counterparts going forward.
SECTOR UPDATE
Automobiles
Thrown out of gear for a while
- The automobile sector has been on a dream run since 2004. A strong economy, easy and cheap availability of finance, rising income levels, lifestyle changes and low penetration levels led to this phenomenal performance. While all the other macro factors remain intact, the rising interest rates and liquidity crunch are severely affecting the sector’s growth, forcing it to take a breather.
- Overall, the sector's sales are expected to pick up with the beginning of the busy season, ie October onwards. Sales for June are also expected to be affected due to the presence of Adhik mahina, an inauspicious period for buying any new product, in this month. The slowdown in the automobile industry will surely affect the earnings of all the major players.
- Considering this we are downgrading our estimates for all the stocks under our coverage. At the current prices, most of the stocks are trading at a discount to the valuations of the Sensex. We expect stocks from this sector to continue to trade at a discount to the index in the medium term and hence continue to underperform the market. However, considering the long-term potential of individual stocks, we maintain our Buy recommendation on the stocks, save for Bajaj Auto, which is being downgraded to a Hold. Our preferred bets are Maruti Udyog, and Mahindra and Mahindra.