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Wednesday, April 7, 2010

Economy may strengthen as key indicators turn positive

Signs of economic improvement are getting stronger in India with the Index of Industrial Production growth having recovered from its lows of -0.2% in December 2008 to hit a high of 16.7% in January 2010. We expect the economy to further strengthen as low interest rates help start another cycle of industrial and consumer credit expansion.Correspondingly, earnings expectations from industries for FY11 are increasing, coming off a low base in FY10. For instance, with global economies improving, we have revised upwards our earnings estimates for metal stocks by 10-20%; similar upgrades have been made for several other sectors.

Overall, we expect the benchmark Sensex companies to register 27% compounded annual growth rate in earnings over the next two years.We expect sectors, such as capital goods, infrastructure, banking and real estate, to lead from the front even as the telecom sector is expected to stabilize in FY12.Historical analysis of all-industry sales data indicates strong year-on-year (y-o-y) growth, with an average growth rate of around 22% during FY03-09. The growth in sales was achieved on the back of a steady increase in capital expenditure, in turn increasing the gross block and plant and machinery (P&M). The average P&M turnover was around 2.5 times during the mentioned period with a peak rate of around 2.9 times in FY09.

Visibly, the headline Wholesale Price Index, which has climbed to 9.9% y-o-y in February, is the main catalyst for the Reserve Bank of India’s (RBI) tightening measures. Food inflation continues to be the main cause for this runaway increase in overall inflation. It remains at elevated levels of 16.3% y-o-y.Food inflation, which was exacerbated by bad monsoons last year, is likely to moderate. At the same time, due to the base effect, over the next six-nine months, overall inflation is likely to once again come down to the manageable 4-5% range.

RBI’s main objective is to control inflation expectations. Nonetheless, just picking up, stifling liquidity is not required. Hence, we expect the rate hikes to happen in small, step-by-step increments. It will take a dozen or more hikes spread over many quarters before one needs to start worrying about high interest rates affecting growth.

In fact, in the previous cycle, even with a 3-4% increase in interest rates, credit demand remained strong due to robust economic activity and opportunity, buoyed by cheap foreign capital and strong domestic savings. Even as fundamental factors continue to show significant upward momentum, the economy is also receiving foreign institutional investor (FII) inflows. In fact, even during the crisis-ridden year of 2009, the country received as much as Rs85,000 crore of FII inflows.

At current levels, the Sensex is trading at 13.4 times estimated FY12 earnings per share against the five-year average of 16.1 times. While valuations are not cheap, at the same time they are not factoring more than 8% gross domestic product growth. With 8% growth looking increasingly achievable, we expect the Sensex to touch 20,992 levels by March.

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