A P : My biggest worry
Interest rates are up over 300 basis points (3 per cent), over the past
12-18 months, and yet
one sees little concern on this issue.
Given the slew of research reports on the subject recently, it is quite
clear that for most India strategists, the issue they worry about most is corporate earnings. I have personally seen at least 4-5 research reports from each of the major sellside houses, laying down its views on this.
The bearish strategists make the case as to why earnings growth
will disappoint, while the bulls make the opposite argument. One can understand this obsession with earnings growth, for India is an expensive market, and the only way that one can justify current valuations is to fall back on the earnings growth plank. Yes, India has the highest multiples in
the region, but adjusted for growth it is actually very cheap—this is
the standard bull case
argument. Also, given the quantum of research on this topic, it is
likely that the earnings
outlook is on top of the mind for most investors as well, as investors'
questions normally
drive top-down strategy research.
While I do accept the importance of the earnings outlook, I am actually
not that troubled by
it. I am pretty sure that with 7 per cent real GDP growth, our corporate
sector will churn out
15 per cent earnings growth on a long-term sustainable basis. The simple
maths is that 7 per
cent real GDP will lead to a growth rate of about 12-13 per cent in
nominal GDP growth
(5-6 per cent inflation). Given the weighting of agriculture in GDP and
the ability of the listed
corporate sector to grow faster and gain share in the economy, 15 per
cent corporate
earnings do not look to be far-fetched. We may have one year here or
there which has
lower growth, but the long-term trend here looks quite solid and
sustainable. If macro
conditions (including rates) remain stable, then earnings should come
through.
The greater worry to my mind, in India, is the outlook for interest
rates. For, interest rates
will drive the outlook for both the real economy and financial markets.
It is quite clear that
we cannot sustain 7-8 per cent GDP growth with our own domestic savings.
We would
need savings rates of more than 30 per cent, unlikely in the short term
with our level of public
sector dissavings.
We run the largest fiscal deficit in the emerging markets universe as
well as one of the few
current account deficits. Many question our ability to sustain 7-8 per
cent economic growth
without rates spiking, given our twin handicaps. Others question as to
whether the
equilibrium long bond yield for a country with our growth and financing
trajectory can be
capped at only 8 per cent. Many cite research work pointing out that in
the long term, as
economies develop equilibrium, long bond yields should settle at nominal
GDP. Those may
be longer-term issues, but even for the short term, in an environment of
rising rates globally,
tightening liquidity and domestic inflation there does exist the risk
that interest rates in India
can spike up further.
Already, interest rates are up over 300 basis points (3 per cent), over
the past 12-18
months, yet one sees little concern on this issue. If you talk to Indian
companies, they seem
to indicate no slowdown in demand for anything, and even bank lending
figures to both
companies and retail still show very healthy growth. While this may be
true for right now, I
cannot imagine a 300-basis-point hike in rates (even higher for most
retail and corporate
loans) not having an impact on both lending growth and credit quality.
These effects have a
lead time, and everything will seem fine until suddenly something gives.
We are also in the
unique position of never having seen a retail credit cycle in India
before. How will the retail
borrower react to rising rates? We have no history to fall back on, no
ability to build credit
models based on past behaviour. Just because credit has not slowed much
yet does not
mean it will not. How does one calibrate credit losses in this type of
an environment? This is
the first credit cycle of rising rates encountered by a newly leveraged
middle class India.
How will these first-time borrowers behave? No one knows, and
surprisingly this lack of
data on past behaviorial patterns does not seem to worry too many
people.
The history of other economies suggests that demand gets hit, credit
defaults rise, and
cyclical sectors experience a significant slowdown. The impact of this
slowdown will impact
the entire economy, directly or indirectly. Since it has not happened
yet, most investors
believe it cannot, and hopefully we are not in denial.
Beyond its impact on demand, rising rates will also hit the profits of a
corporate India
embarking on a capex and leverage cycle. Corporate India has never been
more confident
of itself and its abilities. The rise in confidence is leading to a
greater willingness to leverage.
A significant chunk of the last 3-4 years’ profit growth came from
de-leveraging and lowered
borrowing costs, and both of these factors are reversing.
The other worrying aspect of rising rates is the impact this will have
on PE multiples. When
interest rates collapsed from 12 per cent (10-year bond) to 5 per cent,
it took time but we
did eventually see multiple expansion. In fact, PE multiples effectively
doubled from 2003 till
June 2006. It is interesting, now that rates are going in the opposite
direction, no one expects
PE contraction. PE multiples have a clear negative correlation with
interest rates. The
relationship may break down for some time, but it will eventually
reassert itself.
Also, the higher the current PE multiple, the greater the impact of
rising rates.
If one were to use the so-called Fed model, at 5 per cent long bond
rates we could have
justified a 20 PE, but at 8 per cent yields, the fair multiple drops to
12.5, more than a little
difference.
Thus, more than earnings, I would worry about rates, for rising rates
have the ability to hit
both the levers of equity performance, earnings growth and PE multiples.
If rates can remain
in their current range, we should be ok, but any spike to significantly
higher levels spells
trouble.
The current consensus is that rates will remain stable at these levels,
and I hope for all of us
this is one of the few times that the consensus is actually right.