When interest rate bottom out and leveraging cycle starts, equity starts delivering better returns
The years 2015 and 2016 have been an interesting phase for both equity and fixed income market. Most often investors believe that when interest rates fall, equity markets are likely to deliver reasonable returns. However, experiences in the Western world indicate otherwise. Historically, it has been observed that when interest rate bottom out and leveraging cycle starts, equity starts delivering better returns.
In India, there have been two instances of deleveraging thus far. The first part of the deleveraging cycle played out in Jan-Feb 2016 when non-performing and restructured loans in the banking system were identified and the second part came about in the form of withdrawal of legal tender of Rs 500 and Rs 1,000 bank notes. What is observed globally is that during the process of deleveraging, fixed income can generate returns. So we believe that the outlook of fixed income is reasonably good for the next six months while the outlook for equities, in the near term (three to six months) seem to be volatile.
Now coming to equities, for a good structural bull market to play out, we have observed that three production factors—land, labour and capital—should bottom out. Post demonetisation, we believe that land prices are likely to come down. Interest rates have already come off and labour costs have reduced over the last three to four years. All these are positive for the growth prospects of the economy. Now what is required is the leveraging cycle to play out for equities to rally and this is likely to happen over the next two years.
Essentially, the steps taken by the Reserve Bank of India and the government in the phase from 2013-2015, have made financial assets attractive from a long term investment perspective. Over the last five years, gold has given negative returns in dollar terms while globally real estate too has hardly delivered any returns. So the steps taken by the government have resulted in a boost to financial savings and therefore equity and fixed income have delivered good returns from September 2013 till date. We believe that for few more years, financial assets could continue to do well when compared to physical assets.
To sum up there is a case to invest in equities with a two-year view. This is with an understanding that volatility is most likely to prevail maybe up to next two quarters of 2017. Post that, we believe, leveraging cycle is likely to start playing out and capacity utilisation of Indian industry could go up leading to improvement in the earnings. Valuations on parameters like market capitalisation to GDP are reasonable and profit as a per cent of GDP has come down, substantially. Going forward we expect these matrices to improve which is likely to result in higher corporate earnings.
S Naren is ED & CIO, ICICI Prudential AMC