Sensex surge: Samvat 2070 will not begin on a highly bullish note

If there was ever proof that there is a good degree of divergence between what the equity markets feel and what the reality on the ground is, this is it: The 30-share S&P BSE Sensex closed at its all-time high of 21,196.81, with the markets in a state of euphoria.

There’s the Diwali spirit palpable on the bourses as foreign institutional inflows pour in, powering the indices to new highs. It’s truly been a cracker of a Diwali this year, coming as it does after a tense few months when the rupee’s precipitous decline and its aftershocks sent shivers down the collective spine of the markets.

So all’s well that ends well, and Samvat 2070 is set to begin on a highly bullish note? Not quite. Sorry if this sounds like a party pooper, but scratch the surface and there’s ample evidence that the surge in the Sensex is more a result of liquidity than any dramatic change in fundamentals. In fact, as if to underscore a reality check on a day when bullishness was the norm, the latest purchasing managers’ index came in demonstrating yet again that manufacturing activity was still very much on contraction mode.

The HSBC India Manufacturing PMI print for October showed the number unchanged at 49.6, indicating a third straight contraction. A number above 50 indicates expansion. Business conditions, therefore, continued to be in a state of slump even as the stock markets went dizzy with celebrations. The only bright spot was that even as new orders contracted, export business expanded for the first time in three months.

To be sure, the foreign institutional investor (FII)-led rise in the markets has been at odds even with the general trends in earnings. While FIIs have pumped in close to Rs 90,000 crore into the markets since the beginning of 2013, a Business Standard report points out that the Sensex has risen 18 percent from end-August, even as underlying earnings rose only 6 percent.

Regulator tango

In a sense, the sharp rise in the markets has also come about thanks to two monetary authorities - the US Federal Reserve and the Reserve Bank of India back home. While the US Fed’s latest decision to maintain status quo on its $85 billion a month stimulus programme and postpone the dreaded ’tapering’ drove markets into a frenzy, back home RBI’s new governor Raghuram Rajan played largely along with market expectations, reducing the overnight Marginal Standing Facility (MSF) borrowing rate by another 25 bps to ease liquidity for banks further. Though Rajan did increase the benchmark repo rate by an equal amount to send out another signal against inflation, this had largely been factored in by market players given the continuing rise in both wholesale and retail inflation.

In sum, while the US Fed provided a huge relief, Rajan aided that by not upsetting calculations. Reason enough for the market to get into serious celebration mode.

Finance minister Palaniappan Chidambaram came out on 1 November after market hours and announced investor confidence is still intact and that the fiscal deficit target for FY14 would be met. The stance of the government, he added, would be pro-growth and that the steps taken by the government in this direction had started yielding results.

Optimists rule

Prone to bouts of irrational exuberance and deep despair, the markets-seen by many experts often as bipolar-is busy putting together the pieces of good news from everywhere.

In an assessment of what has been powering this rally, an IIFL report says: “A litany of fresh hopes has further improved the sentiment in anticipation of what lies ahead. There is a strong feeling among market participants that India’s Current Account Deficit (CAD), third largest in the world in absolute terms, will fall in line in the coming months. Official gold imports have drastically fallen in recent months and oil prices are likely to be under check with shale gas discoveries, muted global demand and INR scale back. Exports have also picked up recently. The recent monthly trade data was encouraging to say the least (A mere $6.8bn trade deficit compared to the whopping $17.7bn of the previous year.”

Besides, the easing of liquidity by the RBI, which cooled down short-term rates, has also added to the positive feel. Add to that the chances of a good harvest thanks to the healthy monsoon and there’s hope of a rise in rural incomes. The other vital factor which has, of late, been adding fire to the market is the Modi effect: large sections of the market feels the BJP will fare much better in the 2014 elections thanks to the Narendra Modi factor.

“On the political front, the market is pinning its hopes on a BJP-led government at the Centre. While we believe it’s premature to predict a thumping BJP majority just yet, the fact remains that this very hope is driving the market. Likely BJP wins in the state elections of Rajasthan, Madhya Pradesh and Chhattisgarh may further boost the current rally,” adds the IIFL report.

A mid-October Goldman Sachs report echoes a similar sentiment. Says the report: “India’s parliamentary elections, to be held before May 2014, will likely be an important driver for its markets.

Current opinion polls suggest that the opposition BJP-led alliance has a lead over the ruling Congress-led alliance, but may fall short of a simple majority. The polls suggest that the probability of a BJP-led alliance forming the next government with the support of regional parties is higher than that of the Congress or that of a group of regional parties.”

Reality check

But even as the optimists seem to have gained control of the markets, there’s enough to worry about over the next few months. Despite Chidambaram’s promises and resolve, there’s a serious shortage of actual execution of structural reforms to ease supply-side bottlenecks; with elections round the corner, the execution challenge for tougher reforms can only get more difficult. Big-ticket moves like the introduction of the Goods and Services Tax (GST) are still pending, and despite the CAD easing, the fiscal deficit is still a huge challenge.

The banking system, on the other hand, is beginning to worry about the problem of bad loans as companies find their balance sheets stretched on shrinking demand owing to the slowdown. Corporate earnings, consequently, continue to be lackluster despite segments of good performance. Yet a Reuters report quotes Credit Suisse as saying that Indian markets are clearly more expensive than their regional peers, trading at 14.4 times trailing 12-month earnings, compared to 10.6 times Asian emerging markets.

The BSE IT, pharma, FMCG, auto and oil and gas indices have posted healthy gains over the past year, since last Diwali. As IIFL points out, BSE IT gained a hefty 46.5 percent, BSE pharma 23.8 percent, BSE FMCG 17.3 percent, BSE Auto 13 percent and BSE oil and gas 9.6 percent. The sectors which lost during the year were banks, metals, capital goods, small caps, power and realty. Evidence enough that the bull run is not spread across the board.

But for now, as the Samvat 2069 ends and the markets ready to welcome the new year, few are willing to look at the problems beneath the surface. The market is quite happy riding on the high waves of liquidity.