Big Sensex rally in 2016 unrealistic - said By Saurabh Mukherjea

The rally that began in the Indian market when Raghuram Rajan took charge of the Reserve Bank of India (RBI) in September 2013 lasted until March when the Sensex hit 30,000 points. The first 12 months of this rally were largely driven by foreign institutional investors (FIIs) as they loaded up on India in the run-up to the 2014 general election and for a few months thereafter. However, by the early months of 2015, FII equity inflows began to peter out as corporate earnings growth stagnated.

The last time corporate India produced such dismal earnings growth was during the 2008 financial crisis. Today, in spite of poor corporate earnings, share prices have broadly held up, thanks to retail investors' optimism. To put things into perspective, since May, FIIs have sold local equities worth Rs 45,700 crore, whereas domestic institutional investors have bought stocks worth Rs 51,900 crore as of November.
So, what's going on? Why are FIIs losing their enthusiasm for Indian equities even as they enthusiastically invest in Indian debt? Why are corporate earnings not growing quarter after quarter in a country where nominal GDP growth is close to 10%? And given this predicament, what will 2016 bring?
Modi's resets
Over the course of 2015, we have repeatedly said that Prime Minister Narendra Modi is trying to reform the Indian economy along three specific dimensions:
* Altering the subsidy regime-by cutting subsidies and moving subsidies to the Direct Benefit Transfer platform-thus adversely impacting rural consumption.
* Signalling to crony capitalists that it is not "business as usual" for this subset of Indian businessmen who use lobbying to routinely bend policy in their favour.
* Attacking black money through the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015, which, after a 90-day amnesty window expires, punishes Indians who have undisclosed wealth abroad with a 10-year jail sentence.
How structural reform impacts economies
Structural reform usually entails short-term pain as economic agents (workers, bankers and business people) struggle to cope with the altered rules of economic adjustment. Britain under Margaret Thatcher, India after the 1991 reforms and Indonesia after the East Asian crisis give us a clear picture of what is likely to happen to India as Prime Minister Modi's economic resets hit home:
* In the UK, Thatcher began the economic reform process in 1980. Gross domestic product (GDP) initially contracted 2% due to these reforms, but then recovered from 1982 onwards. In particular, investment initially suffered under Thatcher as she kept monetary and fiscal policies tight. As inflation expectations were brought down, private investment gathered pace.
* In India, economic reforms began in 1991 in the wake of a balance of payments crisis. GDP growth fell to 1% in FY1992 but then recovered from FY1993 onwards.
* In Indonesia, reforms began in 1997 in the aftermath of the East Asian crisis, the economy shrank 13% in 1998 and investment collapsed. Then, on the back of large currency devaluation and more freedom for smaller businesses, investment gradually recovered from 2000 onwards.
These examples have a common feature: economic growth and investment nosedive during the initial phase of reform, as the rules governing the economy are radically altered by reform and economic agents struggle to adjust to this change. Gradually, the reforms put the economy on a sustainable growth path as against the growth fuelled by excessive government spending (as was the case with Britain in the 1970s and India in the 1980s) or by unsustainable external funding (as was the case with Indonesia in 1997).
Impact on the economy
In light of the above, in August, we downgraded our GDP growth estimate for FY2016 from 7% YoY to 6.8% YoY, well below the consensus estimate of 7.5%. We have since said that we do not expect GDP growth to improve materially in FY2017. Our sub-consensus view on GDP growth translates into a corresponding view on earnings growth, which in turn leads us to believe that over the next 12-18 months, it is unrealistic to expect the Sensex to rally by more than 10-15%.
In fact, given the elevated level of stress in the Indian banking system, combined with the gradual deterioration of the gigantic Indian real estate sector, there is a real risk that the Sensex could go as low as 22,000 points, especially if the rupee comes under pressure in the wake of further devaluation of the Chinese currency. Hence, if you are considering investing in Indian stocks, we would suggest that you focus on high-quality franchises that are available at reasonable valuations. More adventurous investment strategies are unlikely to be rewarding in the current economic climate.