The markets are in the grip of euphoria, with the Sensex having crossed the 8,000 mark. Good economic fundamentals, robust corporate earnings growth and continuing foreign fund inflows are keeping the sentiment high, with the benchmark indices ready to climb new peaks.
Are there any risks to this seemingly unstoppable momentum? Not all are convinced about the longevity of the current rally. There are a couple of sore points which if and when they materialise could upset the apple cart. And we are not even counting the regular corrections that are bound to occur.
Top in the list of potential trouble spots are oil prices. Then there are worries about interest rates. And of course, there is a worry about the earnings momentum slowing down, which is, in fact, a statistical reality. Not to speak of comparatively rich valuations vis-à-vis other emerging markets.
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Lets us take a look at these 'spoil sport' factors. Interest rates are the biggest worry for many. While it is generally accepted that the low interest rate regime of the past couple of years has been a big factor in money flowing to equities, times may be about to change.
The RBI has not indicated a return to higher rates. But rising prices and its impact on inflation could force the central bank to raise rates. And if there is a hike in rates, it will most likely impact equity markets, too.
Will interest rates go up?
This is what an analyst with a leading domestic brokerage had to say. "An interest rate hike of at least 300-400 basis points over 8-12 months could have a material impact on the Sensex."
There are others who subscribe to that view. "We expect a 25-50 bps interest rate hike some time in October when the credit policy would be announced," says SBI Capital Markets' head of research Sanjay Chawla.
But interestingly, Chawla's worry is not that any small rate hike would directly impact the markets. He is more worried about the huge government borrowings that could lead to higher interest rate hikes.
"About 100 per cent y-o-y growth is expected in the borrowings this time. If this growth is still higher, it will have a bearing on the interest rates and in turn on the equity markets. If interest rate hikes are so much that they stop capital formation in the economy, markets would be obviously affected," notes Chawla.
Crude reality
Crude oil price hikes are not new and one has seen them going up from about $42-45 per barrel to about $65 per barrel in one year's time. But observers feel that if the prices touch $75-80, then it would have an adverse impact.
"Moreover, if the government removes the existing protective wall insulating India's oil sector, it would be a negative factor," says Chawla. But opinions on oil prices vary.
For example, Manish Shah, head of equities and derivatives at Mumbai-based securities firm, Motilal Oswal Securities, does not foresee any adverse impact of crude price hikes.
While analysts agree that rising crude oil prices have had a negative impact on global markets, they say Indian markets were among a few exceptions. However, with the government already announcing a fuel price hike, things may be about to change.
Earnings growth slowing down?
Statistics reveal that corporate earnings growth may be slowing down. It is now clear that corporate India cannot grow its earnings at 25-30 per cent forever and a more sedate 15-20 per cent is a realistic number.
The Sensex earnings growth of 26 per cent in the 2005 June quarter reinforced the fact that the trend that started at the end of 2004 continues.
From a growth rate in the mid-40s by the end of December, 2004, Sensex companies have reported earnings that have been coming down consistently. "Earnings growth is decelerating and is now half of what it was a year ago," says a report by a foreign research house.
Factors like higher wages in sectors like software and higher capex for manufacturing companies are expected to the impede the growth momentum going forward. According to Chawla, corporate earnings are expected to grow by 21-22 per cent over the next one year.
There are other worries like political uncertainty and a slowdown in global growth rates that can impact future domestic corporate profits apart from the country's burgeoning fiscal deficit.
Some analysts have noted that usual interest rate hikes and rise in crude oil prices have been factored in the Sensex already. This is apart from the rate hikes in the US. So is the sustained rise causing concerns?
"We had estimated an EPS of 576 for FY06E and of 637 for FY07E. We had set a target of 8,281 over a one-year period, which has been nearly achieved in just three months," notes Shah.
As has been the recent trend, analysts expect future growth to be driven by foreign fund flows. But then that is another story.
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