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Explaining Inflation, Valuations and Deficit and Rise of Sensex

April 16, 2010

The Indian Inflation, Valuation and Deficit have all touched a high and Investors question the rising SENSEX amidst such a macro environment. We agree that Deficit is a cause of concern, however, lately Foreign Investors have turned a blind eye on the mis-represented and ever growing Indian Inflation, which is an accepted way of life. As said in one of our previous article, valuations get expensive when Investors see GROWTH ahead – paving way for P/E expansion.

Inflation – Nonfood, non-fuel inflation is currently at 4.9%. Historically, when this number has exceeded 10%, the market has always posted negative returns on a six-month forward basis. However, when the number is lower, equity return implications have been rather random. Indeed, the market is currently positively correlated with both growth and inflation. Correlation of market returns with industrial growth is at 85%. The equity market is clearly saying that what matters right now to it is growth and not inflation.

Valuation – At a 20% premium to emerging markets, this is at the low end of the valuation range in which Indian equities have traded over the past six years. Since then growth forecasts have been bumped up – meaning that equities are still not as rich as they may appear on trailing multiples.

And the Serious problems that can Influence the Equities are,

  • A sudden spike up in crude oil prices could prove damaging, though a steady rise upto $100 a barrel accompanied by capital inflows is not bad for equities.
  • The external deficit measured using the trade deficit at over 10% of GDP seems high in the context of where we are in the growth cycle.
  • The problem for the market is how this trade deficit gets funded. If global financial markets wobble, it directly affects India’s growth – and hence its equity markets.

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