The Sensex and Nifty are holding strong at record high levels of 25,500 and 7600 respectively. The market mood has turned distinctly bullish with various analysts predicting much higher levels for the indices in the coming years. Various theories from the Modi government pushing up economic growth by boosting investments to the fact that the indices are trading well below price earnings of 25x seen in peaks of 2007-08 are lending hands to the bulls.
Equities may have a lot of steam left from current levels but given the state of the domestic and global economy; there are a lot of risks for the market. It is always prudent to keep an eye out on risks playing out even if you are convinced about the long term prospects of the Sensex and Nifty. Five key risks you have to watch out for on equities are listed here.
1. The economy cannot be set right in one budget. The Modi government will be presenting its first budget in July 2014 and has hardly a month to prepare for it. The Indian economy has many structural issues that need to be addressed, right from removing administered prices on fuel and fertilizers to widening the tax base to increase tax revenues. Subsidy as percentage of GDP is over 2% and has stayed high for the last six years. Tax to GDP ratio has hardly moved from levels of around 10.5% over the last decade plus. Government debt has ballooned 3x over the last six years and interest costs are eating up revenues. The government must find ways to raise revenues to spend on investments and that cannot happen in one stroke.
2. Indians expect inflation at double digit levels, even though official data shows single digit inflation. The government has to change the mindset of the citizens by taking strong anti inflationary steps that include pass through of administered prices. There is bound to be some pain as the government takes a tough stance on inflation and it could have an impact on growth as excess demand is curbed.
3. Banks have to find resources to lend and also to find willingness to lend. Bank credit growth has come off to levels of 14% year on year from levels of 18% year on year seen a couple of years ago. Banks are reeling under Non Performing Assets and Restructured Assets that are over 10% of total advances. A growing economy requires banks to grow credit but with banks deposit growth around 15% and with reserve requirements of 26.5% of deposits, funds available to lend is limited. Banks require to shore up capital to adhere to capital adequacy norms given high bad loans and that capital will have to be raised by the government, which will take some time. Immediate credit expansion may not happen and that will put a lid on investments and on growth in the economy.
4. Global risks are prevalent with the first one of the US Federal Reserve stopping asset purchases this year and raising interest rates in 2015. US economy has added all the jobs lost in the financial crisis in 2008 and unemployment rate is down to six year lows. Fed withdrawing asset purchases and raising interest rates would have a negative sentiment impact on FII flows into India as the Rupee could weaken. FIIs withdrawing money on Fed raising rates will impact equities negatively.
5. China is a big risk to global markets. The economy is at lower growth levels of around 7.5% and is facing a threat from asset prices bubbles and bad loans. Shadow banking, which is a parallel banking system that has fuelled lending to property, overinvestments and forced banking sector reforms will hamper growth in the country and its spill over effects into the world economy can be severe. Indian equities could face repercussions if China’s economy affects global economic growth.