Fall in rates, fading memory of losses may sustain rally - Avendus

The next lap of India's interest rate cycle may impart a large impetus to equities. The conditions for equity mutual funds are similar to 2003, when rising gains on the AUM and low rates led to five years of high growth. Rising gains in the AUM during 2012 suggest the memory of losses may fade by the end of the year. FII inflow could sustain, despite lower gains because the yield gap to the Libor is well below the mean. A key risk to Indian equities is the deceleration in earnings growth. However, that may be offset by the high PEG, supported by stronger inflows. Over the next four quarters returns may tilt towards 'nondefensive' sectors such as Commercial Vehicles, Construction, Engineering, PSU Banks, OMCs, Telecom and Utilities.

Equity mutual funds nearing inflection point for rebound in AUM

Two conditions that supported the high growth of equity AUM during 2003-08 may be revived by early 2013—gains in investors' portfolios and low bond yields. The past quarter has seen a steady rise in the gain to an estimated 6.0% at the end of Sep12. AAA bond yields have dipped by c50-bp to 9.2%. Should this yield dip below 9.0% and equity prices hold steady, the conditions would then be similar to those that prevailed in 2003.

FII inflow may be sustained by low yield gap and rising portfolio value

Both the spells of high FII inflow into Indian equities during 2012 followed the months when the yield gap between the Libor and Nifty dipped close to the decade's low. Even after the rally in Sep12, the yield gap is well below the three-year mean. Another positive influence may be the gradual return of a gain in the older equity assets, despite the 7.3% y-o-y fall of the INR against the USD. The combined effect of the low yield gap and rising gains may sustain FII inflow over the medium term.

Downside to rates is large enough to protect equities valuation

The large downside to interest rates is seen in the c7.0% gap between the government bond yield and Libor, well above the mean of 5.3%. The surge in inflation in 2010 elevated Indian rates. Rates could fall over 200-bp once inflation settles back into a normal range. That would make equities significantly cheaper when measured by yield gap to government bonds. In such a scenario, the yield gap would stay near its mean, even with a 20.0% expansion in the P/E of the Nifty.

Rising PEG supports P/E as growth drifts down

The downward drift in the FY13 earnings forecasts is similar to that for FY12 forecasts, a year ago. While the Nifty P/E is well below the stable range of 15.0x-16.0x, the PEG has risen to a two-year high of 1.1 due to the fall in earnings growth. This could present a hurdle to the near-term upside to equity prices, though the robust rallies of the past had seen the PEG rise well above 1.0. Over the next four quarters, our top picks are ACC, Axis Bank, Bharti, BPCL, Cadila Healthcare, NTPC, RECL, SBI, Tata Steel and Wipro.

Source : Equity Bulls

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