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'Share prices could drop further, Sensex seen at 14,500
June, 03rd 2008

 There is a general lack of conviction among investors on India, and all indications are that share prices could drop further near term, says Ridham Desai, managing director, Morgan Stanley (India). Mr Desai said he expects the Sensex to slip to 14,500 and even lower if crude oil prices continue to rise.

All of a sudden, it is raining bad news in Indian equities. Where do you see the market headed?

The market will drift lower, as it is facing three headwinds. There is high inflation, slowing growth and the subsequent risk to corporate earnings, given that operating margins are at all-time high levels. The second is with respect to global risk appetite and what impact that could have.

I think valuations (of Indian equities) are still a little bit on the rich side, in the context of possible negative earnings surprises. The final issue is with respect to sentiment. Key indices have fallen around 28% from the top, but the broad market has fallen a lot more.

This is likely to keep sentiment a little depressed, thereby impacting participation. Already, FII flows are at the worst level in 15 years. Domestic mutual fund flows have been relatively resilient, but even they are coming off.

What is your near-term call on the market?

In the near term, we will see money shifting away from equities. There will be more downside. Our fair value estimate for the index is 14,500. It could, however, go below fair value, particularly if we see oil go to $150.

However, I believe at 14,500 Sensex, certain parts of the market will become a good buy.

How do you see politics shaping market sentiment?

The problem of being in an election year is that it is harder for the government to take decisions which appear tough. What is of concern is the way the fiscal deficit is shaping up. If oil annualises at $130 a barrel, we think the overall fiscal deficit is already at over 10% with current retail prices.

This will be the worst fiscal balance we have had since 1991. That makes the macro look a bit worrying.

What is your outlook on corporate earnings, given the way inflation is gnawing at the bottomlines of most industries?

The issue with earnings is that corporate India is still very confident about what is happening. They seem to be reticent about disclosing any earnings pressure. I believe it is only a matter of time, for there is so much operating leverage out there.

So as growth slows down, it will come with decline in margins.

EBITDA margins are at all-time highs 29% for the top 100 companies excluding energy and financial companies. That could come off and bring earnings pressure, particularly if financial income gets converted into interest costs. Yet, one should remember earnings risk will likely be asymmetric.

In other words, it is not necessary that all sectors go through a slowdown. Certain sectors will be more vulnerable, for instance, financials, real estate, banks, industrials, capital goods companies, auto etc. Consumer staples, telecom etc may be less so. Energy is a tougher call to make as it is a complicated subject.

Do you expect the growth numbers for the economy to be revised lower?

As regards inflation and growth, it is a peculiar situation. Growth is clearly slowing down and investment economy will clearly react to this. Because construction and services demand is still high, overall GDP growth is elevated. But both these sectors tend to behave with a bit of lag.

So, growth slowdown is not something that we will be terribly worried about because the economy was clearly overheated last year. But what we are now faced with is a supply side inflation issue, which clearly does not augur well in a slowing growth economy.

Morgan Stanley GDP forecast is below the street at 7%. The risk is on the downside. Unless commodity prices come off sharply and global risk appetite revives, I think you will see this number under pressure.

How does India fare in comparison to other emerging markets?

India is still trading at a 50% premium to the emerging world, even after under-performing the way it has this year. There are several other markets that are still better. If commodity prices stay strong, than earnings outlook in countries like Brazil and Russia is better than India.

Fundamentally, those economies are more resilient than India right now. In terms of growth outlook, India is a bit off the mark, at least for a one year period. In terms of valuations, China, Korea and Taiwan are much cheaper than ours.

Again, valua-tions, like earnings, are asymmetric which is why we have certain sectors like healthcare, consumer staples, technology that are attrac-tive.

Even auto is attractive on a valuation basis. Others like financials, industrials and utilities are not attractive. Overall, I think the market faces asymmetric outcomes. Its unli-kely to be like the first-quarter sell-off, indis-criminate and across the board. The ongoing down leg will be a little bit more discreet.

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