Ukraine crisis and it's effect on the markets
Even before Russia invaded Ukraine, the Equity markets in India as well as globally had been extremely volatile due to the existing demons: Supply issues leading to lower volumes and contributing to Inflation; Crude oil at elevated levels of above $90; expensive valuations and ofcourse expected rise in Interest rates globally (Albeit, RBI has iterated that it will prioritize growth over inflation). We have exclusively discussed these factors earlier and will not dwell into it further.
Let us look at the past two-three weeks: NIFTY 50 as well as mid and small caps witnessed a not so tepid correction. It has driven the economic situation from a position of uncertainty to certainty, the certainty comes at a cost; Russia after initially signalling that its troops are retreating after finishing so called training and drills went full reverse and invaded Ukraine on the pretext that its citizens are in danger in Donbas. The announcement by Russia to conduct strategic drills in Ukraine is a political and economical disaster.
Before we get to the market valuations, it is not only important to discuss what is the motive and possible end-game of Russia but also the effect on other conflicts on the precipice of breakout globally if US and the other G8 members don’t react - China’s issues with Taiwan and India being the most high risk scenarios.
Every action is based on incentive, the war will result in rising prices for Crude, Wheat, Natural Gas and other commodities that are produced in the nations involved. The old commodity economy has not made major money in the past decade and the scarcity premium will drive prices upwards.
This act by Russia is not a strategic drill as proclaimed by Vladmir Putin, this is a nation that destabilized and swung the winds of election in the most prominent democracy across the world; they attacked air and naval bases in Ukraine which it did not need to for annexing a nation in 2022, it could have easily crippled the nation if it wanted to without even invading.
Russia supplies over 40% of gas required by European Nations, currently it just has Nord Stream pipeline to supply energy to Germany. This is a full-fledged act of war to be able to have oil pipelines going through Ukraine, supplying energy to all of Europe. These are the two end-games that we see – sustained higher oil prices and having steady supply routes on land through Ukraine rather than the ideological and the empire building theories put out by the rest of the Investing community.
In brief, where do we see the markets going from here?
1. From a behavioural standpoint, we have already seen the effect of the Invasion as well as the recovery. If we see historical effects of Invasions on the markets, there is a very low negative effect in a month on the markets. The indices tend to correct themselves fairly quick especially in India. We have also seen similar correction in US over the last couple of days.
2. Higher oil prices mean higher inflation. Remember, the budget estimates for growth have factored in an average crude oil price of $70-75/barrel. Higher inflation could lead to the following:
a. Lower growth in the economy, especially the rural economy.
b. Increase in raw material costs, more so for consumer facing companies due to higher crude prices leading to backward and forward integrated increase in prices for goods.
c. This would consequently lead to a reduction in margins for majority of companies which going by management commentary was considered to be transitory due to supply issues, covid etc.
3. We would only point out a few Valuation metrics to show that the current levels now warrant sizeable entry.
a. Expected NIFTY50 EPS for FY22 and FY23 stands at Rs. 740 and Rs. 850-870 respectively. If we take 1 year forward P/E , it comes to less than 20x.
b. There is very little downside risk from current levels of Rs. 16500 for NIFTY (Possibility of >5% fall is less than 10% according to estimates) due to majority of concerns being factored in already.
c. Despite all the geopolitical risk and higher crude oil prices, if Corporate India continues to generate 15-20% profit growth, which is a very high probability event after low growth over the last few years, majorly due to Covid, markets should also exhibit similar movement.
d. Taking a page out of Kenneth Andrade’s book, with the high capacity utilizations (will soon reach 80% utilizations), and the corporate balance sheet pretty strong relatively (D/E at around 60%), ROEs will go up significantly. These factors also signal that at fair long term valuations (20x P/E and P/B less than 3x), markets look very attractive over the next few years.
e. The aforementioned factor about higher utilizations will also lead to a cycle of private capex to improve capacity.
f. Lastly, if we look at the temperature gauge by Motilal Oswal, which is a quantitative tool, it is currently between 100-105. It signifies fair valuations; the probability of markets gaining more than 10% from here is almost a certainty (93%) and the possibility of a fall is extremely low
If we combine all these factors, it will point to a consolidation in Indian markets; large cap value players who have survived these challenging times and have managed to innovate themselves will do well as high valuations from mid and small caps adjust. (Mid and small caps have adjusted from around 40x and 30x in late October to mid and low 20x multiples now). This also has to do with the fact that the easy money is going to these large cap companies, but also being taken out by the FDI after the expectation of 5-7 rate hikes over the next 18-24 months. This is a time to not be afraid, but get onto the train.