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November 2020 was when we saw the beginning of a broad-based earnings upgrade momentum. This was soon after the unlock after the first wave, where we saw companies experiencing pent up demand thereby fuelling sales across the board.

India Inc and research firms both had started spelling out hopes of revival from the economic downturn on the back of rising consumption leading to higher revenues and profitability for companies.

However, brokerage house, UBS in its latest report has given first hints of how earnings upgrades may now be losing steam.

Earnings growth concerns

“Concentrated big upgrades (for sectors like metals) are camouflaging cuts elsewhere. Twenty-two of Nifty-50 stocks are in downgrade mode versus eleven a couple months ago. Among BSE-200 constituents, nearly 55% of stocks are seeing downgrades,” said the report.

The brokerage has also retained its 12-month Nifty target at 15,500 which actually implies a downside from current level of around 15,800. This is despite the fact that it has an ‘overweight’ stance on Indian markets.

UBS report suggests that upgrades for the metals sector could be nearing an end. On banks it believes that while they are seeing upgrades, they have de-rated since the start of the second wave of Covid-19.

Indian companies had the ball rolling for them under difficult circumstances and posted decent earnings for FY21. This was largely because of massive cost rationalization efforts. Earnings were also helped by benign raw material prices, which aided the operating margins. In Q4FY21, the last reported quarter, volumes also got a push from recovery in demand and a favourable base.

However, for Q1FY22, there are increasing worries on the extent of impact of the second wave of Covid 19. The other major overhang is inflation.

Major headwinds ahead

“Assuming inflation impact for the next two to three years are captured in earnings, our analytical model based on 24-months forward earnings yield would be sensitive to longer-term effects of changes in market interest rates—including faster discounting of future cash flows and business impact from higher rates,” the report added.

On the valuation front too, the Nifty PE (price to earnings) multiples are near all-time highs and the report says, that valuations have been a key factor for market returns over time.

“Taking a 15-year history, we see that 12 out of 15 years have had more than half of Nifty movement explained by PE multiple change, as against earnings growth”, the report suggests.

Indian markets are currently hovering around all-time high levels, and have already more than doubled from March 2020 lows. However, they have been facing volatility at higher levels and resistance to climb to further highs in the absence of fresh triggers.

UBS pointed out that the strength in Indian equities is coming in from the strong flows from households as retail participation has jumped over the last 1.5 years. Foreign inflows to Indian equities too have provided support, however even these have sharply dropped in the last three months.