The year 2015 disappointed hugely. The sharp turn for the worse in global growth and commodities led to a significant correction in earnings. Concerns resurfaced on banks’ asset quality. Legislation ran into a wall and dashed reform hopes that were expected from a majority government. The much-hoped-for rebound in the investment cycle remained elusive. Truant monsoons dragged down the rural economy. Basically, the market was caught in a perfect storm. 2016 should be a year of redemption. The risk to earnings from global growth has declined as the weight of commodity earnings in overall market earnings has fallen considerably. The bulk of consensus earnings cuts in 2015 was driven by global cyclicals. Though the ~19% consensus growth in Sensex FY17F earnings may have some downside, it is likely to be marginal, in our opinion. We expect a floor level of 12-15% growth in FY17F earnings.
Lack of numbers in the Upper House has hindered reforms. Scheduled retirement of members this year will boost ruling party numbers and likely reignite reform momentum in calendar year 2016 forecast, in our view.
CY16F should be the year investment revives as private capex bottoms and public spending picks up. We note that the groundwork carried out in focus areas over the last two years is largely complete.
Consumption has been squeezed out by drought, the growth slowdown and fiscal consolidation. Incrementally, pay commission transfers and a growth revival should improve the prospects for consumption.
India’s macroeconomic fundamentals stand much improved. At the margin, we expect interest rate cuts to be a positive factor for the markets. The market multiple has come off over the past year. We expect it to be underpinned this year by reasonable earnings growth, lower rates and an incremental pick-up in sequential growth momentum.
We expect market return of 15-25%, depending on the external environment.
Sector-wise, we are overweight financials, discretionary consumption plays (autos), IT services, oil & gas and industrials. We are underweight consumer staples, pharma, metals and telecom. Our analysts’ top picks for the year are AXSB, LT, IOCL, MSIL and HDFCB. We note that our Asia ex-Japan strategy team maintains an overweight allocation to India for this year.
Most of the global shocks are absorbed; benefits to follow
The slide in global growth has manifested in multiple ways for India. The immediate impact for the market has been generally negative. However, we expect the benefits to outweigh the positives in the medium term. There are multiple ways in which this slowdown has impacted the economy.
* Near-term impact is negative: (i) Export slowdown—India’s merchandise exports have fallen 18% y-o-y in the first half of this fiscal 2016. This slowdown is in large part due to the price effect. Nevertheless, there is pressure on exports on account of global slowdown which creates pressure on earnings of exporters. (ii) Commodity price declines—The first order impacts are generally market negative as earnings of commodity sectors have taken a large hit on account of the price declines. Secondly, commodity sectors such as metals have been important drivers of the capex cycle and the price declines have created a second round of negative impacts on the capex cycle. Finally, the slump in commodities has created fresh worries for banks which have a large exposure to the sector.
* Medium-term positive impact should follow: (i) The fall in commodity prices is quite positive for BoP (balance of payments) balance and inflation numbers and these benefits flow through with a lag of two to three months. (ii) The government has impounded a reasonable part of the commodity benefits by raising taxes on oil significantly. The benefit of these revenues would follow through in earnest by FY17 as the spending across many of the new thrust areas starts to pick up. (iii) More fiscal room would possibly be created through lower subsidies due to lower fertiliser and oil subsidy bills. (iv) Consumers have also benefitted from lower commodity prices but these benefits are spread out and therefore difficult to capture. We would, however, expect some increase in consumption over a period of time to follow.
The elusive investment cycle should finally start to show
The investment cycle would start to surprise positively in FY17 given the lack of expectations amongst investors, which is evident in the price performance of financials and industrials in the recent past. We believe that there has been enough government action to fix historical issues across policy-challenged sectors and that the visibility of these efforts is starting to come through.
In sectors such as urban development and railways, evolution of policy to drive large-scale investments is largely over and the flow of orders should start to materialise in CY2016. We also expect state level spending in some of the states like Andhra Pradesh (AP), Telangana, Maharashtra and UP to pick up significantly.
Consumption likely to improve on pay commission and agriculture
Consumption has faced multiple headwinds in the past two years—(i) poor growth reducing visibility for incomes and jobs; (ii) poor agricultural growth and slower rise in minimum support prices—reducing rural consumption which was the primary pillar of demand in the last five years; (iii) government policy of not pushing social expenditure on account of fiscal pressures; and (iv) the bust in real estate which was pushing up rural incomes via rising prices of rural real estate. Poor rural sentiment and incomes have also crunched cash flows, leading to higher defaults in rural India, which has made lenders cautious and in turn led to a spiralling impact on rural discretionary purchases. As a consequence, there has been a discernible slowdown in overall consumption in general and a larger slowdown in sectors exposed to rural India. Some of these factors could start to reverse in FY17 as base effects for agriculture come into play, investment cycle starts to rise and due to pay commission awards.
ROEs should rise with rising growth
Even through the slowdown, corporate India has seen rising free cash flows as the capital expenditures come off. Despite the fact that there has been severe stress in some sectors of the economy and the growth has generally slowed down, corporates have started to deleverage their balance sheets as the room created by lower capital spends and stable cash flows has been rising. We believe that any pickup in growth due to additional government and consumption demand can start to create large benefits for corporate ROEs as the incremental capital deployment is falling. Despite rising free cash flow in corporate India, ROEs have remained depressed due to poor utilisation of assets which have been commissioned in the last 3-4 years. We expect this to start changing in FY17.
Policy gloom to start to lift in FY17
Legislative logjam has been the source of one of the biggest disappointments over the last year. Despite a majority government, lack of numbers in the Upper House has made passing key legislation very difficult. The biggest disappointment has possibly happened on account of GST which requires 2/3rd majority in both the houses as it is a constitutional amendment. We expect that the balance of votes would shift in favour of GST by the middle of 2016 when the composition of the Upper House shifts due to retirement of some of the members. We therefore expect GST bill to get passed by the middle of 2016.
Save for a serious global crunch, expect 15-25% returns
We expected the markets to see an expansion in multiples in CY15 supported by: (i) improvement in macro; (ii) growth improvements in the economy; and (iii) a resultant recovery in the earnings outlook. While the first two conditions were more or less met with rate cuts from the RBI on inflation surprises and a clear indication of volume recovery in sectors such as autos, steel and petroleum, earnings disappointed significantly in CY15 as discussed earlier. Thus, the macro gains were offset by losses on earnings and perceived stress on the banking sector due to the decline in commodity prices .
To the extent that we are starting the year knowing the known risks, they seem to be in the price. Additionally, the influence of commodity companies in overall earnings has already waned and would no longer be such a big issue. We therefore expect that the Sensex should be in a position to deliver approximately 12-15% growth in FY17F. On the growth side, we expect government efforts to start bearing fruit and start reflecting in a pick-up in the investment cycle. This, we believe, should lead to improved expectation from the longer term earnings trajectory. In conclusion, we expect the market returns to range between 15% and 25%.