Equity Strategy: Prefer large-caps over mid-caps

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New Delhi | Published: June 25, 2018 2:30:54 AM

Bet on banks (private corporate and retail), discretionary consumption, industrials and domestic materials, while avoiding healthcare, staples, utilities & global materials.

Indian policymakers—government and Reserve Bank of India (RBI)—have made considerable efforts to improve India’s macro stability since 2013.

India is a likely outperformer even as absolute returns are capped by a tepid global equity market outlook. Improving growth, reasonable large cap valuations and a low beta are up against an election year, rising oil prices and higher yields.

Surprise rate hike and its implications

Indian policymakers—government and Reserve Bank of India (RBI)—have made considerable efforts to improve India’s macro stability since 2013, including fiscal consolidation, positive real rates, active management of food supply to keep prices in check, and encouraging a shift in India’s funding mix from FPI to FDI.

Thus far, the government has been unmoved on oil taxes, despite significant political pressure to cut them, and has declared a strong commitment to the fiscal deficit. After RBI hiked rates on June 7 in response to this, there was deterioration in terms of trade due to higher oil prices, the market appeared to accept this and subsequently rallied.

India’s low beta & its implications

The market is recognising India macro’s growing stability, as evidenced by the 37% fall in the country’s beta vs emerging market (EM) since December 2014 to a 13-year low. The implications include the case for a positive surprise in equity returns for India (as expectations are now low, going by beta’s level) with likely outperformance for India vs EM in a low-return world. In addition, India’s falling relative short rates, likely rising relative growth rates and a fall in FPI positioning to 2011 levels add to the outperformance case, in our view.

Higher oil and its implications

To the extent that rising oil prices is demand-led, the deterioration in India’s terms of trade is offset by stronger exports (i.e., BoP is positive). Historically, Indian earnings and stocks have risen along with a demand-led oil price rise. That said, the risks to the fiscal deficit and hence growth cannot be ignored. Rising oil prices could also lead to tighter monetary policy.

Higher interest rates and its implication

The yield curve is at post-2010 highs and correlates positively with stocks. Equities/bond valuations are at the top end of their 2010-18 range—a period when India underwent its deepest and longest earnings recession. For equities to break this range on the upside, growth needs to accelerate. The bond market is probably indicating that growth is back. A combination of supportive global growth, improving capex, government spending and a buoyant consumer coupled with the end of corporate balance sheet recession, strong free cash flow, the low starting point of profit/GDP and a post-GFC high on asset turn are signals worth noting.

Portfolio strategy

We prefer large-caps over mid-caps. We like banks (private corporate and retail), discretionary consumption, industrials and domestic materials, while avoiding healthcare, staples, utilities, global materials and energy.

Edited extract from Morgan Stanley’s India Equity Strategy Alpha Almanac

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