Policy momentum, earnings growth, falling interest rates and domestic savings expected to be the drivers
We identify three macro and six portfolio themes for 2016.
Macro Theme 1: India outperformed its peer group in 2015. Notwithstanding high valuations and positioning, India’s low correlations in a world with low returns as forecast by our macro teams implies India could continue this outperformance in 2016. With other asset classes looking dreary, India’s domestic liquidity super cycle should gain pace in 2016.
Macro Theme 2: The key to performance could be a turn in earnings cycle, which is delayed due to a combination of sluggish global growth, tight fiscal policy in the early part of the year and PPI deflation. Our macro models point to double-digit growth, and the base effect is distinctly favourable, although we must quickly add that we held an optimistic view on earnings at the start of 2015 too.
Macro Theme 3: We expect policy makers in India to be fairly active in 2016, with the focus on building infrastructure, changing India’s age-old tax regime and lowering nominal interest rates further among other things.
Thus, fundamentally the case for India’s outperformance is supported by policy momentum, stronger relative earnings growth, falling interest rates relative to the US Fed and potential flow of robust domestic savings into equities.
Portfolio Themes: A strong US$, revival in rural consumption to add to the nascent recovery in urban consumption, infrastructure spending, GST plays and rate sensitives are the central themes embedded in our recommended lists.
In addition, we look for correlations across stocks, which have persisted at low levels contrary to our expectation that they would rise. A rise will signal a major macro trade away from the stock-picking approach that has worked very well for portfolio managers over the past two years. We also see continuing shift away from quality, as seen in the past three months into growth and cyclicals. Our portfolio approach, therefore, is to keep wide sector positions with a GARP-oriented stock-picking strategy. Our Dec-16 BSE Sensex base case is 28000 (vs. 28600 earlier for Nov-16) and our probability-weighted outcome is forecast at 30200 vs. 31000 earlier.
Risks to our views include: Policy inaction, SOE banks’ NPLs, Fed raising rates more rapidly than what is in the price, or the RBI slowing its pace of rate cuts despite declining inflation, global growth weakness, relative valuations and positioning.
Will the Micro Yield to the Macro?
India outperformed its peer group in 2015. A low-return world augurs well for India’s relative performance in 2016.
India’s correlations with EM have been falling since 2010, and this fall in correlations has accelerated since the end of 2013, when India made a big shift in its macro approach away from a dovish fiscal and monetary stance to hawkishness on both. The hawkish approach has helped India’s macro stability, resulting in a large balance of payment surplus and falling correlations for Indian stocks vs. EM. This means that India is tending to underperform EM rallies and outperform EM corrections.
As a corollary, a low-return EM world augurs well for India’s relative performance although its own absolute performance is also likely to be middling. Our global strategy team is forecasting low-single-digit returns for most equity markets and, if they turn out to be right, it seems likely that India will continue to outperform its peer group in 2016.
Fundamentally speaking, the four factors that are driving India’s outperformance are: (i) policy certainty; (ii) relative interest rates; (iii) relative earnings growth; and (iv) flow of domestic savings into equities. When India’s policy rates are falling versus the US, India tends to outperform emerging markets. It must be noted that the RBI’s recent action to cut the policy rate in front of a Fed rate hike underscores the RBI’s growing confidence in India’s macro stability.
Once again, India outperforms when its policy uncertainty is low. The EPU Index is off its all-time low thanks to recent political setbacks (including the Bihar election loss for the NDA) representing higher uncertainty on the policy front and also expressed in India’s recent underperformance.
Relative performance to the EM index is not surprisingly helped by higher relative earnings performance. The low starting point of equity savings in India is an additional point to support our view that India is in the midst of a liquidity supercycle for equities. We have seen strong flows from households into equities through 2015, and, consistent with our research (India’s Domestic Liquidity Supercycle), we think this will likely continue in 2016 with US$ 1 bn net inflows per month appearing as our base-case number now.
The biggest impediments to India’s outperformance continue to be rich relative valuations and high positioning, even though it appears that the quantum of India’s overweight position across EM funds has declined over the past few months. On relative valuations, these are an outcome of India’s large outperformance rather than absolute gains in share prices. Thus, while the relative price/book multiple is at the 95th percentile, the absolute book multiple is at the 50th percentile.