India’s macroeconomic indicators continue to look attractive and it remains the economy with the fastest nominal GDP growth
Global linkages still pose risks: The year 2015 saw economic and market performance diverge. Broader indices (BSE500) did better than the narrower ones (BSE100/Nifty50). The ‘Next400’ (i.e., BSE500 excluding BSE100) beat BSE100 across time periods and sectors: we believe due to global linkages. The outperformance across sectors, in our view, is explained by foreign ownership being higher in large-caps: persistent FII outflows through CY2015 created greater selling pressure. So long as oil prices remain below $50-60/bbl levels, this redemption-based selling is unlikely to abate, in our view. Acceleration in outflows could cause volatility.
Another reason is their different composition: the BSE100 has strong global linkages, with the primary driver of as much as 53% of BSE100 revenues outside India, and mostly in sectors seeing weakness (e.g., energy and materials). Even some domestic revenues, e.g., banks with loans to metals, get affected. In contrast, the ‘Next400’ (BSE500 stocks not in the BSE100), are dominated by sectors that have more domestic focus (discretionary, NBFCs, construction, or even chemicals priced/consumed domestically).
Domestically, government spending the catalyst(s): Hard indicators like oil and auto demand growth have risen in the last three months, and point to a broader economic pick-up. Next year, the downstream effects of government spending on national highways and railways should show up in demand for labour, construction equipment, and then cement demand. YoY comparisons in March 16 quarter in particular should be robust (March-15 saw an acute fiscal contraction). By June 16, the implementation of the 7th Pay Commission would start an 18-month R4.5 tn consumption stimulus to 34 million people. Most of the incremental spending is likely in processed food, housing, and transportation (cars+fuel). Bulk of this impact is likely to be in smaller cities, where most government employees stay. The decadal Pay Commission, in our view, is an important milestone in the real-estate cycle in smaller towns: recent weakness was likely the effect of the last pay commission fading. It can act as a significant broad-based stimulus, catalysing the dormant real-estate market, which can then drive labour demand.
Prefer local; look out for global risks: India’s macroeconomic indicators (BoP, inflation) continue to look attractive, and it remains the economy with the fastest nominal GDP growth, and the second best earnings growth. However, continuing global weakness could be a drag/overhang, and the divergence between narrower indices and the domestic economy could persist. However: (i) absolute declines in global oil/steel prices cannot be $60/bbl or $300/t from here; and (ii) weights of globally linked sectors have fallen even if slightly. Thus, while earnings cuts may continue (mainly banks and materials), their pace should slow, in our view, and CY16 index EPS growth should settle at 13-14% y-o-y (current consensus CY16: 19%; CY15: 9%). Once pace of cuts falls under trend EPS growth, absolute market upside can emerge. Market returns could track EPS growth as MSCI India P/E premium to MSCI World P/E is still near ten-year lows, economic growth gap persists (which even if unrelated to the large-listed space still has a bearing on relative P/E), and India has low PEG. We stay Overweight consumption despite P/E being at or above one standard deviation from ten-year mean as it provides the best exposure to broad-based economic pick-up, and the Pay Commission stimulus. We are Overweight IT due to its steady cash flows, steady growth and low P/E (price-to-earnings ratio). We stay Underweight financials (positive: NBFCs and private sector banks with retail focus; Underweight: PSU Banks, corporate lenders) given our concerns on asset quality. We also stay Underweight metals and Industrials. Top Outperforms: TechM, HUL, ULTC, TaMo. Recommend shedding positions in SBI and Bharti.