The market has digested a rise in rates, domestic political news, a bank scandal, rise in equity supply, protectionist waves, global market volatility, higher Fed rates, higher oil prices and a reduction in FPI portfolio weights. The concomitant impact has been a 10% drawdown in the Sensex, rise in volatility, a test of the 200 daily moving average, rise in the put-call ratio post 2013 highs, fall in market breadth, corre-c-tion in small- and mid-cap valuations, worsening of market sentiment, INR depreciation and a recovery in India’s relative performance.
Growth cycle is turning
A combination of supportive global growth, improving capex, fiscal 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. The yield curve has appropriately steepened and will take stocks higher with it.
Equities/ bond valuation is at the top end of its 2010-18 range. Unless growth accelerates from here, it is unlikely that equities will break this range on the upside in 2018. Simultaneously, we do not think the narrow indices are pricing in a multiyear growth cycle, implying meaningful upside potential to stocks over the next three to five years.
India will likely outperform EM
India’s relative growth is likely to accelerate in the coming months. We think that the relationship between India’s short rate differential with the US and equity market performance relative to the world will likely be reestablished (falling relative rates = outperformance). The third factor is the collapse in India’s beta to a 13-year low. While fundamentally this means that India’s prospective absolute returns have shrunk, if beta remains low and the world is in a low-return phase, India will likely outperform. Finally, FPI positioning, which has been falling for three years, is now at 2011 levels.
Key risks to our views
(a) Inflation surprise causing higher short-term rates; (b) higher global interest rates; (c) supply shock in crude oil with negative implications for growth; (d) limited fiscal flexibility, reflected in rising long bond yields; and (e) a busy election calendar.
Returns are moderating in 2018. Large-cap valuations look reasonable and better than mid-caps and, hence, we remain more constructive on large caps relative to mid-caps. We like private corporate and retail banks, discretionary consumption, industrials, domestic materials and software, while avoiding healthcare, staples, utilities, global materials and energy.
By: Ridham Desai
The writer is MD, Morgan Stanley India. Edited excerpts from Morgan Stanley India Equity Strategy report