A quick end to the hope trade

Published: July 30, 2019 2:03:13 AM

Nifty is down 6% over 15 days; despite the narrative of slowdown, India is effectively giving up out-performance over emerging markets earned post elections.

MSCI India/Nifty have fallen about 6% over 15 days.

MSCI India/Nifty have fallen about 6% over 15 days. The narrative of a slowing economy, poor earnings and a simmering NBFC crisis is front and centre. Yet we think the Indian market is simply giving up the out-performance (over emerging markets) it earned in May, upon the publication of the exit polls (chart 1). The Budget in early July, which was devoid of any major ‘stimulus’, seems to have catalysed the reversal. This is largely over. Should Indian under-performance continue beyond? Growth is slowing, but so is it elsewhere.

With little happening locally, headline Indian indices are now likely to move with emerging market trends. US Fed action/commentary, US-China trade wars and dollar outcomes are likely to dominate market direction in the near term.

Bottom-up ideas though likely will remain scarce: (a) Earnings beats/upgrades are rare now, (b) valuations are still elevated. Mid-cap premiums to large caps have fallen, but absolute multiples are still high (chart 2). We see little upside to markets through the year (Nifty December at 11,300) and stay overweight financials, IT and industrials.

The index is misleading, but index stocks will dominate: Notwithstanding the current sense of despair, the Nifty is still up about 5% YTD (in dollars). Total market cap of the top-20 stocks (by current Nifty weight) is up 14% from end-December 2017 levels. Market cap of all Indian stocks outside these 20 is, however, down 27% over the same period (chart 3). Almost 40% of BSE500 ex-financials are now below their January 2017 prices. More than half are now below January 2017 forward P/E. Yet it is not that the broader market has become cheap in total: trailing P/E of the top-1,000 stocks (excluding the top-20, chart 4) is still well above January 2016 levels. Nifty weights have played a part as well: the unweighted change in Nifty market cap is less exciting than the weighted change YTD (charts 5, 6). There are two reasons to call a bottom: (a) valuations: this argument cannot still be made for Indian stocks in general, or (b) a recovery in earnings: weak at the moment (though this is where there is room for surprise). Until growth and earnings recover, large cap index stocks can continue to outperform.

Auto sales

Are auto sales weak because the economy is slowing, or is GDP growth down because auto sales are weak?

A good question to ask, but difficult to answer. We estimate about 44% of the deceleration in GDP growth between December 2018 and December 2017 was on account of weaker industry. On first order impact, weaker autos account for about 30% of the moderation in IIP. Yet there are second order effects as well: volumes for tyres, industrial paints, batteries have all fallen recently. We have argued earlier that the weakness in Indian demand is idiosyncratic, a reversal may not consequently be contingent on government policy redemption; trends could auto-reverse with time, and as interest rates fall. Auto components will become favourable in 3Q/4QFY20; headline numbers will appear better. Autos have significant potential for rotation, having underperformed for an extended period, followed by metals, healthcare and staples. Rotation becomes important in a market without a rising tide. Sectors where momentum has started recently are construction, telecom and non-banking financials. And sectors that have lost momentum recently include energy.

(Excerpted from BofAML Equity Strategy report ‘India: A quick end to the hope trade. EM, earnings now matter most’ dated July 25, 2019)

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