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From a turbulent 2018 to a confluence of propitious tailwinds in 2019

We are constructive on the Indian equity market with a medium-term perspective. The turbulence that the Indian markets witnessed since the beginning of the year and particularly in the months of August, September and October was primarily linked to concerns on fraying of macroeconomic fundamentals of the country.

Turbulence & skittishness in Indian equity market: Concerns on fraying of macros due to sharp surge in global crude oil prices till October 2018 and accompanying plunge in Rupee.

India’s macro-economic fundamentals were extremely strong during the first couple of years of Modi-led NDA regime due to a sharp plunge in global crude oil prices which subsequently witnessed a sharp reversal and Brent crude prices more than doubled to a peak to $86/barrel.

The Indian rupee came under sustained speculative assault and plunged all the way to 74 per USD in a very brief period from 68-69 per USD range where it was steady for some time.

So this double whammy of plunge in rupee as a result of the sharp rise in global crude prices led to a massive increase in trade deficit, current account deficit & fears of increase in imported inflation.

Both these factors are negative from the perspective of equity markets and hence one saw the sharp reaction in the Indian equity markets in that period.

Turmoil in credit markets due to IL&FS going belly-up and fear psychosis enveloping NBFCs/HFCs

The fears were also compounded by an event unique to India. One of the largest shadow banks, IL&FS, went bust and the change in credit rating of a large financial institution from AAA to Default gobsmacked everyone.

What happens in such a scenario is that availability of credit goes down and cost of credit zooms up. This deficiency in credit increased in the wake of IL&FS crisis leading to fears on the NBFC front where a large amount of obligations were coming up for rollover. Fear psychosis about whether rollovers would happen or not compounded the crisis.

The other related issue obviously was that incremental funding for these NBFCs was primarily coming from the mutual fund industry and most of the mutual funds’ exposure to NBFCs had moved up very sharply over the last three to four years.

This was a result of PSU banks facing problems due to lack of adequate capital, massive provisioning necessitated due to asset quality review (AQR) that RBI had mandated and bank managements being busy resolving their NPAs.

NBFCs also had an upper hand vis-à-vis banks as wholesale funding costs were lower than borrowing costs from banks. Also, mutual funds were primary gainers in the wake of demonetisation and when IL&FS crisis spilled over into funding for the NBFC sector, the natural reaction among fund managers was to reduce the exposure to what was perceived as a problem sector and hence the scramble for funds among NBFCs intensified.

New RBI Governor to be more responsive to various stakeholders’ interests and better at conflict resolution

Market expects the new RBI Governor Shaktikanta Das to be more responsive to genuine credit needs of sectors like MSMEs & NBFCs/HFCs that have suffered immensely as a result of turmoil in credit markets post IL&FS crisis.

Hopes for an amicable resolution of other key issues of difference between RBI and government like releasing some of the PSU banks from restrictive PCA framework, formulating a sensible policy for dividend payment & adequacy of reserves to be maintained by RBI and having an independent payments regulator is more likely now under the new dispensation.

What has changed now

Plummeting Crude Oil Prices decisively alter terms of trade in favour of a large importer like India benefiting macros

In the last couple of months, global crude oil prices have plummeted by nearly 40 percent from their peak leading to a massive tailwind for the macros of a large oil importing country like India. Global Brent crude prices have plunged from $86/barrel to around $50/barrel despite OPEC and non-OPEC members like Russia deciding to cut production by 1.2 million barrels per day. The rise in prices also got capped because of concerns of impending slowdown in global economic growth in 2019 and 2020.

Substantial opening up of room for MPC to lower rates due to domestic inflationary expectations remaining well-anchored, inflation outlook benign & moderation in expectations of US Fed rate increases in 2019 allaying fears of large scale FII outflows

In the last monetary policy meeting, Monetary Policy Committee (MPC) has lowered inflationary forecast for the second half of FY19 as well as for the first half of FY20. We feel that RBI is well on its way to succeed in ensuring its mandate to keep inflation well-anchored at 4 percent (plus or minus 2 percent).

This is important because it opens up a window for MPC to consider changing their stance to neutral from calibrated withdrawal of accommodation and also lower repo rates by at least 25 basis points in its next meeting.

After the statement of Jerome Powell, we believe that at least two interest rate cuts are possible over the next six months with the first interest rate cut as early as the next meeting of the RBI. This has been taken positively by the markets.

Resolution of large NPAs picking up pace

The other positive aspect is the large scale resolution of NPAs under the Insolvency & Bankruptcy Code (IBC). We are have already seen resolution of some of the large NPAs like Bhushan Steel, Monnet Ispat, Electrosteel, Binani Cement.

This will help a lot of corporate-focused banks with large write-backs of provisions and more importantly it will free the top management to focus on growing their core business of increasing credit rather than focusing primarily on resolution of NPAs.

Worries on political front unwarranted as broad bi-partisanship underpins major structural reforms

Worries on political uncertainty in the run-up to the general elections scheduled in May 2019 are overblown. Most of the key structural reforms implemented by this government are likely to have a multiplier impact on economic growth, increase transparency and help in enhancing ease of doing business.

Thus, it is inconceivable that any change in government post May 2019, if at all it happens, would lead to any drastic upheaval in management of economic policy.

Markets have weathered all sorts of permutations & combinations over the last few decades and have come to focus on economic delivery & structural reforms rather than ideological leanings & constitution of the government i.e. whether it consists of single party majority or a coalition (pre or post poll) of various political parties.

Fears of fiscal slippage overblown

Fears of fiscal slippage are also being apprehended by a section of market participants but the government has been very clear that they are committed to adher to the fiscal deficit target of 3.3 percent of GDP and will not go down the path of populism.

Strong domestic inflows continue to provide strong ballast to market

On the liquidity front, what is important is that domestic inflows continue to remain, especially on the SIP side, quite sticky, between Rs 8,000-8,500 crore per month. This is providing a strong support to domestic market with roughly around Rs 1 lakh crore of inflows into Indian equities on a yearly basis.

FII flows in our opinion should also start picking up because of expected revival in earnings plus the fact that macros have seen sharp improvement.

Rout in small & midcaps: Savage but no different than previous cycles. Discount in small/mid cap valuations vis-à-vis large caps at multi-year high

Talking about the internals of the market, at the start of 2018, mid and small-cap companies were trading at a significant premium to largecap companies. However, due to various factors like compulsory realignment of portfolios by mutual funds due to SEBI directive, introduction of Additional Surveillance mechanism (ASM) & LTCG as well as overall spike in risk aversion there was a sharp reversal in that trend and one witnessed massive erosion in the prices of mid and small cap companies. In fact small cap index is down around 30 percent from its peak in the early months of CY 2018 with the mid cap index not being far behind.

Today we are in a situation where the valuation differential between PE of large cap companies and mid cap/small cap companies is at a six-year high i.e. mid cap companies are trading at a six-year-high discount to large cap companies.

So what we are seeing in the current calendar year is no different from previous cycles (2010 and 2014). What is important is to remain disciplined and continue to scout around for opportunities especially in the mid and small cap space. Accent should be on identifying companies which have which have solid balance sheets, less reliance on debt, generating free cash flows, market leaders, have withstood previous down cycles and emerged unscathed.

Interest rate sensitive sectors to benefit from softening of interest rates & improvement in liquidity

We prefer interest rate sensitive sectors like BFSI, autos & consumer durables as key beneficiaries of softening interest rates and improvement in domestic liquidity.

Information Technology: Massive outperformance in 2018. Large institutional allocations, fair valuations & strength in Rupee to act as headwinds

Technology stocks have massively outperformed the market over the last 1 year and most institutions now have reasonably large allocations to the sector. Companies appear to be fairly valued with not much scope for further re-rating. A strengthening rupee can act as a headwind. If however markets continue to remain choppy in their run-up to the general elections, IT sector could act as safe haven along with pharma.

Global cyclical like metals to remain beholden to developments on global trade & tariff war front. Expectations of revival in capex cycle gather steam with Industrials being prime beneficiaries

Global cyclicals will continue to remain beholden to what happens on the global trade war & global growth front with metal sector being a prime example. On the engineering and capital goods front there is an emerging view in the market that post general elections, revival in private sector capex will happen as capacity utilisation levels, as per RBI, in some of the key industries has moved up over the last 12 to 24 months and currently hovers around mid-70 percent.

Consumption & retail: Secular growth stories leveraging large size of opportunity but at demanding valuations

On consumption and retail companies we believe valuations are quite forbidding in many businesses. But these businesses are inherently very profitable with very high ROE and ROCEs. Many of them operate on very low or even negative working capital. Solidity of balance sheets is one of the best in the industry and premium valuations to a certain extent can be justified because of solidity of balance sheets and reasonably secular & strong growth.

But one has to be cautious here because further re-rating is almost impossible in our view. Risks of high input price inflation eating into gross margins and filtering down to slowing earnings growth can lead to de-rating.

Cement: Waning pricing power saps strong earnings revival

In cement sector there is lack of pricing power despite the industry being highly consolidated. There is some volume growth but it is flowing almost wholly from non-trade i.e. government business for building bridges, highways, culverts, roads, etc. Here pricing is not very strong unlike private sector home building where the activity is not nearly as robust as the non-trade sector.

So even if volumes grow, growth in EBITDA per ton will not be so strong resulting in valuations being capped in the near term. One of the positive tailwinds for the sector would be slashing of GST rate from current 28 percent to 18 percent.

Governmental intervention acts as an overhang on Oil & Gas sector

Lastly on the oil and gas sector we feel that till elections are over, overhang of governmental intervention remains high. Some of these concerns like directing OMCs to take a hit in prices has been alleviated to a large extent with the sharp plunge in global crude oil prices but in the light of huge shortfall in divestment proceeds till date vis-à-vis stiff budgetary target any directive to either merge or buy-back or payment of large dividends will weigh on both upstream & downstream companies. We are constructive on some of the companies in gas space which have characteristics akin to consumer companies.

Markets on the cusp of earnings growth revival. Valuations remain undemanding. Time to commit to Indian equities with a medium-term perspective

In so far as earnings growth is concerned we were expecting Nifty’s earnings in FY19 to grow around 16-17 percent at the start of the financial year.

After analysing first half numbers we now expect FY19 earnings to grow at 12 percent and 20 percent in FY20. There is a 4 percent cut in estimates for Nifty EPS for FY19 & 2.5 percent cut in EPS for FY20 vis-à-vis those at the start of FY19.

From valuation perspective with an estimated Nifty EPS as of December 2019 at Rs 578, Nifty is trading at 18.5 times 1-year forward earnings. Last ten-year’s average of 1-year forward Nifty PE is 17.5 times. We are thus trading at 6 percent premium to last ten-year’s average of Nifty 1-year forward earnings. The premium is quite reasonable as we at the bottom of the earnings cycle revival and if the estimated earnings trajectory holds then it is possible that we will see a re-rating in case of Nifty price to earnings ratio.

In conclusion we believe that investors need to display strong optimism as many negatives have been priced-in by the market and we are now trading at reasonable valuations provided the earnings growth trajectory for FY 19 and FY 20 pans out as per current consensus estimates.

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