Are Indian equity markets being too optimistic?

Please note: All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• In May, a pause in Indian interest rate hikes and buoyant economic growth outlook helped to drive equities close to December’s record high. While momentum might slow in coming months, relative to other large economies, the country compares favourably
• With most of the price and pent-up demand-led top-line growth, as well as margin expansion, behind us, interest rates likely to remain high for longer than expected, and global growth slowing, the rest of this year seems ripe for actively-managed portfolios
• Domestic-oriented commodity-consuming businesses look well-placed, aided by strong consumer demand and credit growth, and easing inflation. Select plays across lenders as well as infrastructure and manufacturing also appeal
• The return of positive real rates and high yields are among the reasons why Indian bonds appear relatively attractive. While interest rate cuts seem to be off the table for this year, supportive market liquidity conditions support investing in a blend of 3- to 7-year corporate bonds and sovereign debt 

As growth slows in many developed markets, with some skirting a recession, the outlook for this year is sunnier in the emerging world. India is a case in point.   

While a weaker manufacturing sector may drag on Indian economic growth, especially due to slowing goods exports, given easing output in many markets around the globe and interest rate hikes, encouraging domestic demand helps to compensate for this. 

The services sector seems particularly buoyant at the moment, driven by strong trade activity, hotels and transport. High-frequency air and rail travel indicators show continued steady demand. Meanwhile, the financial services segment is being bolstered by double-digit credit¹ growth. 

The expansion in consumer credit supports the financial sector as well, and bodes well for demand growth. In the last five years, the share of credit to businesses has fallen from 65% to 58%, whereas the consumer share has blossomed to 34% from 26%. The decline in the former can be partly attributable to subdued domestic private capital expenditure (Capex).  

The weaker manufacturing output was hit by muted activity in export-oriented sectors, like textiles, pharmaceuticals and leather. Indeed, the sector is likely to contribute less to economic expansion over the rest of the year, with export growth showing clear signs of easing. Construction activity remains resilient, driven by a government-led capex push. 

Fiscal consolidation on track 

The Reserve Bank of India (RBI) announced a larger dividend than expected in May, of 874.2 billion rupees², to the government. The contribution compares with the 480 billion rupees2 or so factored into the budget for the dividend.  

Falling energy prices and other imported prices, particularly for cooking gas, crude oil, and fertilisers, could allow public subsidies to be cut, while oil company dividends might rise. Together with healthy tax receipts, this should keep fiscal consolidation on track.  

As such, the fiscal deficit is predicted to hit 5.9% of gross domestic product in this fiscal year (FY), before gliding down to around 4.5% by FY25-26.  

Inflation and rates 

As in many other countries, domestic inflation is easing. Unlike several peers in the advanced world, the headline consumer price index is likely to remain within the RBI's tolerance band in 2023, even if it climbs towards the end of the year should food prices rise due to poor weather.  

Persistently softer inflation – combined with a view that growth may also moderate – is perhaps why the RBI feels comfortable pausing its monetary policy tightening cycle for now. That said, there remains a risk that price rise growth will undershoot target in the coming months, suggesting that rates may remain well anchored, with a softening bias. Several factors support this view: 

• A rapid fall in import price sources, including the oil price being below the central bank's forecasts
• The relatively feeble price increases in seasonal items such as vegetables and fruits
• Significant base effects for near-term headline inflation, aided by the price shock emanating from Russia’s invasion of Ukraine

Margin increases were the dominant contributor to core inflation last year, as producers passed on elevated input costs amid recovering demand. However, with producers wary of increasing output prices too much, the contribution from margin-related increases to core inflation seems to be easing.  

The window for price increases might be closing as the global growth slowdown becomes more apparent and business confidence worsens. But with sticky inflation in essential goods and in regulated sectors, such as health and education, the moderation in core inflation is likely to be gradual, averaging 5.1% in FY2023-24, compared with 6.1% in the previous fiscal year. 

Can Indian equities offer shelter? 

As in many other equity markets, Indian indices have been resilient this year, despite weak growth in developed economies. Indeed, a bounce back from March’s lows had taken the market close to December’s all-time high in May, supported by a revival in global investment flows.  

That said, the Nifty50 index, featuring India’s 50 biggest companies by market capitalisation, still trades near to its ten-year average of 18.6-times one-year forward earnings, according to Bloomberg. Considering the attractive local bond yields, the equity-risk premium at such valuations does not appear to compensate enough for any sudden weakness in flows into the market from abroad. 

Having said that, earnings growth for the Nifty50 constituents is expected to be a healthy 14% in FY 2023-24, powered by macroeconomic stability, strong domestic demand, high infrastructure and capital spending and credit growth.  

With much of the pent-up post-pandemic demand and restocking behind us, most of the margin recovery and input-price expansion, as well as returning pricing power for producers, seems to be factored into stock prices. With interest rates likely to remain high for longer than initially expected, and global growth slowing, the rest of this year might be one made for actively managed portfolios.  

Deriving outperformance from identifying high-quality businesses, that can provide profitable growth, make market-share gains and boost margins, will be key. Among such businesses, domestic-oriented commodity consumer companies look well placed. 

• Consumption themes continue to be buoyed by improving consumer sentiment and confidence, encouraging indications of a near-normal monsoon season, easing inflation and increased discretionary spend
• The auto sector continues to experience secular growth, aided by buyers spending more on purchases, and with a trend towards higher quality in the four-wheeler segment. This is sustaining beyond the increased sales attributed to (post-lockdown) pent-up demand. Easing supply and input prices, as well as easy finance availability, support sales. New model launches from most auto makers, in addition to strong electric-vehicle sales, are also keeping the passenger vehicle segments vibrant. Investor interest in the sector seems to be widening across manufacturers and auto components
• Infrastructure and manufacturing: Capex spending is continuing to support this theme. While this encompasses a wide variety of businesses, with richer valuations and limited quality names, bottom-up diligence and selection is crucial
• Banks and non-bank lenders continue to have reasonable profitability levels, aided by strong loan growth and healthy balance sheets
• Select pharmaceuticals exporters, as well as real estate and logistics plays, might also offer ways to diversify portfolios
• Technology and export-focused businesses are likely to remain under pressure as the global slowdown pressures new-order levels and sentiment. Furthermore, with the interest rates cuts probably several months away, high long-term cash-flow discounting rates may continue to harm valuation re-ratings. Having said that, the attractions of owning good-quality businesses in diversified portfolios makes valuation levels more palatable

Remain overweight debt 

While lower crude oil, commodities and input prices should nudge Indian inflation lower and keep the pressure off interest rate hikes, the RBI is unlikely to cut rates this year. The central bank will remain vigilant with its fight against inflation, given healthy economic growth, some upward potential price pressures from rural wages and expectations of a near-normal monsoon season. In addition, market liquidity should remain buoyant while the fiscal deficit seems to be on budget. 

Bond markets have been particularly volatile this year, despite the supply of sovereign, state and corporate bonds being well supported by demand for debt investments. Positive real interest rates are another encouraging sign.  

The term curve remains relatively flat. Healthy liquidity levels should be helpful and the yield curve is expected to steepen, with front-end yields falling more sharply than those at the long end. With history suggesting that rates can ease quickly, it might be worth considering locking in rates (albeit past performance is never a guarantee of future performance). 

Also, the spread between AAA-rated corporate bonds and government debt has hardly moved from its long-term average level, aiding the appeal for a balanced allocation. A blend of 3- to 7-year corporate bonds and sovereign debt seems preferable at the moment. For investors with the appropriate risk appetite, the non-AAA segment appears attractive from an accrual perspective. 

Alternative assets 

The volatility seen this year in Indian markets, along with others, highlights the importance of diversifying portfolios to reduce long-term investment risk. As such, private markets, for either private equity or private debt, provide opportunities to spread investment risk. 

Furthermore, investing in real estate investment trusts (REITs) and infrastructure investment trusts (INVITs) might offer shelter should a period of low growth and high inflation emerge (known as stagflation). A recent sell-off in REITs and INVITs makes their valuations more reasonable and cap rate compressions may yield good value once interest rates start easing. That said, investments in such areas should be considered as long-term in nature.