How much longer can Indian stocks defy gravity for?

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

• As the developed world skirts a recession, the picture is different in India. Services and industrial-production sectors have helped expand economic output. However, surging food prices have hit consumption levels and worsened sentiment. So, growth could slow 
• Indian interest rates appear to have peaked, with the Reserve Bank of India expected to leave rates on hold at its next rate-setting meeting in October. Bond investors considering locking in yields, might remember that after a rapid hiking cycle, history suggests that they can also fall quickly, even after a longer pause 
• Earnings in the April-to-June quarter illustrated the underlying health of the economy. Profits for the 50 largest companies shot up by over 35% compared with the same quarter last year. The financial, auto, infrastructure, cement and energy sectors appear to be performing particularly well
• With positive net flows of money into the Indian equity market for the fifth straight month in July, complacency is a distinct risk. Despite the strong performance of the local market in recent months, we are cautiously optimistic on the market for long-term investors 

As much of the developed world faces a period of anemic growth and China's much-hailed economic rebound disappoints, India seems to be a beacon of hope, from both a cyclical and structural perspective. 

In the last fiscal year, ending 31 March, the domestic economy expanded by 7.2% year on year¹. It continues to grow at a decent clip, supported by upbeat services growth, industrial production, healthy sales-tax receipts and vehicle purchase numbers. However, there is a potential fly in the ointment: surging prices, especially for food, have dampened sentiment and consumption levels. 

Healthy public finances

The Reserve Bank of India (RBI) is expected to leave rates on hold at its next policy meeting, in October. With a hold priced in by investors, local yields should trade in a tight range in coming weeks. The central bank paid a whopping 874 billion rupees dividend to the government in May², more than double last year’s comparable figure of 303 billion rupees. The increase in the payment was driven by 50.5% year-on-year hike in interest income and a 49.7% increase in foreign-exchange income.  

The RBI should be able to increase the size of its balance sheet more quickly in fiscal-year 2024, with the US and European interest rate hiking cycles having peaked, or nearing their top, and a marked uptick in domestic growth prospects, but that may only materialise after a change in its policy stance. 

Gross bank credit grew by 16.3% year-on-year in June, led by a 8.1% uplift in industry and 26.7% charge in services, according to recently-released data. Also aiding the banking sector is buoyant 20.9% growth in the personal loans sector.   

Equities in demand

Encouraging domestic growth, signs that interest rates in leading economies are near a peak and healthy levels of investment in local financial markets, have supported the positive investor sentiment seen this year. Overseas investors have been net buyers of Indian stocks for a fifth-straight month, adding around $5.7 billion in July.  

The second-quarter, ending 30 June, earnings season had few surprises, with the 50-largest companies quoted on the Indian stock market (the so-called Nifty50 index) seeing low single-digits revenue growth, year-on-year, represent the slowest growth in 10 quarters, while net profitability zooms ahead by north of 35%³. The most positive earnings were seen in the financial, auto, infrastructure, cement and energy sectors. However, earnings disappointed in technology, chemicals, metals, realty and consumer-goods industries.

Since the beginning of the current fiscal year until late August, while the blue-chips Nifty50 index rallied, before retracing 3.6% from July’s all-time high, and delivered 11% growth, the mid- and small-cap index climbed by 30% and the small-cap one by 36% over this period.  

Beware investor complacency

The price-to-earnings ratio (P/E), based on the previous 12 months of data, for the Nifty50 was in line with its ten-year average, at almost 23 times, according to Bloomberg. However, the one-year forward earnings growth for the Nifty50 companies, as per Bloomberg estimates, is around 18%.  

While this may compare well with the earnings growth witnessed in the trailing twelve months, risks of earnings downgrades remain. Also, with volatility levels for the stocks, as represented by Nifty VIX, in a record low range of 10-13, there is a chance that investors become too complacent over prospects.

By comparison with the large-caps, the trailing P/E for the Nifty Midcap 100 index, based on the previous 12-months’ earnings, is around 27.5-times earnings (20% up on the Nifty50). That contrasts with a 10-year average P/E of around 31 for the mid-cap index.  

While mid-caps may appear rich, especially after recent sharp rally in the stocks, the experience of five years ago seems apt. The Nifty 50 saw earnings per share (EPS) surge 23% in fiscal-year 2018, so it was a high earnings growth year. By the end of the year, the Nifty50 trailing P/E of 21.4 was a staggering 11.6 points below the P/E for the mid-cap index. This amplifies, that in a high-growth environment, mid- and small-caps can command much higher valuation premiums than their large-cap brethren.

Cautious optimism 

Further to the recent run-up in domestic share prices, we remain strategically overweight Indian equities, while retaining a neutral stance in the near term. Also, it seems prudent to diversify over the wider equity market, with allocations to mid- and small-caps calibrated to one’s risk appetite.

Given the uncertainty over the path for interest rates and inflation, along with elevated geopolitical tensions, stock selection appears more important than usual, given the speed at which the market can move should company results disappoint. Staying invested usually pays off for long-term investors, within acceptable risk parameters.  

With the government committed to several investment spending programmes ahead of next year’s general election, capital expenditure is likely to remain high, to the benefit of the manufacturing and allied sectors. The auto industry remains attractive with a widening opportunity basket. We also continue to remain optimistic across select banks and non-banking financial companies.

Considering the valuation comfort, our stance remains neutral in consumer goods and pharma sectors, while being underweight in commodities and selectively optimistic in the consumer discretionary area.  

Bond investors keeping an eye on interest-rate prospects

The RBI's primary objective at this late stage of the global economic recovery seems to be preserving macroeconomic stability while keeping the growth rate at an acceptable level. While a low-probability event for now, a surprise shift in the central bank’s policy approach might be sparked by: 

• a sharp organic slowdown in domestic growth; or 
• a severe contraction in global growth, which would most likely hit domestic demand too

Despite the above risks, domestic activity appears well entrenched and slowing global growth is far from collapsing. As such, the RBI has probably reached the peak in rates, provided inflation continues to ease. 

For now, the central bank’s policy bias remains to manage and reduce excess liquidity in the system. While the pace of price rises might be heading in the right direction, the central bank will likely be facing a headline inflation rate of above 6% at its October rate-setting meeting. This should rule out any softening in its hawkish tone, barring a surprise fall in growth.  

Lastly, the US Federal Reserve and other leading central banks are likely to keep peak rates higher, and for longer, than the market anticipates. As such, the RBI has little reason to cut rates too early, provided growth continues to hold up. Indeed, domestic rates look set to be on hold for the rest of this fiscal year, with the first post-hike rate cuts starting between April and June next year. 

With bond yields having soared in the last year, they are at long-last investible again. With Indian policy rates probably having peaked, there is an opportunity to lock into higher yields. Government debt with a maturity of between 18 and 24 months has performed well of late. Meanwhile, given elevated levels of uncertainty over rates, a blend of corporate bonds and sovereign instruments with maturities of between three and five years seems to strike an appealing balance on a risk-adjusted basis. 

Can alternatives shine?

Given the high level of uncertainty over the path of rates and inflation, gold, real estate investment trusts, infrastructure investment trusts and private markets are among the alternative assets that might offer diversification benefits, plus some of the best entry points seen for some time.