Indian markets – stability among divergence?

Please note: This article is written by our Investments team in India, and may reflect a different positioning versus portfolios managed in other regions.

All data referenced in this article is sourced from Refinitiv Datastream unless otherwise stated, and is accurate at the time of publishing.

Key points

• With signs of slowing US momentum and a fragile recovery in China, India’s economy remains the most vibrant of the ten largest economies globally.    
• Dynamism can also been seen in domestic financial markets. The country’s small-cap and mid-cap equities resumed their ascent in the second quarter of the year. Though both sectors’ valuations might seem to be overvalued, relative to large-cap peers, we retain our equal preference towards both.
• The inclusion of India in JP Morgan and Bloomberg debt indices seems to have triggered inflows of perhaps $20-25 billion in the local bond market. Turning to corporate debt, strong performance of late has resulted in significant operational gearing across the curve.
• Events this year have underscored the potential attractiveness of holding gold and private-market investments in well-diversified portfolios. While each carries their own risks and challenges, both offer investors another way to manage portfolio performance.

The global economy remains in decent health, as the aftermath of a series of geopolitical events, such as the conflict in the Middle East and war in Ukraine, impacted inflation and interest rate dynamics. 

US and European policymakers are trying to gauge when to start cutting interest rates in the face of stubbornly elevated inflation, and a healthy jobs market, but also amid signs of a slowdown. By contrast, India has been the most vibrant top-ten economy this year, and last.   

After touching a record high of 2.1 trillion rupees in April (up 12.4% year on year), domestic goods and services tax (GST) collections maintained its robust trend in May, reaching 1.73 trillion rupees (up 10% year on year). In addition, Indian credit growth was the strongest in ten years in the fiscal year that ended in March, rising 16.1% year on year, with the loan-deposit ratio tracking at healthy 77.6%, according to the central bank. 

Meanwhile, the manufacturing purchasing managers’ index (PMI) dipped to 57.5 in May but remains well into expansionary territory. The services PMI was 60.2 in May and has been above 60 for five consecutive months now, on the back of strong demand and rising new orders.  

Reaction to the election

With the Bharatiya Janata Party (BJP)-led National Democratic Alliance’s (NDA) winning a majority of the recent electoral seats, this supports their formation of the government for the third consecutive term. However, the smaller-than-expected mandate received by the BJP, losing its single-party majority in the Lower House (240 seats versus 272 needed for majority), could make it dependent on its NDA allies.  

The markets quickly retreated on news of the result, however, with the event now behind us, all eyes are on how the new government takes shape, with key cabinet and leadership positions to be decided and clarity emerging on government's spending and policy reforms priorities. As such, financial markets are likely to take some time to gain confidence in the stability of the new government.

The full Union Budget (expected in July) should shed more light on the new government's priorities. That said, one of the largest dividends (2.1 trillion rupees) made by the Reserve Bank of India (RBI) to the government and a healthy fiscal position is likely to provide enough room for the ruling party to address both revenue (somewhat populist spending targeting rural consumption) and investment spending, without compromising its tackling of the fiscal deficit.  

Having said that, the tenacity of the party in pursuing its manifesto policy reforms (including major ones like labour laws and land reforms) might taper down in the near term.

Indian equities to track fundamentals and corporate earnings growth  

Once clarity emerges on the shape of the new cabinet, markets should return to looking at fundamentals and valuations. A continued government focus on macro-financial stability and on capital expenditure, investments and manufacturing should sustain the multi-year bull run in Indian equities, although the path may remain volatile in the near term.

Turning to earnings, the Nifty 50 earnings growth for the final quarter of fiscal year (FY) 2024, that is for the 50 largest Indian companies by market cap, rose by roughly 13.5% year on year, beating consensus expectations by a good margin. Growth was powered by domestic cyclicals, like autos. However, revenues at large-cap tech businesses were relatively weak.  

Corporate profits, as a proportion of the country's gross domestic product, have climbed back from their lows in FY 2020, to exceed their long-term average in FY 2024. This might suggest there is less room for further expansion in profit margins. As such, profit growth is expected to be in the range of 14-15% over the next two fiscal years, at a slight premium to the country's expected nominal GDP growth over the same period.

Valuations remain above average levels. However, at the portfolio level, investors should focus on companies with good earnings visibility along with reasonable valuations. Once the clarity on government and cabinet formation comes, inflows into local risk assets should start trickling in, including long-term foreign flows and inflows into local private markets.  

The government's planned investment spending along with an expected pick up in new private capital-expenditure (capex) cycle, low-debt balance sheets and healthy consumption demand should support the economy this year. Such periods have usually been positive for domestic cyclical sectors like manufacturing, engineering and capital goods, power, cement, materials and metals, public sector enterprises and select financials. 

Prudent allocation strategy 

Many of the above sectors had witnessed higher valuations in the run up to the elections with high expectations built around a very strong mandate for the BJP-led NDA government. Most of these stocks witnessed sharp corrections soon after the election results, and they will probably remain under pressure until full clarity emerges on the government's investment priorities, which may not unfold until the full budget presentation in July. 

A prudent strategy, for fresh allocations to Indian equities, would be to diversify portfolios across defensive sectors like consumption, pharma, and IT alongside domestic cyclicals. Active management, with focus on long term fundamentals, is likely to help investors better navigate through this near-term volatile period in markets that may also witness frequent sector rotations. 

Though mid- and small-cap valuations might seem to be slightly overvalued relative to large-cap peers, we retain our equal preference towards both, with allocations in line with broad market benchmarks like Nifty 500 or BSE 500, as we expect mid- and small-cap corporates' earnings growth to continue outperforming their large-cap peers. 

Central bank policy  

The Reserve Bank of India (RBI) kept the Repo Rate unchanged at 6.50% after its last policy meeting, in April, with five members voting to hold rates while one urged a cut. The central bank retained forecast GDP growth at 7% for FY 2025 and inflation at 4.5%.

With a normal monsoon forecast and recent retrieval in oil prices, inflation outlook should remain within RBI's comfort zone, although risks from geopolitical events and their impact on supply chains and commodity prices will continue to keep the monetary policy committee on its toes.  

Lower issuing of government papers in FY 2025, amid large anticipated foreign portfolio investment inflows (both due to government bond inclusion in global bond indexes and favourable carry available in INR bonds), one of the largest dividends given to the state from the RBI, and state budgeted spending, suggests that the fiscal deficit could dip to 5.1% of GDP in FY25, from 5.6% in FY24. This would further support demand-supply dynamics for government debt. 

In terms of the outlook for Indian rates, much will depend on cues from the leading global central banks, especially the Fed. That said, we expect any cut in Indian rates by the central bank to be in the final quarter of 2024.  

Duration and credit 

The 10-year benchmark bond yields hardened in the immediate aftermath of the election results. We see potential for some near-term extension in rate moves as markets digest the vote further. Risks of a shift in the make-up of fiscal expenditure towards revenue expenditure, from capital expenditure, under a smaller BJP mandate could also adversely affect bond sentiment at the margin, as the "quality" of spending changes. With the RBI likely to remain in FX markets to support the stability of the rupee, investors could demand a larger risk premium in local rates instead, as they take time to gain confidence in the stability of the new government. 

Over the medium term, the overall direction of government bond yields remains lower. Market participants should eventually shift back to trading the lower inflation and the fiscal consolidation narratives, which will probably remain intact under a stable NDA government. Select Indian government securities were recently added into JP Morgan Indices and in the Bloomberg Emerging Market Index. In the near term, these moves might see inflows of perhaps $20-25 billion over the 10-month phase-in period for the local bond market. Much of that could be seen in the second half of this year, which would be supportive for adding duration in bond portfolios. 

We continue to look for 10-year benchmark bond yields to ease to 6.75-6.9% by the end of the first quarter of 2025, with the yield curve remaining flattish until the market has a clearer view on the commencement of rates cuts. We also see scope for sharper RBI cuts than the approximately 34bp of easing priced in over the next two years (at the time of this writing); our economists expect 100bp of RBI easing in this cycle, albeit with risks of a shallower cycle if growth remains firm. 

Turning to corporate debt, strong business performance of late, driven by pent up demand, has resulted in significant operational gearing for businesses across the curve. With nearly 305bp of credit spread between three-year government bonds and three-year alternative A-rated paper, compared to its 20-year average of 269bp, corporate bonds, especially below-AAA-rated papers, appear to offer value for those willing to hold investments over an 18-24-month window. 

Gold and private markets   

Gold has performed well this year, supported by increased central bank buying of the yellow metal, expected lower US real rates and its ‘safe-haven’ status at a time of rising geopolitical tensions. Events this year have underscored gold’s attractiveness as a portfolio diversifier. 

Another option in creating well-diversified portfolios is by investing in private markets, something that is becoming increasingly popular in India (albeit that also carries its own risks and challenges). Allocating to private markets can open up fresh opportunities that are not available in public markets, through which one may better manage portfolio risk-adjusted returns.  

Again, when the dust settles on the shape of India's new government, local listing activities are expected to pick up in the final quarter of the year. Also, long-term investment flows, especially in funding capex, M&A activities and in domestic private markets, should also improve. The current backdrop of valuation corrections due to a weak global funding environment and the focus of investors on private companies' profitability bodes well for the attractiveness of the current vintage of private markets investments.

Similarly, recent interest seen in real assets investing, across housing, commercial offices, and warehousing space, should continue to gain momentum, with growing institutional participation driving quality and retail participation through REITs and InvITs potentially driving cap rates compression.