5 reasons why Nomura downgraded Indian equities to ‘neutral’

Indian markets picked up momentum in the second half of 2019 to close the year with double-digit gains but macro concerns, as well as delay in earnings, could cap the upside, Nomura India said in a recent report, as it turned cautious on the Indian equities.

The brokerage downgraded the domestic equities to “neutral” from “overweight”, saying scope for outperformance was limited.

“We downgrade our tactical relative stance on Indian equities to neutral. We would look to turn more constructive on India once the domestic economy recovers much more strongly than currently expected, and/or we turn incrementally more cautious on the rest of Asia, particularly North Asia,” the report said.

The global brokerage house had upgraded India to “overweight” in August 2019. With its back against the wall given the growth headwinds, the government had finally decided to go on an offensive to arrest the decline in GDP growth rates by embarking on a series of reforms and growth-boosting measures, it had said.

At the same time, Nomura felt that a deteriorating external environment (largely due to rising US-China trade tensions) could benefit a large-liquid economy/market like India.

Since then, Indian equities have rallied, mostly due to domestic factors rather than external, and for a while, India even outperformed regional indices, as Nomura expected.

“However, as we stand currently, we find our overweight on India did not work as expected, given that North Asian markets have rallied much harder, due to a better external environment on easing US-China trade tensions,” the report said.

The cautious stance, Nomura said, was only for the short term and it remained constructive on Indian equities for the long term.

“India is home to a number of well-run, high-quality-growth businesses, which justifies its premium valuations. India should also do well if global growth slows down, given its domestic-oriented economy (not necessarily the equity index) and less-than-average exposure to electronics as well as the trade cycle,” the report said.

If US-China trade tensions were to re-emerge and India’s domestic growth recovered, India as a market could do well and outperform, it said.

Namura’s top stocks from Indian markets include ICICI Bank, Axis Bank, Larsen & Toubro and Dr. Reddy's Lab.

Nomura highlighted these 5 factors for the downgrade:

Global equities more attractive

 Nomura believes with the external backdrop is expected to improve marginally and the tech cycle is expected to recover. A domestic-oriented market like India may have a hard time outperforming the more cyclical North Asia markets geared to the tech/growth cycle as well as global growth.

Expectations of slow and prolonged economic recovery

India’s medium-term growth potential remains intact as Nomura continues to believe that the measures adopted, so far, by the government are positive, but more such steps may be needed to boost growth.

The Budget will be carefully watched and the general consensus is that some more “soothing measures” are likely. It is unclear how far these measures will lift the economy and may just boost sentiment on the margin.

The Nomura India Economics team expects GDP growth to average 4.7% in FY20 (year-ending March 2020) and 5.7% in FY21 and are below consensus.

Benchmark Index valuations not inexpensive

Nomura says India benchmark index valuations could remain high (if not expanded further) for reasons such as global/passive flows, channelising of domestic liquidity to stock markets due to fewer investment opportunities elsewhere (e.g. weak property market, and lower domestic deposit rates), and importantly index changes (for example recent MSCI changes added a number of high valuation-high growth stocks which gave, in our view, a one-time boost to index valuations).

Therefore, Nomura does not expect massive mean reversion; however, the brokerage house believes that given the uncertainty on the domestic growth outlook, further multiple expansion is likely capped.

High expectations

With foreign flows relatively strong, expectations are quite high for India to post a recovery soon but Nomura fears that investor patience may be running out.

The investment bank also notes that the Indian equity market (MSCI India or Sensex) is driven by a narrow set of stocks, construed as quality-growth, which has given an uncertain growth outlook.

Nomura is of the view that investors are more than happy to stick to stocks with better earnings visibility.

Rising inflation implies less room for monetary policy

As a house, Nomura expects that policy will continue to take a breather for now, given the rising inflationary pressures. However, it expects the next rate cut in Q2.

There is a risk of fiscal slip

Nomura says the fiscal policy is quite constrained too. The government appears to be using money to fund tax cuts by utilising proceeds from telecom companies (who themselves are funding by raising consumer tariffs, which could inhibit fragile consumption recovery). There is also a risk on fiscal should oil prices remain high.

(The above story is compiled from a Nomura report released on January 10, 2020)

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