Moneycontrol Pro Weekender | Cyclical, Structural or Delusional?

Dear Reader,

Another week, another all-time high. The MSCI All-Country World Index, as on 27th June 2024, was up 2.3 percent this month and 10.6 percent year-to-date. On the same date, MSCI India was up 6.7 percent in the month and 16.3 percent year-to-date. The reasons for the outperformance have been reiterated at length in every report on the Indian economy. GDP growth is strong, and the momentum is so good that RBI researchers, in their State of the Economy report, revised their estimates of growth this fiscal year to 7.6 percent, days after the Monetary Policy Committee had revised it up from 7 percent to 7.2 percent. We all know the many other positives—a stable current account, large forex reserves, strong bank and corporate balance sheets, the government’s focus on building infrastructure, the turnaround in real estate activity, the PLI schemes to boost manufacturing, corporate profits as a percentage of GDP at a 15-year high et al.

The question is: Given current valuations, haven’t all these positives, and more, been already priced in? The RBI's Financial Stability Report says, "Analysis of a longer time series of 12-month forward P/E ratios shows that while Nifty 50 and Nifty smallcap 100 are trading close to their historical averages since 2019, Nifty midcap 100 is trading one standard deviation above its historical average." But historical averages are applicable only when we average over a cycle, not when there has been a structural change in the economy. And there have been quite a few structural changes in recent years, such as the introduction of GST, slashing of the corporate tax rate, the PLI schemes to push manufacturing, defence indigenisation, the rise of Global Capability Centres in services exports, and, of course, the huge improvement in the country’s infrastructure. It is this structural transformation that has enabled the Indian economy to remain so strong despite a sluggish global economy, supply chain disruptions, tightening global central banks and geopolitical pressures.

Most importantly, there has been a massive structural shift in the global economy, with China’s growth faltering and multinationals shifting supply chains to other, friendlier, nations. India has been a beneficiary of this change, and it is also one of the Asian countries least exposed to the Chinese demand slowdown. India has taken over from China as Asia’s new growth engine.

Given these business-friendly changes, there is a case for valuations higher than the long-term average for Indian equities. The question is: how much higher?

Not all the rise in equities has been driven by higher valuations. The Financial Stability Report says, ‘’A standard discounted cash flow model suggests that the rise in the overall Nifty 50 index since March 2022 appears to have been driven mainly by improved earnings projections and to a lesser extent by investors’ risk appetite (declining equity risk premium). Extending the model to analyse the returns on midcap index shows that investors’ higher risk appetite is the major driver of returns when compared to improved earnings projections.’’ Simply put, while higher earnings could be behind the rise in frontline stocks, midcaps are being driven by sentiment more than fundamentals. Most analysts have been calling for caution.

What then is driving the markets up? Retail fund inflows into the market are the reason. As a Kotak Institutional Equities report said, ‘’the high valuations across sectors in general and frothy valuations in specific sectors largely reflect the extremely bullish sentiment among non-institutional investors and even among certain institutional investors.’’ Passive inflows through SIPs have risen continuously. Indeed, the embrace of capital markets by retail investors is another structural change. Moreover, it’s not just domestic retail investors that are pouring in money into the stock market—global retail investors too are coming, via ETFs, as this story by Lisa Pallavi Barbora says. The most recent survey of global fund managers by Bank of America finds that sentiment is the most bullish since November 2021, driving cash levels to a three-year low, while equity allocation is high. Astonishingly, it also finds that global risk sentiment is not yet extreme, which means the global rally could still have legs. This FT story, free to read for Moneycontrol Pro subscribers, says the last remaining bears of Wall Street believe that investors have embraced ‘’fanatical thinking.’’

What could end the party? The Financial Stability Report, analysed here,  says downside risks to the Indian economy, ‘’stem from global slowdown and spillovers, geopolitical risks and their impact on supply conditions and commodity prices, slack in the rural economy and uncertainties related to weather conditions.’’ Add technological disruption to that list. And let’s not forget ‘’The Economic Consequences of Mr Trump’’.

True, an erratic monsoon could spoil the outlook for rural demand and could keep food inflation high. Note, though, that the economy did very well in FY24 in spite of a poor monsoon and high inflation. On the other hand, if inflation remains under control, we could see interest rate cuts this year and a revival of corporate capex, which could provide additional tailwinds. We wrote about how India’s exports are poised for big gains from shifts in global supply chains.

Let’s not forget another big change—the inclusion of Indian government bonds in international indices. As this article points out, index and strategic allocations could potentially result in USD $ 100 billion inflows over the next 3-5 years. That, together with fiscal restraint, makes a strong case for long term yields to decline over the next 1-2 years. That in turn will provide support to equities, while the inflows will keep the rupee steady and add to the attraction of Indian markets for foreign investors.

Will earnings disappointments lead to swift retribution by investors? A Kotak report is sceptical about that, saying, "it may take a number of quarters of consistent disappointment for investors to question the extant narratives, given the strong conviction of the market participants about robust earnings and growth prospects." During peak FOMO periods, the markets can stay irrational for very long. A note by Bernstein sums it up well—it says investors are playing a game of "Fastest Finger First’’, where "There is limited scrutiny on earnings in such phases of markets. Any idea is rationalized as the next wealth generator, and a broad positive 50-year

view on India suffices the investment thesis. Investors rush in to neutralize any valuation arbitrage they see. This kind of “investing”, with a negligible assessment of models and governance, stays good till the cycle peaks. Momentum chasing in the short term is too lucrative to stay away from.’’

In her address to Parliament, President Murmu has promised that "many historic steps will also be seen in this budget" and that "The pace of reforms will be further accelerated." Given the current state of the markets, it is imperative that the finance minister delivers on that promise in the forthcoming budget. Here are some of the stocks that stand to gain if the Budget proves generous for the middle class.

Cheers,

Manas Chakravarty

Here, in case you missed them, are some of the stories and insights we published this week, apart from our technical picks in the equity, commodity and forex markets:

Stocks

Mas Financial, Thangamayil Jewellery, Will a possible move to reduce F&O trading by retailers derail the BSE stock rally?

Allied Blenders and Distillers IPO: Liquid happiness in a bottle?, Landmark Cars, Sky Gold, Vraj Iron and Steel IPO, Are MFI players staring at a bumpy road ahead? LIC Housing Finance offers better valuation than peers, Avalon Technologies, Fedbank Financial—why the underperformance merits a look, Kajaria Ceramics, PI Industries adds another feather in its cap with this new acquisition, The recent correction in this coal stock is just a blip, UltraTech’s stake buy in India Cements — Is a takeover now on the cards?

Markets

Dilution of voluntary delisting norms a blow to minority shareholders, Fiscal prudence from Budget would add to long-term bond market gains, If taxes are used to slow the F&O juggernaut, what should traders expect? Sebi panel to discuss linking F&O exposure limits with individual risk profiles, What stopped the copper rally in its tracks

Financial Times

The “one’’ way for Wall Street banks, An electoral policy for the supply side, World headed for ‘food wars’ amid geopolitics, climate change, warns Olam

Companies and sectors

India’s steel output slows even as consumption remains strong, MedPlus, Has the upcycle in passenger vehicles sales growth played out?, Ujjivan SFB, MNCs are ceding ground to local firms in Indian pharma market, Amara Raja’s risky yet compelling bet on L-ion batteries, Lenders turn wary of plastic, Coromandel International, The impact of drug shortages in the US on Indian pharma companies,

Economy & Policy

Monsoon Watch, Key GST reforms remain in wait mode, India needs more green energy to fuel its data centre ambitions,

Pro Economic Tracker, RBI’s Das points to storm clouds over microfinance, The trouble with central government capex,

Are the tailwinds for offshore wind power strong enough?, India’s water crisis , Vanishing women in the Indian economic landscape

Geopolitics & geoeconomics

The Eastern Window: India weighing options as US pushes it to play Tibet card

Decoding Economics: Why the US wants to rewrite rules of international trade

Tech & Startups

Startup Street: SaaS industry—at a crossroads

Public sector customers fuel SaaS market expansion amid macroeconomic slowdown

Wipro to continue with strategic acquisitions, invest in talent to fuel growth, says CEO Pallia

Personal Finance

How will JPMorgan’s inclusion of India bonds impact debt mutual funds?

Why Zerodha Fund House is looking at solution-oriented funds

Smallcase sets sights on profits, doubling growth in FY25

RuPay takes pole position in debit cards; PhonePe, GPay lead in UPI transactions