India, the silver lining in the cloud

Silver line

As of today, India may be underperforming; MSCI India is up by 10% compared to 16% by MSCI World in terms of dollars. Yet, within the sphere of emerging markets, India stands out as a top performer and has hugely outperformed with a 65% absolute return compared to 37% for emerging markets.

The recent subdued performance of the stock market is attributed to the selling activities of FIIs and HNIs inclined by the global crackdown. The global market is currently in a state of unease due to the escalation in bond yields. MSCI World is down by 5% in the last 2½ months, as on 19th October. This trend is further compounded by the apprehension that bonds will continue to exceed the long-term trend for an extended duration. Consequently, this apprehension is instigating heightened concerns within global stock markets, as the monetary policy aims to curtail economic momentum by restricting the flow of liquidity.

Having said that, the Indian stock market and economy are staying put as a silver line in the cloud. Q1 FY24 was robust for India, and the same is forecasted for Q2. However, a potential outlier risk lies in the lingering effects of the global slowdown, which could potentially hamper India’s economy in the latter half of FY24. Recent reductions in monthly export growth and FDI inflows indicate the relevance of this risk. Despite this, the prevalent consensus indicates a promising outlook for the entire fiscal year 2024, with an expected earnings growth exceeding 20%. This growth is presumed to be driven by stable external demand, led by the expansion of the world supply chain in India. And the solid domestic demand is driven by government spending, infrastructure, and household spending.

Selling by FIIs and HNIs

The Indian markets have been volatile in September and  October. Mid and small-cap stocks bore the brunt, while large-cap stocks remained relatively steady. The direct consequence is the selling of FIIs and HNIs. The selling pressure from foreign investors can be linked to the challenging performance of global equities, leading to a spillover effect impacting the Indian market.

The global market is grappling with a sluggish economy teetering on the brink of high inflation and corresponding interest rates. These factors pose significant challenges to future growth by dampening corporate and household spending. Secondly, both factors are leading to elevated bond yields, which is unfavorable for the equity class, reducing forward valuation. Bond yields and earning yields have an inverse relationship, bringing complexity to the investment landscape.

Reverse relationship between bond yield and valuation

Consequently, this trend has triggered substantial selling across emerging markets, including India, with notable sell-offs observed in countries like Japan, Taiwan, China, and the Euro Area. However, the level of selling by FIIs in India is relatively moderate. This can be attributed to the perception that the domestic economy is positioned to detach itself from the decelerating global growth trajectory, supported by industrialization initiatives and favorable manufacturing policies. It is crucial to highlight that the impact of FIIs’ selling is softened by the positive inflows from DIIs. Net selling by FIIs from September to 17th October was Rs 27,220 crore, which was counterbalanced by net DII purchases amounting to Rs 33,428 crore. However, there is observable selling happening at HNIs desk, particularly concentrated in mid and small-cap, possibly reflecting concentration to book profit after the solid performance of this segment in FY24 thus far.

We are near the peak of bond yields

As mentioned, there exists an inverse correlation between interest rates and the stock market, with the surge in bond yields being a major catalyst for the ongoing selling. Over the past six months, the yield on international bonds has been haywire. The US 10-year yield has surged to 4.95%, nearing the high of 5.25% made in June 2006. These levels were last witnessed before the global crisis of 2008, which stemmed from the financial catastrophe of that period. However, the current spike is driven by post-Covid economic imbalances.

Key countries’ bond yield trend in last 6 months

The key reason for the elevated bond yield is stubborn inflation, which stayed high due to high spending by the government, freebies (a high supply of money), a fall in capacity, and supply constraints. Initially, during 2020-21, it was expected that this imbalance would naturally correct with an increase in supply, but the situation has persisted for an extended period.

Following the monetary tightening policy of the world’s central banks in 2022-23, economic growth has moderated, and inflation has peaked. Similarly, it is anticipated that the bond yield will reach its apex within the upcoming quarters.  However, inflation is expected to stay above the long-term forecast in 2023 – 2024. Consequently, the bond yield is expected to stabilize, albeit at elevated levels, in the medium term.

Inflation returning to normal

Hence, the biggest risk for the stock market is further economic deceleration, as government spending is estimated to be reduced. This is exemplified by the projected -6% fiscal deficit in the US for 2023, with expectations of it remaining high until 2025. Moreover, the estimation of government debt as a percentage of GDP reaching 100% by 2024 further adds to the concern. The prevailing high bond yields are also driven by market demands for premiums when investing in the bond market, as the economy is slowing and the government’s fiscal position is weakening.

Reciprocally, the global equity market has been signaling a slowdown. MSCI World has experienced a correction of 5%. Concerns have arisen regarding the fact that the full impact of the heightened bond yields has yet to be fully reflected in both the economy and the stock market, highlighting the need for a distinct moderation in valuation. The current 1-year forward valuation of S&P500 is trading at a long-term average of 18x, not reflecting the weakening trend of the economy.

Yet again, India is sparkling, and forecast for Q2 is solid

India is currently trading slightly above the long-term average, although we do not anticipate a significant correction due to the smooth functioning of the local economy, which is better positioned compared to the global scenario. Furthermore, Indian corporates continue to maintain a healthy financial position and are successfully generating extra profits. The Q1FY24 for Indian corporate was strong, and a similar result is forecast for Q2, led by an expansion in operating margin and upright volume growth.

FY23 had wrapped up on a subdued note, with subpar earnings growth and soaring valuations. Initially, it had a mirror effect on the future outlook for FY24. However, when the domestic economy remained resilient to global challenges and inflation started to peak, it eventually led to an upswing in India’s corporate earnings.

Q1FY24 yields an improvement in profitability, facilitated by a reduction in commodity input prices. Despite this, skepticism was lingering in the market regarding the sustainability of the positive forecast, given the persistent global headwinds and significant FII sell-offs. Surprisingly, the Q1 actual results not only surpassed the forecast but also delivered an impressive 10% outperformance, with an actual Nifty PAT growth of 30%.

And the delight is that the optimism is expected to continue in Q2. The Nifty5o consolidated PAT is estimated to grow again by a whopping 21% YoY, a similar number forecasted in Q1FY24. If the projected Q2 results, coupled with the actual Q1 performance, materialize as expected, the Nifty50 index EPS is set to witness a robust 25% earnings growth in H1FY24. Market expectations suggest an earnings growth range of 20 to 25% for the entire FY24, surpassing the initial conservative forecast of 10 to 15% put forward by experts and analysts between January and March 2023.

A pivotal factor contributing to the progress of India’s corporate outlook is the commendable performance of the country’s economy during the ongoing global crisis. Government expenditure and the strategic initiative of global entities to diversify their supply chains in India are helping. As the global headwind of high inflation started to peak in 2023, it chipped in profitability for India since demand and volume are healthy.

As of 19th October, Nifty100 (Large cap) is up by 13% in FY24, below the 20 to 25% earnings growth being forecast for large caps stocks today. Concurrently, the broader Nifty Midcap 400 and NiftySmallcaps 250 indices have experienced significant surges of 36 to 42%, suggesting the potential for large caps to outperform in the upcoming period.

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