Emerging markets have underperformed in comparison to their developed peers over the last five years due to dollar strengthening. India, however, stands out like an oasis in a desert among emerging markets. The months of August and September this year witnessed selling by foreign institutional investors (FIIs), led by exchange-traded funds (ETFs) and sovereign funds. Flows of long only funds in listed market and private equity funds in unlisted market are indications that India will stand out in the months to come. Also, a fall in fiscal deficit, current account deficit, inflation, improving growth, stable currency and fair equity valuation should comfort investors.
Domestic investors are now allocating more money to equity than in the past. Partly it is driven by the underperformance of gold and real estate in last few years and partly by the combined efforts of Sebi, LIC, mutual funds and distributors who have worked on educating retail investors. Some 8 million systematic investment plans are the outcome of these efforts.
The government has liberalised provident fund investment norms to enable their participation in equity market. We can expect more than Rs 9,00,000 crore to come into equity market over next 5 years between mutual funds, insurance companies, banks and provident funds exceeding the potential supply of papers from government divestment and retail selling.
Though Indian markets are placed advantageously from a flow point of view, fundamentals need to improve from current levels for a sustained growth. Since December 2014 quarter, corporate earnings have consistently grown at a lower than expected pace. We expect corporate earnings to recover from current muted pace over next six quarters. Earnings recovery will be aided by drop in interest cost as the rate transmission takes place. Exports in FY17 should be marginally better than FY16 on a weaker rupee.
The government is spending money saved from low crude price to build roads (average daily construction of roads has now reached 18 kms), in mining (incremental coal production in FY15 was more than the combined incremental coal production from FY11-14), railways (decentralised procurement and modernisation) and defence (Make in India).
Capacity utilisation across many sectors like cement, metals and power have fallen over last few quarters as demand remained muted. There should be a gradual recovery in demand, resulting in improved capacity utilisation and better margins. Lower commodity prices as reflected in low inflation should improve earnings. There should be a good jump in urban consumption in sectors such as automobiles, white goods and affordable housing on the back of Pay Commission revision in FY16. Corporate earnings should improve albeit gradually and back ended as we transit to FY17.
The economy will also have to overcome the challenges of rural distress caused by poor monsoon and slower revival in private sector investment, which remains constrained by lower return and higher risks on new investments. Delayed project execution across sectors such as power, metal, real estate and infrastructure has created a lot of unsustainable debt burden. Banks, especially PSU banks, are burdened with far more NPAs than disclosed and is reflected in below book market valuations. On ground execution of projects is way below the required pace as complex rules make entrepreneurs’ job extremely difficult.
The economy should be able to overcome the US Fed rate hike and some rebound in commodities. Chinese slowdown should be a blessing in disguise, as it will keep commodity prices under check. Global volatility will have a short term impact on the market, but strong domestic participation should be able to negate the same.
Large cap stocks have underperformed in comparison to mid caps in last 12-18 months. The valuation difference between large and mid cap now favours large caps. Superior returns will be generated by bottom up stock selection as quality stocks are likely to be rerated on lack of new issuances. Private sector banks and NBFCs should outperform on interest rate cuts and increased financial savings. Domestic cyclicals like cements should outperform on improving spending by the government in infrastructure sector. Indian equity markets are on a strong wicket with top down macros better than most of its peers and bottom up stock picking rewarding risk takers with earnings and valuation rebound. We will recommend readers to be a “ fill it, shut it, forget it “ investor and participate in India’s growth story.
The writer is Managing Director, Kotak Mahindra Asset Management Company