Equity markets are continuing to see volatility. After the euphoria post the Corporate tax rate cut announcement, markets saw a rally of 8-10%. However, in the past few days, markets have given back almost half the gains as the risk perception has increased again on the back of ongoing concerns, especially regarding the Banking and NBFC sector and corporates with high promoter leverage.
On the positive side, after witnessing a slowdown in the economy and increasing pessimism in last one year, we have started to see some optimism coming back. The key reason for the slowdown was that even though system liquidity was in surplus, the Non-Banking Financial Company (NBFC) issues led to stricter credit evaluation by banks. With the credit cycle tightening, money did not flow in the economy which increased level of stress, especially for SMEs. However, the government has acknowledged the economic slowdown and changed its stance from ‘fiscal prudence’ to ‘growth revival’. We have seen a gamut of measures designed to release liquidity in the system and get the credit cycle back on track. Reduction in the Corporate tax rate should release equity capital in the corporate ecosystem, encourage the investment cycle and boost Foreign Direct Investment (FDI). The government’s regular consultation and communication with industry is also helping to revive sentiments.
RBI’s dovish stance is also supportive of the economy. In its latest policy announcement, Reserve Bank of India (RBI) reduced the repo rate by 25 bps to 5.15%, bringing the cumulative easing to 135 bps in this cycle so far. RBI will continue with an accommodative stance as long as it is necessary to revive growth, while ensuring that inflation remains within the target. The government has also indicated that it will stick to the FY20 fiscal target and revenue shortfall on account of the recent corporate tax rate cut will be offset by other sources, especially privatization of PSUs.
Regarding other key macro factors, the monsoon is 10% above its long-term average and reservoirs are full which bodes well for the Rabi crop. After a brief spike, crude oil prices have already declined to levels of USD 58 per barrel which is beneficial for India in maintaining its Current Account Deficit. US and China have resumed their trade talks and currencies including the Rupee are stable. With global central banks continuing to reduce rates, liquidity remains easy. Given this backdrop, after seeing FPI outflows in July-Aug, India saw inflow of USD 1 Bn in September.
Going forward, it is critical to see resolution of the ongoing issues in the Banking and NBFC sector. Also, domestic demand needs to come back for the capex cycle to improve. In this regard, the festive season will be a key barometer to see demand uptick. We also need to see increased rate transmission post the RBI rate cuts as well as concrete outcomes on privatization of PSUs.
With the ongoing US-China trade war, many companies are looking at alternatives to China for their manufacturing set up and sourcing. With the reduction in the effective tax rate for new investments to 17%, India can capitalize on this window of opportunity. In order to support this investment cycle with other terms of long-term measures, land and labour reforms maybe next in cards for the Government.
View on the Market:
While Q2FY20 earnings growth is expected to be soft, both GDP growth and earnings growth have likely bottomed out and we should see an uptick from here. We have already seen Nifty FY20 earnings growth getting upgraded by 6-7% post the tax cut to around 22% yoy. Sectors such as Corporate Banks, low-ticket consumer durables, consumer staples, Cement, and Pharma should drive earnings growth.
Over the past one year, the Nifty is now up 8% while the midcap and smallcap indices are down 7-10%. Currently, the valuation in equity markets is reasonable. The PE multiple for the large cap Nifty index is at a 10% premium to its long-term average. Midcap PE valuation is still at ~15% discount to largecaps. Overall, the risk-reward seems to be fairly balanced for Equities.
Quality companies continue to outperform despite high valuation while weaker companies have given away all the recent gains. We remain cautious in the near term and expect the government to take some more steps to lift sentiments, especially addressing the credit flow to NBFCs. Over the medium term, some of the positives like lower interest rate, release of government payables, capitalization of PSU banks, above average monsoons, and easy global liquidity will all help to revive India’s sluggish growth and keep market sentiment positive from a long-term perspective.
Although returns over the short-term could be modest, valuations have potential to offer reasonable returns to long-term investors. Hence any correction in the market should be bought into while maintaining a balanced asset allocation. Investors can allocate 50-60% of the Equity corpus to largecap and multicap funds. Investors may allocate 20-25% of the corpus to midcap and small cap funds from a 3-to-5-year perspective. Investors can allocate around 20-25% of their portfolio to thematic funds focused on Consumption, Banking & Financials, and Pharma.
Source: ABSLAMC Research, Bloomberg
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