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India: March event risks behind us, upgrade to MW from UW
We are upgrading our view on the Indian equity market to market weight from
underweight. In short, we believe the global factors that have weighed heavily on India
over the past year (ie. European credit concerns) have largely abated, the domestic growth
cycle may re-accelerate heading into the second half of the calendar year, and the
uncertainty risk around the Uttar Pradesh elections and the Union Budget for FY2013 are
now behind us. Furthermore, we see upside to consensus EPS growth estimates for 2013
and we find valuations to be relatively attractive in India, certainly more so than they have
been since the Global Financial Crisis.
Global factors – improving but still a risk: India’s significant underperformance
during 4Q last year was due in large part to Indian corporates’ exposure to offshore
financing and credit risk, which emanated from European concerns. As evidence,
Indian equities were the most correlated in the region to Italian sovereign debt yields
(a more direct barometer of European credit concerns). With the introduction of the
LTRO, asset markets around the world have discounted a lower probability of a more
severe European crisis, and we believe these risks will remain relatively muted in the
near-term. As a result, we believe the potential external pressures on India during 2Q
will be less important than the domestic cycle, which may be improving.
Domestic cycle – focus on the growth outlook: As we note in the “macro indicators
that matter” section of this report, we find that the domestic growth cycle, as
measured by our CAI or the public IP data, is the most important macro factor for
Indian equities (also see Exhibit 45). The January print of Industrial Production showed
a jump in growth (+6.8% yoy), which is encouraging, although we believe the recovery
may not be as strong yet as this data would suggest (see India: January industrial
production much stronger on the back of consumer non-durables, March 12, 2012).
Nevertheless, we believe growth will indeed pick up in India over the next one to two
quarters and that the equity market will start to reflect these prospects in the coming
months. We also note that core inflation has been decelerating, most recently to 5.8%,
which should allow the RBI to ease the repo rate by 150 bp during FY13, supporting the
growth view.
Expectations & uncertainty: Since the start of the year, March has been the focus for
India catalysts, namely the UP election and the Union Budget. While neither of these
events turned out to be particularly positive for the market (UP elections were a
disappointment in that the ruling Congress party underperformed and the “play it
safe” budget was relatively neutral), we believe the removal of the uncertainty risk
around these events is a net positive for the equity market. In addition, we find that
expectations for government reforms to be passed this year have deteriorated,
lowering the bar for upside surprise.
Earnings & valuation: From a top-down perspective, we believe Indian corporate
earnings growth may surprise modestly to the upside in 2013, though we remain more
cautious on 2012 relative to consensus. Our macro model for Indian EPS growth, which
incorporates domestic demand, inflation, rupee appreciation, and regional GDP growth,
points to 12% and 16% EPS growth (in INR terms), compared with consensus 14% and
11% EPS growth in 2012 and 2013, respectively. While the percentages are not largely
different, we believe the direction of potential EPS revision is quite important, and that
an upward revision cycle for 2013 earnings may materialize later this year. On the
valuation side, MSCI India currently trades at 13.4x forward EPS, which is in line with
the long-term average since the 1990s, but is one quarter of a standard deviation
below the 10-year average. We do find that India P/E multiples are not a stationary time
series, suggesting comparison with historical averages may not be the most
appropriate, though we would note that a variety of valuation metrics for India (P/E,
P/B and Dividend Yield) are all towards the lower end of the distribution looking at a
shorter (2-3 years) time scale (see Goal – AsiaPac Valuation: What works, and when,
March 12, 2012).
Risks remain – oil and flows: In addition to the risk that European concerns (perhaps
centered around Spain or Portugal) may re-emerge, we believe oil prices present the
most significant risk to our more positive view on India. Oil prices can impact the
budget (which aims to limit subsidies to 2% of GDP) and increase inflation, thereby
diminishing the potential for repo rate cuts. Indian equities tend to exhibit a positive
correlation with oil prices most of the time. However, beyond a certain threshold,
which seems to be around $120/bbl, or when supply-side issues are the cause for
higher oil prices, Indian equities appear to become concerned with rising oil prices (see
Exhibit 44). Finally, we note the significant negative correlation between the INR rate
and NIFTY. Indian currency and equities seem to trade on similar risks, and we are
concerned regarding a reversal of the strong FII inflow of $8.6 billion ytd. A “risk off”
bout in the equity market could be amplified through weakened currency and
significant foreign outflows, and could lead to sharp underperformance given the
consistent selling and lack of equity appetite from DII so far this year.
