Indian equities – the case for divergence
In this final instalment of the six-part series on the outlook for equity markets, financial markets expert B. V. Krishnan shares the outlook for the Indian equity markets.
This is the last part of the six-part series on the outlook for the equity markets. In the first four parts, we covered the outlook for US equity markets. In summary, the perspective is that while the US equity markets are likely to extend their rally in the near-term, the medium to long-term outlook is not positive, and more so if you look at it in the context of the real value of money. We also discussed the increasing role for gold in investment portfolios.
In the fifth part, we discussed where the Indian economy stands, and the near-term and medium-term outlook. In this final part, we will sum up the overall perspective on the Indian equity markets.
Indian equity markets and the US equity markets
Some may have wondered about the extent of discussion about the US markets, before we turned to the Indian markets. To that point, Chart 1 shows the Nifty 50 and the S&P 500 on a normalised (Factor 100) basis from the start of the previous long-term rally on 5 March 2009 till 26 May 2020. As you can see from the chart, the Indian Index has substantially tracked the S&P 500 till both the indices individually reached their respective peaks on 14 Jan 2020 and 19 Feb 2020. There have been differences along the way, but they have pretty much coincided on the start, the end, and the extent of the rally, which is quite spectacular. Of course, in US dollar terms, the Indian Index has underperformed the S&P 500, but their absolute moves have been largely similar.
Coming to the Covid-19 reaction, we saw the Nifty 50 locked in step with the S&P 500 in the first two phases, ie, the sell-off phase, and the hope rally phase. The sell-off phase saw the Nifty 50 drop 38 per cent in 33 days, while the S&P 500 dropped 34 per cent in 33 days. The hope rally saw the Nifty 50 rally 20 per cent in 38 days, while the S&P 500 rallied 31 per cent in 37 days. The relative underperformance reflecting the enormity of the US relief and stimulus, and the latent worry that India will not be able to match it on a relative basis, while still maintaining the essence of hope. Since then both markets have been moving largely sideways, and in a narrower range.
The next phase, ie, the adjustment phase is likely to see the two markets start a trend of divergence. A combination of the US economy opening, positive news from early testing for the virus, and more stimulus measures will likely extend the ongoing US equities rally. India, on the other hand, will likely take longer to see the peak in the growth of Covid-19 cases, weaker openings from the lockdowns, and clearly weaker demand-side stimulus measures. As the Indian markets digest this, it is likely that Indian equities will start underperforming on a relative basis. This phase can extend in time depending on how severe the downturn remains. It will be exacerbated by India’s weak financial sector, as mentioned in the previous piece in this series titled “The elephant comes to a halt”.
The Indian markets have the potential to outperform in the realisation phase that will follow, for the fundamental reasons explained in the previous piece. The timing of the turn, momentum and extent will depend on the fiscal measures and structural reforms that get executed by the Modi government.
Valuations, flows and composition
The S&P 500’s 10-year average trailing P/E multiple is 17.9x, while the 2-year average trailing P/E multiple is 19.6x, and the index is presently traded at a trailing P/E multiple of 20.5x. So, the index has progressively become expensive, including now, and despite the present environment. This is largely thanks to the monetary stimulus and corporate buybacks, which we discussed in the piece titled “The ‘Powell Put’ and more”. This dynamic is essentially set to continue further in the near-term.
The Nifty 50’s 10-year average trailing P/E multiple is 19.8x, while the 2-year average trailing P/E multiple is 23.7x, and the India index is presently trading at a trailing P/E multiple of 17.9x. 10-year average trailing P/E multiple in the Nifty Midcap 100 Index is 24.7x, while the 2-year average trailing P/E multiple is 36.9x, and this index is presently trading at a trailing P/E multiple of 18.6x. A large contributor to the growth in the Indian equity markets has been increased participation in the markets by Indian Mutual Funds. FPIs who had fueled the market after the Global Financial Crisis had started pulling back from 2015.
Aggregate FPI investments in Indian equities between 2015 and 2018 was just 26 per cent of the aggregate of the preceding 3 years, reflecting amongst other things their perspective that India was set to face fundamental issues in the economy with the build-up of NPLs in the banking sector. In contrast, in the 5 years ending 2019, Indian Mutual Funds had invested in aggregate 2.6x the amount invested by FPIs in the Indian equity markets. This was a significant trend also reflecting institutionalisation of savings in India, as money has moved from cash to bank deposits to equities, over time. A lot of this cash had also gone to the midcap, which is where you see the significant divergence in the multiples of midcap companies till recently. As the risk environment has significantly worsened, cash has moved intuitively from the smaller names to larger names, for relative safety.
When you look at composition, we are seeing an uneven distribution of outcomes in stocks after Covid-19, much like what we have seen in the US. The Nifty Bank Index is down 43 per cent since Feb 19, 2020, with some banks down as much as 77 per cent. The Nifty Pharma Index is up 13 per cent since Feb 19, 2020, with some pharma companies up as much as 56 per cent. Others that have suffered include some hospitality companies that are down 74 per cent, and retailers that are down over 60 per cent. Over 60 per cent of the Nifty 500 stocks have lost 25 per cent or more since 19 Feb, while 35 per cent of the S&P 500 stocks have lost 25 per cent or more. So, the churn towards perceived quality has been higher in India.
The next decade could look quite different from the previous one, when you look at equity market performance:
- The near-term for Indian equity markets is likely to reflect the pressures that we have discussed, resulting in relative underperformance, while the medium to long-term outlook is positive. Given this mixed trend, which will involve corrections, there likely will be opportunities to adjust portfolio positioning to reflect the outlook, over the coming months.
- The Indian financial system and the extent of near-term fiscal support (or lack thereof) to revive demand hold the key to the depth of the pressure we will witness. A possible correction in the next several months in the markets could also help invite FPIs in a significant way back to India, especially if it is coupled with progress on the reforms front.
- A combination of fiscal spending on the demand side, together with structural reforms across land, labour, energy, and financial services is critical. The timing of the switch to a long-term positive trajectory for equity markets will be linked to their implementation.
At the end of this decade, the Indian equity markets may prove positively divergent from the US markets. A lot depends on the extent of structural reforms that the Modi government initiates and the success of their execution, to help shift upwards the long-term growth trajectory of the economy.
* Disclaimer: The thoughts in this note are not meant to provide, and do not purport to be, investment advice but are rather in the nature of a narrative about the economic and financial markets.
B.V. Krishnan is a former Partner at KKR, and former CEO of KKR India Financial Services.