India’s decoupling from the global capital market is surprising: Mukul Kochhar

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India has outperformed major global markets over the past year. There are reasons for India’s performance but the extent raises concerns, says Mukul Kochar, Head, Institutional Equities, Investec India. Kochhar, in an interview with Samie Modakexplains the reasons for India’s outperformance and why investors should moderate their medium-term return expectations.

Edited excerpts from an interview.


What justifies India’s outperformance against global equities over the past year?

The extent of India’s decoupling from global capital markets came as a surprise. Indian equities as well as the currency outperformed. The reason for the outperformance is twofold. First, India’s economic cycle was in a sharp recovery as the double whammy of Fed tightening and the commodity crisis hit in the March quarter of 2022. Second, geopolitics helped India, as the world begins its very difficult journey to reduce its manufacturing dependence on China. As 2022 dawns, most of the reforms undertaken by the government over the past six years were expected to bear fruit. These include repairing the bank balance sheet; the implementation of the bankruptcy code; implementation of the GST; the reduction of the business tax rate and the PLI system. As a result of these reforms, corporate profitability has increased significantly (ESB500 after-tax profit doubled in FY23E to over Rs 10 trillion from Rs 5 trillion before the exercise 20). This excess profitability should enable business investment to recover over the next few years.

Although the current consensus is for a modest increase in capital spending, there is a reasonable possibility that the recovery in capital spending will be stronger as new use cases in energy independence, manufacturing supply chains and infrastructure are emerging. India is one of the only major economies in the world, where the consumption and investment cycle looks positive, providing reasonable visibility for high growth. This is the main reason why India remains attractive for global investment and has outperformed other markets.


What are the main headwinds facing national actions?

The biggest risk for Indian stocks is valuation. Indian equities today offer a small margin of safety, especially on a relative basis. India’s premium to other markets is higher than it has ever been. India is 15% more expensive than the United States on a price/earnings (P/E) basis – the most expensive developed market, and almost twice as expensive as Taiwan – the second most expensive emerging market after India. Historically, India has traded online with these two markets. As noted earlier, while India’s outperformance has some reasons, there are concerns about its magnitude. At a time when dislocation in global capital and currency markets remains high, India is particularly exposed to a global risk aversion event. Specific to India, our balance of payments remains negative and, while not signaling a crisis, creates a lasting risk for currency and equity markets.


Do you expect the premiums to decrease?

At any time, a high valuation poses the greatest risk to stock market performance, just as low valuations offer the best downside protection. The Indian stock market is exposed today, due to a high valuation relative to its own history and its emerging market peers. This, at a time when the risk-free rate is rising globally, seems particularly risky. Mean reversion is always a high probability trade in the markets, and India’s premium should be expected to decline over time. For example, our conversations with global emerging market investors reveal that most funds see India’s valuation differential as the biggest impediment to increasing allocation. The additional flows could drive some of this premium correction.


Domestic liquidity has played a large role in the resilience shown by the domestic market. Do you think domestic liquidity will remain strong?

We expect domestic liquidity to tighten from here. However, it is important to understand that India’s inflation problem is not as severe as that of the developed world. In the United States, more than 40% of the CPI basket is linked to real estate rents, which are inherently sticky and slow to correct. By contrast, around half of India’s basket is tied to food and beverages that respond quickly to the impulse of demand. As a result, the RBI hardly needs to create very tight liquidity (as in the US) to contain local inflation – expect domestic liquidity to remain tight, but not threaten growth. India has a balance of payments problem which is exacerbated by the growth differential compared to other countries, but RBI has other tools to solve this problem.


Will high US dollar and bond yields continue to weigh on REIT flows?

Over the past decade, the threat of deflation has kept US Treasury yields on a downward trajectory. Since the United States is the largest provider of capital in the world, this has created an asset valuation bubble, especially in growth assets. Now, as US Treasury yields rise, this will put pressure on asset valuations globally. The Indian stock market is the only one to have resisted this devaluation pressure. High valuations in India are the biggest risk, as well as a barrier to attracting new investment flows.


How was the September quarter earnings season? Do you see revenue reductions in the future?

We expected lower earnings revisions in the quarter and earnings so far have been in line with expectations. While weak (non-energy) prices weighed on earnings in the commodities sector, the rebound in margins in the consumer sectors was below normal as companies were unable to weather the storms. past increases in input prices. Expect some recovery in margins in 2H FY23, but we believe this will not be enough to prevent further downgrades. At the start of the quarter, we expected good performance in sectors such as pharmaceuticals, banking and some automotive stocks. So far, pharma and banking have delivered on their promises, and we remain constructive on the automotive sector. More importantly, we are also comfortable with the valuation of these sectors. In recent months, we have also been attracted to the IT sector, after its strong underperformance. We upgraded the sector to neutral weighting in early July and selectively recommend stocks that are uniquely positioned for high growth, but are still available at a reasonable valuation.


Do you expect the markets to stay in a range like they have over the past year? Or is there a big upside or downside in prospect?

Given the high valuations in India at the moment, medium-term return expectations should be moderate. Although the valuation poses a risk to market performance, any easing in the Fed’s tone should lead to a rally of relief for equities globally. That said, given that Indian equity markets have already performed well, we don’t expect a big upside even in such a scenario. Over the next six months to a year, expect the country’s investment and manufacturing cycle to pick up significantly. This should support earnings growth in certain stocks and sectors, and provide equity investors with the opportunity to earn reasonable returns through stock selection.

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