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  • Writer's pictureTikona Capital

Inflection point for India?

Updated: Sep 25, 2023

Story So far!

NIFTY and Global Indices: NIFTY is up by ~1.3% on a FYTD basis, after correcting for four continuous months. While the 2022 outperformance versus global markets placed Indian markets to the forefront, high relative valuations and challenges involving one of the main corporations led to NIFTY (down 0.6%) underperformance in the last six months. Global markets, particularly China ( up ~30%) and Europe (up ~13% to ~22%), have outperformed in the recent six months due to lower valuations. PSU banks (up ~12%) and FMCG (~up 6%) have outperformed with gains over the last six months. PSU banks have improved their asset quality and advanced growth, whereas FMCG has been more defensive in a slowing growth environment.

Global Economy: The IMF predicts that global GDP growth will fall from 3.4% in 2022 to 2.8% in 2023, with advanced economies experiencing a more pronounced slowdown. Global growth is expected to decelerate due to rising interest rates and Russia's war in Ukraine, while inflation remains high and banking strains in the US and Europe have added greater uncertainty. However, Asia's domestic demand has remained strong despite monetary tightening, and the IMF projects that the region will contribute more than half of global growth this year. This will be driven primarily by the recovery in China and resilient growth in India, with the latter projected to be the fastest-growing major economy in the world. With growth in the range of 5.5% to 6.5% according to various market participants, global institutions, and central bankers.

Inflation: The latest inflation numbers in India have been encouraging, with some pleasant surprises. The most recent measurement of 5.66% in Mar-23 (vs forecast 5.8%) was the lowest since Dec-21 and compared to a high of 7.79% in Apr-22. Furthermore, the WPI, which is the leading indicator and generator of consumer prices, fell dramatically to 1.34% in March-23 from a high of 16.63% in May-22. Likewise US CPI inflation has fallen from 9.1% seen in Jun-22 to 5% in Mar-23. Similarly Euro area inflation has fallen to 6.9% in Mar-23 vs high of 10.6% seen in Oct-22. Because of rising interest rates, sluggish growth, and dropping crude oil prices, global inflation is falling quicker than projected. However, food inflation and the second-order influence on service inflation continue to limit the rate of decline. Overall inflation remains higher than central bankers anticipated.

Interest rates: Interest rates have risen dramatically in the last 12-15 months, rising by 250 basis points in India and 475 basis points in the United States. While the RBI delayed rate hikes at its most recent monetary meeting, the primary question is whether a rate cut would take place in 2023 by the central banker globally. The task of balancing recession worries, inflation expectations, and rather stable economic indicators is what keeps central bankers occupied. Despite high inflation, the financial crisis, and a predicted systemic risk, India's external situation remains robust, as do the balance sheets of consumers, corporations, and governments.

The Near term !

Corporate quarterly earnings and FY24 outlook: While markets have been focusing on the macroeconomic situation for the last 4-6 quarters, attention must shift to corporate performance and business strategy as the fiscal year comes to a close. The outlook for the coming year will be closely monitored, especially given that the base effect of the pandemic has faded away, the recovery phase has now transitioned to a slowing growth phase, and the geopolitical situation is largely known and priced in.

The export-oriented industries such as IT, Pharma, Chemicals, and Auto Anc are expected to experience sluggish growth, while the domestic sectors such as banks, urban consumption, and luxury goods are likely to remain strong in terms of growth. However, discretionary sectors like consumer discretionary and rural consumption may experience slower growth than before. Sectors that have experienced a significant increase in raw material costs such as Autos, Cement, and FMCG are expected to recover their margins, which could support PAT growth. Observers will closely monitor commentary on growth prospects for the year, areas of investment, and strategies for navigating the rapidly changing business landscape.

Banks and NBFC: The banking sector is expected to see a boost in profitability growth driven by robust credit expansion and improving asset quality. Despite these positive developments, the industry will face challenges related to net interest margins, slowing growth on a high base, and potential risks to asset quality, which require careful navigation by market participants. Looking ahead, FY24 is set to be a pivotal year for banks, as their investment in technology gains greater scale and begins to differentiate winners from laggards. Those that have made appropriate investments in this area are likely to experience faster growth, while those that have lagged behind will face slower growth, greater pressure on profitability and asset quality, and less efficient employees.

Capital Goods: The sector is expected to experience a surge in growth due to the confluence of favourable factors such as strong execution during the season, robust order books, and supportive government expenditures at the central and state levels. Moreover, the return of private capex is expected to further bolster growth prospects. Margins are anticipated to benefit from declining commodity prices. The outlook for the sector remains robust as government spending is projected to remain strong, especially in the areas of roads, railways, and defence. The implementation of Production Linked Incentive (PLI) schemes aimed at promoting domestic manufacturing, decarbonization, import substitution, and attracting global supply chains to India is expected to provide a further boost to the sector's outlook and drive order inflows in the short to medium term.

Autos and Ancillaries: The demand for commercial and passenger vehicles is expected to outpace that of 2-wheelers and exports. Replacement demand in the auto ancillary sector is expected to remain stable, leading to higher margins and profit growth. While revenue growth may be lower in FY24 than in FY23 due to the post-pandemic recovery, investors will be looking for commentary on growth, new launches, and electric vehicle strategies.

Consumption: Modest volume growth is expected in consumer staples, along with an improvement in gross margin due to lower raw material prices. However, consumer durables and building materials are likely to be lacklustre due to soft demand impacted by inflation, price hikes, and competitive pressures. Companies focusing on capital-efficient expansion and investing in technology to gain customer insights and execute strategies will likely be the winners in this cycle.

IT Services: Rapid interest rate hikes, high inflation, and fears of recession are expected to keep IT spending in the developed world soft, leading to slower growth for IT services companies. The rate of change in technology, however, is complex, making it difficult for enterprises to handle high expectations of their customers. While the first half of 2023 may be a year of consolidation, demand may return at the end of the calendar year.

Commodities: The metals and mining sector may be negatively impacted by lower pricing and pressure on margins. Lower oil prices and demand impact on capex may also affect the outlook for commodity companies. Sectors like cement are expected to gain on lower raw material prices, expanding their margins. However, moderation of demand in large economies is expected to keep the outlook for the sector in check.

The inflection point! ….

The market outlook remains uncertain as various headwinds such as the war in Europe, rising oil prices, inflation, higher interest rates and increasing COVID cases across the globe continue to persist. Moreover, equities and other risk assets are expected to be adversely affected as central banks withdraw up to $800 billion of stimulus, according to Citigroup Inc. The failure of banks on both sides of the Atlantic has caused central banks to pause tightening and inject liquidity to prevent a crisis. Markets rallied after receiving over $1 trillion of central bank liquidity. However, the US and Europe are expected to continue with quantitative tightening, which they had implemented before the bank crisis. On a positive note, China's economy has bottomed out and is showing signs of a revival, while India's strong balance sheet continues to support growth.

The Indian market is poised to react to global developments, with the IT sector in the US leading the way in terms of stocks. However, in India, IT stocks have underperformed after reporting soft quarterly results and guidance. On the other hand, banks and conglomerates have exceeded expectations with their financial performance so far. The Indian market faces challenges such as rising oil prices, a heat wave, and the possibility of a poor monsoon. Despite this, retail investors continue to show interest in investing in Indian markets, while domestic institutions have sold shares in recent times.

Over the last three years (FY20-FY23), NIFTY earnings have grown at a compounded annual rate of approximately 20%, with FY22 delivering a remarkable 30% growth driven by post-COVID recovery, abundant global liquidity, and healthy margins. However, FY23 was impacted by supply chain issues, geopolitical uncertainties, rising inflation, and rapid interest rate hikes. Going forward, we anticipate earnings to moderate to a CAGR of 14-16% for FY23-FY25, as we enter a more normalised phase with peaking inflation, a stable/falling interest rate environment, and tighter liquidity conditions.

Despite the challenges mentioned above, India has demonstrated remarkable antifragility over the past few years, consistently turning threats into opportunities. While the global situation appears to be deteriorating, sentiments towards India appear to be strengthening. In recent years, India has displayed antifragility in every crisis, turning a threat into an opportunity.

  • While most developed countries have encountered a counterfeit vaccine or a vaccine with inadequate efficacy, the majority of Indians are going around healthy with a digital record of vaccination.

  • Similarly, whereas the rest of the globe has leveraged since the crisis, India has deleveraged since both the GFC and COVID. Government, corporate, and household balance sheets remain strong.

  • Even during the oil crisis, by getting oil from Russia at substantial discount, rather than getting impacted, India has now turned into an exporter of Oil.

  • In a slowing global economy, while merchandise exports have slowed, mobile phone exports have increased, as have exports of business services (captive centres), which have helped the current account situation.

The ongoing banking crisis has presented India with a chance to further exhibit its antifragility. The Indian banking system is well-capitalised, with improving asset quality, and the country's external position remains manageable, ensuring a low likelihood of systemic risk. In our opinion, India is emerging as a winner in a sluggish global environment, providing a sustainable growth opportunity. India's success in areas such as vaccine rollout, fiscal and inflation management, policy advocacy, and technological advancement is already being praised on the global stage. Upcoming reforms in online commerce enablement (ONDC), quick credit for GST-compliant enterprises (OCEN), consent-based financial information sharing (Account Aggregator framework), decarbonization (net zero emissions by 2070), government machinery overhaul (from controller to enabler), and judicial reforms provide a multi-year path for the largest democratic country on earth in the AMRIT KAAL era.

In the previous three years, corporations have faced the worst of pandemics, supply chain challenges, high inflation, rising interest rates, a talent shortage, and rapid technological change. Business leaders and corporations that may transform their businesses are likely to win by :

  • investing in technologies to meet the demands of new generation millienial/Gen z and at the same time serve their loyal customers from past generations,

  • building versatile talent pool equipped with new technology, learnability and execution skills,

  • creating an ecosystem of agile supply chain which can manoeuvre with a volatile environment of availability, cost and specifications to varied markets,

  • establishing a robust ESG framework that prioritises environmental responsibility, fosters inclusive adoption of society, and promotes engaged governance.

Following the consolidation of the last 18 months, NIFTY one-year forward valuations are at 18.5x, close to its long-term averages. On FY25, it is trading at a comfortable 16.5x, with room for upside. We like private banking, fast moving consumer goods, select manufacturing/auto companies. With declining inflation, discretionary consumption is expected to return in a couple of quarters. While export-oriented themes are expected to take a back seat, they may return by the end of the year. Monsoon, oil prices, and election results are key factors to monitor. In our opinion, FY23 will be an inflection point for India, with the divergence between developed and domestic markets likely to accelerate. Once the inflation drops, interest rates start to fall and the global liquidity situation smoothens, we expect the earnings trajectory to accelerate towards the second half of the year.

Stay healthy! Stay Invested in the inflection point of India! Build a portfolio with patience in 2023 to experience AMRIT KAAL of the largest democracy of this planet!

Sumit Poddar

Chief Investment Officer & Smallcase Portfolio Manager

Tikona Capital

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