J.P. Morgan -Indian Equities

Indian Equities Internal Risks vs. External Returns

· Large cap indices declined for the second consecutive week; exporters gained , beta lagged

· Quarterly earnings reported increased 11% yoy; 53% surprised positively

· Consumer companies are reporting muted revenue growth with stable to improving margin performance

· Growth indicators disappoint; long bond yields soften

· Real rate are stabilizing at a higher level compared to last year; limited signs of changing household preference of Financial assets over Real assets

· Changing outlook on global commodity prices is supportive of Indian equity performance; local factors need to turn favorable for a sustainable performance.

Uneasy E’s. Two of the three Es (Earnings, Electoral hopes and Economic indicators) of near term equity performance were not supportive last week. Monthly economic indicators were disappointing. Quarterly earnings reported over the weak failed to boost equity performance. The third and arguably the most important “E” - electoral hopes, provided the cushion from disappointing real indicator. Votes have been cast in 438 of 543 seats. Expectations are high from the election results on May 16th. We saw some profit booking in cyclical and high beta sectors last week.

Figure 1: MSCI India sectoral change in average money flow – Last week vs. last month (INR mn)

Source: Bloomberg, J.P. Morgan

Real rates stabilizing higher. May to August last year was a difficult phase for the Indian financial market. The risk of QE-tapering triggered a sharp depreciation of INR (27%) and MSCI India (US$) correction of 30%. Government and RBI’s urgent policy measures restored investor confidence by September-October. Compared to the last mid-year, one notable difference is that the real rates are stabilizing at higher levels. The one year OIS rate is 140 bps higher now and CPI inflation is ~200 bps lower. A higher real rate makes India a better investment destination for foreign investors. For domestic investors, the desired change in preference from Real assets to Financial assets seems to be progressing at a slower pace.

Reduced redemptions in Equities, lower inflows in debt. After four months of consistent net flows into Indian equity schemes, March turned out to be a month of net redemption. For the complete fiscal year (FY14) the net redemption was 40% lower than the year before. Retail investors have been disinterested in equities for last six years now. The subscription trend in debt funds is relatively better compared to equities but saw reduced inflows compared to the previous year.

Figure 2: Net subscription into Equity schemes

Source: AMFI, J.P. Morgan

Figure 3: Net subscription into Debt scheme

Source: AMFI, J.P. Morgan

Disappointing monthly indicators. The first month of the new fiscal started with the continued trend of weak growth. Car sales declined 6% oya, with market leader Maruti reporting a 13% oya decline. The growth remains relatively better for two wheelers (18 %oya). PMI manufacturing remained unchanged at 51.3. The weak growth indicators and likely increased confidence in RBI’s inflation glide path seems to be helping long bond yields. The 10-year benchmark yield has softened by a significant 35 bps over the last month to 8.76% now.

4Q FY earnings season – Not disappointing. Key highlights are:

· ~40% of Indian large cap companies have reported earnings

· Adjusted profit for the J.P. Morgan covered large cap companies increased 11% yoy.

· Financials have reported better than expected performance on asset quality. Growth in NIMs and fee income has been mixed.

· IT Services companies managed to meet tempered down expectations. Guidance for the next fiscal have been mixed. Company managements seem to be more focused on margin performance.

· Consumer Staples companies have reported in-line sales but modest improvement in margin. Revenue growth has been more subdued in discretionary companies.

· Cement companies have reported better than expected operating earnings, despite a challenging demand environment.

· RIL reported in-line earnings supported by better refining margin and weaker INR. .

For our coverage universe, we expect an earnings growth of 14%, (Ex Tata Steel).

Table 1: Quarterly Earnings Growth – Large cap companies under J.P. Morgan coverage

Sector	4Q FY13 PAT (INR bn)	4Q FY14 Adjusted PAT (INR bn)	Adjusted PAT Growth (% YoY)
Consumer Discretionary	12	8	(35)
Consumer Staples	12	13	10
Energy	84	88	5
Financials	84	95	13
Health care	0	0	NA
Industrials	33	17	(48)
IT Services	88	123	39
Materials	21	22	6
Telecom	14	22	59
Utilities	3	2	(46)
Total	351	390	11
Ex Energy	267	302	13

Source: Bloomberg, J.P. Morgan

Figure 4: Quarterly Earnings: Meet/ Beat expectations composition

Source: J.P. Morgan

Internal Risk vs. External Returns. Over the last four years, Indian equity investors have experienced an interesting combination of returns being influenced by external factors while risks primarily influenced by internal drivers. The external factors of easy global liquidity, India’s relatively more diversified earnings growth profile among key EM countries, and commodities not being a major source of growth have all helped equity performance. On the other hand, local growth and inflation dynamics have consistently failed to turn supportive. There is a hope that post the new Government, internal risk may reduce gradually. Aside of this hope there is an element of risk-dynamics that seems to be changing:

· Global commodity prices have not been the source of primary risk for sometime now. More importantly, the fundamental (ex the geo-political risks) outlook continues to get better. See below the forward curve of the Brent crude oil price. Also, the outlook on China’s growth complexion has likely reduced the outlook on commodity risk.

· IMD forecast of a sub-par monsoon has increased uncertainty on India’s current year growth and inflation. The timing of this risk is also complicated as the investment cycle is extremely weak, inflation is high and governments’ fiscal situation is also under pressure. But, the direct risk of a sub-par monsoon now is significantly lower giver the increased importance of non-agri economic activities

· India’s fundamental vulnerability is getting more indigenized. In a contrast to 2004 to 2008, when a slew of new sectors ranging from Insurance, Retail, Aviation, etc were investing, hardly any new sector, with the exception of Internet, seem to be focused on growth. The road towards a higher growth trajectory will have to start with higher corporate and investor confidence. A convincing action plan by the next Government could change the perception around the internal risk and external return dynamics, in our view.

Figure 5: Brent crude forward curve (US$ / bbl)

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