J.P. Morgan - Beta Breakout: Too Far, Too Fast ?

Indian Equities Beta Breakout: Too Far, Too Fast ?

· Hopes soaring , domestic cyclical surging

· Mid cap outperformance tends to be an early cycle reflection of increased risk appetite; valuation gap vs. large caps has narrowed significantly

· The extent of recent cyclical outperformance vs. defensive is insignificant compared to 2004-2008; sustained growth recovery holds the key

· RBI easing ban on gold imports indicate further improvement in CAD funding outlook; signal supportive of domestic sectors

· Long bond yields softened; liquid funds witness highest inflow in last one year

· FII inflows momentum moderated in equities; DII selling continues

· Quarterly earnings reported increased 12% yoy, 48% surprised positively; breadth of positive surprises are higher in Telecom, Consumer Staples, IT Services & Financials

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Soaring Expectations; Surging Equities. The first week of the new Government was all about getting the stage set. The specifics of what-lies-ahead start today, with the swearing-in ceremony. Investors are optimistic. Sectors that are expected to benefit from the manifesto-mentioned-priorities have been outperforming. Government’s policy signals over the next few months are likely to set the tone for India’s medium term growth potential and also what-to-expect-outline for equity investors. Besides the expectations from the new Government, there were limited triggers for Indian equities. SBI’s quarterly earnings boosted investor sentiment. Global backdrop remained supportive. Most key EM (Ex Thailand) saw net FII inflows last week.

Figure 1: MSCI India – YTD Sectoral performances (%)

Source: MSCI, Bloomberg

Risk comfort. Companies and sectors with higher risk-quotient are doing well. Investor sentiment seems to have changed enough to see risks as opportunities. Low growth in cyclical sectors is now a supportive base for a higher growth ahead. These hopes may become a reality if policy actions manage to meet / exceed investor expectations. How does the current rally compare with earlier recover rally? Some numbers:

· Cyclicals vs. defensives: Equities are known to be ahead of the real economy. If the growth recovery continues, the relative outperformance may also continue. The extent of relative outperformance, unsurprisingly, is insignificant compared to the 2004-08 rally.

Figure 2: Cyclical /Defensive performance

Source: MSCI, Bloomberg. Cyclical: Industrials, Materials, Consumer Discretionary. Defensives: Staples, HealthCare, IT Services and Telecom

Figure 3: Cyclical defensive relative performance and IP growth (% oya)

Source: MSCI, Bloomberg, J.P. Morgan Economics

· Mid caps tend to outperform large caps early in the recovery cycle, as the outperformance is primarily linked to the convergence in valuations. Large cap benefits more from the real economic revival, both from financial and operating leverage perspectives. Valuation gap of the BSE mid cap index has narrowed significantly. The trend herein will also be a function of recovery ahead, in our view.

Figure 4: BSE Mid Cap Index Price to Book ratio

Source: Bloomberg

Figure 5: BSE 100 premium over BSE mid Cap: PB ratio

Source: Bloomberg

· The market cap of listed Indian equities has increased a significant US$ 500 bn over the last three quarters. The amount is almost equal to India’s annual gross domestic savings. The rally, especially investment linked sectors, has “notionally” alleviated the leverage stress. Increased scope of equity fund raising and improved credit flow to the sector augurs well for the growth outlook ahead.

RBI eased norms on gold import. The Indian Central bank announced one more measure to further rationalize/ ease the ban on Gold import, last week. The concerns on CAD funding have eased substantially, and that’s allowing the Central bank to normalize these measures. India’s FX reserves have increased US$ 20 bn YTD. In a linked development, RBI’s fx interventions and seasonal factors have resulted in a southward shift of the yield curve. 3M CP rates have eased below 9%. So, while the benchmark rates are unchanged, cost of capital in India is coming down. RBI’s policy message next week will be keenly watched, especially against the backdrop of expectations of a weak monsoon.

FII buying, DII selling continues. Institutional investor activity indicated the continued trend of FII buying. The pace of FIIs inflow, however, moderated last week. DII’s, on the other hand, continued to remain on the selling side. FII inflow in debt remains healthy, taking the MTD buying to over US$ 2bn.

4Q FY earnings season –Key highlights are:

· ~60% of Indian large cap companies have reported earnings

· Adjusted profit for the J.P. Morgan covered large cap companies’ increased 12% 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.

· Health Care companies are reporting positive surprises led by improved margin performance.

· 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	24	20	(16)
Consumer Staples	37	42	13
Energy	86	98	14
Financials	168	177	5
Health care	12	12	8
Industrials	34	22	(37)
IT Services	88	123	39
Materials	31	37	18
Telecom	14	22	59
Utilities	0	(1)	(547)
Total	494	552	12
Ex Energy	408	454	11

Source: Bloomberg, J.P. Morgan

Figure 6: Quarterly Earnings: Meet/ Beat expectations composition

Source: J.P. Morgan