India Equity Research: J.P. Morgan - The Hurry and the Hurray for Cyclicals

Indian Equities The Hurry and the Hurray for Cyclicals

· Internal signals and external noise remain supportive for Indian equities

· RBI's message can be interpreted as a shift from “hike-or-no-hike” to “cut-or-no-cut”; one year OIS has eased a significant 50 bps since the April policy meeting

· Defensive aggregate portfolio positioning is expediting the cyclical-chase; institutional portfolio beta at historic highs

· Capital inflows momentum continues; YTD long bond yields have softened across key economies

· Government in preparatory discussion and signaling mode; Union budget expected to be presented in first week of July

· Improved sentiment could be helping the bottoming out in growth indicators; analysts remain cautious

· Domestic mutual funds turned buyers of equities over the last fortnight; some new fund offerings announced

Signal and Noise confluence. The upmove in Indian equities continued last week. Since the date of election result, MSCI India has gained (6%) led by high beta cyclical sectors. Key supports for the bulls last week were: 1. Market friendly signals by the new government; 2. Interpretation of RBI’s policy message and monthly growth indicators; and 3. External developments, especially the ECB announcement on negative deposit rate and encouraging growth indicators in select key economies supported risk assets. Overall, the combination of expected higher growth, softening in long bond yields and improved risk appetite supported the performance of Indian equities last week.

Figure 1: MSCI India –Sectoral performances since the National election result (%)

Source: MSCI, Bloomberg

The hurry and the hurray for cyclicals. We highlighted in our earlier notes (links below) that if we see a repeat of 2004 to 2008 kind of accelerated growth momentum, the relative outperformance of cyclicals may continue over the medium term. There are fundamental bottlenecks that need to be addressed. Some of the known challenges are: elevated inflation, banking systems’ constrained capacity, a risk averse government machinery and excessive corporate leverage. The new Government’s initial policy signals have been well received by equity investors towards addressing these macro concerns. Translation of these signals into effective execution is the key towards the performance of cyclicals ahead, in our view. The recent outperformance of cyclicals has dimensions besides the fundamentals. Some facts:

1. Last four years of difficult domestic macro environment were relatively less turbulent for Consumer Non-durables and Export sectors. Domestic cyclical sectors consistently disappointed. The trend combined with low risk appetite resulted in a significant polarization in portfolio positioning and index weights in favor of more stable segments of the economy.

Table 1: BSE 500 index weight - Since the start of current cyclical slowdown

(%)	Mar-10	Mar-14	Change
Consumer Staples	5	10	5
Information Technology	9	14	5
Consumer Discretionary	7	9	3
Health Care	4	6	2
Financials	18	19	1
Telecommunication Services	3	4	0
Energy	15	14	(1)
Materials	14	10	(4)
Utilities	9	5	(4)
Industrials	15	8	(6)

Source: Bloomberg, J.P. Morgan

2. FIIs were the primary drivers of Indian equities over the last four years. Within FIIs, flows were concentrated in regional funds and select India dedicated funds. Aggregate FII portfolio positioning indicates that the funds were primarily deployed in relatively defensive sectors.

Figure 2: Change in FII portfolio weights (March 2010 – March 2014)

Source: CMIE, J.P. Morgan. Data for BSE 500 universe

Figure 3: Institutional holding trend – Indian Equities

Source: CMIE, J.P. Morgan. Data for BSE 500 universe

3. Post the bull-surprise in the national election result, the pace of re-balancing seems to have accelerated. Portfolio beta of domestic mutual funds and FIIs has reached historic highs. The extent of optimism/ risk appetite seems to be higher among domestic fund managers. Also, see below valuations for cyclical / SMID, which have not yet turned “optically” prohibitive based on historical trading range (Price to Book ratio).

Figure 4: Domestic mutual fund equity schemes – Beta trend

Source: Bloomberg, J.P. Morgan. Trend of top 40 growth schemes

Figure 5: India dedicated FIIs – Beta trend

Source: Bloomberg, J.P. Morgan. Trend of 15 key India dedicated funds, with aggregate AUMs of US$ 18bn.

Policy ground work. Media reports (Source: PIP) indicate that the new Government is busy in the preparatory work towards the Union budget and the 100-day-plan. The policy signals are on the expected lines of reviving growth through renewed focus on broader infrastructure and more effective / efficient use of Government machinery. Continuing with the fiscal imperative, Diesel price has been hiked by 0.50 Rs/ liter last week. The Union budget, schedule to be presented in the first week of July, is going to be the first comprehensive indication of new Government’s policy priorities.

RBI signal and external noise: The discussion in credit policy seems to have shifted from “hike or no hike” to “cut or no cut”. One year OIS rate has eased a significant ~ 50 bps since the April policy meeting. Cut in the SLR has limited direct implications. But, it’s a welcome signal with implications for fiscal consolidation and credit availability for the private sector ahead. The trend of lower cost of capital is incrementally positive for capital intensive sectors and not as favorable for sectors with higher RoCE/ cash surplus sectors. Separately, the ECB policy announcement on negative deposit rate, better than expected US non-farm pay-roll and better Chinese PMIs, all supported the performance of risk assets. Surprisingly, most key economies have seen long bond yield softening YTD. The risk of reduced global liquidity is not panning out as much as feared earlier this year.

Figure 6: Changes in 10 year treasury yields - YTD, bps

Source: Bloomberg

Search for Green shoots. The search for green shoots has increased here. There are some early signs of improvement in growth outlook. Monthly car sales increased 7.4% oya. PMI services increased from 48.5 to 50.2, the first print above 50 in last 11 months. The change in PMI manufacturing has been more muted. Core sector IP growth revived to 4.2% oya. The growth in core sector is also important as the sector is widely believed to be most impacted by policy issues and is also the source of substantial NPA problem for banks. Equity analysts remain cautious. Earnings estimates were cut across sectors last month.

FII buying, DII selling continues. Aggregate institutional activity indicates that the upmove in equities is still driven by the FIIs. DII participation has been limited. Domestic mutual funds have turned marginal net buyers over the last fortnight. Insurance companies continue to be net sellers. Retail participation has increased and is also reflected in sharp move in small and mid cap stocks. Trading volumes have increased sharply for small and mid cap stocks. Also, a few key mutual funds have announced new fund offerings, reflecting improved retail investor sentiment.

Figure 7: Mid Cap index and trading volume composition