Annual Strategy 2015 - Give Growth a Chance :: Edelweiss

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The economy will likely gain traction as urban consumption improves on the back of real income gains. Investment demand, as we analyse will (should) be driven by government intervention and/or through policy issues designed to attract private capital. This means infrastructure should get a fillip while corporate capex will continue to lag. We remain worried about pro cyclical fiscal and monetary policies; and would prefer government hand-holding till private demand kicks in. We are confident that inflation/growth dynamics will warrant a fast down-shift in policy rates - expect 125-150bps cut through FY16. We would like to believe that the RBI governor is holding up to rein in inflation expectations. Equity strategy for FY16, builds up on this theme and remain over weight (OW) on early cyclicals like banks and autos. We set a Sensex target of 34,400 by March FY16, with upside risk as cost of capital falls and growth visibility improves. Indeed, we have a Nifty target for 2025 as well - a USD3.5trn capitalisation. Investors will have to think through hard to bet on survivors amidst changing consumption patterns, evolving government regulations and appreciating the impact of radical process innovations.

This is likely India`s decade -everything that needs to go right is going right. Frankly, being not invested in India will be a far bigger risk than not correctly anticipating a minor correction. Happy New Year and have a great time ahead!!

Economy: Ending the growth eclipse

After decelerating for 3 years, economic activity stabilised and in fact gained traction in FY15. We expect this pace to pick up in FY16. Exports momentum (a significant support so far) may temper down, but domestic demand should gradually start complementing. We are bullish on urban consumption (aided by improving real incomes and consumer confidence), although rural weakness is playing out as we anticipated (rural wage growth near 10-year low). Essentially, we foresee domestic demand gradually re-orienting back towards urban.

Still, the larger issue is one of uncertainty around investment cycle. We analyse the trend in capital formation in various sectors over the past 3 cycles - FY98, FY02 and FY09. We find that in FY98, infrastructure capex led the investment cycle while manufacturing lagged. In contrast, FY02 and FY09 cycles saw manufacturing capex leading the way. This time, capex in manufacturing has been hampered by large idle capacity (4-year high), while weak corporate balance sheets are holding back infrastructure (debt-equity at 20-year high). Thus, the government will have to do the heavy lifting through public spending (as in FY98 cycle), until lower cost of capital and recovering demand crowds in the private sector. Indeed, the government`s intention to enhance fiscal allocation to infra projects, easing land acquisition norms and expediting project clearances is a good beginning.

Policy response: Arguing for a 125-150bps rate cut

Pro-cyclical fiscal and monetary policies have been a striking feature of past 3 years of economic downturn, perhaps explained by build-up in macro vulnerabilities. Most demand indicators like core inflation, CAD and credit growth suggest risks are lop-sided towards growth. The RBI governor`s hawkish stance this far is most likely the last assault on inflation expectations. The real debate in our view has now shifted from "when" to "how much". We are confident of a 125-150bps cut through FY16 - this is based on yield curve dynamics seen across cycles in India and the RBI governor`s tacit guidance on long-dated real rates in a normal cycle. The US Fed backs growth with negative real rates in a down-cycle, once inflation pressures have receded. Also, pro-cyclical fiscal consolidation is a self imposed constraint and should be re-visited in the coming budget - Arvind Subramaniam has highlighted so in the mid-year economic review while arguing for counter-cyclicality.

Risks: "Events, dear boy, events"

This famous response of British Prime Minister Macmillan in late 1950s to the question of what could derail his government appropriately captures the risk scenario as we enter 2015. Crude oil is down by more than 50% from its peak, the greenback is unusually strong, while safe-haven bond yields are hugging historic lows. These are typically harbingers of risk and should not be overlooked. While the crude fall is an unmitigated blessing for India`s real economy, possibility of potential default by any large oil/commodity exporter and subsequent EM contagion cannot be ruled out. As regards USD strength, ECB actions hold the key. We argue that EUR/USD may already be pricing in large expansion in ECB`s balance sheet and by the time ECB actually launches QE (late January?), bulk of USD strength should be behind us. In the past, USD too has reacted more to Fed talk of QE than to actual expansion in the Fed`s balance sheet. This should restore risk appetite in global markets. However, any disappointment with ECB, or adverse outcome in Greece elections, would only reinforce greenback`s strength which could be disruptive for global capital flows.

Equity Strategy: The 2015 to 2025 journey

For the very immediate in 2015, our equity strategy builds on our macro theme of a fast reset of policy rates - we favour early cyclicals like banks and consumer discretionary. Despite our conviction on trend in policy rates, our bets are still non-consensus so as to say stick with private sector banks. Unlike previous cycles, PSU`s have pension liabilities, lower CAR and provision coverage ratios which will limit ability to recapitalise through trading gains. Within consumer discretionary, autos remains our big bet with a preference towards four wheelers.

Our second big conviction theme is an eventual return of urban demand even as rural slowdown gathers pace. It`s easier to predict what to avoid rather than what to buy. We are underweight on consumer staples and prefer urban-centric plays like Havells and Asian Paints. Our bets in investments are selective and expect corporate capex and power with high output gap to lag recovery. Meanwhile, government`s focus on infrastructure should pay through direct intervention and/or through policies that attract private capital. We are now turning bullish on EPC companies and expect a cyclical recovery in RoEs. Housing finance companies are the best proxy to revival in the interest rate sensitive real estate sector.

2025: The USD3.5trn Nifty opportunity

While Nifty compounded nearly 14% over FY04-14, almost 40% of Nifty`s current market cap is explained by companies that did not exist a decade ago. This churn demands explanation and will also serve as a guide to better long term portfolio planning. We analyse how: (a) evolving consumption patterns; (b) government reforms/regulations; and (c) radical process innovations re-inforce each other and enable outsized investment opportunities over the long run. Indeed, we believe that the Nifty could be worth USD3.5trn in 2025, of which almost USD1trn could be created through newer categories and/or spin offs. Within financial services, life and general insurance companies will play a key role. Technology could be most disruptive and on demand companies (e-commerce, platform aggregators) could be the new darlings. Consumer discretionary will have more options in organised retail, media, OOH services, etc.

We believe it will be important to think through the critical impact of these big trends. Will India bypass organised retail? Will physical distribution matter? Will brandability increase or decrease? Will data kill voice? Indeed, it surprises me that a new Chinese start-up "Xiaomi" has been able to create USD45bn market capitalisation in just about four years and is the third largest player in mobiles - with an online model only.

We don`t have all the answers but believe it`s time to lead these arguments more forcefully in the investing space.

We are excited getting in 2015 and beyond, almost everything that can go right is indeed going right.. Stay bullish and we wish our clients successful investments in 2015.

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