Monthly Outlook for September 2018

Publish Date: September 07, 2018

Positive global markets, easing of trade war tensions, strong quarterly results (albeit on a low base of Q1FY18), and healthy domestic flows lifted the domestic markets by around 3% in August.

Global markets ended in the black in August on the back of better-than-expected profits in the earnings season. While there was a bit of concern on account of the currency crisis in Turkey, the markets stabilised and even moved up on hopes that a resolution to a trade dispute with China could be on the horizon.

Also, the domestic corporate earnings are on a road to recovery as reflected by the June quarter. The first quarter results of FY19 displayed solid improvement in volumes across sectors, although the growth figures are magnified by a low base of corresponding quarter of the previous fiscal.

Excluding banks and certain one-offs by companies, aggregate profits grew 26.3% year-on-year, which is quite robust even after factoring in the benefit from the low base of the previous fiscal. The misses were from autos, airlines and cement, while metals, pharma and utilities did better.

The industrial output growth in June accelerated to 7% from the May reading of 3.9%, led largely by favourable base effects and pickup in capital goods, infrastructure/ construction, and consumer durables. The retail inflation, as measured by Consumer Price Index (CPI), fell to 4.17% in July from a peak of 5% in June on the back of broad-based easing in food prices and core inflation.

While moderation in inflation reaffirms our view that the Reserve Bank of India (RBI) may remain on ‘hold’ through the rest of FY19, we remain watchful of the Rupee depreciation on the back of ongoing emerging market meltdown in financial assets. We feel that persistence of global risk-off and a consequent runaway depreciation of the Rupee may warrant unconventional measures by the RBI, including further rate hikes.

Events to watch out for this month and their impact

The Allahabad court on August 27, turned down the petition made by a clutch of private power producers, staying the February 12 circular of the RBI. The central bank tightened bad loan rules last week and reduced deadlines for resolving stressed assets through the February circular. The court instead, asked the government to hold consultations with the RBI to get some relief for the petitioners using the provisions of the RBI Act within 15 days. This order is going to affect as many as 80 large borrowers, who will now face the bankruptcy tribunal.

Related Read: Important changes to India’s bankruptcy law.

Crude prices: Any ‘hard’ sanctions by the US government on oil exports from Iran may result in a dramatic decline in Iran oil exports, which will upset the global oil supply-demand balance. The next phase of US sanctions, effective November 5, 2018, specifically targets Iran’s oil industry and among other things include sanctions against the purchase of oil from National Iranian Oil Company and other Iranian oil and gas companies; and transactions by foreign financial institutions with the Central Bank of Iran and designated Iranian financial institutions.

As per our analysis, every increase of USD 10 in per-barrel price of crude has the potential to increase our import bill by USD 11.3 billion per annum and erodes 0.40% of GDP. Higher crude prices would also increase raw material cost, working capital requirements, and operating cost for user industries such as lubricant manufacturers, and chemicals industry (including consumer staples and paints).

Emerging market currency contagion: Emerging markets (EMs), including India, would also have to contend with any contagion effect of the troubles in the Turkish economy with rapid deterioration in the macroeconomic position of the country and weakness in global economy on escalation of global trade issues. As such, EMs have been very poor performers over the past year or so, lagging the strong performance in Developed Markets (DMs). Further, strengthening of the US Dollar relative to EM currencies on the back of continued strength in the US economy and subsequent rate hikes by the US Fed could weigh on EMs.

Current account deficit and falling Rupee: Trade deficit in July widened to USD 18 billion, due to higher gold purchases and elevated oil import bill. With the current level of crude oil prices, we believe India’s current account deficit (CAD) could rise to 2.6-2.7% of the GDP for FY19E. This could keep the Rupee under pressure.

The currency has depreciated by more than 10% YTD against the Dollar, which is much higher than the long-term average as the Dollar continues to strengthen against all emerging markets led by steady growth, rise in US interest rates, and deteriorating macros in emerging markets. In our view, any further slip on fiscal deficit, given the election year, higher inflation and rising crude could further pressurise the Rupee in the coming months. However, India’s low foreign debt to GDP remains a mitigating factor.

We feel that the combined effect of a widening CAD and subsequent Rupee depreciation is likely to increase the borrowing costs of Indian corporates and also hurt incremental cost of foreign debt through higher hedging costs.

Government’s disinvestment programme: With a view to meet its fiscal deficit target, the government is intensifying efforts to raise the targeted divestment proceeds of Rs 800 billion in FY19. According to media reports, the government is looking to raise Rs 100-120 billion via share buybacks in 6-8 PSUs in the ongoing financial year. It may also mop up over Rs 100 billion through sale of stake in Coal India. Media reports indicate that a stake sale in BHEL, NMDC, MMTC and NTPC is also being planned.

We feel that in case there is a slippage in garnering the targeted divestment proceeds, there would be a risk of fiscal slippage. The BSE PSU Index has underperformed the Sensex in the past 12 months. With the government finalising plan to divest holdings in PSUs, we believe this could weigh on PSU stocks.

GST monthly collections: On the Goods and Services Tax (GST) front, revenue collections for August needs to be watched when it gets released in September. Because the government had slashed rates on nearly 100 items (mainly consumer durable goods) in July. In case GST revenue collections are weaker, it might stoke fears of fiscal slippage, especially given risks from possible pre-election spending by the government, higher crude prices, MSP hikes, and National Health Protection Scheme. This may lead to further pressure on bond yields. The government is banking on higher compliance on the direct and indirect tax side to mitigate the impact.

Fund flows: In August, FIIs bought shares worth only Rs 0.7 billion (till August 29). However, purchases from mutual funds have slowed down further to Rs 38 billion (till August 29). For YTD, FII’s remained net sellers to the tune of Rs 33.3 billion and MFs remained net buyers to the tune of Rs 763 billion.

Market valuations

The valuations of the Indian market continues to be at a premium relative to other emerging market peers as well as its own historical trend. There has also been a significant disconnect between high equity valuations and weak macroeconomic outlook (higher CAD and slippage in fiscal deficit).

India remains a richly valued market and is trading at 61% premium to the MSCI Emerging Markets Index, which is much higher than the 10-year average premium of 38%. India’s market cap-to-GDP ratio is trading above its long-term moving average (78%), but despite the sharp rally in recent years, it is still lower than the peak seen during the bull run of calendar year 2007.

On the positive side, however, earnings outlook is turning better. Consensus estimates now project 18-20% and 22-24% growth in net profits of Nifty-50 Index for FY19 and FY20. This recovery in net profits is driven by:

• 1. Lower loan-loss provisions in banks in FY19-20, post peaking of NPLs in FY18 and creation of sufficient provisions in FY17-18.
• 2. Higher global commodity prices from FY18 levels
• 3. Moderate domestic economic recovery

What we recommend

In the circumstances, we recommend investors to focus on companies capable of delivering strong earnings growth. Nifty index is currently trading at 22.2x and 17.7x on FY19E and FY20E forward earnings respectively, which is at a premium to the historical five-year average.

Portfolio strategy

We prefer accumulating stocks of companies that are exhibiting improvement in earnings (IT and banks), export-oriented sectors that are beneficiaries of Rupee depreciation, and infra players that are benefiting from government spending in a pre-election year (infrastructure companies).We also see good traction in consumption-related stocks from the automobiles and consumer durables sector.

However, key risks to our recommendation include further increase in Brent crude; emerging market risk-off trade; weakening GST collections; and slowdown in buying from FIIs and domestic mutual funds.

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