Notes from the CIO's Desk: A Comprehensive Analysis of the Indian Market

As India navigates through its crucial election season, the market's response has been telling. The country stands at the cusp of solidifying its position as one of the world's largest and strongest economies, driven by an investment-led growth phase. This period coincides with an earnings season that aligns with expectations, showcasing the resilience of domestic cyclicals amid broader market dynamics. Amidst this backdrop, geopolitical influences and institutional investor behaviours add layers of complexity and opportunity. With the Indian market contributing significantly to the global market cap and displaying remarkable corporate profitability, the interplay of these factors paints a compelling picture of India’s economic ascendancy and future prospects.

Market Stability and Adjustments

The widely discussed India Volatility Index (VIX)complacency has finally adjusted, returning to normalized levels observed during the previous Lok Sabha elections. This adjustment underscores the short-term impact that narratives and collective perspectives can have on the markets. The VIX index has doubled from its levels around April 23rd, now reaching sub-20 levels. Notably, the discussions surrounding earnings or geopolitical distortions have had minimal influence on this adjustment.

Election Turnouts and Market Implications

Lower voter turnouts for the ongoing election have been observed, with overall turnouts for all four phases being approximately 3% lower than the 2019 average. While this trend is subject to various interpretations and potential biases, we would stay away from reading too much into it. A positive aspect is that electoral outcomes in India are becoming more decisive, with widespread expectations to address socio-economic imperatives. The continuation of this trend would be a welcome development.

Earnings Season and Market Performance: A Reflection of India’s Global Market Growth‍‍

Concurrently Q4’s earning’s season is underway. The season commenced with 28 NIFTY companies announcing their results, which as expected, aligned with market expectations. Domestic cyclicals continue to bear the bulk of the burden for NIFTY, with segments such as staples, consumer discretionary, IT, and Pharma lagging. The net profit has increased by 14% YoY, sales growth by 9%, and operating profit by 7.3%. The broader consensus projects NIFTY Earnings Per Share (EPS) to grow by late single digits in FY25 and by 12%-13% in FY26.

‍We have maintained the view that the current phase of India’s growth is investment-led, and the latest quarterly results reflect this. Cyclicals and capital-intensive sectors have once again outperformed expectations. The investment ratio- Gross Fixed Capital Formation/Gross Domestic Product (GFCF/GDP) is hovering around the previous peak observed about a decade ago, approximately 34%. Along with this, the improved quality of spending is poised to create an overlapping positive effect, while Private Final Consumption Expenditure (PFCE) has witnessed a downward trend since 2022.

This has driven the continued outperformance of BETA, Value, and Size.

‍In terms of market valuations, India’s contribution to the global market cap is at an all-time high of 3.9% over the last decade and a half, ranking 4th globally in market cap to GDP ratio at around 130%.‍

Today the mid and small caps constitutes lightly over 36% of India's market cap. Interestingly, the small cap segment’s share has nearly doubled in the last 5 years, making large caps appear relatively cheaper.

The corporate profit pool is expanding, with the widely tracked corporate profit to GDP ratio exceeding 5% for the past two years. Balance sheet deleveraging has been a significant enabler, with corporate debt to GDP now at 55%, down from 62% a decade ago.

The profit pool for NIFTY Small cap 250 and their contribution to NIFTY 500 was negative in March 2018. However, by March2023, it had grown significantly, surpassing INR 1 lakh crore in a span of five years, coinciding with nearly doubling of the index's market capitalization. The trend is even more pronounced for the Midcap basket. The NIFTY Midcap 150 profit pool grew from sub-INR 7,000 crores in March 2018 to over INR 1.80 lakh crore in the next five years. Combined, the profit pool for these indices is nearly a staggering INR 3 lakh crore.‍

Their index compositions are set to undergo reasonable changes, with a significant representation from new-age ventures. The quality curve has improved, with the Net Debt to Equity Ratio (net D/E ratio) for NIFTY Small Cap 250 now at 0.28, compared to more than twice this number 5-6 years ago. The Return on Equity (ROE) has improved from 10% in 2020 to 14% in 2023, with a 21% decline in absolute net debt value, providing scope for future capex.

Given the limited comfort around valuations and incremental risk-reward concerns, the stability of the earnings profile becomes a critical consideration for any potential re-rating. A bottom-up approach becomes increasingly valuable, with a focus on reorienting allocations to managers or frameworks where agility, active top-down rotation, and value consciousness remain central.‍

‍Monsoon Forecast and Inflation Trends‍

The Indian Meteorological Department (IMD) forecast predicts an above-average monsoon this season, a welcome relief from the current severe heatwave. The collective impact of the heatwave is yet to be fully ascertained, with the food basket, particularly perishable items, remaining vulnerable. The Consumer Price Index (CPI) has been on a downtrend, with core inflation providing the requisite cushion. As such, the Reserve Bank of India (RBI) is likely to remain cautious regarding rate cuts, given India’s macroeconomic cushion, and will continue to use liquidity management as a primary tool to anchor rates.‍

‍Urban vs. Rural Consumption Patterns

Urban consumption remains stable, while rural recovery presents a mixed picture. The differential data for two-wheeler versus tractor sales and modest wage growth highlights this contrast. The government continues to be a dominant force in overall capital expenditure however, all necessary conditions are in place to encourage increased private sector participation. Capex utilization in India is around the long-term average, and the gradual deleveraging of India inc., a cleaner banking system, and rising profitability will provide the necessary cushion for private entities to expand their capex plans.

Currency Stability and Eye on US and China

India has demonstrated top-tier policy acumen in managing currency-led volatility. The INR has remained stable, courtesy of the overall stability of its external balances. The relative outperformance of the INR has been quite intrinsic to managing the overall inflation trajectory. Imagine the distortions coming into play & negative overlapping effect of the “fragile 5” days.

The US remains a key driver of global policy divergences. Despite the country-specific macroeconomic developments, most central banks are likely to align their monetary policies with the US Federal Reserve System (FED). The inconsistencies in the US policy narratives have led us to focus on the secularity and sustainability of relevant lead data.‍

Moving our focus on China, we see policy support continuing to gather pace, but broader recovery remains patchy. Its Q1 GDP exceeded consensus expectations with a final print of 5.3%, while real estate, Index of Industrial Production (IIP), and unemployment data highlight underlying weaknesses. We are comfortable being a late entrant to this recovery cycle instead of being a part of potential value trap (if any).

Geopolitical Risks and Market Dynamics

Geo-political distortions continue to remain a concern. Any potential escalations could be well measured and timed, making it a complex scenario for overall ring-fencing. We are of the view that geo-political concerns are going to be a recurrent phenomenon and will require continued rethinking around risk mitigation. Subtle complacency in this current environment, could result in an unfavourable surprise.

Foreign vs. Domestic Institutional Investors

Amid these concerns, it is important to focus on the dynamics between Foreign Institutional Investors (FIIs) and Domestic Institutional Investors (DIIs). There is limited merit in focusing on short-term flows, especially those driven by Foreign Institutional Investors (FIIs). A pivotal aspect of the discussion is the growing influence of Domestic Institutional Investors (DIIs). The FII to DII ownership ratio is at an all-time low of 1.10 as of March 31, a significant drop from 1.99 in 2015. The share of domestic mutual funds' ownership in the National Stock Exchange of India (NSE) is at an all-time high of 8.81% as of December 31, 2023, while FII ownership within India has reached its lowest level ever.‍

This dynamic suggests that any sizeable market correction is likely to be absorbed quickly, as observed from mid-February to March, while a prolonged or long-dated correction seems unlikely for now.‍

In A Nutshell‍

India's macroeconomic story is well-established and widely discussed. Lead indicators continue to show robust performance, with minimal concerns about sustainability. With national elections concluding soon, discussions will shift towards future policy directions. Barring any major surprises, it will be business as usual.

Investors who have prudently built buffers will be well-positioned, while those in for the long haul need not be overly concerned. A significant market de-rating appears unlikely at this stage. Earnings trajectories will be closely watched, given their importance to India's market premium. The second half of the year may see time corrections rather than price corrections, presenting opportunities for strategic deployments.

Until then, capitalize on market noise that offers a margin of safety, as it may not last long given our macroeconomic stability. Patient capital knows what needs to be done.