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India: Strong Growth tempered by INR weakness and high oil prices
CIO team, 30.09.2018
Concerns around the banking sector, INR weakness, impact of stronger oil prices, along with elections less than a year away are raising questions around the trajectory of Indian capital markets. Having said that, real rates are positive, the current account deficit is range-bound, the fiscal deficit is reasonable and inflation remains under control. As a result, our long term investment thesis for Indian equity and fixed income markets remains unchanged. We are, however, cautious for the short-term and would tactically reduce exposure to generate flexibility, to be able to seize the opportunities once we see stability in the INR and oil prices.
Strong growth to continue: The IMF predicts that Indian growth should reach 7.3 percent in FY2018/19 and accelerate to 7.5 percent in FY2019/20, on strengthening investment and robust private consumption. India and China now account for around half of global growth in Purchasing Power Parity terms.
Chart: India – the fastest growing major economy
Source: IMF Sept 2018
Over the last five years India has been the fastest growing major economy, with GDP increasing by an average 7.2 percent, ahead of China’s 7.1 percent. However, India’s economy is currently far smaller than China (GDP is $2.6tn and its GDP per capita is $2,000, compared to respectively $12.0tn and $8,600 for China). However, when activity is weighted by market exchange rates, India is the third largest contributor to global GDP over the past 5 years, behind only China and the US.
Headwinds to growth have emerged with rising oil prices, tighter global financial conditions, spillover risks from a global trade conflict and rising regional geopolitical tensions. India's current account deficit “CAD” widened to $15.8bn (2.4 per cent of GDP), in the quarter ending June as compared with $15bn, a year before. The weakening of the Indian Rupee (INR) against the US dollar and the rise in crude-oil prices have swelled the CAD during Q1. The INR has been Asia's worst performing currency this year, touching a record 72 against the US Dollar last week. The currency, which was around INR 63.4 at the start of the year, has depreciated by 13.6% since then.
The trade shortfall of 2.5 per cent of the GDP in fiscal Q1 is more than the Jan-March quarter’s 1.9 per cent. The widening trade gap on a year-on-year basis was primarily because of a higher trade deficit at $45.7 bn compared to $41.9 bn a year ago. Benchmark domestic yields have also followed EM peers, posting losses across the curve. The ten-year maturities currently yield 8.02 percent. However, this segment should recoup its recent losses and head towards the median consensus of around 7.8 percent.
Fundamentally, India’s macroeconomics are relatively more robust than their EM counterparts.
Chart: EM - Current account balances % of GDP
Source: Bloomberg as of September 2018
While real yields in India appear attractive, the latest forecasts for inflation from the Reserve Bank of India (“RBI”, August) are respectively 4.6 percent for 2Q FY 2019 and 4.8 percent for the second half. Inflation looks to be stable with base effects on food, housing and gasoline and a tight fiscal and monetary policy. Reduced indirect tax rates on goods and services are partially countering the pressure of rising oil prices.
The recent economic review convened by Prime Minister Modi to address the depreciation in the INR has largely focused on the capital regulations. The government has also promised to undertake measures to address the growing CAD by curbing non-essential imports and boosting exports.
India’s foreign exchange reserves are healthy and should provide adequate buffers during times of financial stress. There has been some depletion of reserves year to date due to the macro headwinds. The INR has been the worst-performing currency in Asia year to date.
Chart: Indian Rupee at Record Lows
Post sizeable intervention, the RBI’s foreign exchange reserves fell c.$24 bn during the first five months of FY 18-19, but still stand at a robust c.$400 bn. Moreover, India’s external ratios are healthy. Import cover is high, at almost 10 months, and up from a recent low of 6.7 months in August 2013.
Chart: India’s foreign exchange reserves dipping, but still strong
Concerns surrounding the non-banking financial corporations (NBFC) resurfaced early this month. Since August, Infrastructure Leasing & Financial Services Ltd., “IL&FS”, an Indian conglomerate has missed payments on several of its debt obligations. IL&FS has been facing liquidity issues for some time and has defaulted on INR 10bn debt from Sidbi, INR 1050mn Commercial Papers and INR 800mn inter-corporate deposits (ICDs). The company announced it needed to raise more than INR 300bn ($4.2bn) by selling assets to reduce debt. The company has been categorized as a “systemically important” NBFC by the RBI. Investors are concerned that defaults by IL&FS, which has total debt of $12.6bn, 61% in the form of loans from financial institutions, could spread to other parts of the Indian shadow banking system. IL&FS lost its domestic AA rating in August 2017 on their non-convertible debentures (NCD) and loans. That said, State-owned insurer LIC did comment that it will not allow IL&FS to collapse and would explore all options to revive it. LIC has the largest shareholding in IL&FS. As many NBFCs depend on short term borrowing, the recent developments have created reluctance in lending to them and there has been a further cascading effect in the debt markets causing yields to soar. RBI, SEBI and SBI have swiftly announced that they will intervene to ensure market and financial stability.
Implication for Equity Markets
We recommend some caution in the short term, and would suggest to take profits on the best performing names, and reinvest into broader Emerging Market equities or China. The volatility between the current FX tensions and the 2019 elections should provide opportunities to add, at a better entry price, to benefit from the secular positive outlook.
Indian equity markets have had a bull run since 2009 as the Nifty Index is up 208% (in US$) and 345% in INR, without a sustained drawdown of 20%. Indian midcap companies have outperformed large caps over a 5 year period as domestic demand and consumption have led to an exponential growth within this segment. This trend reversed in 2018 as the large caps continued the 2017 rally, however midcaps have not kept up. In Rupee terms, year to date total returns (net dividends reinvested) for the MSCI India Index are 5.2 percent whilst the MSCI India Midcap Index has fallen 13%. The devaluation of the INR has however taken its toll on foreign institutions and in US$ the MSCI India Index is down 7.6 percent year to date i.e. total returns (net dividends reinvested).
Chart: Indian midcap companies have outperformed the large caps over a 5 year Horizon
Source: Bloomberg data as of 24th Sept 2018, normalized to 100 as of 27th Sept 2013
Indian equity markets have been supported by strong domestic inflows which have helped balance outflows from international investors. Mutual funds have stepped up their buying in September.
Chart: PI / FII Investments - Net Equity flows
Source: National Securities Depository Ltd. 25 Sep 18 (INR bn)
Chart: Net DII Investments
Source: Moneycontrol.com (INR bn)
Corporates are confident on business growth over the next 12 months – the upcoming earnings season could show further acceleration in revenue and earnings growth. CAGR in earnings for the broader market is at 25%. Apart from the fears of a currency and trade driven financial crisis, the key risk for markets remains the election outcome in May 2019.
MSCI India is trading at a Price/ Earnings of 22.4X which is close to its average over the past two years. Growth remains an important factor for market performance. Though the Indian market has historically always traded at a premium to emerging markets it is currently almost double that of the MSCI EM Index which trades at a Price/ Earnings of 12.2X.
Sector view: Whist we are cautious in the short term, for the longer term we would position portfolios towards the stronger consumption plays as the 1.34bn population and increasing middle class will continue to reshape the economy. Hindustan Unilever (consumer staples sector) as well as Mahindra and Mahindra (auto sector) are examples of consumer companies that have outperformed the market and will remain leaders as they are in two of the highest growth sectors in India. We would also focus on consumer companies where valuations are not excessive and who are focused on India’s digitization and would benefit from the under penetration of ecommerce and digitization. . Some of the private banks who have suffered from the tension in the financial sector offer attractive entry points. We would book profits on the Technology Services sector as the weaker INR has helped IT companies achieve gains of 50 to 60% year to date.
Implication for Bond Markets
Our conviction on Indian debt remains intact and our fundamental viewpoint has not materially changed on our investment horizon. That said, we urge investors to be selective with a valuation focus within the hard-currency corporate debt. Pragmatically, we believe that in this environment, investors need to be adequately compensated for the risk. For IG with a duration of 5 to 7 years, credit spreads should be around 175bps to 200bps and sub-IG or high yield should offer credit spreads of close to 300 bps.
Chart: Indian bond yields under pressure and at levels seen in 2014
Source: Bloomberg as of September 25 2018
The banking sector has always enjoyed a strong technical backdrop, particularly amongst the international community and credit spreads remained relatively rich when compared to broader EM credit on a risk adjusted basis. We prefer the lower IG and sub-IG non-banking corporate bonds in the 5 to 7-year bucket. Oil India, Adani Transmission and Adani special economic zones, Bharti Airtel, Tata Steel, JSW Steel, Vedanta, Jain irrigation and Delhi Airport services, to name a few. However, selectivity on strong fundamentals will not protect investors from sentiment driven tensions on spreads.
Some of the measures announced by Finance Minister Arun Jaitley;
Minutes of the Reserve Bank of India’s August policy meeting point to its latest rate hike as being pre-emptive. Policy makers underscored the central bank’s emphasis on containing the recent increase in inflation at the cost of growth. Given that inflation has already started to surprise to the downside since the last meeting, we maintain the view that the trend should persist. The key highlight of the minutes was made by committee member Ravindra Dholakia, who noted inconsistencies in the RBI’s assessment on growth and inflation. He argued that the central bank’s baseline inflation projections are outsized as they account for certain upside risks and not for recent downside surprises.
Chart: Proactive policy setting by the RBI
Source: Bloomberg as of 24 September 2018
The shift in domestic bond yields has been across all EM nations driven by a combination of external factors (US tightening of monetary policies, USD-strength, global trade concerns) as well as macro and micro economic challenges (current account imbalances, fiscal and monetary policy setting etc.)
Chart: Sovereign yield curve shift
Source: Bloomberg as of 24 September 2018
Wealth Management – CIO Office. Contact: +971 (0)4 609 3564
Anita Gupta – Head of Equity Strategy
Syed Yahya Sultan – Head of Fixed Income Strategy
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