India's decoupling from global capital market surprising: Mukul Kochhar

Country attractive for global investment because of 'visibility for high growth', says head of Institutional Equities, Investec India.

India has outperformed major global markets over the past one year. There are reasons for India’s performance but the extent creates concern, says Mukul Kochhar, head, Institutional Equities, Investec India. Kochhar, in an interview to Samie Modak, explains the reasons for India’s outperformance and why investors should temper their return expectations for the mid-term.

Edited excerpts from an interview.

What justifies India’s outperformance to global equities over the past year?

The extent of India’s decoupling from the global capital markets has surprised. Both Indian equities as well as the currency have outperformed. The reason for the outperformance is two-fold. Firstly, the Indian economic cycle was in a clear upswing, as the double whammy of Fed tightening and commodity crisis struck in March 2022 quarter. Secondly, geopolitics has helped India, as the world starts its very difficult journey of reducing its manufacturing dependence on China. As we entered 2022, most of the reforms undertaken by the government in the past six years were set to pay off. These include banking balance sheet repair; the bankruptcy code implementation; GST implementation; business tax rate reduction and the PLI scheme. As a result of these reforms, corporate profitability has increased substantially (BSE500 profit after tax has doubled in FY23E to Rs 10 trillion+ from pre-covid Rs 5 trillion in FY20). This excess profitability should allow corporate capex to pick up over the next few years.

Even as current consensus expects a modest increase in capex, there is a reasonable possibility that capex recovery could be sharper, as new use cases in energy independence, manufacturing supply chains, and infrastructure emerge. India is one of the only major economies globally, where both the consumption and investment cycle look positive, providing reasonable visibility for high growth. This is the primary reason why India remains attractive for global investment, and has outperformed other markets.

What are they key headwinds that domestic equities face?

The biggest risk to Indian equities is valuation. Indian equities today offer low margin of safety, especially on a relative basis.  India’s premium to other markets is higher than it has ever been. India is 15 per cent more expensive than the US on a price-to-earnings (P/E) basis – the most expensive developed market, and almost twice as expensive as Taiwan – the second most expensive emerging market after India. Historically, India has traded in line with both these markets. As spoken before, while there are some reasons for India’s outperformance, the extent creates concern. At a time when dislocation in global capital and currency markets remains high, India is particularly exposed to a global risk off event. Specific to India, our balance of payment remains negative, and while not signalling a crisis, creates enduring risk to the currency and equity markets.

Do you expect the premiums to shrink?

At any time, high valuation is the highest risk to equity market performance, just as low valuations provide the best comfort on the downside. The Indian equity market is exposed today, owing to high valuation relative to its own history, and EM peers. This, at a time of increasing risk-free rate globally, seems especially risky. Mean reversion is always a high probability trade in markets, and one should expect India’s premium to shrink over time. For instance, our conversations with global EM investors reveal that most funds see India’s valuation differential as the biggest hurdle to increasing allocation. Incremental flows could drive some of this premium correction.

Domestic liquidity has played a big part in the resilience shown by the domestic market. Do you expect domestic liquidity to remain strong?

We expect domestic liquidity to tighten from here. However, it is important to understand that India’s inflation problem is not as severe as the developed world. In the US, more than 40 per cent of the CPI basket is linked to housing rents, which are inherently sticky and slow to correct. By contrast, roughly half of India’s basket is related to food and beverages that is quick to react to demand impulse. As a result, there is little need for RBI to create very tight liquidity (like in the US) to rein in local inflation—expect domestic liquidity to remain tight, but not growth-threatening. India does have a balance of payment problem that gets exacerbated by the growth differential versus other countries, but RBI has other tools to address this problem.

Will elevated US dollar and bond yields continue to weigh on FPI flows?

Over the past decade, the threat of deflation has kept US treasury yields on a declining trajectory. Given that the US is the biggest provider of capital to the world, this has created an asset valuation bubble, especially in growth assets. Now, as US treasury yields increase, it will create pressure on asset valuations globally. India’s equity market stands alone in having resisted this devaluation pressure.  High valuations in India is the biggest risk, as well as a hurdle to attracting fresh investment flows.

How has the September quarter earnings season panned out? Do you see any earnings cut going ahead?

We were expecting earnings downgrades into the quarter, and so far, earnings have delivered as per expectation.  While price weakness (ex-Energy) has weighed on commodity sector earnings, margin rebound in consuming sectors has been below par as companies have been unable to pass through past input price increases. Expect some margin recovery in 2H FY23, but we believe it will not be enough to prevent further downgrades—we calculate about 5 per cent earnings cut in BSE500 earnings (ex-banking) for FY23E.  Going into the quarter, we were expecting good performance in sectors like pharma, banking and select auto stocks.  Pharma and banking have delivered so far, and we remain constructive on the auto sector. More importantly, we are also comfortable with valuation in these sectors. Over the past few months, we have also been attracted to the IT sector, post its substantial underperformance. We upgraded the sector to neutral weight in early July, and are selectively recommending stocks that are uniquely positioned for high growth, but are still available at a reasonable valuation.

Do you expect the markets to remain range-bound like they have over the past one year? Or there is a big upside or downside in the offing?

Given high valuation in India at present, return expectation over the mid-term should be tempered.  While valuation does pose a risk to market performance, any softening of tone from the Fed, should result in a relief rally for stocks globally. Having said that, given that Indian equity markets have already performed well, we do not expect a big upside even in such a scenario.  As we get through the next six months to a year, expect the investment and manufacturing cycle in the country to pick up substantially.  This should support earnings growth in select stocks, and sectors, and an opportunity for equity investors to make reasonable returns through stock selection.