Industrials may shed gains after May 16

For rally to sustain, capex revival, fall in interest rates and reversal in currency depreciation needed

Industrials or capital goods and construction sector companies have had a good run over the past six months. These stocks have outperformed the broader market by 48 per cent on the assumption that a reform-friendly government is set to come to power in May. But weeks before the results, strategists are asking whether this run-up is justified and if elections have any bearing on these stocks. Morgan Stanley has analysed six elections since 1992 and has come to the conclusion that there is a positive correlation between the performance of industrials and elections. The outperformance lasts for nine months, two-thirds of this is typically before the elections.

Clearly, the hope rally peters off after the actually government takes charge. JPMorgan’s Asia Pacific equity research teams says: “Hope that a reformist and stable government will take charge post general elections is fuelling a broad-based rally in industrials and asset owners. The promise of swift policy action to remedy bottlenecks is a potent one, but in select stocks, expectations appear disconnected with fundamentals.”

  Even if a reformist government comes to power, fundamentals of companies will not change overnight. Several companies in the industrials space are battling high debt and negative cash flows, in one of the weakest capital expenditure cycles the country has seen in 40 years. While the euphoria of a turnaround in investments is a lure, cautious analysts are advising investors to stick to companies like NTPC, Adani SEZ, Tata Power, JSW Energy, which own assets, have balance sheet headroom and a strong pipeline of projects.

Currently, the market is pricing in a favourable government to get a clear majority. However, this seems rather optimistic, as the base case seems to be one of the two large coalitions (UPA or NDA) forming the next government, with the help of regional parties. But a new government is no guarantee for economic revival. At present,  infrastructure developers, EPC and capital goods companies are faced with a severe cash crunch and a weak capex cycle. As much as reforms are important, three things have to fall in place for a sustained improvement in the earnings of these companies. The capex cycle has to revive, interest rates must fall and some of the currency depreciation needs to reverse, such that these companies can repay foreign debt. Morgan Stanley says: “A return of capex is key to survival – several large companies in the industry are already in corporate debt restructuring or have applied for it.” While the capex cycle is set to pick up, interest rates and currency are unlikely to turn in a hurry.