Global strategy

Market outlook

Alexander Redman Indian equities: On borrowed time

[email protected] Ten reasons to book profits on India
+44 20 7614 7173
We call time on the 20-month rally in Indian equities, lowering our exposure to
India within an AC APAC ex Japan portfolio to 40% underweight. Our concerns
range from elevated energy and broader input price pressures applying downward
pressure to margins, the current account balance and thus currency outlook, the
withdrawal of RBI stimulus, and a lack of upside implied by Indian equities’ typical
macro drivers. Rich valuations, a high probability of earnings disappointment, and
a potential lack of marginal buyers add to our motivation to book profits on India.

12 November 2021 So far 2021’s top performing Asian equity market

Delivering a US dollar price return of 147% since the March 2020 trough (or 29% since
Global 1 January 2021), India ranks first among Asia regional peers on year-to-date US dollar
performance – outperforming MSCI AC APAC ex Japan by 56%. Among the larger emerging
Macro Strategy markets, it has been outpaced only by net energy exporting countries.
High energy costs, peak margins and stimulus withdrawal top our list of concerns
We call time on the 20-month rally For at least the past two decades, elevated energy prices have been closely associated with
in Indian equities, lowering our phases of Indian equity underperformance. We are now back in such an episode of energy
exposure to India within an pricing for the first time since 2013. More broadly, a record PPI over CPI spread heralds the
AC APAC ex Japan portfolio to
start of margin compression from peak levels. Moreover, the RBI has begun the withdrawal
40% underweight.
of its stimulus programme with a visible reduction in banking system excess liquidity.
Slowing macro drivers, lack of marginal buyers and potential EPS disappointment
Based on CLSA projections for India’s industrial production, M3 money supply, rupee
exchange rate, and the headline US ISM survey, our regression model process indicates no
further US dollar upside potential for Indian equities over the next 12 months. Plus, after
strong non-resident purchases of Indian equities in 2020 followed by sustained domestic
buying driving 2021 returns, there appears to be a lack of marginal buyer looking into 2022.
Demanding consensus EPS forecasts (25% 12-months forward) may likely be once again
subject to a slew of negative revisions as has typically been the case in India historically.
Rich valuation, eroding external position, weak credit growth, inferior value creation
India is trading on 31.6x cyclically adjusted earnings (versus 14.7x for overall EM), more
than one standard deviation above its 18-year average of 22.6x, with investors paying more
than twice the book multiple for Indian assets versus EM despite the market offering the
same profitability. As India’s current account position slips back into deficit, we forecast a
commensurate c.4% weakness in the rupee to USDINR78.5. Finally, we argue that limited
credit growth will continue to constrain India’s overall GDP and that a backdrop of inferior
relative value creation (versus EM) is typically not conducive to sustained outperformance.

India absolute and relative performance versus energy prices

www.clsa.com Note: *Brent crude; ^Australia (Newcastle) thermal coal FOB. Source: CLSA, MSCI, Refinitiv

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 Indian equities: On borrowed time Global strategy

So far 2021’s top performing Asian equity market

Delivering a US dollar price return of 147% over the 20 months since the
March 2020 trough, MSCI India has outperformed MSCI AC APAC ex Japan by 56%
over the duration.

Figure 1

India has been Asia’s most MSCI India absolute and relative performance (US$ price return)
lucrative 2021 investment
destination for equities

Source: CLSA, MSCI

India is ranked first among Asia regional peers on year-to-date US dollar

performance (on MSCI indices). Among the larger emerging markets, it has been
outpaced only by the net energy exporters of Saudi Arabia, UAE, Russia, and Kuwait.

Figure 2

India versus emerging market and selected developed market indices (US$ year-to-date price performance)

Source: CLSA, MSCI

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 Indian equities: On borrowed time Global strategy

Ten reasons to book profits on Indian equities

We take India to a 40% We lower our recommended exposure to India within an AC Asia Pacific ex Japan
below benchmark allocation equities portfolio to 40% underweight on account of the following 10 concerns:

1. High energy prices are associated with Indian underperformance

India imports 83%, 56%, and 30% of its oil, gas, and coal consumption, respectively,
on BP statistical data (averaged over the past three years), with oil, gas, and coal
accounting for 29%, 7%, and 55% of the country’s primary energy needs,
respectively. Thus, acutely high energy prices (as defined by the average of the real
oil and real coal price in excess of US$100 in 2016 dollars) are typically consistent
with the erosion of India’s external position, sustained episodes of Rupee weakness,
and ultimately Indian equities’ underperformance of regional equities.

Figure 3

Elevated energy prices India absolute and relative performance versus energy prices
typically spell the end of a
rally in Indian equities

Note: *Brent crude; ^Australia (Newcastle) thermal coal FOB. Source: CLSA, MSCI, Refinitiv

Importantly, a sustained fall in oil and gas exploration and production investment
by global supermajors owing to the 2014 through 2020 oil price decline, coupled
with intense pressure from ESG-related shareholder activism, may well sustain this
phase of elevated hydrocarbon pricing.

Figure 4 Figure 5

Global oil&gas sector CAPEX versus proved reserves Global rig count versus real oil price

Source: CLSA, Refinitiv - Datastream, BP Source: CLSA, Baker Hughes, Refinitiv

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 Indian equities: On borrowed time Global strategy

Moreover, demand dynamics are fast normalising as the global economy reopens
through the latter stages of the pandemic. OPEC spare capacity has corrected back
to its historical range, while US reserve days of consumption have dropped to the
lowest levels since 2008.

Figure 6

Meanwhile demand US petroleum reserve* days of consumption versus OPEC spare capacity
dynamics are fast
normalising

Note: *Total reserves including SPR. Source: CLSA, US DOE, OPEC

2. Soaring input versus output cost pressure will erode margins

Evidence of corporates struggling to pass swiftly rising input costs – related to
global energy price appreciation and pandemic-induced supply chain disruption –
on to end customers (as proxied by the PPI less CPI differential) threatens margins.

Although this is a global phenomenon, this is particularly acute in India where the
positive spread of PPI (or WPI) over CPI at 640bps is by far the highest in two
decades. Given the strong historical coincident association between this differential
and India’s corporate margin cycle, we argue that this heralds the start of margin
compression for India with important implications for the country’s relative
profitability dynamics and, thus, relative asset-based multiples versus broader
emerging markets (see point 7 below).

Figure 7 Figure 8

India net profit margin versus PPI (WPI) less CPI Global net profit margin versus PPI less CPI

Source: CLSA, Refinitiv – Datastream Source: CLSA, Refinitiv - Datastream

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 Indian equities: On borrowed time Global strategy

3. The RBI has begun the withdrawal of its stimulus programme

On 8 October, RBI Governor Shaktikanta Das announced the suspension of the
central bank’s Government Securities Acquisition Programme (quantitative easing)
while maintaining the benchmark repo rate at 4%.

Banking system excess liquidity (defined as net borrowing from the RBI adjusted
for banks' excess cash reserves held at the RBI), which peaked at INR10tn in early
September, has moderated to INR8.4tn by early November and is subject to further
withdrawal via the RBI’s use of reverse repos.

On CLSA economics team forecasts, Indian inflation will fade towards the RBI’s 4%
medium-term target by end-FY2024 (March) from an uptick to 6.2% in March 2022,
while they anticipate the first interest rate hike in April 2022 for a cumulative 50bps
of tightening by March 2023.

Figure 9 Figure 10

India banking liquidity index* India inflation versus policy rate

Note: *Daily outstanding banking system net borrowing from the RBI adjusted Source: CLSA forecasts
for banks' excess cash reserves held with the RBI. Source: CLSA, Bloomberg

4. The outlook for India’s typical macro drivers suggest no upside

Four-fifths of MSCI India’s monthly US dollar price returns over the past two
decades may be explained by the combination of monthly movements in India’s
industrial production, M3 money supply, rupee exchange rate versus the US dollar
and the headline US ISM survey. Currently, this framework suggests a significant
disconnect between the index level change warranted by momentum in these
underlying variables and the actual index level to the tune of MSCI India appearing
some 23% overbought.

Summing the products of the historical regression coefficients (calculated using

year-on-year changes in the independent variables) with our 12-month forecasts
for each of these traditional macro drivers of Indian equities, enables us to generate
a US dollar MSCI India price target. Looking a year ahead, there appears to be no
upside potential for MSCI India based on the following suite of macro projections:

(i) India’s year-on-year IP growth moderating to the two-decade average of 3.2%

from the current 6.0%;

(ii) US ISM moderating to 56 consistent with the CLSA 2022E US real GDP growth
forecast of 3.8% from the current survey print of 60.8;

(iii) CLSA’s forecast for 12.6% M3 growth over the duration; and

12 November 2021 [email protected] 5

 
  
 Indian equities: On borrowed time Global strategy

(iv) A USDINR exchange rate at 78.5 in 12 months’ time on CLSA economics team
projections (see Eye on Asian Economies: Rebalancing, tightening and critical mass,
26 September 2021).

Figure 11 Figure 12

Model predicted versus actual MSCI India Four factor regression model for MSCI India

Source: CLSA, MSCI, ISM, MOSPI, Reserve Bank of India, Refinitiv Source: CLSA, MSCI, ISM, MOSPI, Reserve Bank of India, Refinitiv

5. There is an absence of fresh marginal buyers for Indian equities

In the 12 months from April 2020 through end-March 2021, net purchases of Indian
equities by non-resident investors surged by US$38.4bn (or by 1.8% of total market
capitalisation) versus a cumulative US$8.7bn recorded in the five previous years.
Then since the start of April this year the pace of net foreign equity purchases
slowed considerably and has latterly started to modestly reverse for a cumulative
US$1.2bn of net selling over the past seven months.

Even so, pan-emerging market equity investors (those funds tracked within the
EPFR Global universe) remain 1.3ppt (or 1.1x) overweight Indian assets relative to
the MSCI EM benchmark (ie, at a 13.5% allocation versus the 12.2% index weight)
– see Global Quant strategy: Know the flows, 8 November 2021.

Whereas demand for Indian equities has been primarily domestically driven this
year (with cumulative net equity investments by domestic mutual funds of US$8bn
since February), the pace of these purchases has also more recently begun to wane.

Figure 13 Figure 14

India cumulative non-resident net equity purchases India cumulative net equity investment by domestic mutual funds

Source: CLSA, Central Depository Services (India), WFE Source: CLSA, Securities & Exchange Board of India, WFE

12 November 2021 [email protected] 6

 
  
 Indian equities: On borrowed time Global strategy

Furthermore, with the equity allocation on average among Indian domestic mutual
funds already the highest among emerging market peers (39% versus the simple
peer average of 19%) and the earnings yield to bond yield ratio at just 0.7x being
the lowest since May 2008 (indeed it has only been lower for 6% of the time this
century), there is questionable incentive for an extended episode of the current
domestic equity euphoria.

Figure 15 Figure 16

India earnings yield to bond yield ratio Asset allocation of domestically domiciled mutual funds (% of
total, as of end 2Q2021)

Source: Bloomberg, IBES, MSCI Source: CLSA, Investment Company Institute

6. Significant risk of disappointment from demanding EPS outlook

As is the case for the majority of emerging markets at present, delivered EPS growth
for India is positively surprising versus consensus expectations made 12 months
ago. However, this is a particularly rare occurrence for India – a market in which
consensus expectations have a well-deserved reputation for optimism. Indeed, the
actual EPS growth outturn has disappointed relative to estimates for 83% of the
time over the past 26 years and by, on average, a significant 14ppt margin.

The only sustained episode of EPS growth surprise for Indian equities since the mid-
1990s lasted for 24 months through 2006/07, averaging a 7ppt greater than
anticipated growth outcome over the duration versus consensus forecasts.

Figure 17

EPS growth estimates have MSCI India earnings growth: forecast versus delivered
disappointed in India for
more than four fifths of the
time since the mid-1990s

Source: CLSA, MSCI, IBES

12 November 2021 [email protected] 7

 
  
 Indian equities: On borrowed time Global strategy

The latest headline 25% consensus 12-month forward local currency EPS growth
estimate for India (for overall EM it is 11%) appears particularly demanding given
12-month trailing delivered EPS growth is running at 32%. Moreover, overall market
earnings revisions have now neutralised. Indeed, India recorded amongst the
swiftest reversal in earnings revisions of any emerging market from their respective
2021 cycle peaks. However, at an individual sector level, revisions for financials,
consumer, and energy have now moved into net negative territory.

Figure 18 Figure 19

India earnings revisions versus performance momentum India sector earnings revisions

Source: CLSA, IBES, MSCI Source: CLSA, IBES

Furthermore, although India has an established reputation as a ‘growth’ market –

not entirely unwarranted given the 27-year Cagr in trend US dollar EPS at 6.7% –
for the past decade the market has been anything but. The 10-year Cagr in trend
US dollar EPS since November 2011 has actually been negative, albeit very
modestly (-0.6%).

Yet sell-side analyst consensus growth estimates remain as buoyant as ever, despite
being meaningfully revised down from woefully optimistic initial first forecasts for
every year since at least 2011. Thus, there is almost a sense of inevitability that a
set of aggressive EPS forecasts (now for 2022 and 2023) will once again be subject
to a slew of negative revisions and disappointment relative to initial expectations.

Figure 20 Figure 21

India US dollar EPS progression MSCI India consensus fiscal year EPS estimates

Source: CLSA, IBES, MSCI Source: CLSA, IBES

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 Indian equities: On borrowed time Global strategy

7. Relative valuations are richer than at any point in the last decade
Trading on a 31.6x cyclically adjusted P/E, India is currently at the most expensive
earnings-based valuation since June 2008 at more than one standard deviation
above its 18-year average of 22.6x. This contrasts with overall emerging markets
trading on less than half India’s multiple at 14.7x, or cheap to its respective 24-year
average of 16.6x.

Figure 22 Figure 23

India CAPE Emerging Markets CAPE

Source: CLSA, IBES, Refinitiv Source: CLSA, IBES, Refinitiv

India’s return on equity is precisely in-line with that of overall emerging markets,
yet investors are now paying more than twice the book multiple (3.9x versus 1.9x)
for Indian assets versus MSCI EM. Even given generous adjustment for cost of
equity and/or growth differentials for India, we find this premium unwarranted.

Likewise, a 1.0% dividend yield for India versus 2.2% for overall emerging markets
places India at the most unattractive relative yield since December 2010.

Figure 24 Figure 25

India ROE and PB relative to EM India absolute and relative dividend yield

Source: CLSA, MSCI Source: CLSA, MSCI

Finally, Indian banks appear particularly expensively positioned versus regional and
emerging market peers on a price book relative to profitability framework.

12 November 2021 [email protected] 9

 
  
 Indian equities: On borrowed time Global strategy

Figure 26

Indian banks trade on close India versus EM and APAC regional banks ROE vs PB
to three times the book
multiple of EM peers while
offering similar profitability

Source: CLSA, MSCI

8. We anticipate INR pressure with an eroding external position

On CLSA economics team forecasts, India’s basic balance of payments position will
move back into deficit from March 2023 onwards with a March 2024 estimate of
-0.8% of GDP (current account deficit of 2.5% of GDP and net foreign FDI inflows
at 1.7% of GDP). They are projecting a commensurate weakening in USDINR to 78.5
by March 2023 as the Federal Reserve leads the way on the removal of ultra-
stimulative monetary policy.

Importantly though, this forecast for c.4% rupee weakness is very measured relative
to the 21% taper tantrum-related depreciation between May and August 2013
owing to India’s steady reserve build over the duration to 20.9% of GDP currently
versus 15.2% in May 2013, as highlighted by CLSA India economist Indranil Sen
Gupta – see India thematic: A virtuous INR cycle, 14 September 2021.

Figure 27 Figure 28

India external position (4Q rolling, %GDP) India: REER versus global export market share

Source: CLSA forecasts, Oxford Economics Source: CLSA, Bloomberg, BIS, IMF Direction of Trade Statistics

12 November 2021 [email protected] 10

 
  
 Indian equities: On borrowed time Global strategy

9. Limited credit growth caps potential GDP and thus EPS growth
CLSA forecasts loan growth in India to remain at or below the pace of nominal GDP
for the medium-term as undercapitalised PSU banks continue to constrain Indian
economic output as they struggle to meet demand for credit extension.

With India’s relatively closed economy and domestic sector orientation, there is a
superior relationship in India versus emerging market country peers between
nominal GDP and EPS growth trajectories. Given the two decade historical
association between the two series, CLSA’s forecasts for nominal GDP are also
indicative of over-optimism by the sell-side analyst community for the prospects of
corporate earnings over the next couple of years (see discussion point 6 above).

Figure 29 Figure 30

India: nominal GDP versus loan growth India: nominal EPS versus nominal GDP

Source: CLSA forecasts, Reserve Bank of India, Oxford Economics Source: CLSA forecasts, IBES, Oxford Economics

10. Inferior value creation provides a headwind for outperformance

We note that historically, sustained episodes of India’s equity outperformance of
emerging markets have typically occurred with a backdrop of superior value
creation (spread of ROE over COE) for India relative to the overall EM asset class.

However, India’s value creation at 645bps is now 232bps inferior to that of EM.

Figure 31

Unlike previous episodes of India versus EM: relative value creation against relative performance
Indian equity
outperformance, this latest
phase has not been
characterised by superior
value creation

Source: CLSA, MSCI, Datastream – Refinitiv

12 November 2021 [email protected] 11

 
  
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