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Equity Market Update - March 2017

Indian equity markets continued the strong up-move in the month of February 2017. The large cap Nifty index rose by 5% (USD terms) while the Nifty Midcap index rose 8.24% (USD terms). This has been aided by strong flows into domestic mutual funds and some signs of revival in net inflows by Foreign Institutional Investments (FIIs). The net investments into equity markets by FIIs in the month of February 2017 stood at USD1.40Bn while Domestic Institutional Investors (DIIs) were net investors to the tune of USD138Mn. Despite, the month of February 2017 being an event heavy month, the Indian markets have been resilient. The month started with the presentation of the Union Budget which clearly outlined the governments focus on rural and infrastructure spend. This was followed by the completion of the corporate earnings season and the monetary policy announcement. The market will now focus on the outcome of the state elections (particularly Uttar Pradesh and Punjab) as well as the timelines for the implementation of the Goods and Services Tax (GST). The government has stated that they are on track to implement the same by July1, 2017, having received the consent of all the states. The implementation of GST would be a key structural reform in the overall legislative landscape of India.

Q3FY17 earnings: Better than feared; FY18 earnings growth trajectory now key to valuations

Despite many apprehensions, the Q3FY17 earnings season saw a steady pace of earnings growth with the Nifty universe reporting a 10% YoY growth in profits. There has been a reduction in the pace of earnings downgrades post the Q3FY17 results which augurs well for future earnings trajectory. Earnings growth was led by commodities and financials (off a low base) while telecom, technology and Pharmaceuticals reported muted trends. Smaller private sector banks and retail banks also exhibited healthy trends in terms of both loan growth and asset quality while corporate banks saw high provisioning requirements. IT companies had a tough quarter in line with seasonal trends with slower demand impacting revenue growth. Contrary to expectations, earnings numbers did not reveal a sharp impact of demonetisation in domestic sectors baring a few (e.g.: two wheelers). This is likely due to a strong festive season and the fact that the segment most impacted post demonetization would have been the un-organized one, data of which is not captured in the listed universe.

We expect that FY18 would see revival in earnings growth on the back of an improving GDP outlook and waning impact of demonetization. Growth, we believe would be predominantly led by consumption recovery as well as pockets of improvement in infrastructure spend. With the implementation of GST, we also expect that the structural movement of market share from the unorganized to the organized segment would gather steam. The large cap Nifty Index is now trading at 21xFY17e EPS and 17.5x FY18e EPS (Free float basis).

Structural shift towards financial savings likely to continue; positive for flows into mutual funds and life insurance

Post demonetization, there has been a clear shift towards savings in financial assets. This we believe would be a structural trend going forward given that investments in real estate and gold do not hold significant promise anymore. One point to note is that while financial savings as a percentage of GDP stood at 7.7%, deposits constituted 41% of the total and equity and debentures constituted only 6% of the total.

With interest rates having come down sharply , the attractiveness of deposits as an investment avenue has also reduced considerably for Indian investors. This we believe would result in a shift in financial savings from deposits to equities and debt. Post demonetization, banks have seen a sharp rise in their deposit base (mainly low cost savings and current account deposits). As the pace of re-monetization picks up, we expect to see some outflows from bank deposits towards other avenues of investment. Further, with the government encouraging use of digital channels for transactions, it is likely that the usage of cash in the economy would see a downward movement as well.

Monetary policy: shift in stance from accommodative to neutral

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) voted unanimously 6-0 to leave the policy repo rate unchanged at 6.25%, against our expectations of a 25bp cut. Further, RBI has also shifted its stance from accommodative to neutral with the focus on achieving the 4% CPI inflation target (within a +/-2%) over the medium term. Achieving a structurally lower inflation trajectory, in the opinion of RBI requires a significant decline in inflation expectation especially since the services component of inflation that is sensitive to wage movements, has been sticky. The shift in the policy stance to neutral even while keeping rates on hold is to assess how the transitory effects of demonetisation on inflation and the output gap play out. However, the ‘ex ante' liquidity stance will continue even while surplus liquidity should decline with progressive remonetisation.

Policy decision highlights:

  • The Repo rate remains unchanged at 6.25%
  • Consequently, Reverse Repo rate remains unchanged at 5.75% and MSF (Marginal Standing Facility) rate at 6.75%
  • All six members voted for the pause

The key reason for keeping policy rates on hold appears to be the stickiness in core inflation. Excluding food and fuel, inflation has been at ~4.9% since September 2016. RBI states that the persistence of core inflation could set a floor on further downward movement in headline inflation and could trigger second order effects. It however, acknowledges that CPI inflation in Q4FY17 would likely be below the 5% targeted by RBI and thereafter pick up pace as growth improves and the output gap narrows. The central bank sees upside risks to its base inflation projections from higher oil prices, exchange rate volatility and fuller effects from the housing rent allowances under the seventh pay commission.

With the change in policy stance, we believe that policy rates would stay on hold in the near term (this is opposed to our earlier expectation of reduction in policy rates by 25-50bps).

The room for further rate cuts would open up if:

  • Core inflation moves significantly below the 5% mark
  • Global commodity prices stay benign and
  • Fed's interest rate cycle is more benign than is currently built in

As per our estimates, we believe that CPI inflation would average 4.5-5% in FY18.

Real GDP Growth: Q3FY17 numbers reveals limited impact of demonetization; Growth recovery likely in FY18

The Central Statistical Organization declared the numbers for Q3FY17 GDP growth as well as the second advanced estimates for FY17 real GDP growth. The second advance estimate (2nd AE) for FY17 surprised with real GDP growth of 7.1% implying that demonetization has had limited impact on the economy. However, CSO's real GVA (Gross Value Added) growth estimate for FY17 has now been revised down to 6.7% as against the first estimate of 7.0%. The relatively better net indirect taxes growth estimates helped keep real GDP growth steady at 7.1%.

Real GVA growth in Q3FY17 stood at 6.6% YoY only marginally lower than 6.7% in Q2FY17. The GVA growth by economic activity in Q3FY17 was led by strong growth in agriculture, manufacturing and government spending. On the expenditure side, while the strong growth in government expenditure was largely expected, the resilience of the private consumption expenditure was somewhat surprising. While we do view the data with some degree of caution, it is likely that advancement of purchases, strong Diwali led demand in October 2016 and limited data capture of the unorganized sector (which was affected the most due to demonetization) have probably aided GDP growth.

The remonetisation process is likely to be completed by Mar'17, which should help normalise economic activity going into FY18. We expect a consumption driven pick-up in growth in FY18 led by lending rate cuts, central and state pay commission pay-outs, healthy agricultural output in FY17 leading to improvement in rural wages and improved consumer confidence levels. In this respect we expect real GVA growth in FY17E at 6.6% and FY18E at 7%. Some downside risk to growth may come from the possible shrinkage of the informal sector post the implementation of GST.