Investing in India: A tale of two cycles

Traditional Hindu scriptures imagine the existence as a series of repeating cycles. Modern science and economics also find evidence of cyclicality in many phenomena. In analysing the problem of investing in Indian equities, we examine two major cycles.

The business cycle - This is driven by the performance of the Indian economy and determines growth and profitability for a large proportion of listed Indian equities. The market cycle - This reflects the risk appetite of investors and is more difficult to quantify. It is determined by the opportunity cost of investment, confidence around growth and the fuzzy feeling investors refer to as “sentiment.” Evidence of the second cycle shows up in earnings multiples for listed equity.

Traditional valuation theory suggests the two cycles are interlinked. We argue that does not hold even for a market as large as India. The market cycle has been behaving independent of the business cycle for a while, and is determined by a broader global risk tide.

We believe the Indian business cycle should move up over the next few years. Corporate utilisations are currently low, and increasing demand combined with limited capex now mean utilisations will likely move up. This in turn will ignite corporate capital expenditure and help accelerate GDP growth.

A second, more powerful factor should help India’s economic growth – significant policy changes made over the last few years. However, there is a meaningful lag between legislation and implementation, as the ongoing process of the GST rollout clearly illustrates. Nevertheless, measures such as the GST, Bankruptcy Code and the RERA can materially improve economic efficiency over the next few years.

There is also the minor issue of arithmetic. The demonetisation exercise and GST rollout led to some disruption in FY17 and FY18. We believe this will create a very favourable, low base for macro indicators and corporate earnings in the near term. The equity investor can look forward to an improvement in the Indian business cycle from these recent lows.

The market cycle, however, is at highs and has recently started to sputter. We think strong global liquidity and rising global equity prices have led to a significant rise in Indian equity multiples. The trailing 12 month PE for the Nifty increased from 21x in January 2017 to 24x in January 2018. The re-rating for mid-caps has been larger. Trailing PE for the Nifty mid-cap index increased from 27x to 45x over the same period.

Is the re-rating a result of investors pricing in a recovery in the business cycle? Is the market prescient enough to price in the impending earnings recovery? The answer is “No”. Multiples have increased in most regions. India, on headline, has in fact underperformed emerging markets as a whole in 2017.

Indian equity investors have to therefore keep a hawk’s eye on the global market cycle. Factors such as US bond yields, the U.S. dollar and Chinese monetary stimulus will also determine local equity returns. While we are positive on the Indian business cycle, that in itself is insufficient to secure equities upside. We are cautious as we see the second, more volatile trend turning down in the near term.

By: Sanjay Mookim
(Mookim is India equity strategist, Bank of America Merrill Lynch)