REALITY MEETS HYPE
After 18 months of outperformance (Jun-21 to Dec-22) vs. the MSCI Asia ex-Japan Index, the India market has started to give up its gains. The MSCI India is down almost 9% year-to-date (YTD). The retracement was not entirely unexpected. The manufacturing renaissance story of India has been hyped up since Covid-19. China was struggling under a zero-Covid tolerance policy and buckling under the weight of a property down cycle.
Two things changed at the end of 2022. First, China’s policy changed; with a path towards normalization laid out, China’s discount to Emerging Markets (EM) vs India’s premium to EM became glaring. Second, India’s corporate earnings and commentary started to take a downward tilt. The Indian consumer had been basking in the post Covid-19 spend. Post-Diwali, the strain of inflation and higher interest rates weighed down on household wallets. To add salt to the wounds (of the domestic economy), the demand outlook of the Internet Services sector turned murkier when a series of bank failures in the US & Europe dented confidence that information technology spends of the largest global banking customers would hold up ahead.
In essence, reality has started to collide with the hype of the ‘Remaking India’ story. Some valuation mean reversion was bound to happen. We remain positive on the longer-term, structural direction of India. We expect the India market to continue its upward trajectory once it gets through this period of aligning reality with expectations.
DATA POINTS FROM THE DOMESTIC ECONOMY
The post Covid-19, K-shaped recovery has been a feature for a while now. While the luxury segment of consumption remains relatively resilient, the mass end of consumption has taken a turn for the worse in recent months. In our view, there are a few reasons for this. Energy inflation at the pump was capped last year, as the government made the State-owned companies bear the pain of higher diesel input prices. The effects of higher commodity prices took their toll on corporate earnings quite quickly. The fast-moving consumer goods (FMCGs) and paint companies, that tried to pass on the raw material inflation, found volumes stalling at best. The consumer durables companies found that they could not pass on the raw material inflation (due to competition) found both margins and volumes suffering. As small business struggled with inflation, business confidence gradually eroded and hiring slowed. Hiring momentum in the IT sector contracted even more acutely. Consumer spending is a function of how confident one is with your income outlook and household budgeting. It took about six months for the inflation to seep into the India economy. The positive thing is that end-consumer prices have eased for most categories.
IT’S ALL ABOUT EARNINGS…
The corporate earnings squeeze is not just on the consumption sector. In the Materials sector, falling commodity prices outpaced cost decline (mostly energy). In the Pharmaceutical sector, higher logistics costs, fade-out of Covid-19 drugs and the return of United States Food and Drug Administration (FDA) inspections meant that expectations of blockbuster launches had to be scaled back. More recently, expectations for the IT Services sector took a more severe scale-back in March 2023, as global banking crisis dents confidence that the sectors’ biggest clients (banking and finance sector) will be as willing to spend on their tech budget. As highlighted in the prior paragraph, 2023 is about aligning overhyped earnings expectations with reality…
LOOK BEYOND SENTIMENT: IT’S A SLOWDOWN, NOT A CRISIS…
As global equity sentiments stutter, we see it natural that India’s valuation multiple would also retreat in line with global Indices. However, we doubt that India’s market valuations would retreat back to mean levels or below-mean levels. There are clear structural developments going on and that has not changed. We increasingly hear of corporate guidance of rising exports, greater traction with global clients, multi national companies (MNCs) willing to relocate manufacturing facilities into India. Within the domestic banking sector, we do not see any material negative impact from the negative impact of banking turmoil in the US and Europe. Most banks have high portion of retail deposits and any impact from the mark-down of bond securities on their books is relatively modest, given that yields have increased a much smaller quantum vs. developed world. The problems that the Indian banking sector typically has to deal with, is that of a traditional asset quality issue. India banks look to be relatively good bargains as the market fades.
On the bright side, if the events of March trigger a retreat in global aggregate demand (i.e. recession), falling rates and commodity prices tend to have a positive effect on India. We remain watchful for any major selldowns to add to our positions.
All data are sourced from Lion Global Investors and Bloomberg as at 21 March 2023 unless otherwise stated.
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