Hurdles ahead for Indian equities


India’s gross domestic product (GDP) growth of 7.2% year-on-year for its third quarter of financial year 2018 (3Q18) beat consensus expectation of 7% growth. In 2017, India saw a disconnection between its growth figure and equity return as the nation’s stock performance topped the board, but lagged in earnings and economic growth.

Investment picked up favourably while private consumption continued to slump over the quarter. Improved construction and manufacturing activities were fuelling investment growth.

The deceleration in private consumption growth was in line with our view that consumers and businesses would take time to get accustomed to the inception of the Goods and Services Tax (GST) last year.

Is the growth of private investments sustainable at this rate? We doubt so, as corporate balance sheets issues are stilla concern and the recent banking sector woes and election activities throughout 2018 could further hinder investment growth recovery.

If history is any guide, the slow-paced recovery of private consumption growth is likely to place a cap to India’s GDP growth over the next two to three quarters.

The worries around US inflation and rising bond yields triggered a pullback in shares in early February including India. The incident coincided with

the return of long-term capital gain tax (LCGT) following India’s budget announcement which worsened investors’ sentiment.

Foreign investors withdrew about US$700 million (RM2.74 billion) worth of funds from Indian equities last month.

Year-to-date (as of March 14, 2017), the Sensex Index delivered a tepid gain of 0.2% in rupee terms as Malaysian investors suffered a loss of 5.3% from the ringgit’s strength.

Manulife India Equity Fund suffered a loss of 8.3% over the same period.

Equity investors have enjoyed a tax advantage against other available asset classes in India such as realty, gold, debt funds, etc.

The introduction of the LCGT puts equities on a more level playing field. However, its tax rate is currently lower than other asset classes and together with the grandfathering provision, the negative impact on Indian equities should be modest in our view.

Analysts were generally upbeat on consumer durable, metal, and oil and gas (O&G), together with the fast-moving consumer goods (FMCG) sector.

O&G counters now enjoy better earnings prospect against a backdrop of higher oil prices.

Similarly, consumer durable and FMCG companies have better earnings visibility as demand for quality goods and services is trending higher in rural India.

Consumer discretionary and auto have dimmer prospects given consumers are cautious of the high tax rate on these luxury goods post-GST implementation.

The banking sector has several tough hurdles to clear. Poor balance sheet health, increasing non-performing loans and inadequate capital are existing challenges. The government vowed to inject funds to boost the banking system stability last year, but the recent state bank fraud has dealt a blow to the already fragile banking framework and investors’ confidence.

The restructuring efforts from policymakers that follow suit are likely to add strains and downward earnings pressure on Indian banks.

India’s information technology sector is feeling the pinch from the H-1B visa programme reforms of the US’ Trump administration.

The new legislation on visa and immigration will raise operational costs of Indian firms, while the weak US dollar environment will increase pressure on margins. Consequently, analysts are cautious on the earnings prospect for technology companies.

The various structural reforms do not bode well with earnings prospects of Indian companies as reforms usually are accompanied by short-term shocks to the economic system.

As a result, Indian firms have posted laggard earnings results thus far. The expectations of better economic prospects ahead and equity inflows over the past three years have supported the expansion of valuation multiples for Indian equities.

We believe the reforms in India will continue at this juncture and the Moody’s Investment Service sovereign rating upgrade in December last year could be the peak of its structural growth story.

Going forward, our base case is that the pain of reforms will ease gradually while the stronger foundation for the Indian economy is vital.

Market participants and equity investors are awaiting for the benefits to flow into the bottom line of Indian corporates and businesses as the high valuations suggest.

Growth-seeking investors may want to look at other Asian and emerging markets with valuations more compelling and robust earnings growth.