Dear investors
In this edition, let us discuss the following
- It continues to be time for alpha (vs large caps)
- Midcaps and small caps are seeing earnings tailwinds
- New sectors have emerged where runway of growth is long
- The direction of the economy has changed. It is Now capex led vs consumption led between 2008 and 2021
- HDFC bank increase in weight in MSCI index
- China+1: EU increases tariffs on Chinese cars
- US fed interest rate expectations
- Chinese market: consolidation phase after a sharp rally
- Expectations from the budget
- Valuations and portfolio positioning
It continues to be time for alpha
We have been talking of this for a long time now. Our basis for expecting alpha generation (vs large cap indices) is as follows:
- We believe markets follow earnings growth. After a long while, first time since 2000s, the midcaps and small caps are seeing earnings growth momentum, which has lasted for four years (since 2020) and has been significantly more than the larger caps. Since, earnings growth is higher in this space; the performance here could be expected to be higher and provides managers with an alpha opportunity.
- There are new investible areas which have emerged over the past few years and have a long runway of growth. Some of these spaces are New tech (fin tech, consumer tech companies for example), electronic manufacturing services companies, renewable power space, electric vehicles, hospitals, defense, etc. Newer spaces are less present in an index and have a longer and stronger growth runway providing alpha opportunities
- The direction of the economy has changed. After being consumption driven from 2008-2021, we are again a capex driven economy and in this respect, this period is similar to the 2000-2008 period. Change in economy direction implies lower weighted spaces outperform making it a time for alpha.
HDFC bank increase in weight in MSCI index
Domestic mutual funds (DMFs) have continued buying HDFC Bank and taken up their ownership in the company by 80bps. It is reasonable to assume that some of this may have come via selling by FPIs. This may create the required foreign room and take-up the weight of HDFC Bank by 4pp in the most popular FPI benchmark by the end of August. An inclusion into the benchmark would drive US$4bn passive buying in HDFC Bank. In addition, there is a second derivative impact for active funds. The O-WT of FPIs on banks as well as the broader financial space is less than 4pp. Therefore, this jump in neutral weight would convert FPI portfolios into U-WT on financials and banks for the first time on record. Given attractive valuations, strong earnings growth, a favorable near-term macro with no imminent rate cut, FPIs could buy more banks to bring themselves back to O-WT. This could make banks outperform just like banks in some other large markets like the US.
We are underweight banks because we are focused on spaces with far higher growth prospects. However, towards this event, we could try to bridge the underweight gap to reduce the threat of underperformance while the event plays out. Also, banks are the most liquid part of the market and positions in F&O would reflect the expectations, reducing price impact.
China +1
On June 12, after an eight-month probe, the EU’s executive arm accused China of unfairly subsidizing its industry with tax breaks, cheap loans and the like. It fears that cut-price imports pose a “clearly foreseeable and imminent injury” to European carmakers. Provisional tariffs of between 26% and 48%, compared with 10% for other imported cars, will be imposed from July on Chinese EV. China is expected to retaliate. China has hinted at raising its tariffs on large-engine (in other words, German) vehicles from 15% to 25%. Incidentally, the mover of this probe was not a company but France. While European and American car makers in China would also suffer, it reduces the attractiveness of China as a manufacturing destination. Recently, US quadrupled import duties on Chinese EVs to over 100% and doubled semiconductor duties to 50%.
US FED interest rate expectations
FOMC meeting took place in June. While the FED continued to hold as expected, the forward signals were more hawkish than expected. The median expectations is for just one cut of 25bps in 2024 (vs three in March) while there is a possibility of two cuts. Expectations for 2025 and 2026 though shows four cuts vs three. Total rate cut expectations remain the same though there is delay in the commencement of the same.
US bond yields, which had spiked over 4.7%, have dropped to 4.2%. We believe that any sustained flows to emerging markets could arise only after the yields drop below 3.5%. Lower yields would encourage investors to increase the emerging market risk in the portfolios, else FPIs flows would be contingent on re-allocation of monies from other markets. There is, yet, a low chance of investors preferring EM assets and bringing in strong inflows and Indian market should move on domestic money and fundamentals.

This is where the budgetary measures are important. Indian election outcomes could have been more definitive. Budget would be the next most followed event.
Chinese market is now consolidating and JP Morgan index inclusion debt flows are starting:
After a sharp rise from the bottom over Jan to Apr 2024, Chinese market has now been consolidating. China is the largest EM and when it works, it sucks in money from all other EMs. FPI selling in India coincided with Chinese market uptick. Before that, they were buyers in Feb and March. Now that this market is again consolidating, we expect the pace of FPI selling to reduce. In the event of the budget being good, FPIs could even turn buyers as they again reallocate. They were net positive until June 21.

FPI flows are starting in debt as well with inclusion in JP Morgan debt index and an inflow of USD2bn a month for the next 10 months. This should keep the forex situation comfortable in the coming period and hence higher relative stability of the INR.
Budgetary expectations
Net direct tax collection (provisional estimate) until June 17 was at Rs4.6 tn (21% growth) compared to Rs3.8 tn in the same period last year. The collections include Rs1.8 tn of corporate taxes and Rs2.8 tn of personal income tax. The tax buoyancy we saw last year continues.
There is a wide expectation that the government would increase spend on social causes. A budget where fiscal consolidation continues to be adhered to supported with strong buoyancy in tax collections would be helpful to the markets. Higher dividend from the RBI provides a cushion over the interim budget assumptions. Since salary and interest costs are fixed and should not change between the interim and final budget, the higher money can be spent on capex/defense/providing a helping hand to the needy, lowering direct tax surcharges, or for further budgetary consolidation.
Reduction in taxation would be celebrated. Areas which would be in focus would be dividend taxation where there is an element of double taxation. Also, peak personal taxation in India is now amongst the highest in the world and could see some reduction in surcharges.
We do not expect any adverse changes in capital gains tax rates for equities. The demand for convergence is for improvement and not worsening of the terms of taxation. Moreover, other asset classes do not pay STT. Interest of debt is tax deductible for corporates while divided is on tax already paid and yet both are taxed similarly in the hands of the recipient. Unlisted asset classes command indexation benefits and there are tax benefits for investing in real estate which do not exist for other asset classes. Equity is the smallest asset class vs real estate and debt and yet the tax collection from equities may be higher than other asset classes.
Moreover, if the taxation converges, the asset classes should be made fungible with loss in one allowed to be set off against the profit in others. We believe the ask is reduced term (from 2 to 1 year) for long term taxation for unlisted asset classes and is much easier to provide.
Indian public has been warming to equities just over last 3 years and has helped insulate our markets from the whims of the FPI, a victory which has required a lot of regulatory support and intervention. Domestic investor has come of age. On a day of the election results when the market was down sharply, mutual funds received net inflows. In fact domestic flows have been relatively stronger in months when market has been down, displaying a buy on dips investing focus. All of this is welcome, gives the market a degree of freedom over fickle FPI flows and hence, we don’t expect any large taxation led disruption while minor tweaks are possible.
PLI schemes have been the instrument of choice for the government to spur industrialization in the country. Many spaces have seen PLI benefits being extended. More of the same is expected to increase the depth of manufacturing in the country. For example, after the relative success of electronic assembly in the country, we expect to see benefits for component manufacturing to be rolled out to include and benefit more players and same could be the case for electric vehicles. Incentives and focus for manufacturing, R&D, defense, infrastructure and other areas of nation building are expected.
Budget is also an event when contours of future structural reform are often revealed. However, we believe most of the big structural reforms are now behind us and the time gap between the election results and budget is relatively short to present a fully fleshed out scheme. Our expectations on this count is low.
Overall, we believe that budget would be neutral to positive for the market.
Valuations and portfolio positioning
We are a high quality growth focused house and have built some of the highest growth EPS portfolios in the industry. We continue to be focused on global themes like renewables, China+1, and defense and domestic themes like healthcare infra, luxury consumption, capital market, new tech, telecom, etc where growth in sales and earnings is expected to be sustained over the next few years at significantly higher than index levels, leading to outperformance.
Overall, markets are valued in line with historical trends for the large cap spaces but the earnings growth outlook is better. Quality of businesses is also better with improvement in return ratios. Reduction in debt levels and improved margins are an indicator of better free cash flow generation. These are two parameters that are inputs for valuations and both are looking better. Reverse globalization and positive policy making environment is helping India Inc. We had noted in our previous editions that with better growth in earnings outlook, better governance and prospects of interest rate cycle changing direction, current period could see sustained better than average valuations, in the process pulling up long period averages supported by positive policy momentum.
Cost of capital reduction should increase the competitiveness of growth businesses over value part of the market and should provide our portfolios further tailwinds
Thank you
Happy Investing
May the Good Times Continue
Prateek Agrawal
Executive Director
Motilal Oswal Asset Management Company Limited
Source: NSE Indices, Bloomberg, MOAMC Internal Research
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