Dear Investor
In this monthly outlook we shall look at the following:
• Macro situation is less favourable vs last period
• Time for alpha
• How the market has shaped up over the last 2 decades
• Valuations
Indian market, Nifty, has just crossed its previous all-time high. However, since over 6 months have passed in the interim, valuations are still 6-7% lower than the previous time the index traded at the same level in Nov’22 on account of compounding of earnings in the interim.
Over this period, different sections of the market have performed differently.
Midcap index had crossed 32,500 levels in Nov’21 and again came to same level in Dec’22, however, it is now trading around 10% higher, preserving valuations. Nifty, which had made previous highs during similar periods in the past, has just about achieved its past peak as has the small cap index.
Past period thus, has been favourable for midcap companies and it is seen in the performance of the space and we had been pointing out the same. Some of the reasons are as follows: –
Policy environment has been very pro-growth. From Covid lows, we have seen the government roll out policy initiatives like Make in India, Defence indigenization, rolling out of PLI benefits across the sectors, sourcing cheaper Russian crude, Ethanol policy, etc and also provided for import duty protection. India has been a beneficiary of the global sentiment to diversify supply chains away from China. Banking sector has also seen strong growth in AUM and low NPAs as a consequence of continued positive policy momentum which has resulted in improved corporate profitability and employment opportunities. While the policies benefit businesses across the market cap, but for larger cap companies, the benefits are relatively smaller given their size. Small cap beneficiaries, on the other hand, have quickly moved to the mid cap range. The key beneficiaries hence lie in the midcap space. With disruptive environment of the past period, now normalizing, the performance of the midcap part should continue after a period of consolidation.
Macro situation is less favourable vs last period
As was widely expected, after successive rounds of increasing interest rates, with inflation coming down globally, US policy makers also paused rate increase while keeping a hawkish stance. China, which is the factory to the world, has seen inflation drop to low levels as has India which is the service provider to the world. In line with drop in inflation in the source base, the end market should also see a continued drop in inflation. Lower rainfall would need to be watched for another price spike and that is a concern. Markets now expect another up to 50bps of rate increase and the US 10-year yield has moved up by around 30bps. Continued increase in interest rates in the US would mean that RBI may also wait for longer before cutting interest rates. Indian policy makers, as yet, continue to enjoy higher policy independence because our forex reserves are comfortably high and stable, though our 10 year yields have also moved up.
However, if inflation drops and remains low, we could see a change in stance of the policy makers. Higher interest rates are a headwind for growth assets. On the positive side, Q1 numbers should be better than expectations on withdrawal of Rs.2000 currency notes. People have either spent them or are exchanging them. Spending should result in better than expected sales while bank deposits have resulted in surplus liquidity in the banking system.
It is time for alpha
The positive policymaking environment has been great for the midcap space as described earlier. This has meant that the outlook for continued alpha generation is strong. New spaces such as new tech, engineering, defence, hospitals, chemicals, EMS, capital market plays have all been introduced in the market and many are seeing sustained positive business tailwinds. Since these spaces are not present in any large weight in the larger cap indices, performance here provides alpha tailwinds. At the same time at the top end of the index, we see headwinds of consolidation/ regime change in large banks and a slowdown in IT services as a result of the global slowdown. Commodity companies also face the headwinds of continued policy focus on inflation. With a significant part of index facing headwinds, and sustained growth in many spaces/themes as described above, alpha generation should be good for managers going forward.
How the market has shaped up over the last 2 decades
Over a period of time when the market moved from one peak to the another, we have seen derivative volumes move up sharply vs cash market. While derivative volumes have been strong and are gaining the volume share, cash volumes have also been buoyant over a period of time. From Rs 8trn annual market volumes in 2002, cash market volumes have expanded to Rs 143trn in FY23. While these are trends for the longer term, in the short term also we have seen derivative volumes expand and margin funded trade book increase and this should be watched. In terms of number of active demat accounts and new account opening, the pace has slackened. This is good because typically, a market peak, draws in a lot many new investors and this does not seem to be the case this time. If we track the net inflows into MFs, again an interesting pattern comes out. We have seen stronger net inflows into MFs during period of market drop vs when markets are buoyant. This does indicate that the domestic investor has come of age and has modulated investing patterns to benefit from market volatility.
Valuations
Our construct for year-end market level is 18-18.5 multiple to a year ahead index EPS. We expect FY24 EPS for the Nifty to be around 950 range and FY25 EPS to be around 1100 range. This implies a year-end target for Nifty to be in the 19500-20000 range, around 10% higher than the present. This implies less than a percent a month of index compounding and leads us to expect a period of consolidation in the market.
We continue to be focused on the growth themes as shared in the last edition such as China+1, health infrastructure, new tech, software services companies focused on growth verticals, retail banks, etc. We believe that as we go forward and economic recovery normalizes, generating sizeable growth on a sustainable basis would become more difficult and companies which are able to do so would command a premium, providing tailwinds to our high quality high growth focused investing. Any reduction in yields as a consequence of lower inflation, economic slowdown or otherwise, would also provide tailwinds to this style.
Happy investing
May the good times continue
Best Regards,
Prateek Agrawal
Executive Director – Motilal Oswal Asset Management Company Limited
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