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Change – In Macro and Equity Investments

May 28, 2018

“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” – Mark Twain

India’s Macro Situation Could Be Improving Soon

When we stated last fortnight that macros can change quickly, we certainly did not imagine things would change in a week. But change, it appears, is afoot. Late last week, the Saudis and President Putin, representing two of the three largest suppliers of oil in the world, voiced concerns about high oil prices and stated an intent to increase crude production in the second half of the year. Brent and WTI sold off immediately, with Brent down to $75.00 from $80.50 a few days earlier.

A case can be made that crude has peaked for the year. That’s great news for equities and India, and markets made a sharp recovery late in the week. With crude selling lower, India’s weakening macro situation alleviates immediately. Were President Putin’s comment stating comfort with crude in the $60s to come about, India’s growth would only accelerate.

Current Quarter Earnings Have Led to Progress on Valuations

The second worry that ails equity markets is high valuations. Good news here as well. We computed bottom up P/Es on the 291 companies that have reported earnings to date in the CNX 500. PSU banks have reported huge net losses this quarter to the tune of a massive 46,131 crores, and we’ve excluded them from our calculations. The trailing P/E of the remaining 291 companies in the NSE 500 is 23.4 times, on quarterly run-rate earnings. As we stated last fortnight, the Modi regime average trailing P/E has been 22.9 times, so we’re not far from average and have made progress on valuation. We note though, that it’s 291 companies, so it’s premature to make conclusive statements, but the trend is certainly heartening.

A Clear Trend in Accelerating Earnings Growth Is Emerging in CNX 500 Companies…
…Especially in Mid and Small Caps

A Clear Trend in Accelerating Earnings Growth Is Emerging in CNX 500 Companies

Earnings Growth Quarter to Date Is Up 13.3%*…
…But Much Higher for Mid Caps at 29.4%

Earnings Growth Quarter to Date Is Up

… and Mid Cap PE/G and EPS Growth Are Also Superior to Large & Small Caps…

and Mid Cap PE/G and EPS Growth Are Also Superior to Large & Small Caps

CNX 500 Quarter to Date Earnings are Up 13.3% YoY, with Profit Acceleration

Earnings for the universe of 291 companies quarter to date are up 13.3% YoY. The bottom up P/E for small caps is 31.2 times, while mid caps are at 23.2 times and large caps are 22.2 times. This takes the mid cap P/E valuation to in line with large caps, while offering a much higher historical growth of 19% vs 9.9%.

While the mid cap PE/G is at 1.2 times, the large cap PE/G is 2.2 times and small cap PE/G is 3.2 times. Large caps sell at a premium to mid caps due to the predictability of earnings and business models, and demonstrably better performance during sell-offs.

The Changing Structure of Equity Investments

As we outline in the chart below, we examine rolling 100 day flows into equities by foreign institutional investors, domestic institutional investors and equity mutual fund investors. We find that the primary cause for volatility in steep sell-offs in prior years has been the volatility from foreign institutional flows.

Waning FI Flows, Rising Domestic Ownership and Stronger Domestic Flows Means We’re Less Beholden to FI Volatility

Two factors have changed the structure of equity investments in India. First, the rapid depreciation of the Rupee in the summer of 2013 decimated dollar based FI returns in India, and has led to gradually lower FI flows into India. Second, the domestic SIP investor has doggedly bought the market. Even as FIs have been sellers of Indian equities in 2015, 2016, and 2018, the market is within comfortable shooting distance of all time new highs. This is important, because it suggests that the Indian market is morphing towards a more stable and less volatile structure.

Rising SIP Flows are a Game Changer…
… FI Selling Caused a Major Sell-off in 2015…
…However, FIs Selling in 2016, 2017 and 2018 Has Been Offset by DI Buying…
…And We Expect Stabler, Deeper Equtiy Markets Going Forward

Rising SIP Flows are a Game Changer

Investment Outlook


The economy remains healthy, earnings are coming through, and structural reforms are underway. The third leg of private investment could come forward. We remain in the midst of a structural reform, productivity and demographics led bull market. Last fortnight, we made the case that equities beat other asset classes even when bought at market peaks, and valuations are likely to stay elevated due to the Modi premium, demographics, financialization and equity returns.

Reasons for Optimism

Should OPEC come through on rising supply, and the U.S. continue to raise production, rising inflation is unlikely, and RBI rate hikes are off the table for 2018. As the momentum in earnings picks up, economic growth will also pick up.

In our April 30th commentary, we noted that the economic fundamentals were healthy, but we were cautious in the short term about the weak technicals of the rally. (Investment Commentary, “The Nifty 50 and CNX ex Nifty”, Apr 30th). Markets since sold off in May, and we exited our protective put position last Thursday and Friday with respectable profits. We also reduced our cash position and deployed money into equities on Friday morning.

Significant damage has been inflicted on equities in the past few months, particularly mid and small caps. We’ve held a more cautious stance since last Fall in anticipation of these outcomes and advocated protective strategies at times of elevated risk. As usual, like a tropical storm coming out of nowhere, things can change quickly, and probably will. However, equities look better positioned today than they have in some time now.

Quality Growth Will Continue to Deliver…
Indian Titans – Sanctum’s Multi Cap PMS Portfolio…
…Is Up 23.7% During the Past Year…
…Outperforming the Nifty 50 by 12.2% and its Benchmark by 11.8%

Quality Growth Will Continue to Deliver

Fixed Income

We update our asset pairs this week in the following pages. With crude possibly topping out, the fiscal math improves immediately. Inflation fears abate. The economy remains in growth mode, and rising earnings will raise tax collections. In light of fading risks from crude, inflation and higher interest rates, we advocate a move away from short term bonds towards corporate credit. Further, current yields would appear to be at attractive levels for long term debt investors to lock in.

A case for a small exposure to duration can be made, but remains a risky call, as we have no visibility beyond a couple of quarters on interest rate movements. Our preferred strategy remains corporate credit, with exposure to both accrual strategies and credit opportunity strategies.

Earnings Growth Trends By Sector Remain Solid…

Earnings Growth Trends By Sector Remain Solid

Asset Allocation Pairs Quarterly Update

We update our asset allocation pair recommendations this week. The pairs suggest a slight tilt towards bonds over equities, a slight preference to large caps over mid caps, preference for corporate bonds over G-secs, short term over duration in debt, a tilt to U.S. Dollar strengthening, and a small underweight in Gold.

Equities Vs. Bonds

Neutral, with a slight preference for bonds on valuation concerns at the Index level

Equity earnings-to-bond yields favor bonds

Equity earnings-to-bond yields favor bonds

Delving into fundamentals, overall, the health of the domestic economy remains fairly rosy. Non-food credit growth has started picking up on the back of reviving credit to industry, PMI has remained healthy and in an uptrend in the last 2 months, and exports have grown faster than imports in Apr-18. CPI and WPI readings have ticked higher, but could stay within the glide path with expectations of lower crude oil prices in the second half.

Domestic economy healthy

Domestic economy healthy

Similarly, the earnings so far for corporates have come through decently with the majority (>50%) either beating or delivering results in-line with consensus estimates. However, the dispersion in long-term earnings expectations between large and mid-caps is marked. While mid-caps are expected to outperform on an absolute basis, consensus now expects a significant improvement in earnings for large-caps vs. a deceleration in mid-caps i.e. the latter are currently seeing earnings downgrades. Net-net, across equities, this paints a broadly balanced picture.

Large cap Vs. Mid cap

Neutral, with a slight tilt towards Large Caps

Both large and mid-caps trade at significant premiums on forward and trailing multiples vis-a-vis long term history. So, looking only at prices and valuations does not yield significant insights. On the contrary, earnings and forward prospects throw up stark differences between the two. Our models suggest a tilt towards a large-cap exposure on the premise of a more stable earnings growth delivery in an increasingly likely volatile market sentiment. Earnings expectations for mid-caps have de-rated in recent months while large caps have seen more positive revisions.

Earnings revisions positive for large cap

Earnings revisions positive for large cap

Corporate Bonds Vs. G-Secs

Prefer corporate bonds on conducive macro: Valuations commensurate with fundamentals

Analysing valuations, the general trend is that G-Sec yields have run up solidly since May-17 (+100bps vs. only +70bps for Corporate bonds) mainly on the back of challenging fiscal math, worsening NPAs and heightened inflation expectations. Being more liquid, a higher element of the inflationary pressure seems to have been priced in the G-Secs than in the lesser liquid Corporate bonds. We expect the spread to revert back to 5-year average levels of ~80bps (currently at 70bps) as corporate bond yields expand, notwithstanding the already significantly high term premium at 180bps.

Potential for corp. bond yields to harden

On the macro front, particularly convincing is the upgrade / downgrade ratio of company credit ratings (wherein the ratio has been on a steady uptrend since the start of CY18: currently at 1.56 vs. 1.37 on Dec-17) and the increasing preference seen in the corporate bond market as companies appear eager to substitute their bank financing (due to significant slow-down primarily in PSU credit lending) with bond issuances. The receptiveness of market participants is encouraging, case in point being the successful debt issuances YTD which have been lapped up with (over) subscription levels ranging up to 7.3 times.

Short-Term vs. Long-Term

Attractive valuations and inflation upside risks tilt scales towards the short end of the curve

Over the last 1 year, G-Sec yields have risen nearly 80bps, while the Government 1-y yield has risen only 40bps. However, the latter has recently (i.e. on YTD basis) accelerated strongly while the G-Sec has slowed down (only 40bps hardening vs. 50bps for the 1-y). Such a strong increase in a relatively short span for the 1-yr could prompt a downward moderation in short term yields thus making the 1-y appear attractive.

Short-Term vs. Long-Term

On the macro front, hawkish minutes by the RBI citing upside risks to 10-y yields from poor monsoons and sticky core inflation further contributes to our preference for the shorter end of the curve.


Crude and flows continue to favor a strengthening USD

Current account deficit is likely to remain under pressure from a 24% increase in Brent over the last 6 months which is also likely to weigh on Balance of payments and eventually the INR.


Further, data on flows do not reveal any strong support for the INR. EMBI spreads (i.e. yields on emerging markets (EM) bond indices) look to be bottoming out likely on waning interest in EM assets. The uptick in yields is confirmed on a domestic level as well as 10y G-Sec has spiked in the last 1 year strongly as FII outflows from debt have been severe YTD, pulling out nearly $1,850m.

Risk appetite for EM assets appear negative with momentum waning

Gold vs. Cash

Relative valuation yet remains unattractive for Gold though market volatility remains rampant

Relative to black gold, yellow gold still trades at a significant premium as the gold-to-oil ratio still trades 1 standard deviation above long term mean. Further, the recent strength in the trade-weighted U.S. Dollar index augurs negatively for Gold given the strong inverse correlation seen historically.

Yellow/Black Gold remains elevated

However, with material spikes in volatility, there could arise a case for a rotation of capital into relatively more safe haven assets such as gold. However, ETF holdings are yet to signal any accumulation of the yellow metal.

Increase in volatility likely to spur gold


After the selloff in first half of the week, equity markets managed to stage recovery in the latter part. The Nifty closed flat for the week at 10605 levels. On the daily chart index has formed bullish candlestick while on the weekly it has formed Dragon fly doji a sign of reversal and indicating buying at lower levels. For now index is likely to continue its bounce back, but confirmation of bottom will come once index starts to trade above 10929 levels. Crossing and sustaining above 10630 levels, expect to further rally towards 10675 and then 10735 levels heading into expiry week. In Nifty options, Call unwinding was seen in strike price 10700 which has opened room on the upside. But strike price 10800 has highest open interest for Calls and is likely to act as resistance. While in Put options highest open interest is seen at 10500 and significant amount of addition was seen in 10500 to 10600 suggesting as writing activity which is likely to act as support. On the downside immediate support is seen at 10500 levels and then 10417 which is the major support now. However, breaking below 10417 levels will see resumption of decline towards 10170 levels. INDIA VIX coming off its recent highs of 14.4 to 12.6 is also supporting the market.


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