EM valuations moderate but Indian stocks still expensive

According to Morgan Stanley, the clouds should clear for emerging markets (EMs) after a rough ride in 2018. The foreign brokerage house has moved EMs and EM Asia to an overweight rating, from underweight earlier, signifying a rare double upgrade. The rationale given is that valuations of these markets have derated sufficiently to compensate for uncertainties, such as China’s easing cycle, US trade policy, reform implementation in Brazil and South Africa, and the elections in 2019 in India and Indonesia.

Equities in markets such as Turkey, South Africa, Indonesia and South Korea corrected sharply after the recent currency rout. The one-year forward price-earnings (P-E) multiple of the MSCI Emerging Markets Index has corrected from its highs of around 13 times and is currently at around 10 times forward earnings. In relation to developed markets, the valuation differential has widened meaningfully, leading to the double upgrade in EM ratings.

While Morgan Stanley has an overweight rating on Indian equities as well—the same as before the recent EM upgrade—things aren’t as appealing on the valuation front. If anything, MSCI India’s valuation premium has expanded compared to earlier this year.

As the chart shows, the one-year forward P-E multiple of the MSCI India Index is hovering around 17 times. Although the valuation has come-off from the peak of 19 times seen in this calendar year, the Indian stock market is not cheap by any means. Its premium over MSCI EM has risen to around 65%, from 42% at the beginning of the year.

What’s more, there are a slew of domestic factors that Dalal Street should be worried about.

True, global crude oil prices have fallen and the rupee is stabilizing as well, but whether this improvement will sustain is anybody’s guess. Even if it does, for the India’s current account deficit or corporate balance sheets to benefit, it could take a quarter or two. And by that time the 2019 Lok Sabha election, a key swing factor for the stock market, would have arrived, keeping volatility high.

“Overall market valuations are still on the higher side despite the sharp correction over the past three months. Unfavourable outcomes in the forthcoming state elections and tighter global monetary conditions pose headwinds and potential risks to the market,” Kotak Institutional Equities said in a report on 15 November.

As for the earnings, India Inc.’s performance in the September quarter was a mixed bag, with companies across the board battling margin pressure amid lack of pricing power. Bloomberg’s one-year forward consensus earnings per share (EPS) estimates for Nifty 50 are not encouraging. The Nifty EPS forecast has fallen from ₹ 603.80 in April to ₹ 554.

At the same time, key external risks cannot be overlooked. For instance, a full-fledged trade war could have a material impact on global growth. Similarly, faster-than-anticipated interest rate hikes by the Federal Reserve will be good for the dollar, but a setback for EM equities.

Liquidity push by domestic institutional investors is a key positive that has been fuelling the Indian stock market’s rally, but that alone isn’t enough to justify the current high valuations.