Indian equities’ premium now at highest point of year
On Monday, the Indian equity market’s premium to its Asian counterparts scaled the highest point in a year. This, along with low volatility levels mirrors investor confidence in a bright future for Indian companies. Chart 1 gives a short history of the India premium over the year.
Demonetization and implementation of the new goods and services tax (GST) disrupted the domestic economy and supply chains for most of 2017. Yet, the MSCI one-year forward price-to-earnings (P-E) multiple for India touched 17.8 while that of MSCI Asia ex-Japan hovered much lower at 14.6. Importantly, India’s P-E ratio expansion during 2017 till date is thrice that seen for Asian markets, excluding Japan.
That apart, the gap between the two slowly widened as India’s P-E ratio kept rising while that of Asia contracted. Fears of oversupply in commodities and overvaluation of China cooled off the euphoria seen in broader Asian markets in early 2017.
Certainly, the rising premium shows that expectations are ruling high on future earnings growth in India, when compared to other Asian economies. On the flip side, it also implies that the rally is not backed by earnings expansion but more money coming into Indian equities. In fact, MSCI’s one-year forward earnings per share estimates for Asia ex-Japan rose at a far greater pace than that of India.
The weaker earnings forecast for India is not surprising given that earnings growth during the first three quarters of calendar year 2017 (CY17) was lacklustre. The note ban, stricter vehicle emission norms and GST in addition to tighter norms for the real estate sector are some of the few changes that adversely impacted revenue and earnings growth. There is a visible delay in capex revival too.
Nifty earnings growth during the first half of the fiscal year was flat year-on-year. A report by Kotak Institutional Equities Research adds, “Interestingly, the net profits of Nifty-50 index firms (based on the current composition of the index) will grow 31% between FY2014 and FY2018, which is a paltry compounded annual growth rate of 7%.”
In other words, earnings are yet to catch up with market sentiment. Yet, investors appear sanguine that these disruptions will wane and morph into a healthy growth in earnings over the next 12-18 months. Two consecutive good monsoons along with the seventh pay commission-linked salary hike, raises hope of higher domestic consumption both in rural and urban areas in 2018.
That’s not all. India has witnessed greater political stability compared to most nations. The outcome of some recent state elections like Uttar Pradesh and Gujarat signal political continuity too—a comforting factor for investors. This explains the lower level of volatility as seen in the sharp drop in the Volatility Index (see Chart 2). Fund flows into the markets, both domestic and foreign, have been strong.
However, there are downsides to valuations too. High levels of inflation in the country and higher oil prices seen recently may threaten profitability and earnings of firms. The first two quarters of FY19 will be critical to determine whether the faith in earnings expansion is justified. Besides, given that the P-E ratio is at a high point of the year leaves little scope for further expansion in valuations. Hence, as the Kotak report says, “Strong earnings growth (15% or higher) for FY2019 is imperative for the broader market to deliver positive returns in CY2018.”