‘Markets have priced in most of the good news’

Markets are at historic highs. Are you convinced about the prospects of the rally given the mixed bag of earnings in Q1?

Markets have surged significantly this year, with the Nifty up 16% YTD and the S&P up 17%. In India, optimism is fuelled by potential rate cuts, falling inflation, strong gross domestic product (GDP) growth in FY24, and political stability. However, looking ahead, we don't expect significant gains over the next 12 months.

The Nifty may deliver high single-digit returns in our base case, but with rate cuts already priced in, a sharper rally (from hereon) seems unlikely. That said, softening commodity prices due to weak global demand could boost earnings for Indian companies, with Nifty earnings potentially growing by 10-11% over FY24-26.

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Despite slow profit after tax (PAT) growth in Q1, sales growth was strong, though there were variations across sectors.

Small caps and mid-caps have continued their lead over large caps. Do you see this continuing?

Small and mid-caps have been leading due to higher earnings growth, with the NSE Midcap and Small cap indices trading at very high valuations 33x and 22x 12-month forward earnings, respectively. Only high earnings growth going forward can justify these valuations. We see value in large and small caps on a relative basis, but not in mid-caps.

Which sectors are you inclined towards and which ones will you avoid?

We favour sectors like consumer, healthcare, cement & building materials, insurance, and electric equipment manufacturing. The rate cut cycle will benefit select NBFCs (although we believe microfinance institution (MFI) stress has not peaked yet). We're cautious about capital goods and EMS (electronics manufacturing services) due to modest order inflows and high valuations, autos because of declining sales volumes, and IT, where weak US demand remains a concern.

Locally and globally, what are the factors that can lift or upset market optimism?

Globally, key factors include the US presidential election, China's slowdown and overcapacity (leading to dumping across the globe), inflation and increase in interest rates in Japan, and geopolitical tensions like the Middle East unrest, Russia-Ukraine war, and China-Taiwan tensions. We think that the rate cuts in the US will be of significant influence as well. Domestically, GDP growth, fiscal deficit management, upcoming state elections in Maharashtra and Haryana, and government steps towards digitalization and artificial intelligence (AI) adoption will be crucial.

 

Any earnings revisions you see and in which sectors for FY25?

Over the last three months, retail, Internet companies, and QSR (quick service restaurant) sectors have seen earnings upgrades, while real estate, media, private banks, and chemicals have seen downgrades.

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A strong monsoon may drive consumption, benefiting consumer staples and discretionary companies, while the festival season should help paint companies. Lower crude prices are favourable for OMCs, and rate cuts will support NBFCs. However, with the capex cycle yet to pick up, we remain cautious on capital goods companies. We expect private capex upcycle from the second half of FY26.

We have also seen mutual fund (MF) investors redeeming given the steep appreciation in stock prices recently. Does this worry you given that we are at historic highs?

While Nifty is trading at almost +1.5SD (standard deviation) from historic mean, supported by strong earnings growth (23% compound annual growth rate (CAGR) for Nifty and 30% for Nifty Midcap between FY20 and FY24), valuations are still reasonable compared to other emerging markets on a PEG (price/earnings to growth) basis. Valuations are a bigger concern for small and mid-caps although we see no signs of a bubble as of now. MF flows, especially systematic investment plans (SIPs), remain healthy at $2.8 billion per month, which helps mitigate concerns.

 

What are the odds of a rate cut or policy stance change by the Reserve Bank of India (RBI)?

We expect a 25-basis-point (bps) cut from the RBI in Q3 FY25, with a stance shift to ‘neutral’ likely in October and a rate cut by December. India's rate-cut cycle will be shallower than US, as India’s hikes weren't as aggressive. Overall, we anticipate a 50bps reduction in FY25, bringing the repo rate to 6% from the current 6.5%.

Both the external members in the Monetary Policy Committee (MPC) who were voting for a rate cut until now, won’t be part of MPC in the upcoming meeting as their tenure is over. Hence, we should carefully watch the views of new external members on rate cuts and growth. Slower growth in 1Q (GDP growth at 6.7% year-on-year) should lead to more discussions on growth than inflation within RBI MPC.

What's the view on fixed income, gold in relation to stocks?

Indian 10-year G-sec yields are around 6.8% and could fall further due to rate cuts and healthy bond inflows following India’s inclusion in the JP Morgan Bond Index. With equity valuations high and earnings momentum slowing, fixed income offers better risk-adjusted returns. The global environment remains uncertain, with geopolitical tensions, weak demand (China’s overcapacity, crude prices at around $70/bbl), and the upcoming US elections. These factors may create a risk-off scenario where fixed income could outperform equities.

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Gold has already risen over 20% in 2024, but there's potential for further gains as lower interest rates drive demand for gold. Central banks are also increasing gold reserves, possibly to reduce reliance on the US dollar, which could further support gold prices. Historically, our analysis shows that gold performs well during the Fed (US Federal Reserve) rate cut cycles.