IT and pharma sectors look tactical buy in short- to medium-term peak

This week, the domestic market reached the psychological milestone of 25,000, with a peak at 25,078.30 before closing at 24,717. The market experienced a brief surge, in the last 7days, before consolidating due to subdued quarterly results & clampdown in Asian market like Japan. Initially, the week started positively as the budget-related volatility eased, but the rally lost momentum as the muted earnings reports emerged. These underwhelming results do not justify the substantial premium valuation India holds today. MSCI India one-year forward P/E is at 24x and MSCIEM is at 12x, 100% premium. India's advantage lies on the ability to decouple from other emerging markets, that earnings growth is slowing in Q1. 

The domestic market's rally over the past month is largely due to the improved performance of laggard sectors like IT, Pharma, and FMCG, which had been subdued over the previous year. These sector’s upward momentum pushed the market to new highs. Meanwhile, CPSE has sustained its positive trend year-to-date. However, slowdown is visible in the best performers like metals, reality, PSUB, and capital goods due to extreme valuation.

Importantly, the current domestic rally of India is a catch-up syndrome with the rest of the world, as it was underperforming before the national election and budget. Additionally, the positive trend of the US market, up by 3.5% in the last one month, drove the domestic trend. The optimism is propelled in expectation of an ease in the US interest rate in the medium term, owing to benign inflation & weak economy data like increase in jobless. FED held the rate on July policy and indicated a cut in September.

Regarding global rates, the BoE cut the rate by 25bps to 5%, first time in more than 4yrs. In contrast, the BoJ increased its rate to 0.25%, which has had minimal impact on global markets but led to a sharp decline in the Japanese market, 5% down in the last 5days. The BoJ is likely to hold the hawkish view and increase the rate in 2025, which could influence the carry trade in the future as the gap between yen & dollar interest rate reduces.

The sustainability of India’s rally is being questioned due to high broad market valuations, particularly among midcaps, and a decline in earnings growth. For Q1 results, as of August 1st, Nifty50's PAT growth is 6%, down from 13% in the previous quarter for the same companies. Also, if we dissect the growth into Finance and Non-Finance, the YoY growth is led by Banks at 18% and 2% only for non-bank, respectively. It is indicating slowdown in core industries, leading to the view that premium valuation is elevated. 

Conversely, the market remains optimistic that earnings will rebound in the upcoming quarter, with expectations of a 12-14% earnings growth for FY25. This positive outlook is based on the belief that current profit pressures is a temporary blip caused by high inflation. And as CPI trends is on a downward and the WPI is rising, to 3.6% in June from 0.26% in March, the market anticipates a return to stronger earnings growth. 

At the same time, sectors with strong growth prospects, such as manufacturing, electronics, IT, renewables, healthcare, e-commerce, infra, agriculture, and consumption, remain attractive, suggesting that premiumization will stay in the medium to long-term. However, broad market is expensive, so it is crucial to focus on stock fundamentals, avoid overvalued stocks, and adopt an accumulation strategy.

To safeguard investors' capital, sector-wise rotation is a prudent strategy. Shifting exposure from the outperformers to value sectors is the way forward. Further, the improvements in rural areas, agriculture, and government expenditure are anticipated to benefit sectors connected to the domestic economy, such as staples, FMCG, fertilizers, telecom, cement, and consumer durables and non-durables. 

The government’s emphasis is on enhancing rural consumption and capital expenditure will benefit these sectors. Efforts to improve agriculture income through increasing production and supply chains will expand demand, mitigate inflation, and lower consumer sector input costs. The government’s continued focus on aquaculture, through measures to cut customs duty, reduce input costs, and extend financial support to double seafood exports in the long-term, is a major boost for aquaculture companies. As the market nears its potential short- to medium-term peak, investing in defensive sectors such as IT and Pharma is a tactical buy.