Jun 25, 2018
Broad top-down analysis of the Indian equity markets by sector and capitalization.
Performance Breakdown of Sectors and Market Caps
Strong Sectoral Rotation Trends Underway
An analysis of the market by sector demonstrates a highly fluid market environment driven by strong sectoral rotation trends. IT was the clear winner during the beginning of the calendar year, but has ceded leadership to Pharma and PSU in the past month. The Pharma index is up 13.5% and PSU bank index is up 13.7% in the past month, while IT is up 4.2% and the market is up a scant 1.9%. We’d note that PSUs remain down 18.3% for the year, and Pharma is down 3.1% YTD. Despite all this furious noise at the sectoral level, the Nifty 50 remains up 2.6% YTD, and does not reflect the volatility visible at the sectoral level.
Metals, which have been strong winners during the prior two years, are down -11.7% and Real Estate, which was a big winner last year, has rolled over, down -17.4% YTD.
Trailing PEs Have Risen and ROEs Have Contracted…
P/Es Have Risen While ROEs Have Contracted
Separately, sectoral trends demonstrate that P/Es have contracted in Autos and Media, stayed stable for FMCG, but risen for all other sectors, and the market as well. Meanwhile, ROEs have declined marginally for all sectors with the exception of Metals and Media, but stayed stable for the Nifty 50.
Autos have consistently delivered strong earnings growth despite the relatively cyclical nature of the industry. Trailing P/E for Autos have come down as a result of earnings growth, but remain at a premium to the market. ROEs on the sector have also come off marginally from highs a couple of years ago, down to a still healthy 17% from 19% a year
Vehicle Volumes Data Remains Robust
ago and nearly 21% two years back. While top-lines remain resilient, driven by robust auto volumes, margin compression remains an issue for the industry. The auto ancillary is particularly vulnerable in this regard. The sector remains in consolidation mode, with earnings growth of 13.6% balancing P/E compression of 17.9%; however, strong top line growth will eventually translate to bottom line growth as crude oil stabilizes and fundamental demand remains strong.
Banks and Financial Services
Private Banks and Financial Services have witnessed a dramatic acceleration in their P/Es alongside a contraction in ROEs. On the Public Sector banks, NPAs continue to remain a focus point, but stringent regulations, reviews and corrective actions for recovery via IBC, RBI’s allowance of spreading MTM losses are in place, seem to suggest the we are near the peak on provisioning. Bottom line earnings delivery remains opaque and volatile, however.
The Government of India’s push on digital transactions should help both Public and Private sector banks in terms of volumes, but translation to bottom line is yet to be seen. Credit trends remain strong, particularly in personal credit and credit to services. The government is also pumping investment capital into infrastructure, and alongside rural demand improving, strong trends in commercial vehicle financing are aiding the sector.
Credit Trends Remain Strong…
Downstream Oil & Gas companies have witnessed strong downward corrections year to date. Gross refining margins peaked in Q3FY18, and have remained under pressure in the face of high crude prices. Consequently, valuations have dipped as earnings have weakened in the last quarter. While high crude should benefit upstream players, separate subsidy and profitability concerns remain prevalent alongside the government’s restructuring of the Oil & Gas giants creating opacity and uncertainty. On the LNG front, there remain concerns about distribution infrastructure, supply and a rise in competitive pressures. OPEC’s decision to raise production alongside rising U.S. production will aid in stabilizing prices around current levels with slight downside bias.
FMCG earnings trends have improved considerably, driven largely by improvement in the rural consumer’s financial situation as a result of better monsoons, government’s farm loan waiver and investment stimulus in infrastructure. Much of the earnings growth has been delivered from volume growth and the FMCG pack has been able to translate top line into bottom line EPS growth effectively. Hindustan Unilever has been the major driver of volume growth for the industry. The recent rally has been driven by PE expansion in the sector, rightfully so in light of the recovery in volume growth. Performance looks to remain healthy looking ahead.
Of the two beaten down sectors in CY17 (Pharma and IT), IT first witnessed a significant re-rating with Mindtree seeing the first signs of reversal in Q4FY18 as the company reported convincing constant currency QoQ topline growth. While large cap IT has not shown a meaningful turn-around in reported numbers, the markets have seen through to improving performance and high expectations are in place. Select mid cap IT names have shown a turn-around, as we finally start witnessing emerging models that are tailored to the digital driven world. Alongside an expected improvement in fundamentals, IT companies are also investing excess cash reserves into accretive M&As which are starting to generate shareholder value. Case in point being Cyient’s DLM/Rangsons, Mindtree’s BlueFin and to a certain extent even Infosys’ restructuring of shedding off Panaya. Simultaneously, tight cost control have aided margins, which will be aided further via operating leverage and improvement in top line.
The sector has witnessed strong declines in earnings in recent quarters. Much of the poor earnings compression can be attributed to cyclicality in the metals and mining industry, poor execution, as well as volatility in raw material prices. Vedanta, arguably the leader of the pack, has also been impacted by closure of its Copper operations in Tuticorin and expectations for the company and sector are now tempered.
With the rise of over the top (OTTC), broadcasters have been forced to re-think their business models and focus on direct content to audience, bypassing traditional distribution channels that air content at pre-defined times. This has led to content investments in the sector which has constrained cash flows and bottom-lines. Media has remained an underperforming sector year to date, despite optimism about rising ad spends with upcoming elections. Consumer viewing tastes are shifting rapidly, and traditional distribution models are likely to face disruption risks in the future.
While being out of flavor for the majority of CY17, there appears to be some sentiment driven buying in the sector in the recent few weeks on the back of:
Despite Sectoral Volatility, Market Volatility Has Declined Since Feb ‘18
While volatility has been evident at a sectoral level, market volatility has counter-intuitively been on the wane over the past few weeks. Year to date, weekly volatility has dropped to long term averages. Separately, the India VIX has shown similar trends, with volatility post Feb-18 tapering down notably.
Implied Volatility Has Been on the Wane
Sectoral moves demonstrate a market in search of turn-around sectors, such as Pharma, IT and PSU banks. While the market has anticipated earnings pickup in these sectors, whether it comes through remains to be seen. Separately, large caps have outperformed over the past year but remain rank underperformers over the longer cycle. The move is largely driven by a flight to quality, predictability and SEBI re-classification.
Earnings Growth Expectations for the Nifty 50 and Midcap Index
Macros Remain Generally Healthy, with Sectoral Calls Rising in Importance
We see little in the macro picture to indicate a worry about the economy. The economy is best characterized as a consumption and personal credit driven economy, with pockets of government stimulus. Private investment remains on the side-lines. Moreover, markets are re-adjusting to the new reality of Fed liquidity withdrawal and FI outflows, with some measure of volatility related to the re-classification of fund schemes. The OPEC agreement on crude and rising U.S. output helps alleviate concerns around crude contributing to inflation.
Rising Repo Rate and Fed Funds Rates Are Additional Headwinds
The currency has stabilized albeit at a slightly weaker level. Domestically, while the RBI remains in neutral, there is clear recognition that a couple of additional rate hikes are likely should the data worsen. The Fed’s intended rate hike path will continue to add to dollar strength and FI outflows.
Net net, the economy remains on sound economic footing, and RBI policy remaining in neutral will be necessary for markets to move higher. Key market drivers remain RBI policy, crude, earnings growth and clarity on elections. Sectoral allocation could be a source of meaningful alpha. Rates remain fixed in the high 7% range, with no visible impetus for a meaningful change from current levels.
CNX 500 Sectoral EPS Trends
The Nifty closed flat for the week at 10821 levels. Index has been range bound between 10700 and 10860 odd levels for last couple of weeks. On Friday index rallied smartly from lower end of the range to form a long bullish candle for the day. Index has resistance zone at 10835-10860 levels and needs to clear this hurdle to will confirm the strength on the upside. Then Nifty can rally towards 10929 levels which is May month high and then possibly even higher towards all-time highs. However on the downside 10700 levels is now critical support level for the market breaking below which market can see decline towards 10550 levels and resumption of decline. In Nifty options, Put writing was seen in strike price 10650 to 10800 and Call unwinding was seen from 10700 and 11200 suggesting market participants expect index to rally higher.