Mid- and small-caps have room to rally

Investors should continue to build equity exposure for the long term

The market witnessed a rally in May on the back of a strong mandate for continuity and stability in the election results. On the other hand, global equities witnessed a sell-off due to weak macroeconomic data and deteriorating sentiments on trade disputes. With the election-related uncertainty behind us, let’s address the key questions on investors’ minds now — is there a risk of a long-drawn out trade war, can we expect a revival in domestic growth, and what is our outlook for equities going forward?

External factors

On the global front, US-China trade tensions re-escalated in May with negotiations breaking down and tariffs being raised by both sides. Global growth is likely to slip, and this is getting reflected in slowing global trade and PMI (Purchasing Managers’ Index) numbers. The US Federal Reserve is now expected to cut rates by 50 bps over the course of the year on concerns of slower growth and low inflation. The Chinese government is also expected to support the economy with additional fiscal and monetary stimulus. The market seems to be anticipating an ‘extended escalation’ scenario, wherein negotiations continue for the next few months and a resolution is expected to be hammered out by the end of the year. For India, the risk is that exports may fall this year due to the weak global environment. However, a positive data point is that while increased uncertainty led to some emerging markets seeing FPI (foreign portfolio investment) outflows in May, India saw an inflow of around $1.2 billion as FPIs continued to correct their light positioning.

On the domestic front, with the general elections concluding, a key uncertainty weighing down the Indian economy and markets has been removed.

The immediate priority of the new administration would be to revive cyclical growth. India’s Q4 FY19 GDP growth came in at 5.8 per cent y-o-y and dragged down the full-year FY19 growth to 6.8 per cent y-o-y, a five-year low. The slowdown was likely due to the NBFC stress and liquidity issues in addition to the election uncertainty. With slowing growth and the inflation being below target, the RBI cut its policy rate by 25 bps and also changed its stance from neutral to accommodative, confirming further scope of rate cuts in the future. Also, the system liquidity is expected to come back to a surplus in June post the elections.

To boost farmer income and alleviate rural distress, the government has already announced that it will roll out the PM KISAN scheme to all farmers and is also working on measures to close the gap between the prices the end-consumer pays and what the farmers receive. It is also a pleasant coincidence that, like in 2014, when the government started its new term, crude oil prices have seen a significant decline. This should keep both inflation and the current account deficit in check.

On the investments side, private capex — which typically slows down 1-2 quarters before elections — should also pick up post-elections. The new Budget will be passed in July after which the government capex will begin. Simplification of GST, increase in direct tax collections, and divestments should lead to an increase in revenue, which will enable public sector capex. The $1-trillion-plus infrastructure push will be a key priority to boost job growth, especially in the informal sector.

Post the election results, we have seen a rally, with the large-cap Nifty and the Sensex crossing all-time highs of 12,000 and 40,000, respectively. However, in comparison to a 11 per cent rise in the large-cap Nifty index year to date, the mid- and small-cap indices have risen only 1-2 per cent. With confidence coming back to the markets, mid- and small-cap stocks still have room to rally further.

In Q4 FY19, sales and PAT (profit after tax) for Nifty companies grew 10 per cent and 16 per cent, respectively, largely aided by financials. Excluding corporate banks, Nifty PAT grew just around 2 per cent y-o-y, and the broader earnings growth for the market remains muted. At 19.5-times one-year forward P/E multiple for the Nifty, valuations are at a premium to their long-term average. However, valuations for the broader market can still offer a reasonable return for long-term investors.

Outlook

With the election-related uncertainty over and the incumbent government getting a strong mandate, we remain constructive on India’s overall economic growth in the medium-to-long term and suggest that investors continue to build equity exposure for the long term, especially through the SIP route.

However, considering the current weak global growth environment, it seems difficult for the GDP growth to go above 7-7.5 per cent unless we see some major structural reforms and large investments both from the public and private sectors.

Also, sustaining domestic flows will be key to driving revival in the broader market.

Select themes that we are looking to participate in are consumption (consumer and consumer discretionary), financials (private and corporate banks, and select NBFCs), and industrials (capital goods, cement and select infrastructure companies).

The writer is Co-CIO,

Aditya Birla Sun Life AMC

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