National Democratic Alliance (NDA) secures second term in the 2019 general elections. The result is almost in line with the 2014 outcome and is even better than what few exit polls suggested over the weekend. Bharatiya Janata Party (BJP) – on a standalone basis has been able to cross the halfway mark of 272 by leading 295+ constituencies out of 542. This clearly signifies the strong hold of the Prime Minister; Narendra Modi after BJP achieved a mammoth victory in 2014 on the back of anti-corruption wave and ousted the United Progressive Alliance (UPA) government. Exhibit 1 shows the shift in control of the government from UPA to NDA in 2014, a classic example of anti-incumbency as UPA was unable to deliver what was expected on the reform agenda front.
Come to 2019, actions taken by the current government on the national security front, has helped BJP in securing a second term. This victory will give the current government a second chance to push their reform agenda focusing on agriculture sector, increasing household income and infrastructure development.
Market Reaction
It was quite a volatile day for the local equities with the large-cap index (S&P BSE Sensex) touching an all-time high level of 40,124, while closing at 38,811 level on back of profit booking. Equities scaled up more than 2% during the current week (as on May 23, 2019), with S&P BSE Sensex up 2.32%, whereas the mid-cap (S&P BSE Mid-Cap) and the small-cap (S&P BSE Small-Cap) indexes were up 2.39% and 3.35%, respectively. Among sectors, the S&P BSE Capital Goods (up 6.68%), S&P BSE Realty (up 6.30%), S&P BSE Industrials (up 5.74%), S&P BSE Energy (up 4.81%) and S&P BSE Bankex (up 4.20%) indexes lead the rally during the current week. Whereas, S&P BSE FMCG (down 1.03%) and S&P BSE IT (down 2.20%) indexes were the major detractors. The rupee appreciated 0.30% against the U.S. dollar during the current week, closing at INR 69.95/USD. Year to date, Foreign Portfolio Investors (FPIs) inflows into Indian equity markets stood approx. at $9.2bn, whereas Domestic Institutional Investors (DIIs) were net sellers with outflows of approx. $1.4bn. A stable government at the center is expected to encourage FPI inflows into Indian markets.
Macroeconomic outlook
On the macroeconomy front, few lead indicators such as weak auto sales, air passenger traffic, muted growth in personal and consumer loans and sluggish rural demand suggest a moderate pace of growth in private consumption expenditure (Exhibit 2). PMI data also suggest a slower pace of expansion in the manufacturing and service industry. Although, private consumption is expected to get a fillip from public spending in rural areas and expected an increase in disposable income of households due to income tax benefits. Resolution of stressed assets is expected to improve credit flow along with a pickup in fixed investment supported by higher construction activity is expected to drive investment activity. Further acceleration in capacity utilization and credit to industry sector could improve the growth prospects.
On the other hand, government expenditure is expected to pick up in NDA’s second term with a focus on agriculture and rural economy. This will also help to counter the imminent risk of any impact from slowing global economy. Government spending could be supported by increased GST revenue, which is expected to rise by 18.2% (BE FY20). However, much of it is dependent on improvement in compliance and reduction in disputes. Going ahead, reform agenda undertook, adherence to fiscal discipline and resolution of stressed assets will broadly drive the growth prospect in the second term of NDA.
Exhibit 2 Auto Sales – PMI – GDP (Source SIAM, IHS Markit and MOSPI)
Several factors might provide RBI room to go ahead with another rate cut in the June MPC meeting, including consistent fall in food prices, benign food inflation outlook, expectation of normal monsoon, fall in core inflation, lower growth rate projection, widening of output gap with increased headwinds from a slowdown in the global economy. To an extent, a rate cut expectation is already factored in by market participants as the yield on the 10-year benchmark G-sec is down by 20 bps in the last two weeks. Although, the rate cut would benefit the economy and support NDA’s growth agenda; however, the inefficient transmission of rate cuts has led to a partial and delayed reduction in the lending rate of banks.
What do our Valuation Implied Returns (VIRs) indicate?
Our valuation implied 10-year return forecasts (Exhibit 3) at an market index level suggest that Indian equities continue to be overvalued – particularly mid-caps where profit margins reversion (i.e. current high margin reverting to normal fair margin forecast) is expected to bring down the returns. Large-caps, on the other hand, look relatively attractive as the negative impact of earnings, margins and ROE reversion to fair value is forecasted to be lesser than that of mid-caps and small-caps.
On the fixed income side, 10-year return forecasts look fairly stable across the short, medium and long term, and are in the range of 7.2% - 7.9% with medium- and long-term debt offering a tad higher return relative to short term debt. Although, any additional market borrowing via central/state government securities for FY20 along with reduced OMO purchases in coming months (potentially due to the success of dollar swaps being conducted by RBI), rising crude oil prices and concerns over fiscal slippage may put some pressure on the long-term G-sec yields.
On the international equities front, U.S. equities have enjoyed a period of strong performance over a decade. From a valuation lens, U.S. equities are expensive and are not adequately compensating investors for the risk of the permanent loss of capital. Emerging markets or Asia ex-Japan equities look relatively attractive as ongoing trade tensions have reinforced the valuation opportunity with investors becoming overly pessimistic on the outlook for emerging markets.
Source: Morningstar Investment Management
How have we positioned our Managed Portfolios?
Despite the upbeat market sentiment, our long-term valuation-driven process leaves us generally cautious as valuations look stretched across many markets. Based on our valuation-driven asset allocation approach we’re currently underweight equities, particularly Indian and US equities, and overweight fixed income – vis-à-vis neutral or benchmark asset allocation defined for each of the four portfolios. Within Indian equities, we favor large caps over mid and small caps. On the international equities front, we’re underweight U.S. equities and overweight Asia ex-Japan and Europe equities vis-à-vis neutral or benchmark sub-asset class allocation.
On the debt side, we’re overweight short, medium and long-term debt, amid attractive real rates. Given equity valuations are looking stretched, we are holding more cash than what the neutral allocation suggests. This should help us in providing ammunition as attractive investment opportunity arises and protect ourselves in case the current optimism unwinds.
Recent data suggest that short term (3 to 5 year) corporate bond spreads have come off from their recent highs and are trading near their long-term averages, particularly the AAA & AA rated universe. One needs to be mindful of the current stress in the credit market and stick to high credit quality banking and PSU bond funds and short-term corporate bonds funds from a risk-return perspective.
Valuation-driven Investing
“Stop trying to predict the direction of the stock market, the economy, interest rates, or elections, and stop wasting money on individuals who do this for a living. Study the facts and the financial condition, value the company’s future outlook, and purchase when everything is in your favor.” – Peter S. Lynch.
The Peter Lynch quote above is more pertinent in the current environment where the investors tend to focus more on the short-term optimism and ignore underlying fundamentals both at a security and market levels.
Valuation driven investing involves investing across a range of asset classes. To achieve this, we assume that prices of various asset classes or securities revert to fair value over five to ten years, roughly in line with the economic cycle. Estimated returns vary over time, reflecting changes in price, fair value, and expected income returns. Over the long term, prices follow fundamentals, while in the short term, a multitude of factors drives markets, including investor sentiment, risk aversion, supply/demand, macro surprises, and government policy. Long-term investors are able to look beyond this noise and complexity to the underlying cash flows, to invest based on fundamentals, and to take advantage of deviations between price and fair value. This is one of the most enduring advantages of valuation-driven asset allocation.
Valuation-driven asset allocation is about investing over the long term in assets that are priced to deliver attractive returns. This means holding investments much longer than market-timing-based
strategies. Discipline and a willingness to be different, anchored to fundamentally derived valuation, defines valuation-driven asset allocation as truly bottom-up investing.
Investors who trade on emotion and short-term market moves are more likely to sell after markets have gone down and buy after they’ve risen. We seek to do the opposite, in part by sticking to our principled approach to investing, which is designed to keep us rational in a sometimes-irrational world. In this regard, we are prepared to be buyers if and when valuations provide an attractive buying opportunity.
