India Not A Small-Cap Market Any More: Morgan Stanley's Ridham Desai

Yes, I think we are looking in a base case scenario for another good year for equity markets. There are, of course as usual, many imponderables, and it's certainly not lost upon anybody that the general elections of 2024 will occupy everybody's Top of Mind recall and what happens in those elections will probably determine the course of the market in the second half. But I do expect a pretty good first half. The other imponderable is of course what happens to the world at large and the world is going through its own tumultuous phase. We have seen real yields in the U.S. rise and then fall, the Fed seems to have taken a pause. Morgan Stanley's view is that Fed is done. Fed has not explicitly said that, but if it is done then I think we are probably looking at almost implausible, soft landing in the U.S. and that does give you a good setup for 2024.

My base case is the market will assume that India will vote in a majority government with continuity and therefore, will actually bid share prices going into elections and then of course, what happens in May next year, assuming that the elections happen as per the current schedule, which will then decide whether the market continues that, or goes through a volatile phase. If the elections produce an outcome that is not in the market’s favour, then I think we could get a pretty significant drawdown.

India’s correlation of returns with global equities has been declining now for a few years and in fact, India’s data to EM is now down to 0.4. Defensive market in the world and if the world outlook remains fragile, then India, I think on a relative basis at least, will continue to power ahead. The absolute return cannot be exceptionally good, if the global returns are not good because remember, India is not a small cap market anymore. It's a large market in the global context, so it cannot really be out of sync with the world. Now, the points that you raised; one, on geopolitics; it has to translate into something which matters to the Indian economy, which is oil. The two of them are closely linked. If geopolitics is not producing a bid on oil, as we are seeing right now, despite the two unfortunate wars that are happening, it's not like oil prices are surging ahead. They are struggling to make headway and in fact, they have fallen in more recently. So, if oil remains range bound and in the searches for lower levels, for geopolitics it doesn't matter.

What the Fed does is important because I don't think the RBI will want to front-run the Fed. So, inflation in India is coming into the range, core is actually quite well behaved. I think some of the food price volatility will ebb as we get into the winter months. So, even the headline inflation will look pretty okay. But I think RBI will wait for the Fed to signal that it's done, before it actually acts on the interest rates on the downward side. Now that said, because India’s growth is quite good, I think the RBI will continue to air on the side of caution and not attempt an aggressive rate cut. So, let's see the impact of what the Fed does.

The third aspect which you didn't raise is what happens to global growth. China is showing some recovery of growth. But all eyes are on the U.S. Can the U.S. escape a steep rise in interest rates with a soft landing? History suggests that doesn't happen. Given the nature of the rate hikes in America, the equity markets and the bond markets, until recently, thought a recession is almost invariably going to happen. Of late, the market seems to be getting a bit more relaxed and if the Fed does engineer a soft landing, that I think will make the global backdrop quite good for India.

This is how I would analyse the global factors and then going back to your question, therefore, we come back to domestic events, which will still account for the bulk of how India performs within that. Of course, earnings, which I think will look pretty good at least in the next two quarters, and then elections, which we discussed, but we can go into greater detail.

That's exactly how I think it pans out. The relative case for India remains strong. The absolute returns will start looking less attractive, as they have been for the past few months. It will not like the mark. It's done a lot since the last Diwali, but in the context of what the world has done, the Nifty is looking very good and that continues to be the case. India is attracting long term capital allocation. What investors are struggling with is the headline valuation and that I think is the conundrum of a market that has strong earnings growth. The multiples will not come down just like that. It will need a crisis for the multiples to come down and then what happens is when a crisis actually hits you and stocks become cheaper on the headline basis, nobody wants to buy them. This is the conundrum of rich multiples. In fact, I don't think the multiples are that rich.

I think the market is not oblivious to the medium-term earnings potential of India and therefore, stocks will not ordinarily become cheap on the P/E basis, until you get an event which rattles the markets sentiment. On base case basis, if the world is struggling then India does well in a relative count and if the world makes a bit more progress and if growth starts stabilising and rates have peaked, then India will also make an absolute upside case.

I think this is a much-debated subject and it's almost over-analysed. India does not compete with China for flows, in my view. The EM basket has been struggling in large part because of China and EM has not been getting flows. EM related flows into India have continued to remain weak because unless EM as a basket receives flows, India will not get its fair share, or even less than its fair share. India is not a small EM market; it is one of the biggest EM markets. For India to get EM flows, the EM sentiment has to turn.

Ironically, if China starts doing better, and if that causes sentiment towards EM to do better, then flows into India will improve. They will not actually deteriorate. They are already bad actually. So, there's no case here for them to deteriorate.

You made a fair point of the thawing relations between the U.S. and China. Now I think you know; there the structure story is that the multipolar world thesis, that Morgan Stanley has been talking about for quite a few years now, is very much entrenched. This thesis is about multinational companies seeking newer markets for production and for consumption and India is extremely well placed globally, as we discussed last year, following our Blue Paper on this count, both in terms of its consumption potential, as well as its ability to deliver large scale manufacturing. India will find favour amongst MNCs for further investments, that is not going to change, even if there is a slight shift on the U.S.- China front. China being well is not a bad thing for India. 

If you see, the earning cycle began sometime in the depths of Covid and it was triggered by a shift in government policy, that now favours corporate profits compared to the previous years. We have seen a lot of reforms including GST, Real Estate Regulation Act, the cut in Corporate tax rates, reduction in incentives, which are all pointing towards better corporate profits. The theory here is that if corporate profits are better, then they will invest and, if they invest, they will create jobs and that leads to greater prosperity. So overall, economic growth starts improving.

What has happened in the previous decade is that a large part of it was lost because corporate profits were declining. Companies were deleveraging, coming out of the excess investments that they had seen at the start of the previous decade, and even prior to that. All that has now got flushed out. We are now looking at corporate balance sheets in India, which are very light, the policy environment that favours earnings, and therefore the share of profits in GDP, which were at about 2% in 2020, now at around 5%. I think it will go past its previous high and head to maybe 8% over the next three, four years. For GDP, that's posting at least 10% nominal growth. This means corporate profits in India could be compounding at 20% and the point I am making on valuations is that when you have earnings compounding at 20% for three or four years, buying stocks at 20 times earnings is really not rich. It would actually make India look quite attractive because there aren't that many places on the planet, which has that type of growth, that is economics.

The earnings outlook I think on a medium-term basis remains good. The short-term earnings I think also look good. This quarter will be quite strong, I mean in the quarter ending December, which reports in January, will be quite strong for many reasons. Not excluding the delay in Diwali because of adhik mass in the previous quarter, the Cricket World Cup and other factors at play. We should actually aim for FY24 on a pretty good note.

Then I think the election outcome may have some bearing on how earnings shape up. If there is an adverse election outcome, then there may be some restraining of corporate sentiment and investment spending, which may then start affecting earnings in FY25. If the election outcome is in line with what the market wants, then I think we should be good, FY24 will also be another strong year.

I think the state elections may not have much bearing on how the market behaves. I can give many examples of how the state elections do not have predictive power. In 2018, the NDA, or the BJP lost the three Hindi heartland states and yet swept there in the general elections. Exactly the opposite happened in 2003-4. So, I don't think they have great predictive power. The market will probably get a little bit volatile around these election results and then continue to make headway. Again, the context here is that I am not assuming any upheaval in global markets. So, keeping that aside, India I think will continue to make headway, the market, as you rightly pointed out. If you look at the past few elections, going back all the way to the 90s has a tendency to be positively biased, unless some really strong evidence emerges that there's going to be a greater polarisation.

If the opposition alliance, which calls itself as I.N.D.I. Alliance, demonstrates that it is able to share seats and create a united opposition and therefore make the election outcome less predictable. I think that's the only case for the market not to trade higher going into May of next year. Otherwise, my base case is that the market will assume that India will get continuity and India will get a majority government and then we will see what actually happens and accordingly, trade the actual election results. If it comes in line, the market will actually correct a bit because you know, you buy the rumour, sell the news. But. if the election results happen to be totally in contrast to what gets priced in then I think, we will be in trouble because then I think the 2004 template works. The Nifty fell double digits on a single day then and I think this time around the fall will be even more dramatic and we could be looking at a serious drawdown in share prices. So that's how I think about the elections.

It could be a combination of many things, including the two things that you suggested. It's also because there is still capacity in the system, which is getting exhausted. So, companies will tend to make investments depending on the lead time into setting up capacity, depending on how their capacity realisation shapes up. I think there are many factors at play here. But on a scattered basis, I think corporate capex is already showing signs of a revival and we will get more and more signals going into the next six months.

There could be a setback if the country chooses a minority government and a change in government. But that I think is not something I can predict very well. So, in my base case, again, I think we are in the midst of a recovery in capex that could last for a few years, led by private investments. Just remember that the government has spent money on cyclically-owned capex quite aggressively. In fact, it surprised all of us, including me, that they chose to spend on infrastructure capex in the previous budget, which was the last budget before the elections. The tendency of previous governments has been to spend on subsidies and on supporting consumption spending, rather than infrastructure capex and I think this shows the mindset of the current government; that we need to have the capex in place in order to have more sustainable growth. This counter cyclical capex may continue until the corporate capex spending becomes more entrenched and then it will give way for corporate capex spending and the government can retract some of the spending that it is doing.

I think that's also because there are technical factors that come into play when you look at the markets on a shorter horizon. Ownership matters, incremental paid matters, and in the banks, I think the incremental offer has been larger than the paid because of the extent of ownership, especially with foreign portfolio investors, that they have long held in banks. So, I think they are diversifying their portfolios now and therefore, banks are getting more offers from them. That I think may shift as a template going into 2024.

Fundamentally, I think the banks are hurt because of thresholding, and I think the market is completely convinced that the depression is over. What we think is that the worst is getting behind us. We think credit growth will remain quite good. The only one imponderable is the extent of credit losses that may come on some parts of the retail portfolio. I don’t think it's going to be a very major thing. There may be scattered losses in some of the unsecured personal loans. But we are very, very far away from any protracted build-up in credit losses. I think the template for bank earnings looks good.

The large cap private sector banks are actually trading quite attractively on valuations and in many of the cases, it is the cheapest that we have got them in many years. So, I think, going to see inflow of domestic money where the ownership is not as large as it is with foreigners, and I think as soon as this bid offer gets tilt. I think you will see the share prices perform.

I will still back financials quite heavily going into 2024 and I think the only other place where things look quite good is consumption.

Household balance sheets are leveraging. They are spending their future income, it's something that India has not seen in the past. It's a trend that I think will continue to persist over the next few years. India is breaking out in terms of per capita income. From this ‘23 mark, there were a lot of basic consumption tends to peak out in real terms, basic means Roti-Kapda- Makaan, that tends to peak out. Incremental income will go into discretionary spends of all kinds. I think consumption is a good theme and we have already discussed investments. I think industrials will also continue to find favour. So that's how we think about the sectoral outcomes in the market for 2024.

I think I am hoping that we do not get any upheaval in the election outcome, which derails India's macro story because India is in a very sweet spot. It's rising in the global order. It is the destination for a lot of MNCs and for a lot of global investors. I converse with a lot of them and in fact, my meetings and conversations are at what is happening, and it just tells you about the interest that is there and people politically, and I think we are set for a golden period in in India's performance, both on the macro as well as the stock market.