Why Goldman Sachs Is Bullish On Earnings-Driven Returns Amid India Valuation Concerns

Sunil Koul: I would say, look, I think in terms of the foreign flows, you're right, like India has been seeing foreign outflows, I think the month to date, we already saw about 2 billion foreign selling from the July peak. It's probably around 3 billion selling. But I think, as you mentioned, we also have to look at the broader context in terms of what's happening around the globe. So obviously, we had a lot of volatility in the markets in July and August. So if you look across the region, in Asia, but also broadly in the EM, we have seen close to 18 billion selling in the markets.

So, I think India was just a part of the global risk of what we are hearing also from the clients, is that even though markets have recovered in August, people are still kind of de-risking across the regions. We are not seeing it just in India, but also in Taiwan, in Korea, in China, onshore markets as well. So, I think it's a part of a global selloff and to be fair, I think India, in fact, has been outperforming in performance terms, both in July and August in general. I think that just shows India's resilience in the face of the global selloff. So I wouldn't read too much into the global sort of outflows in India. It's just the broader de-risking in the region which India is also a part of. 

Sunil Koul: There is, I mean, in fact, I think valuation remains the topmost, I think concern from clients in terms of India's story. I think the great fundamental story is pretty well known, but in the greatest pushback we continue to see around valuations. But I would say a couple of things about that. Tamanna, I think if you just look at the aggregate market, Nifty is trading at roughly around 21 times forward earnings, MSCI India is a bigger index, and has a bit of mid-caps in there as well.

So, trades are a bit more expensive, around 23 times forward. But if you look at what we think, the fair value for Indian equity is based on the domestic growth outlook, global growth outlook, the fund flow situation, we think around 20 times forward earnings is a fair multiple. So, I would put India's valuations as richer, but not sort of in the overvalued territory, if you look at that, in that context, I think it's also important to look at India's valuations relative to everything else, particularly emerging markets or the other region and in Asia.

So, India is, right now, trading at 80% premium to the region. So, the last five years average is around 50% but the peak was around 100% plus. So again, I think if you look at that metric, it will tell you that India is kind of trading like a growth stock, where foreign investors are giving it a premium, but it's not super expensive from that standpoint. I think the last point I would make is that you also have to look at the valuations in the context of the market performance and underlying earnings. So in MSCI India terms, the market was up 20% eight months into the year, we are another up 20%. So the market has had like 40% plus returns in the last 20 months or so. But if you disaggregate that 40% returns into how much came in from multiple expansion versus how much came in from underlying earnings, almost 30 percentage points and a little bit more of that has come in from underlying earnings.

So the multiple expansion has been only in sort of single digits. So, if you came into 2023 India was trading at, MSCI India was trading at 23 times multiple today is 23 and a change, 23 and a half. So in aggregate, the multiple hasn't expanded. Obviously, different sectors have moved a lot, but a lot of the underlying move has been drawn/driven by underlying earnings, which we think is obviously a good thing to have, and which is why we are positive on the market.

Sunil Koul: Probably not on the back of the rebalancing, because the rebalancing is kind of more of a technical event. It happens at the end of the month. The reason India is getting sort of 4 billion-plus inflows is because you have seven stocks that are coming into the index in MSCI India and so the number goes from 140 plus stocks to nearly 150 stocks there. So the flow is very concentrated in these names that are getting included.

Also, you have the largest private bank where the foreign inclusion factor was increased. So that's also driving a lot of flows. So I think it's really kind of concentrated in a few stocks, and large technical in nature, which is why, because of the index rebalancing, the passive will have to do it. But we don't think it necessarily means that active will need to follow. But I think the bigger picture here Tamanna Is that, as you show in the picture, that India's weight in the emerging market is going to increase, or MSCI, and this is going to increase so from 19% or 19.4 as you saw, is showing the table, it's going to be close to 20% of MSCI EM, and China is at 22.

So, India is kind of a close number two in terms of the weight. So that means that it will be the second largest market in EM, and very close to China, and so over time, we think that will encourage more active investors to come in and increase exposure to the market.

Sunil Koul: Look, I think the risk appetite sort of waning is, again, sort of something we are seeing across the region. As I said, I think in general, for Asia, for emerging markets, when you talk to clients, it's very clear that, obviously, markets have been super volatile in the last couple of months. We also have, as you started the show with sort of Fed policy coming in, Chairman Powell, comments coming up. But more importantly, you have US elections coming in November. So I think the general sense is that markets are likely to remain volatile across the globe, and so people are generally going to be risking into the event, which is why we kind of are seeing risk appetite barometers, not just in India, but pretty much across the board, at lower levels, and a large part of that is because of the foreign selling we just started the show with.

But I think domestic flows are obviously a separate story, which is what has been holding up the market as we know. I mean, to ask, that seems like a structural trend, because, as we know, India's household balance sheet exposures are still pretty low compared to, sort of, regional peers. 6%, 7% of the household balance sheets are in equity markets. In the U.S., that's north of 40%, in Europe, that's 20-30%, even in Asia, I think the average is more like 15%. So we think this is kind of a structural trend, and it has more room to grow. I think, therefore, domestic flows will continue to support the market here.

In addition to that, you also got mutual funds sitting on decent cash balances, around 4% of AUM, which in absolute terms, is north of 10 billion US dollars. So, you got sort of more money coming in from retail in terms of SIPs, which are hitting new highs every month and then you also got mutual funds by themselves sitting on large amounts of cash balances, which we think will continue to support the market here.

I think what it means is that in these environments of global risk of, India will continue to be sort of outperforming on a relative basis, even if, directionally, it may be kind of more flat lining or go down, but it will still be outperforming the emerging markets, broadly speaking, over the next few months.

Sunil Koul: No, I think that's a fair question. I would say, look, I think the fact that the market is becoming bigger, economy is becoming bigger, and you've got liquidity improving in the market, I think that should get more investors into the market and so obviously it's kind of already sort of a four trillion economy and an equity market and liquidity which was always concentrated in the top, kind of 50-odd stocks and Nifty 50, is obviously broadening out. The way we started the show, I think MSC India is a good example of that. A few years back, it used to only have 60-70 stocks.

Today, you are double of that index which has both a market cap and a liquidity criteria. So you're kind of seeing the market broadening out and we are also seeing people or foreign investors taking risk beyond the top stock. So I think that that's important, and I think that's a trend that will continue. We are also seeing more and more funds that are having sort of non-China mandates, Asia X China, EM X China mandates and in that sort of scenario, India sort of is almost 25%-plus of the mandate.

So, I think you're also seeing sort of that trend play out. I think the global funds being underweight India is something which is true for many markets in the region and EM in general, because many of these global funds tend to have a DM bias in their allocations, and part of that comes in from sort of home country bias as well, or where they are sort of domiciled. A large part of them are in Europe or actually in the U.S. So it's not specific to India, but what we are seeing is that when a market becomes larger in indices, and with decent liquidity and size, you typically start to see allocations improve.

So we are therefore hopeful that, given the superior fundamental story and the market becoming much more liquid and bigger, you should see foreign money sort of coming back into India. I think, as we see from the foreign allocations or foreign ownership data, I mean, the foreign ownership is at 11-year low, and mutual fund allocation is still conservative. So we think there's a lot of room for allocations to improve here, if earnings continue to support.

Sunil Koul: No, look. I mean to sort of lay out our view there. I mean, our core view on the US economy is that the U.S. economy will continue to sort of expand, rather than a recession scenario. So, we have the U.S. economy growing at sort of 2-2.5% run rate over the next few quarters, or over the second half of the year. So, we think that the U.S. economy is still strong.

Obviously, some conflicting data points, as you mentioned. We had the employment numbers picking up. We had a weak jobs report. I think our sense for that part of that was also coming in from more supply side, in terms of migrant labourers and all of that, as opposed to kind of demand-side weakness in the labour market data and in fact, I think the latest U.S. economy data that came out in terms of retail sales was actually pretty decent.

So overall, I think we do think that even though recession risks have increased, we have increased our subjective probability of recession from 15% to 20% but we still think that overall, the economy is in a decent shape. In terms of the Chair Powell's comment, I think they will be important, because more likely, they will probably continue to reiterate the fact that disinflation trends are in place, but the labour market seems to be weaker, which is sort of consistent with our overall rate-cut view, which is that the Fed will go in September and they will have three rate cuts, this year, September, November and December. I think the market is pricing close to four rate cuts for 100 basis points cumulative this year. So, we are at three cuts, but I think that the Chair Powell comments would probably be consistent with the three-cut scenario. Then we have a quarterly path of 25 basis points rat cuts next year, with a terminal rate of three to 3.25 for the U.S. 

Sunil Koul: Look, I think if Chair Powell, as I said, reiterates the fact that disinflationary trends are in place, which means there is kind of room to sort of cut rates, and at the same time say that there is some weakness in the labour markets. I think that the combination of both of those should be a cue for the market that the rate cuts are coming. I think there is an outside case that it could be even more dovish to the extent that if he says that the rates are too high, obviously, that could be an indication that the rate cuts are imminent.

But our sense is that even if they broadly reiterate the message that you have inflation coming down, and you have some weakness in the data and that should be a signal for the market that rate cuts are imminent, and the market, in fact, will obviously pricing in more than 100% sort of chance for a rate cut in September and we think in a base case, that's more likely to happen.

The other thing in terms of rate cuts and equity markets, the linkage, what's important is that, I mean, if you look at the Fed rate cut cycles, because we get this question from investors often, is that, how does markets react to Fed cuts, Asia or EM or India for that matter? I think if you go back, there are sort of eight Fed rate cut cycles going back to the early 90s. Four of them have ended up in recession over the next 12 months. Four of them have ended in a non-recessionary sort of Fed rate cuts. It's very clear that if there is a recession scenario, despite Fed cuts, the market doesn't do as well, but in a non-recessionary Fed cut environment, that's generally good for risk assets, good for Asia and Emerging market equities, including India, and that should spur inflow. So, in our base case, as I mentioned, if we do, if you're right in terms of the fact that the U.S. economy will continue to expand, and you get Fed cuts starting September, I think that should be better for risk sentiment overall.

Sunil Koul: Look, I mean, as you said, Tamanna, a lot could happen in the next two and a half months. I mean, the prediction markets have sort of moved all across the place in the last two months, since sort of Biden pre-debate versus now Harris coming in and so depending on, I mean, so if you look at the scenarios, obviously there is sort of Republican Presidency versus the Democratic Presidency, and then there is the divided house versus the sweep. So there are four scenarios in between, and the outcome for the asset markets would be pretty different depending on what comes out and obviously there's a lot of uncertainty, as I said at the moment. But I think what's true is that even though the polls are predicting a tight race, there will continue to be news flow around the U.S. elections over the next two months plus, which is why I think we have taken a generally a sort of more defensive and cautious view on the markets.

A lot of the client questions we are getting around is, is more around the potential impact of tariffs, and if they come through, which market should be more impacted? Which markets would be less impacted? I think that's where people are running some scenarios at the moment. But I would say I think in context to India, I think India is still a market where the spillovers from the U.S. election should be fairly sort of limited or contained. So, I think when people are kind of looking across the emerging market and thinking about sort of potential tariffs, I mean, you want to be in the markets which are largely kind of domestic in nature, which are largely kind of isolated from these risks, and potentially have lower risk of tariffs if they come through.

So, I think India kind of checks those boxes, along with some other more defensive pockets in the EM. So, it also, therefore, is a decent sort of defensive hiding spot for the next few months in that context. I think there's a fair degree of agreement within the client community, on that, as well. So, I would say, look, I think it would probably keep markets volatile across the emerging markets in general. I mean, China is a big part. So are Korea, Taiwan, which might be impacted. Obviously, Mexico and Black-Tie markets also in 2018-19 were impacted from all of that. So, there are a lot of EM markets which probably are more impacted from this event. But our sense is that India has relatively less sensitivity to these risks. So, it should hold on pretty resiliently.

Sunil Koul: Look, I mean, we don't have strong views in terms of the actual outcome of the elections, but I would say in terms of a different scenario, as I mentioned, I think clients do think that in case of a Republican Presidency, that probably means lower tax rates, that probably means sort of more fiscal sort of push, which is good for growth, which should be good for sort of asset markets in general, whereas, if you see a Democratic Presidency, and again, depends on whether it's a divided house versus sweep, in terms of what they can pass or what they can't pass. But in general, that means probably higher taxes, corporate tax rates. I mean the Harris' administration has talked about that, and that particularly may not be so great for asset markets. So again, we need to see how this plays out. But I think if there is one thing we could be certain over the next couple of months is that market volatility will probably continue to pick up which has been the case in the last couple of months.

Sunil Koul: Look, I think we still like the domestic sectors in India, and so we are overweight on things like autos. That has done very well for us, I mean, but that's a position we still hold. We are overweight industrials on the generals of focus, continued focus from the government on infrastructure and obviously that got reiterated in the budget. We still like some of the defensive pockets, including telcos with tariff hikes.

So, we do like insurance within the financials, as well as a defensive place where a lot of the regulatory headwinds are behind us. So, I think in general, our preference continues to be kind of domestic sectors or some of the external facing sectors. Then we also like a lot of the Thematic pockets in the market, including the themes of, sort of Agri and allied industries, the theme of clean Energy, or energy security in general, Defence is an area which we have been emphasising, and this sort of broader theme of, sort of Make In India, PLIs that's also something we have in reiterating.

So, I think beyond the headline index, where the broad view remains that the market still goes higher in 12 months on the back of underlying earnings, and we have a 26,000 target on Nifty. I think beneath the headline index. There are a lot of these thematic pockets, which we think will continue to have stronger interest over a medium term.