India

Indian stocks have gone up this year even as the broader EM markets have been falling. How long can Indian markets continue to rise?

Indian EPS growth is set for major disappointments vis-à-vis the lofty expectations. Weak domestic demand amid tight fiscal and monetary policy entails more downside in stock prices. Stay underweight.

In this Special Report, BCA Strategist Ritika Mankar highlights that India may prove to be a sanctuary of safety in what promises to be a volatile 2023. Indian equity outperformance could continue, as India ends up offering relatively high growth at a time when EMs at large must contend with the effects of declining exports, high global interest rates, and exhausted fiscal stimulation capabilities.

India’s lofty EPS growth expectations are set for a major disappointment. The RBI has overtightened monetary policy despite the absence of any genuine inflationary pressures in India. Fiscal stance is also restrictive. Stay underweight this bourse in EM and Emerging Asian equity portfolios.

Listen to a short summary of this report.     Executive Summary US Lead On Mega-Sized Firms: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? The US has been the star protagonist of global equity markets for decades. It offers investors the rare combination of a big economy and a large universe of mega-sized listed companies. In fact, the overwhelming majority of the top 20 largest firms globally by revenue today are American. But can the US maintain this degree of presence on this list over the next decade? We think that this is unlikely. For starters, a decline in the US’s footprint could be driven by the fact that there is a peculiar stagnation in the works in the middle tier of American firms. Given that this tier acts as a talent pool for big firms, a stagnation here could mean that the US spawns fewer super-sized firms. The high market share commanded by big American firms could also end up being a liability. This dominance could bait regulatory attention, thereby affecting these firms’ growth prospects. Finally, slowing GDP growth in the US, as compared to its Asian peers, will prove to be another headwind that American firms must contend with. What should strategic investors do to prepare for this tectonic shift? We recommend reducing allocations to US equities over the long run since the US’s weight in global indices will peak soon (or may have already peaked). Bottom Line: Irrespective of what the Fed does (or does not do), the US’s footprint in the global league tables of big firms by revenue will weaken over the next decade. Strategic investors can profit from this change by reducing allocations to US equities while increasing allocations to China as well as a basket of countries including Korea, Japan, Taiwan, and Germany.   Dear Client, This week, we are sending you a Special Report by Ritika Mankar, CFA, who will be writing occasional special reports for the Global Investment Strategy service on a variety of topical issues. Ritika makes the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. We will return to our regular publishing schedule next week. Best Regards, Peter Berezin, Chief Global Strategist US: Home To The Largest Number Of Big Listed Firms 2022 has been a turbulent year for US markets so far. But it is worth bearing in mind that the US has been the star protagonist of global equity markets for decades. This is because the US has offered investors a near-perfect trifecta constituting of: (1) A mega-sized economy; (2) A large universe of mega-sized listed companies; and (3) A track record of market outperformance. Specifically: Largest Economy: For over a century now, the US has been the largest economy in the world – a title it is expected to defend over the next few years (Chart 1). Large Listed Companies: The US’s high nominal GDP has also translated into high sales growth for its listed space. This, in turn, powered a great rise in the American equity market’s capitalization (Chart 2). In fact, the US’s market cap is so large today that it exceeds the cumulative market cap of the next four largest economies in the world, by a wide margin. So unlike Germany or China (which have large economies but small markets), the US has a large economy and is also home to some of the largest, most liquid stocks globally. Chart 1The US Will Remain The World’s Largest Economy For The Next Few Years America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 2The Listed Universe In The US Has Grown From Strength To Strength America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 3Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Growing Sales In The US Have Powered Its Outperformance Over The Past Decade Long History of Outperformance: And most importantly, the US market has a strong track record of outperformance. US markets have outperformed global benchmarks over the past decade thanks largely to the rapid sales growth seen by American firms (Chart 3). Notwithstanding the US’s star role in global markets thus far, in this report we highlight that the US’s heft will likely decline over the next decade. The Fed may or may not administer recession-inducing rate hikes in 2022. But irrespective of what the Fed does over the next 12-to-24 months, the US’s loss of influence in global equity markets appears certain because it will be driven by structural forces. Chart 4US Lead On Mega-Sized Firms: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Firstly, while behemoths such as Apple and Amazon have been attracting record investor attention, it is worth noting that the next tier of mid-sized American companies is no longer thriving as it used to. The reason why this matters is because history suggests that the pool of mid-sized companies acts as a superset for the big companies of tomorrow. So, if this talent pool is not booming today in the US, then there is likely to be repercussions tomorrow. Secondly, the US’s largest firms will have to contend with two structural headwinds over the next decade, namely increased regulatory attention and slowing growth. To complicate matters for American firms, competitors in Asia will not have this albatross around their neck. Hence, the US may remain the largest economy of the world a few years from now but is unlikely to be home to as many big, listed companies as it is today (Chart 4). The rest of this report quantifies the strength of these forces, and then concludes with actionable investment ideas.   Trouble In The Talent Pool Chart 5The US Is Home To Nearly A Dozen Mega-Sized Firms Today America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? 2021 produced a special milestone for the American economy. This was the first year that ten listed American firms1 surpassed $200 billion in annual revenues (firms we refer to as ‘Big Shots’ from here on) (Chart 5). The US has been a global leader when it came to the size of its economy for decades, but last year it also became home to the largest number of big, listed corporations (Table 1). American Big Shots were striking both in terms of their number as well as their scale. In fact, such was their scale that the combined revenue of these ten Big Shots now exceeded the nominal GDP of major economies like India (Chart 6). Table 1The US Today Dominates The Global List Of Top 20 Firms America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 6The Revenues Of US Big Shot Firms Are Comparable To India’s Nominal GDP! America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? While the world has been captivated by the size that the US’s Big Shots have achieved (as well as the ideas of their unconventional founders), few have noticed that the talent pool for tomorrow’s Big Shots is no longer burgeoning. History suggests that most Big Shot firms tend to emerge from firms belonging to a lower revenue tier.  For instance, Amazon and Apple, which have revenues in the range of $350-to-$500 billion today, were mid-sized firms a decade ago with revenues in the vicinity of $50-to-$100 billion (Chart 7). Chart 7Most Big Shots Today Were The Mid-Sized Firms Of Yesterday America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? This is why it is worrying that all is not well in the US’s ecosystem of mid-sized firms. If we define firms with annual revenues of $50-to-$200 billion as ‘core’ firms, then their share in the total number of American firms has stagnated over the past decade (Chart 8). Even the revenue share accounted for by core firms has been fading (Chart 9). This phenomenon contrasts with the situation in China, where the mid-sized firms’ cohort has been growing over the last decade (Charts 10 and 11). Chart 8Share Of Mid-Sized Firms In The US Has Stagnated America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 9The Revenue Share Of US Mid-Sized Firms Is Also Falling America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 10Share Of Mid-Sized Firms In China Is Expanding America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 11The Revenue Share Of Chinese Mid-Sized Firms Is Rising America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Japan’s experience also suggests that when the mid-sized firms’ ecosystem weakens, the pipeline of future potential mega-cap companies get affected. In Japan, the proportion of core firms (Chart 12), as well as their revenue share (Chart 13), has not been growing as is the case, say, in China. And this is perhaps why, despite being the third-largest economy in the world today, Japan is home to only one listed mega-sized corporation with revenues of over $200 billion (Toyota). Image Chart 13The Revenue Share Of Japanese Mid-Sized Firms Has Plateaued America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? The US May Have Hit Peak Oligopolization The fact that ten Big Shot firms (i.e., firms with annual revenues of over $200 billion) exist in the US today is remarkable. After all, the number of Big Shot firms in the US today exceeds the total number of Big Shots in the next four largest economies of the world combined (Chart 14). Chart 14The US Today Is The Global Hub For Mega-Sized Companies America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? So why will the US’s leadership in this area come under pressure going forward? One reason is that the large size of American firms could itself become a liability. Specifically: Public Backlash Against The US’s Big Shots: The ten Big Shot firms of the US today account for more than a fifth of the revenue generated by all firms that constitute the MSCI US index (Chart 15). Also, the number of Big Shot firms, as a share of total firms, is high in the US (Chart 16). Chart 15Big Shots Account For More Than A Fifth Of Revenues Generated By The US Listed Space America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 16A Large Proportion Of Firms In The US Are Very Big America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Notably, market leaders across a range of key sectors in the US account for an unusually large chunk of the sector’s revenues. Financials, Information Technology, and Consumer Discretionary together account for about half of the US equity market index’s weight. The dominant firm in each of these three sectors (as defined by MSCI) accounts for 15%-to-25% of that sector’s revenue (Chart 17). Market power usually benefits investors. But too much market power can be a problem. The growing oligopolization of the US economy has caused public dissatisfaction over the influence of corporations in the US to hit a multi-year high (Chart 18). Over 60% of Americans want major US corporations to have less influence. It is for this reason that the record scale acquired by American firms could prove to be an issue. American mega-scaled firms’ high market shares will provide them with pricing power, but this very power will end up baiting regulatory attention and anti-trust lawsuits which, in turn, will restrict their future growth rates. The fact that the US Federal Trade Commission (FTC) today is headed by a leader who wants to return the FTC to its trust-busting origins, and made her name by writing a paper arguing for Amazon to be broken up,2 is indicative of which way the wind is blowing. Chart 17Market Leaders In The US Are Too Big America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 18Public Dissatisfaction With US Big Shot Firms Is High And Rising America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Interestingly, the speed at which the US restricts the market power of big firms will determine how quickly the US’s mid-sized firms begin to flourish again, thereby setting the stage for the US to spawn a new generation of big firms. Besides the growing regulatory risks for the US’s big firms, three other technical factors will end up slowing the pace at which the US can generate large firms, namely: Slowing GDP Growth: Since the US is a large and mature economy, the pace of its growth is bound to slow (Chart 19). Besides the deceleration in the US’s growth rate relative to its own past, it is projected to end up being lower than that of major economies like China. Chart 19US GDP Growth Is Set To Slow America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Big Business ≠ Big GDP Growth: While GDP growth receives a fillip when small firms grow, the high pricing power that very large firms command can end up constraining an economy’s growth rate. This is because large firms can charge monopolistic prices, thereby restraining demand. Secondly, mega-sized firms may actively invest in manipulating institutions to block upstarts,3 a dynamic that can restrict productivity growth as well. Chart 20The Revenue-To-Nominal GDP Ratio Is Already Elevated In The US America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Approaching Revenue Saturation: A cross-country comparison suggests that the revenue-to-nominal GDP ratio in the US is high1 (Chart 20). Only Japan has a superior ratio, which is likely to be an aberration rather than the norm (owing to Japanese firms’ unique tendency to prioritize revenues over profitability). Given that the US revenue-to-nominal GDP ratio is already elevated, it is likely that even as the US’s nominal GDP keeps growing, the pace of conversion of this GDP into revenues will stay the same or may even diminish over the coming decade.   Prepare For A Brave New World “German judges…first read a description of a woman who had been caught shoplifting, then rolled a pair of dice that were loaded so every roll resulted in either a 3 or a 9. As soon as the dice came to a stop, the judges were asked whether they would sentence the woman to a term in prison greater or lesser, in months, than the number showing on the dice…On average, those who had rolled a 9 said they would sentence her to 8 months; those who rolled a 3 said they would sentence her to 5 months; the anchoring effect was 50%.” – Daniel Kahneman, Thinking, Fast and Slow (Farrar, Straus and Giroux, 2011)   The US has been the largest economy in the world and has also been able to nurture some of the largest mega-scaled companies of today. Such is the might and size of these firms that it is impossible to imagine a world where American firms’ leadership could be disrupted. Moreover, it is mentally easier to extrapolate the US’s lead today into the future. It may even seem like there is no other alternative to the US since Japan’s economy has been stagnating, Europe lacks innovation, and the political environment in China is contentious. Also, it is true that the US today is the undisputed leader when it comes to qualitative factors such as the ability to attract top global talent, its education system, and its legal system. However, the case can be made that this belief (that the US’s lead on mega-sized companies will spill into the next decade) runs the risk of becoming a Kahneman-esque anchoring bias. This is because: History Suggests That Upsets Are The Norm: History suggests that the evolution of the top 20 global firms (by revenue) has been a story of upsets. For instance, Europe’s hold over this list in the 2000s was striking by all accounts (Chart 21). Back then, it would have been almost blasphemous to question Europe’s lead (Chart 22). But today firms from three Asian island-countries account for more companies on this list than all of pre-Brexit Europe put together. Chart 21In The 2000s, Europe Was The Epicenter Of Global Mega-Sized Firms America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Chart 22How The Mighty Can, And Do, Fall America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? ​​​​​​​China’s Disadvantages < Its Competitive Advantages: Despite its political baggage, China has the most formidable capability today to displace the US’s leadership position on the league tables of top 20 global firms by revenue. This is because China has a thriving ecosystem of core firms (Chart 11) and is set to grow at a faster clip than the US over the next five years (Chart 19). Moreover, while the Chinese government’s tolerance for large tech giants could remain low, the establishment could be keen to grow firms in the industrials as well as financials space for the sake of common prosperity. EM Listed Space Can Catch Up: The listed space in the US has developed at an exceptionally fast pace relative to its peers. The gap between US nominal GDP and listed space parameters is low (Chart 20), while the gap is wider for countries like Germany, China, and several other EMs. Even in a ceteris paribus situation where nominal GDPs were to stay static, an increase in the size of the listed universe in other countries can adversely affect the US’s current footprint. So, what can investors do to prepare for this coming tectonic shift? We recommend reducing allocations to US equities since the US’s weight in global indices will peak soon. It is worth noting that this strategic investment recommendation dovetails nicely with our earlier view that strategic investors should rotate out of US stocks. Currently, about half of the 20 largest firms globally by revenue are American (Map 1). Owing to the dynamics listed above, the number of American firms in the global league of top 20 could fall from this high level to 7 or 8 over the coming decade. Given that this change is indicative of things to come, we would urge investors to reduce allocations to US equities in a global portfolio over a strategic horizon. A confluence of micro and macro factors is likely to result in the US’s weight in global indices to crest sooner rather than later. Map 1Could The Global Epicenter Of Big Firms Drift Eastwards Over The Next Decade? America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? In fact, US equities’ weight in a global index like the MSCI ACWI could have already peaked (Chart 23) and could fall by 500-to-600bps over the next decade if the last year’s trend is extrapolated into the future. As regards to sectors, health care appears to be the key industry where the US’s footprint could weaken (Table 2). Chart 23Loss Of US Influence Will Create Space For Underrepresented Markets To Grow America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? Table 2China’s Weight In Top 20 Firms Is Set To Grow America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? As the US cedes its leadership position, we expect the global epicenter of mega-sized listed corporates to drift eastwards (Map 1). Specifically: China: Currently, less than a quarter of the 20 largest firms globally by revenue are Chinese (Map 1). It is highly likely that the number of Chinese firms in the global list of top 20 firms will increase. China should be able to spawn more mega-sized companies since it already has a cache of promising large and mid-sized companies. Chinese companies will also benefit from the high growth rate of China’s domestic economy. From a sectoral perspective, financials and industrials appear to be two sectors where China’s footprint could grow the most (Table 2). Asia Ex-China: Asian countries like Korea, Taiwan, and Japan could potentially end up growing their weight in global equity indices by becoming home to more than one company that makes it to the global league tables of large companies. Besides the high GDP growth rate on offer in their domestic markets (Chart 20), firms in these countries could increase scale by feeding a stimulus-fueled industrial boom in the US. Additionally, these Asian countries have a competitive advantage when it comes to high-tech manufacturing capabilities (Chart 24). This will ensure that they will accrue any offshore opportunities that arise. Taiwan has the potential to grow its presence in the Information Technology space, given its innate competitive advantages (Chart 24) and the positive structural outlook for global semiconductor demand. In the case of India, it is worth noting that the country’s influence in the world economy will be ascendant over the next decade as its growing middle class flexes its muscles. Despite this, the probability of an Indian firm making an appearance among the largest firms of the world is low given the unusually small size of Indian companies today. Europe: Distinct from the Asian countries listed above, Germany could benefit from the industrial boom in the US given its capabilities when it comes to high-end manufacturing (Chart 24). ​​​​​​​Even as we believe that oil faces a bleak future on a structural basis, if a commodities supercycle were to take hold over the next decade, then the UK and France could improve their presence in global equity benchmarks given that Europe is home to some large firms in the energy sector. A commodities supercycle will also end up benefiting China and the US, since some large energy producers are also located in these countries. Chart 24Korea, Japan, And Germany Have An Edge In Manufacturing, While Taiwan, Japan, And China Have An Edge In Semiconductors America's Lead On Mega-Sized Companies: Is A Peak Nigh? America's Lead On Mega-Sized Companies: Is A Peak Nigh? ​​​​​​​Appendix The Methodology The starting point for most country-level economic analyses tends to be a country’s nominal GDP. But as market economists we realized that some key advantages could be unlocked by focusing on ‘revenues’ generated by the listed universe of a country. These advantages include: Investment Focus: As compared to nominal GDP which ends up picking up signals about the health of the listed ‘and’ unlisted firms in any country, focusing on listed firms’ revenues allows us to home-in on the health of the listed space. This is a valuable merit since the listed space is what public equity investors can buy into. For example, India is the fifth largest economy of the world and is also one of the fastest growing economies globally. But India is also characterized by a listed space where the largest companies have revenues of only around $100 billion. This makes India less investable than countries like Taiwan or South Korea that have far smaller nominal GDPs as compared to India but are home to firms with revenue of around $200 billion. Taking note of this difference - between the size of a country’s nominal GDP and the size of investable firms in a country - is key for our clients. Focus On Cause, Not Effect: It is fashionable today in the financial press to focus on the daily changes in market capitalization of assets (and non-assets too). But it is critical to note that the market cap of a stock or the price of a security is a dependent variable. Revenue, on the other hand, is a key independent variable that influences prices. So, a focus on forecasting movement in revenues of companies in a country ten years down the line, can be a more fruitful exercise for strategic investors. Steady And Stable: Revenue generated by a firm, is also a superior measure as compared to the market capitalization of a firm because the latter can be volatile. Whilst it could be argued that earnings of a company as a variable also offer stability and influence prices, earnings suffer from one drawback which is that it is a function of revenues as well as costs. Revenues of companies on the other hand have a direct theoretical link to the nominal GDP of a country. So, to rephrase a popular adage - market cap is vanity, nominal GDP is sanity, but revenue is king. This is the reason why in this Special Report, we analyze investment opportunities through the lens of revenues generated by listed firms in some of the largest economies of the world. We do so by focusing on the constituents of MSCI Country Indices (Equity) for major world economies in 2021. ​​​​​​​ Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Footnotes 1  Based on MSCI ACWI data for 2021. 2  Kiran Stacey, “Washington vs Big Tech: Lina Khan’s battle to transform US antitrust,” ft.com, August 2021. 3  Kathy Fogel, Randall Morck, and Bernard Yeung, “Big Business Stability And Economic Growth: Is What’s Good For General Motors Good For US?”, NBER Working Paper No. 12394, nber.org, July 2006.

Executive Summary Following an unprecedented exodus by foreign investors, Indian stocks’ absolute valuations have cheapened significantly. A breakdown in crude oil prices will help put a floor under Indian firms’ profit margins. India’s decent domestic fundamentals indicate that non-financial firms’ topline (revenues) should hold up. That entails only a limited drop in EPS, given that margin compression is late. Lower commodity and crude prices will help tame inflationary pressures; and will necessitate less rate hikes from the Reserve Bank of India (RBI). The rupee might be at a risk in the near run as the broad US dollar overshoots, but the currency’s medium- and long-term outlooks are positive. That said, Indian stocks’ relative valuations versus their EM and Emerging Asian peers remains far too expensive to recommend an upgrade just yet. Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Bottom Line: Equity investors should stay underweight this bourse in EM and Emerging Asia portfolios for now, but place this market on an upgrade watchlist. Absolute return investors should remain on the sidelines given the strong headwinds faced by global equities. Fixed-income investors should continue to accord a neutral allocation to India in EM and Emerging Asian domestic bond portfolios. Feature Indian equity markets witnessed an unprecedented exodus of foreign investors over the past nine months. Net equity outflows, at $36 billion since October last year, have now reversed the entire foreign equity inflows of $38 billion that took place during the preceding 18 months. Indian stock prices – which are highly sensitive to foreign investor inflows – have fallen in tandem (Chart 1). Chart 1Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Chart 2India Has Rcecntly Underperformed As China Has Outperformed India Has Rcecntly Underperformed As China Has Outperformed India Has Rcecntly Underperformed As China Has Outperformed The large selloff by foreigners has been instrumental to India’s recent mild underperformance relative to its EM and Emerging Asian counterparts (Chart 2, top panel). We had tactically downgraded Indian stocks to underweight in March this year, which has so far worked out well.  Notably, India’s recent underperformance versus the EM benchmark has been mostly due to investors rushing back into Chinese stocks, which had fallen to very low levels earlier this year. Indian stocks’ performance has been at par with EM ex-China equities in recent months (Chart 2, bottom panel). That said, global macro backdrops are changing gradually. Oil prices have begun to break down, which is a net positive for India, a large crude oil importer. India’s domestic growth indicators also appear to be decent – pointing to a steady top-line (revenues) outlook. This bourse therefore might begin to look attractive again to foreign investors whose Indian equity holdings are now quite low. On the negative side, India’s relative valuations versus EM and Emerging Asia remains very stretched – both by regular measures and in cyclically adjusted terms (Chart 3). Weighing all the pros and cons, we recommend that equity investors stay underweight this bourse in EM and Emerging Asia portfolios for the time being, but put it on an upgrade watchlist. Absolute return investors should remain on the sidelines given the strong headwinds faced by global equities.  Is The Multiple Compression Over? The ongoing selloff in Indian stocks can be attributed to derating (Chart 4). The trailing P/E ratio has fallen substantially from a pandemic high of 39 to 21; whereas the forward P/E has also fallen from 24 to 19. Chart 3Indian Markets Are Still Very Expensive In Relative Terms Indian Markets Are Still Very Expensive In Relative Terms Indian Markets Are Still Very Expensive In Relative Terms Chart 4The Ongoing Selloff In India Can Be Attributed To Multiple Derating The Ongoing Selloff In India Can Be Attributed To Multiple Derating The Ongoing Selloff In India Can Be Attributed To Multiple Derating   That said, the contraction of multiples, one of the two drivers1 of stock prices, appears to be at a late stage. The reasons are as follows. Chart 5Falling Commodity Prices Will Help Put A Floor Under Indian Firms' Profit Margins Falling Commodity Prices Will Help Put A Floor Under Indian Firms' Profit Margins Falling Commodity Prices Will Help Put A Floor Under Indian Firms' Profit Margins As we explained in our previous report on India, commodity prices are the sole source of current inflation in this economy. Receding global commodity prices will therefore rein in the inflationary pressures in general, and producer prices in India in particular. The top panel of Chart 5 is showing that Indian producer prices track global commodity prices closely. Hence, the former is set to decelerate significantly in the next few months. What this means for Indian firms is that their cost of raw materials will ease up. At the same time, since global commodity prices have much less of an impact on India’s consumer inflation, the latter will not subside as much. In other words, CPI will rise relative to PPI, as shown in the middle panel of Chart 5. When this happens, it is usually a positive for firms’ profit margins (Chart 5, bottom panel). As such, in the coming months, one can expect firms’ margins to have some support. If we consider only crude oil, we see a similar dynamic. Any drop in crude prices (shown inverted in Chart 6) do help boost Indian firms’ margins, albeit with a few months lag. Hence, in the months ahead, as crude prices break down, firms’ margins will also find a floor sooner rather than later.  Profit margins, in turn, are a major driver of stock multiples (Chart 7). India’s multiples have already fallen to pre-pandemic levels in anticipation of more margin compression in the future. If margins do not compress as much, it’s reasonable to expect that further multiple contractions would also be limited. Chart 6Weaker Crude Prices Are Also Positive For Indian Firms' Margins Weaker Crude Prices Are Also Positive For Indian Firms' Margins Weaker Crude Prices Are Also Positive For Indian Firms' Margins Chart 7As Margins Compression Ends, So Will Equity Multiple Derating As Margins Compression Ends, So Will Equity Multiple Derating As Margins Compression Ends, So Will Equity Multiple Derating   The message is the same if we look at India’s cyclically adjusted P/E (CAPE) ratio: it too has cheapened to the lower end of the past 10-years’ range – thereby already discounting a massive amount of EBITDA margins compression (Chart 8). Chart 8India's CAPE Has Fallen Meaningfully, Already Discounting Material Margin Compression India's CAPE Has Fallen Meaningfully, Already Discounting Material Margin Compression India's CAPE Has Fallen Meaningfully, Already Discounting Material Margin Compression A similar argument can be made in regard to firms’ interest costs. Indian firms’ interest expenses might not rise as much if inflation can be reined in without substantial rate hikes by the RBI. Indeed, India’s headline and core CPI remain largely range-bound (Chart 9) − unlike in most developed economies as well as in Latin America and EMEA. Odds are that they would subside marginally with easing commodity prices. If so, the central bank would be less inclined to raise interest rates considerably. Chart 9Rangebound Headline And Core CPI Mean Too Many Rate Hikes Are Unlikely Rangebound Headline And Core CPI Mean Too Many Rate Hikes Are Unlikely Rangebound Headline And Core CPI Mean Too Many Rate Hikes Are Unlikely Chart 10 shows that India’s trailing P/E has fallen to pre-pandemic averages – already discounting a significant amount of future rate hikes. If interest rates do not rise as much as feared previously, further derating of stocks will also be limited.   How Much Of An Earnings Squeeze Lies Ahead? Indian firms’ raw material and interest costs are likely to alleviate somewhat. Unit labor costs are also unlikely to rise much as wages remain subdued, and robust capital investments suggests that labor productivity gains would remain decent. All this will stop profit margins from contracting much further. And yet, for corporate earnings growth to continue, firms need rising revenues too. So, the next question is, how much top-line growth can be expected? Chart 11 shows the revenues of major non-financial corporations in India. They have already far surpassed their pre-pandemic levels in both local currency and US dollar terms. The outlook for their future revenues also appears to be satisfactory:  Chart 10Multiple Derating May Stop, As Already Discounted Rate Hikes Do Not Materialize Multiple Derating May Stop, As Already Discounted Rate Hikes Do Not Materialize Multiple Derating May Stop, As Already Discounted Rate Hikes Do Not Materialize Chart 11Indian Firms' Top Line Outlook Is Satisfactory Indian Firms' Top Line Outlook Is Satisfactory Indian Firms' Top Line Outlook Is Satisfactory   The purchasing managers’ indices for manufacturing and services are all at decent levels of expansion (Chart 12, top panel). Further, if the order books are of any indication, the expansion should continue in the foreseeable future (Chart 12, bottom two panels). Notably, India is not a major exporter of manufactured goods; and therefore, an impending contraction in global consumer goods consumption would not hurt it as much as it would many other EM economies. An industrial outlook survey by the RBI indicates that firms are expecting their capacity utilization and employment count to rise markedly in the near future. This points to a robust economy ahead (Chart 13). Chart 12Robust Order Books Indicate Economic Growth Will Stay Decent Robust Order Books Indicate Economic Growth Will Stay Decent Robust Order Books Indicate Economic Growth Will Stay Decent Chart 13Firms Are Expecting Rising Capacity Utilization And Employment Firms Are Expecting Rising Capacity Utilization And Employment Firms Are Expecting Rising Capacity Utilization And Employment         India’s bank credit impulse has accelerated strongly – which indicates rising economic activity. Industrial production usually follows suit with a couple of months lag, and this time should be no different (Chart 14). Chart 14Accelerating Bank Credit And Industrial Productions Indicate A Robust Economy Accelerating Bank Credit And Industrial Productions Indicate A Robust Economy Accelerating Bank Credit And Industrial Productions Indicate A Robust Economy Finally, strong post-pandemic capex growth indicates that bank loans have much further to accelerate. Notably, leverage in the Indian economy is still low. Bank credit has hovered at around only 50 - 55% of GDP over the past decade. Total debt levels including bond issuance by non-financial firms have also been flattish at a mediocre level of 65 - 70% of GDP. Limited leverage means there is plenty of room to borrow and kickstart a new capex cycle.  If that transpires, it will be very bullish for Indian stocks in general, and bank stocks in particular – which has the largest weight in the MSCI India index at 23% More importantly, a capex-led growth would boost Indian firms’ competitiveness and profits in the long run. Capex boosts labor productivity, which helps keep unit labor costs down. That, in turn, improves both competitiveness and profit margins. It will also contribute to alleviating structural inflationary pressures in the economy – as lower unit labor costs would keep prices down. The bottom line is that, given the decent economic growth outlook, the top line of most Indian corporations is unlikely to see a contraction in nominal terms. In that case, a minor drop in their profit margins from current levels would entail that EPS contraction, if any, will also be limited. In sum, the outlook for both drivers of India’s stock prices, multiples and EPS, is not as dire as it appeared earlier this year. That at least warrants to place India on an ‘upgrade watchlist’ in an EM equity basket from the current underweight status. The reason we are hesitant to upgrade it outright is that although India’s absolute valuation has eased, its relative valuation vis-à-vis EM and Emerging Asia remains highly stretched.  Finally, in terms of absolute stock prices, the risk-reward of global stocks remains poor as the Fed and US equity markets are on a collision course. As such, investors should wait out the ongoing turbulence before getting back to market. What About The Rupee?  Chart 15Peaking Crude Prices Will Help Ameliorate Trade And Current Account Deficits Peaking Crude Prices Will Help Ameliorate Trade And Current Account Deficits Peaking Crude Prices Will Help Ameliorate Trade And Current Account Deficits The Indian currency has been depreciating versus the US dollar as both current and capital accounts were under downward pressure. That said, both are likely to get marginally better in the months ahead. High global commodity prices caused India’s trade deficits to slide to new lows in June. The current account balance is also weakening (Chart 15, top panel). If, however, commodity prices have peaked in this cycle (which is our view), India’s trade and current account deficits would ameliorate in the months to come. In regard to the capital account balance − which slipped into a rare deficit recently − the deterioration can be attributed to portfolio outflows. FDI and other capital flows, which are more stable in nature, continue to report decent inflows (Chart 15, bottom panel). Given that foreign portfolio repatriation has largely run its course, odds are that the capital account balance will switch back to surplus in the coming quarters. This is because while net portfolio outflows would recede significantly from current high levels, other components of the capital account will likely stay in surplus given the country’s decent long-term growth outlook. If so, that could mean that the depreciation of the rupee is also late. Chart 16 shows that changes in India’s capital flows greatly impact the Indian currency. While the ongoing risk-off sentiment globally may cause the dollar to overshoot in the near term, the rupee outlook is quite positive over the medium to long term.  Chart 16As Portfolio Outflows Wane, Capital Account Will Be Back In Surplus, Benefitting The rupee As Portfolio Outflows Wane, Capital Account Will Be Back In Surplus, Benefitting The rupee As Portfolio Outflows Wane, Capital Account Will Be Back In Surplus, Benefitting The rupee Chart 17The Rupee Is Extremely Cheap In PPP terms Vis-à-vis The US Dollar The Rupee Is Extremely Cheap In PPP terms Vis-à-vis The US Dollar The Rupee Is Extremely Cheap In PPP terms Vis-à-vis The US Dollar Incidentally, the rupee is already extremely cheap vis-à-vis the US dollar in PPP terms. Further depreciation, if any, should therefore be limited. It also makes the rupee attractive for long-term investors (Chart 17).   Notably, the rupee did well compared to other EM currencies over the past several years − in line with our view. It should continue to do so, as growth in India will likely stay stronger than most EM economies. That will attract capital from the rest of the world − beyond any near-term jitters − propping up the currency.  Finally, as the rupee will be under less downward pressure with the improvement in the balance of payments, the RBI will be less intent to raise policy rates in a bid to mitigate currency depreciation. Less rate hikes, as explained before, is positive for stock prices. Investment Conclusions Currency: Amelioration in both terms-of-trade shock and in portfolio outflows will ease up the downward pressures on the rupee in the months ahead. It will also likely remain among the best performers in the EM world even as an overshoot in the broad US dollar in the near term remains a risk. Equities: The key risk to Indian equities are global developments: the rate hike cycles underway globally, slumping DM growth, a strong US dollar, mediocre Chinese growth, and the negative ramifications of the war in Ukraine. As such, Indian absolute stock prices remain vulnerable in the months ahead. Absolute return investors should therefore stay on the sidelines. India’s relative performance versus its EM counterparts has been highly contingent on relative multiple expansions (Chart 18). The recent diversion between them is therefore untenable. And if history is any guide, the relative multiples and relative stock prices should converge to the downside. This argues for staying cautious on India’s relative performance too. We recommend remaining underweight India in EM and Emerging Asian equity portfolios for now; but put this bourse on an upgrade watchlist in view of decent macro fundamentals in India and falling crude prices. Domestic Bonds: Indian government bonds are not as attractive to EM fixed-income investors as the yield differential vis-à-vis other EMs has already narrowed substantially. Going forward also, the yield differential might not move in India’s favor. The reason is that Indian yields will likely inch up, or at least stay firm, with the economy gaining traction (Chart 19). Chart 18India's Relative Performance Remains At Risk India's Relative Performance Remains At Risk India's Relative Performance Remains At Risk Chart 19Indian Bond Yields May Not Fall Much,As They Move With Economic Growth Indian Bond Yields May Not Fall Much,As They Move With Economic Growth Indian Bond Yields May Not Fall Much,As They Move With Economic Growth   Notably, an imminent slowdown in global trade will not hurt India’s growth as much as it would most other EM countries. That reduces the odds of Indian yields falling more relative to its EM counterparts. Chart 20Stay Neutral On Indian Bonds As Their Yield Advantage Has Narrowed Substantially Stay Neutral On Indian Bonds As Their Yield Advantage Has Narrowed Substantially Stay Neutral On Indian Bonds As Their Yield Advantage Has Narrowed Substantially We downgraded Indian government bonds from overweight to a neutral allocation in EM and Emerging Asian domestic bond portfolios in March this year. That recommendation still makes sense (Chart 20). Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1     The other driver being the EPS (Earnings-per-share); discussed in the next section.