It has been a challenging year for Indian asset classes such as equities and bonds. The 10-year bond yield is close to its 2018 high — there has been a sharp rally in crude-oil prices, lower demand for government bonds and higher global yields. Worsening of India’s macro fundamentals at the margin amid foreign outflows has resulted in weakness for the rupee. The rupee is currently among the worst performing currencies in emerging markets.
Volatility has also returned to equity markets amid a confluence of negative factors. Continued banking-sector concerns, and imposition of capital gains tax on equity amid rising trade tensions worldwide has dampened equity sentiment. But all is not gloomy. There are still several positives for the equity and bond markets.
Many tailwinds for bonds
Controlled inflation, stable RBI rates and oversold conditions favour Indian bonds.
CPI (consumer price index) inflation is unlikely to breach RBI’s upper target of 6 per cent, even after accounting for a higher crude-oil price. Moderation of the one-off effects of higher house-rent allowances and GST would exert downward pressure on prices.
The RBI is likely to stay on hold in the near term, with recent CPI reading below the RBI’s trajectory. This has resulted in the banking regulator lowering its own inflation estimates.
A return of oversold conditions is a good opportunity to add to bond holdings. Government bond spreads are at a peak and real yields at a near-term high. The difference between the 10-year government bond yield and the repo rate is at about 170 basis points compared with a five-year average of 65 basis points. Real yields (inflation adjusted) of 3.5 per cent remain among the highest relative to emerging market economies.
We favour short-maturity bonds over medium- and long-maturity bonds on worsening bond demand-supply dynamics amid liquidity support. We also see selective opportunities rising in corporate bonds as the business cycle improves.
However, the RBI’s policy stance towards heightened inflation uncertainty, higher crude-oil price impact on inflation as well as India’s twin deficits (fiscal and current account) and unfavourable bond demand-supply dynamics are key risks to Indian bonds.
Why equities are attractive
The macro environment is still supportive of equities — business-confidence indicators remain in expansion mode, industrial production growth is the strongest in many years, and credit and auto sales are sustaining the pick-up seen over the past few months. Cyclical growth recovery amid controlled inflation and historically lower borrowing costs are likely to aid revenue growth and profitability of Indian companies.
Earnings outlook is also improving with Nifty 12-month trailing EPS (earnings per share) growth at about 16 per cent year-on-year, a three-year high. Consensus estimates expect 2018-19 earnings of Nifty companies to move upwards of 20 per cent on favourable base effect, growth recovery, higher commodity prices and better operating conditions in select sectors. However, banking-sector woes is a key risk to future earnings visibility.
Valuations are not a constraint to future performance. The Nifty 12-month forward P/E is at 17.6 times, lower than the recent high of 18.5 times in January 2018, though still higher than the five-year average of 15.7 times.
We favour large-cap equities over mid-cap ones given their higher margin of safety in terms of valuations. Notwithstanding the recent correction in mid-caps, they continue to trade at a premium of about 22 per cent to large-cap equities, significantly above a historical 10 per cent discount to large-cap equities. Foreign investors pulling out of the market is a risk given higher-than-average valuations.
Rupee likely to stabilise
Post the rupee’s recent weakness, it is likely to stabilise going forward, given attractive yields even now, strong growth momentum, expectations of broader US dollar weakness in the medium term and sufficient foreign exchange reserves (enough to cover 11 months of imports) with the RBI.
Overall, we retain a constructive outlook on Indian assets as macro fundamentals are still supportive of growth and domestic liquidity remains strong.
The writer is MD and Head, Standard Chartered Wealth Management, India.