Indian equitiesIndia – A land of many (re)turns

CIO WM Research | 17 May 2016Hartmut Issel, analyst

• After recently introducing an overweight position on Indiain our Asia ex-Japan and emerging market strategies, toadd emphasis to our conviction we are opening the theme"A land of many (re)turns." Even allowing for a milddepreciation of the rupee, we think the market has thepotential to provide a double-digit return toward the year-end.

• This is based on our observation of a host of early turningpoints, including corporate revenues and profits. Several highfrequency data releases, such as personal and commercialvehicles as well as power generation and petroleum productconsumption, also point in the right direction. While someothers are still sluggish, this is part and parcel of investingearly. We expect India's purchasing managers' indices toremain largely in expansionary territory.

• Some investors seem dissatisfied with the government'sreform efforts, but we believe the sum of lower-level ongoingmeasures still creates a powerful framework for longer-term, inflation-friendly growth. The market's valuation hasreverted to levels that essentially price out a meaningfulimpact from the two-year-old Modi administration – a notionwe disagree with.

1) Earnings are turning, but where to from here?To be clear, we are not arguing for a rapid GDP growth accelerationin India. We believe growth will gradually pick up from 7.4% inFY2017 (ending March 2017) to 7.6% in FY2018. However, by anyglobal standard, be it emerging market or developed market, thisgrowth level creates a conducive environment for a profit revival ontop of very easy base effects. Several factors slowed down economicgrowth to just over 4% last year. Most of them, however, areturning.

In the biggest earnings contributor – financials – growth hadeased to single digits amid slowing loan growth and corporateasset quality issues. The Reserve Bank of India (RBI) sensibly putpressure on banks toward faster recognition of non-performingloans (NPLs). Following multiple interest rate cuts, we expect loandemand to start to gently accelerate (see Fig. 2). Balance sheethealing, especially among borrowers in the commodity, industrial,and power sectors (via the UDAY debt restructuring program),should bring signs of relief, without implying that all issues willbe solved at once. In addition, most banks have front-end-loadedhigher NPL recognition into the December and March quarters.

Source: iStock

Fig. 1: Corporate earnings returning to agrowth path

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Source: Bloomberg, UBS, as of May 2016

This report has been prepared by UBS AG. Please see important disclaimers and disclosures at the end of thedocument.

Other areas where fortunes are turning include oil and gas as wellas mining, where underlying prices have seen stabilization and baseeffects are easy. Other domestic sectors such as vehicles and cementshould also see an upturn based on rising volumes.

All told, we expect to see earnings growth of close to 17% forFY2017; and even if that number is not reached, the growth tra-jectory should be very compelling and hard to find elsewhere.

2) The broader economy – more visible signs of improvementCurrently, a debate is raging as to whether an economic upswingis in the making or not. High frequency data has painted a mixedpicture in recent quarters, but increasingly the numbers are showingpromise. Oil consumption, for example, soared 11% in FY2016,likely aided by low oil prices, with March charting yet another high(up 18%). Other signs of a slightly more vibrant economy includethe 30% jump in commercial vehicle demand, a double-digit risein power generation, and a 20% jump in tax revenues. To be sure,some figures benefited from a low base of comparison and maynot stay up. Furthermore, steel production paints a more subduedpicture, as does the money supply in general. But the latter, in par-ticular, has a chance to improve given easier RBI policies, so weshould not view it too much as a forward-looking indicator. Themanufacturing PMI has climbed back into expansionary territory,and given the sharp rise in tenders for public infrastructure and theincreased new project numbers from private industries, the indicatorhas a fair chance of remaining resilient. While not every data pointirrefutably indicates an upcycle, the numbers in combination bearthe hallmarks of an early phase of an uptrend.

On the other side of the macro improvement coin stands struc-turally lower inflation. Here, the heavy lifting has already happenedto some degree, but we do expect a trajectory closer to 4% over thecoming two years, aided by subsidy curbs as well as budgetary dis-cipline. These are key ingredients despite possible temporary cross-fires from spiking oil prices or weak monsoons. The base line is thatthe RBI continues to have a benevolent view toward inflation-damp-ening measures, and will use the window that we think will openagain later this year to lower rates further.

3) Expectations have been toned down in recent monthsAs mentioned, our case is not one of dramatic GDP growth accel-eration, although the run rate is very decent as it is. After the Modiadministration came to office two years ago, some pundits pro-claimed the prospects of 9% GDP growth. Their prophesy clearlydid not materialize, and they then bemoaned that nothing the gov-ernment had promised was delivered. We disagree with this viewfor two reasons. First, real and to some extent unpopular reformsor measures of better execution need time to take hold, and animmediate nationwide U-turn was not realistic to begin with. Wenote, however, that measures such as "de-bottlenecking" projectapprovals, re-casting laws for mining auctions, and more recentlythe passing of the new bankruptcy code, are just a few examplesof improved policymaking. Second, long-term growth needs a solidbase via curbed inflation expectations. This also means that justpushing the short-term growth pedal, especially in combinationwith fiscal laxness, would not be credible to markets.

Fig. 2: Credit growth shows tentative signs ofturning

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Source: CMIE, Citi, UBS, as of April 2016

Fig. 3: Markets have priced out any majorbenefits from reform and execution efforts

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Source: Bloomberg, UBS, as of 16 May 2016

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We note that the de-rating of India's stock market over recentmonths suggests that the Narendra Modi-led NDA governmentdoes not make a difference. As a yardstick, we use a forward price-earnings valuation for the Nifty. It becomes apparent that investorsare much less euphoric than they were at the time the NDA winstarted to get priced in and during the early quarters of the term.Based on our earlier arguments, we believe a moderate re-rating isin order in recognition of the many credible efforts the Modi gov-ernment has already made.

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Appendix

Terms and AbbreviationsTerm / Abbreviation Description / Definition Term / Abbreviation Description / DefinitionA actual i.e. 2010A COM Common sharesGDP Gross domestic product NPL Non-performing loansp.a. Per annum (per year) Shares o/s Shares outstandingUP Underperform: The stock is expected to

underperform the sector benchmarkCIO UBS WM Chief Investment Office

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