Tuesday, March 28

Is this EM powerhouse cheap to enter after the recent rout?


WE turned negative on Indian equities and downgraded its star rating back in October 2022. One of the key reasons anchoring this downgrade was the region’s lofty valuations which reduced the upside potential and raised the risk of de-rating.

Since our update, the country’s valuations have declined slightly but the Sensex Index is still trading at a 20 per cent premium to the long-term average. Indian equities also remain pricey relative to Asian equities, despite the recent rally in north Asian and Asean equities.

If a global recession were to materialise this year (our base case), Indian equities will be entering it with historically high valuations, akin to levels seen during the global financial crisis and the pandemic. We see a high risk of a significant valuation compression in a recession.

While near-term risks are present, India’s growth potential remains firmly intact and is one key reason why we are keeping Indian equities on our radar.

Powerful and synergistic domestic tailwinds, as well as positive reforms, buttress India’s long-term growth potential.

We maintain our cautious view as upside potential remains muted due to steep valuations. While we acknowledge India’s growth potential, we are hesitant to pay an extended premium at this point.

That said, we are keeping Indian equities on our watch list and await a better point of entry.

Lofty valuations were one of the key reasons

Relative valuation has declined – Indian equities have become cheaper relative to Asia ex-Japan equities.

In October 2022, we turned negative on Indian equities and downgraded its Star Rating from 2.5 Stars ‘neutral’ to 2.0 Stars ‘not attractive’. One of the key reasons anchoring this downgrade was valuations, which were not only inflated on a historical basis but also much steeper relative to regional equities.

Other concerning factors were the risk of earnings downgrade and an unsustainable recovery.

In 3Q22, valuations were driven higher after the rally in early October, pushing the forward PE close to 23 times, which was a 21 per cent premium relative to the long-term average.

This also made Indian equities much pricier in comparison to the larger basket of Asian stocks (gauged by the MSCI Asia ex-Japan Index).

While Indian equities tend to trade at a higher forward PE ratio than Asian equities, this premium widened further in 3Q 2022 as valuations for the former rose while that of the latter fell.

The elevated valuations also meant that the longer-term upside potential for Indian equities has fallen and is less attractive. We forecasted a 10 per cent upside by FY2025 (end-March 2025) back in October.

India is the most expensive equity market in Asia.

Besides the unappealing upside potential, lofty valuations also raise the risk of a de-rating as multiples come under greater pressure, especially with heightened macro headwinds.

Have valuations come down after the recent market rout?

Indian equities will be entering a recession with historically high valuations, akin to levels seen during the GFC and pandemic.

Indian equities have largely been on a decline since early December.

More recently, the Adani controversy has also caused equities to slide further as markets remain jittery after the news was brought to light.

However, valuations (in terms of forward PE) have only declined marginally despite the market rout as earnings estimates were revised downwards in the same period.

With the Sensex Index currently trading at a forward PE of 22.8 times, this leaves valuation elevated compared to history – almost 20 per cent premium to the long-term average.

On a slightly positive note, Indian equities are now less pricey relative to Asian equities.

The recent flurry of positive news from China has not only uplifted Chinese equities but also supported the broader Asian equity markets, driving PE multiples higher.

Valuations for Indian equities did not follow and instead declined marginally for the reasons highlighted above.

However, this is not convincing enough for us. Valuations in comparison to regional peers might have declined but Indian equities are by no means cheap.

Relative valuations (gauged by the forward PE ratio of India over Asia ex-Japan equities) has declined from a peak premium of 121 per cent in October 2022 to 80 per cent, which is still much higher than the historical average premium of 53 per cent.

Simply put, Indian equities are almost 1.8 times more expensive relative to Asian equities.

This can also be observed when comparing valuations across Asian equity markets.

Within Asia, Indian equities are still expensive as the region not only trades at the highest forward PE ratio amongst its Asian peers, but also a staggering 32 per cent premium over Thailand, which is the next most expensive Asian market after India, with a forward PE ratio of 17.3 times.

If a global recession were to materialise this year (our base case), Indian equities will be entering it with historically high valuations.

These are levels similar to the 2008 global financial crisis and the 2020 pandemic, during which valuations contracted significantly shortly after, driven by a plunge in share prices.

Expect further earnings downgrades

Same observation across other major Indian equity indices.

Earnings estimates for the Sensex Index have seen a minus two per cent downward revision in FY23.

Thus far, the downgrade in earnings estimates has been largely driven by cyclical sectors like energy, materials, and industrials. Reliance Industries, an index heavyweight and one of the constituents of the energy sector, saw steep downgrades over the past quarter.

The materials sector has also been hit with broad-based downgrades from Tata Steel, Asian Paints, and Ultratech Cement. Larsen &andToubro, a construction leader and industrial sector constituent, was also hit with major downgrades.

While earnings downgrades are a common occurrence, what we remain concerned about is further cuts moving forward, suggesting a higher risk of equity downside.

This is a likely outcome in 2023 as weakening economic growth will further erode corporate profitability, especially for pro-cyclical companies.

Thus far, India’s recovery has been driven by a combination of consumption, exports, and investment spending – we think only the latter may sustain this year.

Domestic consumption has started to moderate as pent-up demand runs its course and high inflation pressures households. While services remain resilient, goods consumption is weakening.

With global growth decelerating and domestic drivers likely to give way, India’s growth should slow further this year, putting pressure on corporate earnings.

We expect earnings downgrades of around minus 10 per cent in FY24, similar to what we highlighted in our previous update.

Secular opportunities abound and unhindered

Indian equities tend to experience EPS downgrades across the fiscal year.

While nearer-term risks are present, we are still keeping Indian equities on our radar. A major reason is its secular growth potential, which remains firmly intact, as highlighted in our previous update.

On one hand, powerful and synergistic domestic tailwinds, such as demographic dividends, middle-class transformation, and consumption evolution, help drive a positive long-term consumer story. On the other, positive reforms in recent years, such as the production-linked incentive scheme, as well as the continuing reform momentum, have also bolstered the nation’s long-term growth.

We believe one of India’s biggest secular tailwinds will come from its position as a key beneficiary of the ‘China plus one’ strategy, which is an ongoing move by multinational companies to divest and relocate supply chains away from China.

With the combination of a young and educated labour force, government incentives, and established infrastructures, India has met the demands that many multinational companies seek. As such, it is a prime destination.

The government has made efforts to draw investments away from China to India in recent years and we expect further measures to support companies pursuing a ‘China plus one’ strategy, especially in securing a larger share of the global supply chain.

Waiting for a better entry point

Earnings forecast and price performance of the Sensex Index.

With our designated fair PE of 19 times and revised EPS projections over the next two years, we project a maximum upside potential of nine per cent by March 2025 (end-FY2025).

The upside potential remains muted due to steep valuations and is less appealing when compared to other Asian equity markets, as many boast much cheaper valuations.

Together, the unattractive upside potential and the risk of a de-rating continue to be key reasons why we remain negative on Indian equities.

While we acknowledge the strong secular growth opportunities in India, which is an attractive trait amongst emerging markets, we are hesitant to pay a big premium for it – at least not when many Asian and emerging market peers are trading cheaply.

As such, we are keeping Indian equities on our watch list and waiting for re-entry once valuations become more palatable and risk subsides.