Strategy: A not-so 'trump-ant' rally - Kotak

A not-so 'trump-ant' rally We believe global macro factors will continue to be more relevant for the Indian market without a stronger domestic economic and earnings recovery. The Indian market has performed exactly in line with the EM MSCI Index over the past 12 months. Meanwhile, global bond markets (yields) and central banks' actions are caught between (1) growing policy paralysis in the US and low global inflation and (2) steady economic recovery and improving labor markets in DM economies.
Global macro factors mixed; no one-way street for global bond yields

The ECB's mixed signals about the direction of its future monetary policy post the current QE program that ends in December 2017 and the Bank of Canada's recent 25 bps increase in policy rates have added to the confusion around the direction of global bond yields, especially as the US administration has stumbled in its efforts to deliver reforms in the areas of healthcare, infrastructure and taxation. Low inflation despite tighter labor markets has further added to the confusion with respect to the direction of policy rates and bond yields.

EM markets see further rally as US bond yields and currency slip on political impasse

Growing concerns about political impasse and policy paralysis in the US have led to a decline in US bond yields (see Exhibit 1) from their recent highs and further weakness in the US dollar (see Exhibit 2), which has propelled a further rally in EM markets. EM markets have seen large debt and equity inflows in 1HCY17 (see Exhibit 3) as the US dollar has declined sharply from its end-CY2016 highs when the market had high hopes of swift reforms in the US.

Indian market has performed largely in line with EM Index; so much so for domestic factors

We note that India has performed exactly in line with the EM MSCI index over the past 12 months (see Exhibit 4) and its superior CYTD performance simply reflects a rebound from the demonetization lows in end-CY2017. The Indian market has largely followed the drumbeats of global macro factors despite the market's excitement about (1) large inflows into domestic mutual funds and (2) expectations of economic and earnings recovery. In our view, (1) low global bond yields since the global financial crisis and (2) large inflows to domestic institutional investors over the past three years have distorted equity risk premiums and cost of equity.

Valuations are what they are and earnings will be what they will be

The Indian market (Nifty-50 Index) trades at almost 21X FY2018E 'EPS' and 17X FY2019E 'EPS' (free-float basis); see Exhibits 5-6. As discussed before, top-down market valuations have low relevance given (1) the wide disparity in valuations across sectors and (2) large contribution of the 'low P/E' sectors (metals, oil & gas, power utilities) to the net profits. More importantly, our projected earnings growth over FY2017-19E is predicated on (1) higher global commodity prices, (2) lower loan-loss provisions in the case of banks and (3) domestic economic recovery (see Exhibit 7). We are more comfortable with the first two assumptions than the last one.

Model Portfolio changes

We remove ARBP (200 bps earlier) from our Model Portfolio (see Exhibit 8) and reduce weight on RIL by 100 bps (500 bps now). Both the stocks have performed quite well over the past one month and RIL has been a strong performer for the past few months (up 46% CYTD). We have been reducing our recommended position in RIL stock from a peak of 8% in the middle of February 2017. More importantly, both the stocks are trading close to our 12-month fair valuations and reward-risk balance is less favorable after their strong performance. We allocate 100 bps to IOCL (300 bps weight now).

We include Hindalco in our Model Portfolio with a weight of 200 bps leading to 10% weight of metals stocks in our Model Portfolio. Among metals stocks, we have had recommended positions in JSTL, TATA and VED noting (1) large free cash flow generation and potential deleveraging in the case of TATA and VED and/or (2) option to participate in industry consolidation in the steel industry and acquire assets at potentially large discounts to their replacement value in the case of JSTL and TATA.

These stocks have high sensitivity to commodity prices undoubtedly but we would note that (1) the domestic steel industry has some amount of 'assured' profitability for the next few years and (2) VED has large cash on its balance sheet (through HZ), which cushion their exposure to commodity prices. Also, VED is a play on strong volume growth in aluminum (almost 100% over FY2017-20) and zinc (20% over FY2017-20E).

Among our preferred metal stocks, Hindalco is perhaps the only 'pure' play on commodity prices with low volume growth over FY2017-20E. Thus, we have been somewhat reluctant to recommend the name without proper clarity on China supply situation. However, we are more confident about capacity closures in China with China having announced capacity closure of 0.5 mtpa with likely total closure of 1.8-2.5 mtpa by October 2017.

We note that Hindalco stock has high sensitivity to aluminum prices with a US$150/ton change in aluminum prices impacting FY2018E EPS by Rs2.4 (2% change in EPS for 1% change in aluminum prices) and FY2019E SoTP-based fair valuation of Rs250 by Rs46. Our FY2018E EPS and FY2019E EPS stand at Rs19.3 and Rs24.3.

Source : Equity Bulls

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