Strategy: Equities turning out to be a lead indicator for the economy; irrational to overstretch the trend

'Stock prices are relatively better predictors of future GDP' than the other way round: In our earlier note (dated 15-Oct'19), we had argued that lagged GDP data has no correlation with stock returns although stock returns are relatively better predictors of GDP numbers. During March'20, while the quantum of fall in economic activity due to the pandemic was still being debated, equities gave their verdict immediately by falling 38% from the peak level during the start of the year, which in hindsight appears an overstretched reaction on the downside. Lagged GDP data for Q1FY21 was released on 31st August and validated the market verdict by showing a contraction of 24%. The sharp decline in Q1FY21 GDP grabbed headlines, but by then NIFTY50 had already bounced back ~50% to 11,700.

High-frequency data for Sep'20 validating the bounce-back from March bottom: The market rebound was driven by stocks across market cap sizes (large, mid and small) while within the NIFTY50, sectors driving outperformance included conglomerates, IT, pharma, metals and auto. High-frequency data for September is now validating the market upmove with sharp improvement in Manufacturing PMI at 56.8, GST collections at Rs945bn, robust wholesale auto sales, improvement in mobility data, petrol sales (+2% YoY), electricity demand (+2% YoY), improving exports (+5.3% YoY) etc. However, NIFTY50 index has started to consolidate since September and could again be a lead indicator for economic recovery.

Extrapolating the normalisation effect would be irrational; current consolidation phase implies rational expectations: If we go by the current market behaviour of consolidation from September till now, it implies that economic activity would probably plateau going forward after normalising to pre-Covid levels, which in our view is a rational expectation. However, extrapolating the bounce-back in economic activities from the March bottom to exceed pre-Covid levels will again be a case of overstretched reaction on the upside. Expecting economic activity to rise beyond pre-Covid level without large fiscal and monetary stimulus would be erroneous as aggregate demand in the economy was already weak before the impact of the pandemic. Valuations based on forward P/E are stretched at +1 s.d. driven by the outperforming sectors thereby reducing their expected returns.

Top picks:

Large caps - TCS, SBI Life, HDFC Bank, SBI, NTPC, UltraTech, Bharti Airtel, and Abbott India

Mid-caps and small-caps - Balkrishna Industries, HPCL, Jyothy Labs, Alkem Labs, Century Plyboards, and Prince Pipes and Fittings

Clarity on NPAs, fiscal space, Covid curve, discount rate and US elections to influence markets in the near term

- Market pricing in higher NPAs: YTD NIFTY Bank index is down 29% vs 4% for the NIFTY50, which implies the NPA deterioration is being factored-in by markets to some extent. More clarity on bank NPAs in Q2FY21 results against RBI's baseline assumption of systemwide NPAs rising by 400bps to 12.5% by FY21-end could result in market volatility but, given the caution, a sharp drawdown in stock prices is unlikely.

- Fiscal stimulus ahead of festive season - market expectations are low on fiscal spend: Although there have been some talks of a likely fiscal stimulus to boost demand ahead of the festive season, a significant booster is unlikely given the already weak finances of the government. Going by the earlier stimulus of Rs20trn announced by the government, incremental liquidity support along with marginal fiscal support to stressed sectors cannot be ruled out.

- Has India flattened the curve? New cases of Covid continue to be elevated, but the trend of new cases over the past three weeks does appear to be flattening in India. Anecdotal evidence also indicates that, at the ground level, people are no longer inhibited to move out despite high number of new cases as recovery rate continues to be the highest in the world.

- 10-year bond yield (driver of discount rate) dependent on inflation and government finance: CPI above 6% and elevated government borrowing has kept10-year yield elevated. Consensus and our own view is that incremental rate cut by RBI for the rest of CY20 is not likely. However, positive surprise on inflation cannot be ruled out in an environment of record kharif output and improving supply-side conditions, which could open up space for incremental rate cuts by RBI although positive surprise on government finances appears unlikely.

- US election outcome could bring volatility in stocks: As per the current US polls, Joe Biden is ahead of Donald Trump in the Presidential race. Signs of a clear victory for Biden could bring in short-term volatility for stocks because of his tax policies, which favour higher tax for corporations and wealthy individuals. Another source of volatility for stocks, bonds and currencies could be if there is no clear winner emerging in the run-up to elections.

Source : Equity Bulls

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