Even as Indian equities hit record highs on Tuesday (19 August), global brokerage HSBC has maintained its “neutral” weighting on India as the valuations still look too rich for investors.
The BSE Sensex on Tuesday closed 29.7 points higher at 26,420 while the NSE Nifty closed 23.25 points higher at 7,897 on account of positive foreign inflows and oil retailers surging as Brent crude prices hovered near a 14-month low.
Herald Van Der Linde, Head of Equity Strategy, Asia-Pacific, at HSBC, said India is the second most expensive market in the Asian pack (ex-Japan) after Philippines.
He said most funds are already invested fully into Indian markets, while “marginal money is currently going into China and Korea”. He believes the upside to Indian equities is limited due to already-high ownership levels of foreign mutual funds.
The Sensex has already rallied 24.8 percent this year while the Nifty has rallied 25.3 percent. So, in essence, the upside is capped for the year.
HSBC estimates MSCI India trades at 16.5 times 12-month forward earnings vs a long-term average of 15 times.
Another risk to higher valuation is the possibility - though not probability - of the RBI increasing interest rates, rather than cutting them, if inflation accelerates more than expected led by a spike in food prices. In June, industrial production slowed due to weaker consumer goods sales, which offset the improvement in other sub-sectors such as basic and capital goods. As Firstbiz said earlier"the June numbers show that capital goods production soared 23 percent, while consumer goods dropped 10 percent – with a sharper drop of 23.4 percent in consumer durables and flat growth in non-durables. What this means is that people are still not buying more TVs or fridges even though there is now greater optimism on the economic front."
On inflation, while the CPI rose, the WPI fell. If the CPI spike continues, there is a risk that price pressures will become generalised, given elevated household inflation expectations, said Frederic Neumann, Co-Head of Asian Economic Research at HSBC.
Thirdly, recent escalation of tensions in the Middle East are another reminder that inflation could also spike due to a rise in energy prices. The brokerage believes that the speed and nature of economic recovery will determine rate cuts.
"A sharp recovery supported by a boost in consumption demand would stoke inflation given the weak supply response in the economy arising from structural constraints. Moreover, the room to cut rates is further limited with the US Federal Reserve raising rates possibly sooner than expected," said Neumann.
Net-Net: There is a risk of interest rates rising, or staying higher for longer than what the market is willing to accept.
Lastly, it may still take the BJP more time to implement reforms since it does not have a majority in the Upper House of Parliament and will probably need to build alliances to push through critical reforms, which means the markets should be patient and not expect speedy implementation of reforms to kickstart the growth process.
According to Neumann, the government has already moved with unaccustomed alacrity on a number of reforms, such as opening up the railways to foreign investment and providing new guidelines for a more streamlined bureaucracy.
"But the stuff that will lift economic growth over time requires deft and delicate handling," he said, noting resistance to reform from various states and the challenges of pushing legislation through the Rajya Sabha.
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