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Strategy: Stabilising commodity prices and bond yields are setting a floor for equity valuations; Q1FY23 growth trends robust

Posted On: 2022-06-06 09:46:13 (Time Zone: IST)

Reducing 'shock and awe' effect of omicron wave, nuclear brinkmanship, inflation scare and rising bond yield: CY22 began with the omicron scare, followed by the sudden escalation of Russia-Ukraine conflict in Mar'22, thereby pushing the world into an unprecedented phase of nuclear brinkmanship. This impacted the 'equity risk premium' (reflected in spike in VIX). It also resulted in a surge in commodity prices, especially crude oil, thereby triggering an inflation scare. This was followed by the more than expected hawkishness of the US Federal Reserve and India's RBI resulting in an increase in the 'risk free rate' as sovereign bond yields spiked and acted as a double whammy for equity valuations. However, post the initial spurt, omicron has receded sharply while commodity prices and bond yields have started to stabilise. Also, the Russia-Ukraine conflict will likely be scaled down from global nuclear brinkmanship to a local conflict. Dip in the latest PCE inflation data for the US, general cooling down of commodity prices and the expected increase in oil output by OPEC+ will likely add credence to the peak inflation argument.

Outlook and top picks: The above trends are visible in the fear index (VIX) receding and will most likely put a floor on equity valuations on a 1-year forward P/E basis, which fell from around 23x in Oct'21 to less than 18x during the May'22 sell-off. High-frequency indicators for Q1FY23 so far appear robust and indicate economic recovery is on course.

Incorporating the above factors and trends, our Mar'23E target for the NIFTY50 stands at 19,000. We are overweight on stocks driven by investment rate, savings rate, credit growth, exports and pent-up discretionary consumption.

Top picks: SBI, Axis Bank, HDFC Bank, Aditya Birla Capital, SBI Life, Larsen & Toubro, NTPC, NHPC, GAIL, Oil India, Coal India, UltraTech Cement, Bharti Airtel, Tata Communications, Gujarat Fluorochemicals, Phoenix Mills, Brigade Enterprises, Greenpanel Industries, Indian Hotels, Jubilant Foodworks, Metro Brands, Sapphire Foods, Inox Leisure, TVS Motors, Eicher Motors.

Q1FY23 is the first quarter of no covid restriction on movement since the onset of the pandemic in 2019. High-frequency indicators for the quarter so far indicate robust economic recovery, which should gather momentum going forward.

- Strong manufacturing & services: Average PMI-Manufacturing at 54.7 and PMI-Services at 58.4 for Q1FY23 (Apr-May'22) are robust. Export growth at 15.45% YoY and GST collections at Rs1.41trn for May'22 are also robust. Formal job hiring robust for Apr-May'22 and is on structural uptrend (Refer our note on 'employee cost')

- Core sector and credit growth improving: Core sector growth for Apr'22 was at 8.44% YoY and non-food credit growth for May'22 stands at 11.2% YoY.

- IMD forecast is of a normal monsoon (103% of LTA) in CY22.

- High tax buoyancy helps fiscal position although trade deficit is expanding: Fiscal deficit for FY22 was lower at 6.7% vs the Budget estimate of 6.9% as gross tax revenue at Rs27.1trn surpassed the BE. However, trade deficit remains elevated and rose to US$23.3bn in May'22 driven by rise in gold import.

Q4FY22 earnings robust despite the challenging environment with aggregate corporate 'profit to GDP' ratio reaching 4.5% in FY22.

Contribution of industrials and financials to the aggregate profit pool rises: On a trailing 12-month basis (TTM), aggregate corporate profits (excluding loss makers) of the top 1,000 companies by market cap was Rs11.5trn in Q4FY22 vs Rs8.1trn in FY21. Industrials are accounting for almost half (46%) of the aggregate profit pool at Rs5.3trn, highest in the past decade. Highest profit share of industrials on a TTM basis was 57% between FY05-FY06.

On the flip side, aggregate profit pool share of 'services, consumption and healthcare' has dropped to a 2-decade low of 28% (Rs3.2trn). Financials are back to contributing more than a quarter of the profit pool (Rs3trn) after emerging from the NPA cycle, which began in CY16.

The above trend of rising share of industrials and financials in the corporate profit pool is a positive sign for the nascent investment and credit cycles. However, commodity price led expansion in profit base of industrials will recede as commodity prices show signs of stagnation.

Nominal earnings base will continue to expand over FY22-FY24E going by high-frequency indicators for Q1FY23 and Q4FY22 results, which indicate more beats than misses implying earnings growth expectations are not unrealistic. Overall, the number of beats exceeded the misses during Q4FY22, especially in the midcap space.

Valuations are excessive for a relatively smaller profit pool: Aggregate market capitalisation of the profitable companies within the top-1,000 stocks is Rs238.6trn, which implies a trailing P/E ratio of 20.8x. Industrials plus financials, which constitute 72% of the aggregate profit pool, are reasonably valued at a trailing P/E of 15x-20x compared to historical levels while the remaining 28% of the profit pool (services, consumption and healthcare) is still at a high trailing P/E of 33x.

Market correction and profit expansion have resulted in valuations receding to reasonable levels based on the following valuation methodologies.

- On an ex-post basis, forward P/E for the NIFTY50 index at around 18x is at its lowest level since CY16 (excluding the brief covid period), while P/B at 3x is at its long-term average level and 'market cap to GDP' is marginally above the 100% mark.

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