Summary

• May proved to be another month of wide dispersion in returns for Indian equities, a trend that has been evident all year. Larger-cap indices posted flat returns in May in Indian rupee terms, but with the currency's falling returns US dollar terms were negative. Mid/small cap stocks bore the brunt of selling, falling between 7-9% (Indian rupee terms).
• India’s macro data ended the month on a high as first quarter GDP grew 7.7% compared to a year ago. This was better than expected and a decent jump from the prior quarter’s 7.2% growth. Inflation however picked up in March with CPI rising 4.58% largely due to rising energy costs.
• Despite better top-line growth in the latest quarterly results season, domestic as well as international politics dominate sentiment. Opposition parties united to retain Karnataka state in its May election, and global geopolitical developments continue to post a negative bearing on sentiment.

Fund activity

The Fund underperformed in May, following a strong April, with pressure on mid-caps and some disappointing quarterly numbers from a few of our stocks hurting. While we have also had some very good results from portfolio holdings, price action in the market is marking down worse-than-expected results more than rewarding better-than-expected results. 

We wrote last month about Motherson Sumi, an auto ancillary stock which had announced a very decent international acquisition. The stock reacted favourably to that announcement but unfortunately the company this month declared worse than expected quarterly results. The main area of disappointment came from parts of its European operation. Good results from India were outweighed by falling European margins and rising cost pressures. There are also increasing concerns over the global auto demand outlook, and in addition President Trump has mooted tariffs on German luxury cars which would damage sentiment towards this sector. We have held this stock since 2016 and while it is undoubtedly a very well-run and well positioned company, the risk reward has turned negative for auto related stocks with global exposure. We have therefore sold the stock, but retain auto-related exposure in two other companies in the portfolio that are primarily focused on the domestic two-wheeler and mining sectors.

Outlook

The month ended on a high note with India’s first quarter GDP growth accelerating to 7.7% in the three months ended 31 March, the fastest in seven quarters. Growth surprised on the upside led by government spending and investment with agriculture (4.5%), manufacturing (9.1%) and construction activities (11.5%) being particularly strong. We expect this growth to moderate slightly in the period ahead as positive base effects start to wear off (due to demonetisation and the Goods and Services tax introduced in the last year) as well as a fall in government led investment activity as we near the election next year.

With these strong growth numbers and consumer price inflation ticking up to 4.58% in March, some on the street are beginning to anticipate an interest rate increase from the Reserve Bank of India (RBI) at its June’s meeting. We hope the RBI sees through the short term increase in inflation, as we find little evidence of an economy operating at the top of the cycle. Inflation in the short term has been increasing led by technical factors (the base effect has pushed the number higher), energy and commodity price rises and some volatility in agricultural prices. In addition, the Indian rupee has seen some depreciation this year which raises the cost of imported goods.

Fundamentals at this juncture do not justify higher inflation – growth has been weak and is only just beginning to recover, liquidity is tight and the monsoon is forecast to be good pointing to subdued agri-inflation. Even though growth is finally rebounding India still has a large output gap, corporates have limited pricing power and capacity utilisation remains at 75%.

Sentiment towards Indian equities remains subdued, with greater interest elsewhere in the emerging market space. This is reflected by the fact that foreign investors have now turned net sellers of India year to date, and ownership levels are at multi-year lows. Investors remained singularly focused on the rising crude oil price and its negative impact on the country. In addition with an election under a year away sentiment is gyrating in the short term depending on domestic political news flow and views on what might happen next year.

Although politics can have a significant short-term influence on the outlook for Indian equities, the key factor remains a return of earnings growth, which in turn will lead to a more broad-based investment cycle with participation from the private sector. Better news is that while headline earnings from the last quarterly numbers from India were somewhat lacklustre (due to banks getting aggressive writing off bad debts), underlying earnings growth (excluding banks and oil companies) grew 9.6% over the quarter which was better than expected. Consensus earnings growth for fiscal year 2019 for the Nifty Index stands at 20%.

We remain focused on the recovery in earnings growth as this is a good reflection of the underlying recovery of the Indian economy. Indeed our various interactions with companies in the portfolio and others does seem to indicate that an investment led recovery is taking place, albeit at a nascent stage. With foreign investors’ attention turned elsewhere and valuations becoming more attractive, we are positive on the outlook for Indian equities.