Summary

• MSCI India outperformed both MSCI Emerging Markets and MSCI Developed Markets over October. Mainline Indian equity indices (Nifty, Sensex) experienced a significant correction in October, although Indian mid and small cap stocks held up substantially better, with the Nifty Midcap index actually gaining on the month in local currency terms.
• The Reserve Bank of India (RBI) surprised markets at the beginning of the month by not raising interest rates. With consumer price inflation (CPI) remaining benign the central bank stuck with its strictly domestic mandate, despite interest rates rising globally. Markets marked down the Indian rupee in response, although the currency did recover towards month-end.
• The second quarter 2019 (quarter ended 30 September) result season has started in earnest. Analysts are looking for 27% revenue gains year-on-year for the Nifty Index, with a more subdued profit gain (due to cost price increases). With over half of companies still to report, results so far are slightly better than expected.

Fund activity

October followed September with more equity and currency market weakness, particularly in the first half of the month. Indian equities did outperform both developed and emerging markets after a decent bounce over the last week of October, although still sustaining absolute losses. It was noteworthy that Indian midcap stocks significantly outperformed, with the Nifty Midcap index actually closing the month in positive territory (in Indian rupee terms). The Fund outperformed its benchmark in October, for the first time in some months as midcaps started performing better and some of the large index stocks came under selling pressure.

We undertook one significant change to our holdings this month, which was the purchase of GAIL India. GAIL is India’s largest gas transmission and marketing company and is nearly 54% owned by the Government of India. We used the recent market volatility to initiate the position, with GAIL falling into our preference for more defensive growth counters in this period of local and global uncertainty. The company has consistently improved return metrics and has very recently been awarded long awaited upward tariff hikes for a number of its pipelines in its transmission network with still more to come before December 2018.

The tariff hikes plus underlying increases in Indian gas demand mean the company is in a structural sweet spot and additionally, India is encouraging greater gas usage for environmental reasons. GAIL also has positive leverage to higher crude oil prices and a weaker Indian rupee that make it a good macro hedge in the portfolio. Earnings are expected to grow 15% annually over FY 2018-2021, with return metrics consistently improving and the balance sheet being debt free meaning the GAIL has a decent and sustainable dividend yield. The stock is trading significantly below its historical valuation averages despite the tariff hikes and positive outlook.

Outlook

The scale of the selloff over the last two months has not been seen since February 2016, and has been led by foreign portfolio investor (FPI) selling. At the end of September FPI holdings of the broad market have fallen to the lowest level since June 2013, at 18.5%. Domestic institutions have remained steady buyers into this correction, resulting in their holdings of the market reaching record highs at nearly 14% of the market whilst controlling stakeholders increased their stake to over 46%.

The epicentre of the current drawdown has been firmly focused on Indian financial stocks. However, over October financials have stabilised as the fallout from the IL&FS default looks to have been contained and credit markets are operating again, albeit at higher spreads. Non-bank financial stocks were given a boost towards month-end when a large housing finance company successfully raised its liquidity requirements via commercial paper and corporate banks were aided by some better-than-expected quarterly numbers from ICICI Bank. This sector is the largest in India and critical to the future of the country. We have good exposure to quality banks and non-bank financials which will benefit from the current disruption, with increased market share and improved franchises.

The fallout from rising spreads has caused concern about recent strong credit growth, especially to the consumer facing sectors. The result has been the recent underperformance of the consumer discretionary sector, especially auto related companies. Rising auto demand is undoubtedly structural in India, but cyclical factors do impact growth in the short term. Rising credit costs and increasing raw material prices are hurting auto company margins, but the market has been quick to price in these worries. The Fund has little exposure to auto stocks, but has instead favoured two wheeler plays where we are exposed to rising aspiration via Royal Enfield motorbikes, as well as auto-parts stocks that play into increased spend per bike as a result of more stringent environmental standards.

As we progress through the current quarterly result season it will be important to focus on the guidance that companies are giving for the period ahead. We have been consistently saying that India is finally emerging from a near seven year earnings recession and we see no reason to alter our stance. Whilst we would anticipate some fallout to be felt from the IL&FS issue over the next couple of quarters, the underlying growth dynamic should not be significantly impacted. With the recent sell-off in equity markets India’s valuation has reduced to long term average levels, although we do find individual stocks in many instances are much cheaper. We would expect volatility to continue for a while longer, particularly as we approach a number of important state elections in December that could have a significant impact on sentiment. We are therefore continuing to adopt a more defensive growth stance within portfolio, with a bias towards domestic sectors that have been heavily sold off and offering a supportive valuation buffer in the current environment.