Jefferies surprised by Indian market’s resilience post election; says midcaps face greatest correction risk

The first reaction to the general election result was negative with a 5.9% decline in the Nifty index on June 4, though the market ended last quarter up 9.7% from where it closed that day. The initial reaction was no surprise since the failure of the BJP to obtain the 272 seats to run a government on its own was a genuine surprise.

In a recent note, brokerage house Jefferies pointed out that BJP's failure to secure majority is a negative since coalition governments are inherently messy while the whole virtue of the first two five-year terms of Prime Minister Narendra Modi has been a single-minded focus on the pursuit of policy. There is, therefore, a question mark over whether Modi can operate as effectively in a coalition.

Going ahead, the brokerage believes there's a renewed risk of market corrections and this remains the greatest in the mid-cap space. The Nifty MidCap 100 index now trades at 32.2x one-year forward earnings, compared with 20.6x for the Nifty.

Meanwhile, it further predicted that there will be a temptation for investors to tilt the portfolio more towards consumption plays, relative to investment plays, on the view that the incoming government will focus more on populist measures whereas a feature of the past ten years has been a fiscal deficit driven by spending on physical infrastructure rather than transfer payments.

This will become clearer in the budget likely to be announced later this month when the Parliament’s Monsoon Session begins. The new coalition government is reportedly considering consumption-boosting measures worth more than ₹50,000 crore (US$6bn) in the upcoming budget, including tax cuts for lower-income individuals, added Jefferies.

Jefferies also believes that a portfolio adjustment in favor of consumption plays, particularly rural plays, makes a certain sense tactically. Still, the base case here remains that India is in a property and capital spending upcycle.

In this respect, Jefferies’ head of India Research Mahesh Nandurkar noted in a recent report that the 2004 shock defeat of the BJP provides an interesting precedent. The Nifty declined by 19 percent in three days following the result, but the then-nascent capex cycle gathered strength and the Indian market rose by 43 percent in the following 12 months. If a similar pattern unfolds, the recent election outcome might diminish the likelihood of SOE reform and public sector divestment, initiatives that investors had anticipated Modi would prioritise in a third uninterrupted term of BJP governance, believes Jefferies.

FII and DII flows

The stock market was driven in the months preceding the election by surging retail investor inflows. Jefferies’ India office estimates that total domestic retail inflows into Indian equities, including direct retail trading, mutual fund inflows, and flows via other sources, were an enormous US$7bn a month in the first five months of this year as investors moved to discount an assumed BJP landslide.

Domestic equity mutual funds’ net inflows have risen from ₹15,600 crore (US$1.9bn) per month in 2023 to ₹30,300 crore (US$3.6bn) per month in the first five months of 2024.

If there is a risk of renewed share price declines, there is one major positive from a flow of funds perspective, noted Jefferies. That is foreign investors will view any significant correction as an opportunity to add since a combination of India’s outperformance in recent quarters and high valuations, most particularly in the mid-cap space, has meant that most dedicated emerging market investors are no longer overweight on the market, it pointed out.

Indeed, foreign investors were net sellers of Indian stocks last quarter. They sold a net US$1.2bn last quarter after buying a net US$1.36bn in 1Q24 and a net US$21.4bn in 2023 though, importantly, they have bought a net US$4.95bn since 7 June, added Jefferies.

Macro

From a macro standpoint, Jefferies’ India office forecasts annualised earnings growth of 16 percent in the FY 24-26 period. Meanwhile, the key negative of the recent earnings season was a 31 bps YoY decline in the net interest margins of the banking sector, declining from 3.7 percent in Q4FY23 to 3.4 percent in Q4FY24 for the eight banks under Jefferies coverage, in the context of otherwise healthy 16 percent loan growth.

As per the brokerage, this has probably already been discounted by the underperformance of private-sector banks in recent quarters. The Nifty Private Banks index has underperformed the Nifty by 11 percent since mid-May 2023. The banking sector also faces a near-term issue. That is recent regulatory pressure from the Reserve Bank of India to slow loan growth in the retail segment, particularly in the area of unsecured loans, and to “manage” loan-to-deposit ratios.

Finally, from a monetary policy perspective, the RBI has room to cut rates if necessary. The real policy repo rate, deflated by CPI, is now 1.7 percent. Still, like other central banks in Asia, it is waiting on the Fed.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.