How Robust Domestic Economy Propels Indian Equity Markets To New Highs?

India's equity markets have soared to record highs, with the NIFTY up 10.9% year-to-date (YTD), outperforming global counterparts, due to strong economic growth, controlled inflation and robust domestic liquidity. The continuity of the central government, whose recent budget focused on narrowing the fiscal deficit and boosting agriculture and employment, has bolstered investor confidence. Despite high valuations, sectors, such as fast-moving consumer goods (FMCG), infrastructure and financial services, are poised for growth thanks to potential rate cuts on the horizon, among other catalysts enhancing the positive outlook. Information technology (IT) remains a sector to watch, with US economic shifts likely to create attractive investment opportunities.

Strong YTD performance relative to large global markets

Indian markets have sustained their upward trajectory, with the NIFTY registering a gain of c.10.9% YTD - above other Asia-Pacific markets'. Japan is the second-best performer, returning c.+4.6% YTD. In contrast, the Hang Seng Index remained largely unchanged, while Shanghai markets lagged behind, retreating c.3.1% YTD. The underperformance of the Chinese markets can be attributed to the country's economic slump and ongoing issues within its property sector. Furthermore, Indian markets have also outshone the US and Europe. S&P 500 has moved c.9.6% YTD northwards, while Germany's DAX has advanced c.4.6% YTD. On the other hand, France's CAC40 returned c.4.4% YTD.

Healthy macroeconomic trends

The outperformance of the Indian market has been the product of economic stability and strong macroeconomic outlook. India's gross domestic product (GDP) grew a sharp 7.8% in 4Q FY24 (ended 31 March 2024), surpassing the consensus estimate of 6.7%. This marks a fourth consecutive quarter of above 7% growth (3Q: 8.4%, 2Q: 7.6% and 1Q: 7.8%). By sector, manufacturing increased 8.9%, construction expanded 8.7%, public administration, defence and other services ramped up 7.8% and mining and quarrying rose 4.3% in 4Q FY24.

The Reserve Bank of India (RBI) expects FY25 GDP growth at 7.2%, higher than the International Monetary Fund's recently revised 7.0% (+20 basis points [bps]) growth. On inflation, India has witnessed a steady decline in the consumer price index over the last few quarters. 1Q FY25 inflation stood at 4.9%, down from the 5.35% in 4Q FY24 - both were within the RBI's 4.0% target ±2.0% margin, providing the central bank elbow room to make monetary policy decisions.

Additionally, the outcome of the recent general election has been received positively. The National Democratic Alliance, headed by Prime Minister Narendra Modi, retained its majority for a third consecutive term. The result has reassured investors about the continuity of major development policies. Besides, the full budget, presented last month, has offered many positives. Finance Minister Nirmala Sitharaman announced a target to contract the country's FY25 fiscal deficit by 20 bps to 4.9%, on track to meeting the long-term goal of 4.5% by FY26.

The budget focused on increasing farmers' incomes and generating employment. INR1.52 lakh crores was allocated to agriculture and allied sectors, and three schemes for 'employment-linked incentives' were introduced. These policies, designed to provide direct transfer benefits, will likely create jobs, boost disposable income and enhance farmers' earnings, thereby supporting rural growth.

Indian markets are trading at relatively higher valuations; however, they are supported by robust flows from domestic investors

On valuation, the Indian market is currently trading at a price-to-earnings ratio of 21.9x - slightly higher than the 10-year average of 20.6x, based on one-year forward earnings, with an estimate of c.12% earnings growth for FY25. 1Q FY25 results have so far been subdued, with c.10% top-line growth and c.6% earnings growth. The past couple of months have seen significant volatility in Indian markets, due to various events such as elections and the budget.

In June, on the day of the election results, the NIFTY fell c.6%, wiping out all its YTD gains. However, it recovered in subsequent sessions, driven by material liquidity and macroeconomic stability. A strong rise in the country's domestic institutional investors and retail investors (evident in Demat accounts surpassing 160m in June 2024 from 40.9m in March 2020) and record inflows into equity mutual funds (INR40,608 crore in June 2024, marking 40 consecutive months of positive equity inflows) are playing a more significant role in shoring up the markets.

At current levels, the market is trading above its historical averages. In our view, certain sectors will likely outperform in the coming quarters thanks to various tailwinds.

The positive long-term outlook for consumers, financial services and infrastructure sectors

We expect consumption-related themes to perform well in the coming quarters, driven by overall above-normal rainfall in July and forecasts for normal to above-normal rainfall in August by the India Meteorological Department, along with positive budget announcements. These factors should benefit sectors such as FMCG, retail, automobiles (specifically, two wheelers) and agricultural equipment including pumps. FMCG has underperformed the market, with a one-year return of c.19.5% (vs the NIFTY's c.23.2%). Nonetheless, given the positive outlook for the sector, we believe FMCG will likely outperform in the coming quarters.

Additionally, infrastructure stocks, which tend to benefit from government capital expenditure, are likely to outperform. In the full budget, the finance minister allocated INR11.11 lakh crores in capital expenditure to the sector, an increase of over 11% year-over-year. CME's FedWatch tool is factoring in more than a 100bps Federal Reserve rate cut by December 2024 and a 69% chance of a 50bps cut in September (up from 22% last week); we expect the RBI to follow the Fed's path.

Given that current inflation is within the RBI's comfort zone, we expect a rate cut in the October meeting, which should likely be positive for private banks and non-banking financial companies (NBFCs). The overall financial services index has underperformed the market, with a one-year return of c.13.7% - private banks have posted a return of c.7.6% vs. the NIFTY's c.23.2%. Nonetheless, given positive guidance, we believe private banks and NBFCs will likely catch up in the coming quarters and outperform the market.

Investors can keep IT stocks on their radar, as a Fed rate cut will likely boost the sector. Substantial IT revenue is powered by US order books, while foreign exchange movements affect earnings. We anticipate some deceleration in the US economic fundamentals in the near term, likely hurting sector performance in this period. On the other hand, a sign of reversal in US economic data, coupled with cooling inflation and the announcement of rate cuts by the Fed, will likely make the sector attractive. The IT sector registered a one-year return of c.24.7%, outperforming the NIFTY marginally. Correction in the coming days fuelled by US economic slowdown will likely open up buying opportunities in the sector.