Assessing the cycle: 2019 in better shape than 2018
Morgan Stanley

Medium-term relative returns for India vs EM could be in India's favour in 2019

India's relative policy uncertainty appears to be at a cycle peak. When we combine this with the fact that India is heading into elections, a roll over is the most likely outcome. Surprisingly, despite high policy certainty for four years running, India's relative performance against EM has been weak. This tells us that on its own policy certainty is not enough to drive share prices.

The investment rate has now gone well below trend--reminiscent of the 2002-03. With the counter cyclical government capex already in place, capacity utilization and asset turn above average, and growth likely improving, a private capex cycle is in the offing post elections. This sets the stage for an improvement in corporate profit margins.

Growth appears to have troughed, led by benign inflation, a turn in government capex, recovery in consumption and exports, and the passage of one time shocks like GST and demonetisation. As a consequence, credit growth, which put in a bottom last year, seems to be entering a new cycle. Indeed, the peak of previous cycle was way above history and thus the recent trough was well below history. India's terms of trade went through a yo-yo ride last year.

For now, with crude oil suffering a supply-led price fall, the terms of trade have once again shifted in India's favour. India's responds to supply shortage led spikes in oil – we have tried to identify these by measuring oil performance to copper (both commodities assumed to respond similar to improvement in global demand). We find that India's USD equity performance plots directionally against the oil/copper relative performance (as one would expect).

Whether the 10-year yield's recent peak is the peak of this cycle will demand primarily on how India's growth pans out next year. Since we are constructive on growth, to us it seems that bond yields may have further to rise in this cycle.

Consistent with the economic cycle, short rates are likely to move higher albeit with a pause in the coming months given the benign headline inflation and reasonable real rates.

Revenue growth for Corporate India is already accelerating for the past several quarters and is now at a five-year high. Revenue growth could be heading higher in 2019.

The share of profits in GDP or profit margin seem to be putting in a trough and could be entering a new medium-term cycle, which could last for five years and result in strong profit growth.

Like with profit margins, ROEs also seem to be putting in a bottom and preparing for a new up cycle. Asset turn has already risen.

Valuations appear to be mid-cycle compared to fundamentals, which seem to be coming out of a cycle trough. We prefer to use PB as a valuation metric versus PE given how depressed earnings are relative to trend.

Valuations could head either way in the short run depending on factors other than fundamentals such as India's election outcome and global events.\

EV/sales is also at long-term averages and pricing in some of the recovery in margins that could be in the pipeline.

Relative to bonds, equities are at the top of their post crisis range. If a growth cycle is not forthcoming, the relative valuations will turn down as they have since 2010. In contrast, if profit growth starts accelerating (as we expect), the relative equity/ bond valuations could break the range.

Sentiment indicators also appear to be cycle troughs like our sentiment indicator, which made a post crisis low in October

Market breadth, one of the components of our sentiment indicator, has come close to a new all time low. An upturn is in the offing, which means the broad market's relative performance to the narrow indices will likely improve in 2019.

FPI flows have also made a cycle low, and with India ownership in the average EM portfolio down to seven-year lows, there is a good case for a turn in FPI flows in 2019. This is also consistent with our constructive EM call. Which domestic flows are making new highs, we would caution against using a cycle argument here since domestic flows seem to be in a structural uptrend.

Inter day volatility has risen sharply over the past three months and it is likely to come down in the coming months. That said, the market has to negotiate the usual rise in volatility associated with elections.

Medium- and long-term equity returns could have put a floor last year and may continue their ascent in 2019.

Likewise for medium term relative returns for India vs EM, which could be in India's favou r in 2019. Accordingly we are overweight India in our EM country portfolio.

The correlation of returns across stocks has been rising in 2018 after putting an all time low during the year. This tells us that macro/markets are driving stocks rather than idiosyncratic factors (i.e., stock picking is not in vogue for now). These correlations have still some distance to go to previous peak levels so the portfolio narrative is still one of rising market/macro effect rather than picking stocks.