Looking at the bearish case for Indian equities

Matein Khalid discusses why 2016 could be a bit rough

The BJP's decisive election win in May 2014 triggered Modimania among the world's fund managers. In 2014, Indian equities generated a 34 per cent total return for US dollar investors. Yet disappointment over Indian earnings, the loss of reform momentum and the BJP's political defeat in Bihar had led to a six per cent loss in the Nifty index in 2015 while the Indian rupee has depreciated to 66.50 even though Reserve Bank of India Governor Raghuram Rajan has cut the policy repo rate from eight per cent in January 2015 to 6.75 per cent now. Despite seven per cent-plus GDP growth, a pro-reform government with a parliamentary majority in the Lok Sabha, successive rate cuts by the central bank and massive inflows into domestic Indian mutual funds, I am negative about the prospects for Indian equities in 2016. Why?
One, valuation. India trades at 17 times forward earnings, a significant premium to the Morgan Stanley Asia ex-Japan index's 10.8 times earnings multiple. This valuation premium is no longer justified since India's fundamentals have deteriorated alarmingly in the last six months of 2015.
Two, the 18 per cent earnings growth expectations in 2016 are totally unrealistic. Indian corporate earnings got a boost from a fall in inflation and a $50 billion windfall in the cost of imported crude oil yet EPS growth was negative in the aggregate in 2015. I expect current trends to persist next year.
Three, India's oligarchs and corporates have amassed $180 billion in bad debt, a systemic threat to the public sector banks who dominate 70 per cent of the banking system's assets. The plunge in commodities prices has created a nightmare for India conglomerates who borrowed recklessly in US dollars during the credit bubble era, especially steel oligarchs. A banking crisis or a high profile corporate default will gut the Indian rupee, GDP growth rate, sovereign credit rating, corporate earnings and loan growth. Is this scenario priced into the stock market? Absolutely not.
Four, India was the consensus overweight for global fund managers in 2014 and early 2015. Yet I notice foreign institutional investors have been slashing their exposures to Dalal Street in October. This was the reason the Indian rupee was Asia's worst-performing currency against the US dollar in November 2015, even though crude oil prices plummeted during the month, as did the current account deficit. Domestic funds have kept the Nifty and the Sensex to stratospheric levels. But for how long?
Five, while the RBI has cut rates by 1.25 per cent in 2015, banks have only cut 0.60 per cent in their lending rates to Indian corporates and consumers. This means real borrowing costs in India have actually risen as inflation fell, not a good omen for a country dependent on a credit driven consumer spending binge for its seven per cent headline GDP growth rate and a debt laden corporate sector with huge debt loads, mired in a banking credit crunch and unable to boost capex. Indian infrastructure funds are some of the most dangerously overleveraged in Asia. Exports cannot rise when world trade shrinks. A GDP growth scare is inevitable in early 2016.
Six, India is underspending the BJP government's budget deficit target. This will limit the ability of the BJP government's willingness to bail out Congress-allied conglomerates in distress or play a classical, Keynesian countercyclical role in 2016. Though the BJP has boosted foreign investments in banking, insurance and aviation, constituted a new coal and mining regime, it has still not enacted a bankruptcy code or Goods and Services Tax.
Seven, international events in 2016 will lead to a contraction in global US dollar liquidity. The China hard landing has led to shock waves across the commodities and emerging markets. The world's fund managers are nervous about the macro prospects for Asia. A 20 per cent fall in the Indian equity index in 2016 as my base case scenario. While nervous about India, I see huge investment potential in Pakistani and Sri Lanka shares. Thankfully, South Asia is not just Dalal Street for me!

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