Most of the recent high frequency data points have been pointing towards a continuing sluggish economy. However, large cap indices such as Nifty and Sensex have been trading at or near all-time highs. This sort of most seemingly straightforward dichotomy between economy and stock market is baffling majority of investors and financial advisors. However, if you look deeper, ill-effect of slowing economy is very evident in mid and small cap basket. While midcap index is more than 20% below its earlier high, small cap index is over 40% below its earlier peak.
As we look back, the current market cycle started in late 2013 as optimism of the first NDA win gained momentum thereby propelling the mid- and small-caps to extreme outperformance over the large caps. The sell-off since Jan’18 ensured that the significant relative outperformance of mid and small-caps has disappeared completely. Midcaps in India have now underperformed by over 30% vs large caps over last 2 years and today, the valuation discount of mid-caps vs large caps is now close to decadal highs.
In our opinion, the bottoming out process of broader market seems to have begun. Many mid and small caps where second quarter earnings were good showed decent investor interest, and moved up sharply along with large cap segment in the last quarter. We believe that the incremental money is gradually moving into select midcap names. While liquidity and sentiments may continue to drive market in the near term, we believe that the floor for market levels has been pushed up due to lower corporate tax rates.
We expect gradual recovery in economic growth in FY21 on the back of the following:
- Lagged effect of fiscal policy changes (through corporate tax cuts already implemented)
- Improved transmission of monetary stimulus (135bps of policy rate cuts of 2019)
- Improvement in health of financial sector balance sheets resulting in reduction in risk aversion and
- Some demand side recovery as the structural changes undertaken start impacting demand positively
One of the key factors to watch out for in 2020 would be the pro-reform stance by policy-makers. In this respect, some of the key measures, which we believe would start bearing fruit, include the following:
- Strategic disinvestment and privatization led reforms resulting in improved fiscal headroom
- Quicker resolution of the NBFC sector challenges with NBFCs being brought under the IBC
- Large recovery on non-performing loans under IBC paving the way for further recoveries from large accounts and strengthening of bank balance sheets
- Transmission of policy rate cuts with banks moving to external benchmark linked lending rates for retail and SME loans
We remain positive on sectors such as private sector banks, capital goods, engineering, cement and gas utilities. We have also increased our exposure to Chemicals space. We are maintaining underweight stance on consumer driven sectors such as automobiles, durables and FMCG on the back of weaker demand outlook.
Given relative valuation comfort for mid and small caps over large caps, we believe that it is time for increasing allocation to this basket. While the volatility may remain high, we are quite optimistic of equity returns over the next year and beyond. With expectations of continued volatility in the short term, we advise equity investors to make disciplined and regular investments with long term focus, and not chase momentum in the market.
Harsha Upadhyaya is the CIO – Equity, Kotak Mahindra AMC. The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.