Why is CLSA bullish on India despite stretched valuations?

Hong Kong-based brokerage CLSA has raised its recommendation on Indian equities to a 20% overweight, up from a 40% underweight previously. This makes India the most preferred market within CLSA’s Asia ex-Japan portfolio. The upgrade was funded by lowering exposure to China and Australia.

With this, CLSA’s portfolio now deviates considerably from MSCI’s Asia ex-Japan index.

In MSCI, China leads with a 28.7% weighting, followed by India at 15.1%. Taiwan and Korea round up the top 4 with weights of 14.5% and 11.5% respectively.

However, CLSA tweaks the weightages.

It keeps China’s weighting unchanged at the benchmark level.

India sees the largest increase in CLSA’s model portfolio, raised to 18.2% from MSCI’s 15.1%.

Australia faces the biggest reduction by far, with CLSA taking it to an underweight of just 8.7% versus MSCI’s 15.9% allocation.

Korea and Taiwan are moderately overweighted by CLSA by 231 bps and 73 bps respectively. Meanwhile, weightings for Hong Kong, Singapore and the Philippines are kept at index levels.

The only other underweight is Malaysia, trimmed from 1.3% in MSCI to 0.7% in CLSA’s portfolio.

In summary, CLSA’s convictions are reflected in sizeable overweight positions in India, Korea and Taiwan, funded mainly by a large underweight to Australia. In a report titled “Incredible India: Raising Exposure”, CLSA cited 8 reasons for its bullish view on India:

  1. Rebounding Credit Growth Signals Strong Equity Momentum

Credit growth refers to the incremental loans being disbursed by the banking system to individuals and businesses. CLSA expects nominal credit growth in India to sustain around 12% over the next 3 years, the strongest pace regionally.

The rebound in credit impulse, which means the change in credit-to-GDP ratio, has historically correlated well with upside momentum in Indian equities. When credit is expanding faster than the economy, it provides a boost to growth and corporate earnings.

Banks also have room to expand lending, with a loan-to-deposit ratio of 74%. This means banks have sufficient deposits to fund further credit expansion.

The outlook for steady credit growth supports consensus forecasts for bank return on equity to average around 15% over the next 3 years. Higher lending allows banks to increase profitability.

  1. Lower Impact From High Energy Prices Due to Russian Imports

While elevated energy prices have typically led to equity underperformance in import-dependent India, CLSA believes the impact will be more muted this time.

India has rapidly increased oil imports from sanction-hit Russia to 45% of total, replacing traditional Middle East sources like Saudi Arabia and Iraq.

With Russian crude trading at a 10-13% discount to global benchmarks like Brent, India is less exposed to the jump in international oil prices this year. Discounted Russian supplies cushion the blow from rising crude prices.

  1. External Position Improvement and Bond Inflows May Aid Rupee

CLSA expects India’s basic balance, which measures the current account deficit plus net Foreign Direct Investment (FDI), to narrow to zero by FY25 as exports rise.

This will reduce pressure on the rupee. A smaller current account deficit implies lesser need for India to attract foreign capital, resulting in a more stable currency.

Furthermore, India’s inclusion in J.P. Morgan’s emerging market bond index from 2024 could drive $20-30 bln of inflows into domestic debt, providing additional support.

India’s bond market will now feature on JP Morgan’s influential GBI-EM index, which could draw large passive inflows from global bond funds tracking the index.

At 3% below trend, the rupee also does not appear overvalued based on REER or Real Effective Exchange Rate, which accounts for inflation differentials with trading partners.

  1. India To See Strongest Growth Among Major Emerging Markets

Consensus forecasts India’s GDP growth at 6.2% in 2024, the fastest rate among top emerging economies like China, Brazil, Mexico and Indonesia.

This is almost double the ex-China EM average growth rate. India is seen as the engine driving emerging market growth over the next 2 years.

Upward revisions to India’s growth estimates have also been modestly positive in recent months. Analysts have been progressively turning more optimistic about India’s economic rebound.

  1. Equities Trading At Fair Value With 22% Upside Potential

An econometric model based on industrial production, USDINR, money supply and US ISM suggests MSCI India is no longer overvalued relative to macro conditions.

Econometric analysis tracks the historical relationship between equity performance and key economic indicators to assess fair value.

The same model points to 22% upside in US$ terms over the next 12 months for Indian stocks, nearly twice CLSA’s projection for the broader EM index.

  1. Return to Superior Profitability Metrics Versus EM

After hitting cyclical peaks in 2022, CLSA expects India’s margin compression to ease. This should drive a marked improvement in corporate return on equity.

India’s ROE advantage over EM is seen widening to 450-600 bps by 2024 as domestic firms suffer less margin pressure compared to EM peers.

Consensus EPS forecasts may also be achievable given supportive GDP growth. Stock analysts expect 13-15% earnings growth in FY24-25, in line with above-trend GDP expansion.

  1. EPS Growth Breaks Trend, Backed by GDP Outlook & Revisions

Despite analysts’ poor track record, CLSA believes consensus EPS forecasts of 13-15% growth in FY24-25 appear achievable this time, based on above-trend nominal GDP growth.

Nominal GDP growth has historically correlated strongly with earnings growth in India. So if CLSA’s GDP estimates are right, corporate earnings could surprise on the upside.

Moreover, earnings revisions recently turned positive for the first time since 2021, historically an indicator of upside momentum. Improving analyst sentiment is a good sign for earnings and stock performance.

  1. Foreign Investors Not Overexposed to Indian Equities

At 17.5% of market cap, foreign ownership of Indian shares remains well below previous peak of 20.6% in 2021.

Net purchases by foreign investors also remain in line with post-2015 trend. This suggests room for more inflows, unlike previous episodes of overheating.

International investors still have scope to increase their India allocation without pushing shareholdings to excessive levels.

Two Factors Remain a Concern

However, CLSA pointed out two factors still posing risks to its constructive view – expensive valuations and policy tightening by the RBI.

On forward P/E and cyclically-adjusted P/E ratios, India trades at a near-record premium to emerging markets.

India’s CAPE or Cyclically Adjusted Price Earnings ratio of 28.9x is one standard deviation above its own long-term average. CAPE smooths out business cycle fluctuations in earnings.

Even on a sector-adjusted basis, India’s P/E commands a 89% premium to EM, although lower than last October’s 120% premium.

CLSA’s monetary policy scorecard also suggests the RBI or Reserve Bank of India has little room to pivot to rate cuts. With inflation running well above the 4% mid-point target, India ranks among the least likely EMs to ease policy in the near term.

As one of the most hawkish EM central banks still tightening policy, the RBI also remains heavily tied to the Fed’s trajectory. RBI has limited space to diverge from the Fed’s interest rate stance.

CLSA believes the constructive drivers outweigh the risks, driving its upgrade to an overweight position despite India’s expensive valuations.

The brokerage sees upside of over 20% for Indian equities over the next year. However, with limited policy flexibility and extended valuations, India could be vulnerable to external shocks or growth disappointments.

If global risk sentiment worsens, foreign investors may cut exposure, leaving India’s stretched valuations exposed, it noted. The RBI may also struggle to provide stimulus if the economy loses steam.

But CLSA is betting that India’s fundamentals are robust enough to sustain outperformance versus other emerging markets in the year ahead. The overweight call, it said, is a high conviction bet on India’s growth and earnings recovery.