Prime Equity Outlook 2023

In our Prime Equity outlook in 2022 we said “We would expect any correction triggered by global rates to take the Nifty 50 down to the 12,500 to 15,000 range. In this range, investors should deploy cash and swoop in on buying opportunities rather than develop cold feet!”.

The equity market world over did see a correction in 2022 along these lines and as geo-political factors took hold. Indian markets too, experienced a rout in the first half of the year hitting close to our predicted range at 15,200 by mid-June. 

Even so, India did a lot better than its emerging market peers. The Nifty 50 closed the year on a positive note, with a modest 4% return. Simply buying the Nifty 50 would have delivered a good 18% from June until December 2022. Our own stock picks delivered well in 2022, too. 

But with global recession on the cards, still high Nifty 50 and a hostile rate scenario, can 2023 be better than 2022? For Indian markets, there are some key trends that we think can play out. We look at where the Nifty 50 could be headed, and where opportunities lie. 

Likely trends in 2023

There are three trends that we see taking hold in markets over the next few quarters. These trends will also impact how the Nifty earnings can move.

#1 Nifty PE may stabilise

A long term average for the Nifty PE works out to 15-18 times – far lower than what it is today at 21.5 times and at 19 times 1-year forward earnings. While the index is trading at a premium, it’s important to understand why valuations have been at an elevated zone for a good while now. In our view, this comes from two primary reasons. 

One, the changed composition of the index. In the Nifty 50’s current composition, 65% is represented by private sector financials, FMCG, IT services and auto. Reliance accounts for another 11%. There is a further 3% weight to consumer durables (Titan and Asian Paints).  With the entire private sector financials scoring high on qualitative parameters and half of Reliance’s market value coming from consumer and telecom businesses, the higher valuation appears justified.

This is in contrast to commodity and heavy asset-based companies that made up the Nifty a decade and a half ago, deserving lower PE. They were not only highly cyclical but also often carried vulnerable balance sheets thus receiving lower valuations. Therefore, it may be reasonable to assume that Nifty will not go back to the 15-18 times PE valuation and that this band may be a less useful benchmark. 

Two, the interest rate scenario. The very low interest rate, especially in the aftermath of Covid, for the past decade has also meant elevated equity PE and rising rates should trigger a derating by this yardstick. 

But a good part of this has played out.  From 29 times consolidated PE in June 2021, both the market correction and an expansion in earnings have since brought the PE to 22 times current year earnings and 19 times forward earnings (at Nifty level of 17,957). It may be fair to assume that 20-22 times PE is something that the market has accepted even in the current high interest scenario, given the index composition. 

Moving forward, slowing domestic and global growth may pose a threat to earnings growth and thus affect valuations. But margin recovery may play a key role as commodity prices have started to cool off. This may positively impact earnings of sectors like FMCG, auto, industrial goods and cement. 

Much of the margin compression and earnings downgrades have already happened for these sectors in Q1 and Q2 of FY23 and could be heading for a recovery. This leaves hope that earnings growth of 15% is achievable in the coming financial year. If this be the case, the current PE does not appear stretched.

#2 Capex story revving up

While capex has been one of the big themes that went for a tailspin in the last decade, investors are betting on a capex led boom in this decade, globally. This is led by a change in the world order in supply chains post Covid, followed by investments in energy transition and defence due to the Russia-Ukraine crisis. 

This apart, fiscal spending led capex growth is visible worldwide. A very relevant interview with market strategist and historian Russel Napier draws attention to the fiscal stimulus led capex boom in Europe and the contours of US Inflation Reduction Act, 2022 helps understand why this capex boom could last.  

Sectors in the limelight in the 2003-13 boom were power, metals, cement, infrastructure, and real estate. Post the 2008 financial crisis, these sectors  faced troubles on account of falling commodity prices and real estate prices, slowing economic growth, excess capacities, and high debt burden. This eventually ended with absorption of these excess capacities by larger players through NCLT only during 2018-21, leaving a long gap in the capex cycle. The downturn and Covid did not help the poor capacity utilisation, either. 

But this is changing for the better now as data steadily shows improved capacity utilisation. Double digit credit growth also points to companies getting ready to invest for the next wave of a capex boom. Private capex led by China +1 strategy and production linked incentive (PLI) schemes seem to be taking off well in sectors such as chemicals, electronics, and auto components.

(Some of these sectors also represent the broader manufacturing opportunity where India is expected to do well in the coming decade. A report by Bain Capital puts it as trillion dollar manufacturing exports opportunity for India)

The new engines of capex such as renewable energy, health care, real estate and data centres are expected to continue their momentum as also reflected in the performance of companies catering to automation, robotics, renewable energy, auxiliary power, etc. 

On government capex, buoyant tax collections and cool off in commodity prices has provided room for continued government spends. Sectors such as housing, infrastructure, defence, and railways may get a boost from Budget 2023 as it is a pre-election budget as well. But the room here may be constrained by the need to maintain fiscal discipline in the wake of rising current account deficit, expected at ~3.3% of GDP in FY23. 

#3 Financialization of savings to support liquidity & growth

When our finance minister applauded retail investors, it was reflective of a significant shift in the savings habit of domestic investors. SIP inflows of mutual funds during 2022 touched Rs.1.5 lakh crores (~$20 billion, and up 31% over 2021) helping to absorb a major chunk of the $34 billion that FIIs had sold. This combines with the recovery of the banking sector from the troubles of the past to best-in-class performance on all parameters to set up a perfect pitch for economic growth to accelerate if companies press the capex pedal.  

While banks are in a great shape to raise money as well as lend, the mutual fund inflows and insurance money can ensure buoyant secondary market liquidity. This space – from banks, small finance banks and NBFCs to brokerages that have re-invented themselves – provides pockets of opportunities especially at valuations that are still reasonable. 

Nifty 50 earnings and PE in 2023

The IMF forecasts recession in one-third of global economies in 2023, led by the larger ones. But fund flows seeking out growth markets may bring significant relief for markets like India. 

Institutional investors predict the peaking-out of the dollar index and the rate hike cycle in the first quarter of 2023 and China removing its zero-Covid leading to increased flows to emerging markets, including India. 

But we are taking this positive prediction with a pinch of salt. A very strong reason for this is the attractive fixed income opportunity that has emerged in the US almost after 3 decades. Locally too, the debt market is showing clear sign of yields staying at high levels. 

In this backdrop, earnings growth will decide the quantum of fund flows to our market. The threat to earnings growth can also emerge from a hard recession in the US combined with a slowing domestic economy, leading to a divided opinion among institutional investors on our market’s performance for 2023.  The forecast for our real GDP growth in FY24 is ~6%.

So let us move to the brass tacks of Nifty earnings. As mentioned earlier, of the Nifty 50 composition, financials, IT, FMCG and auto form 65% of index weight. Add Reliance and it is 76%. Two scenarios may be likely here:

• If all the top 4 sectors + Reliance are able to fire together, then the Nifty may be able to achieve earnings growth of 15-20%, assuming margin recovery in FMCG and autos. In this case, market valuations may hover around 20X earnings. This is a probable scenario in the case of a shallow recession in the US and Europe.
• A hard US recession may lead to more modest earnings growth of 10-15%, leading to contraction in market valuations to 18X earnings. Even in the US market, earnings downgrades that factor a hard recession are yet to happen. 

This is captured in the table below. The highlighted numbers show earnings growth and corresponding Nifty ranges in the above scenarios.

The possibilities that emerge from the table above are as follows: 

• As mentioned above, it would need all the top sectors to deliver strong earnings growth and double-digit index returns. This is a difficult ask, at this juncture.
• If earnings growth is more modest at 10-15%, the upside for the Nifty 50 will be limited. 
• There is also a possibility of a fall in the Nifty 50 if the market is willing to pay only 18 times PE, especially if global investors view that Indian valuations are at a premium to emerging peers. 

This mid case of modest earnings growth and modest returns appears a more likely scenario at present. 

If this be the case, let us look at the opportunities that the market can offer. 

Pockets of Opportunity

Looking beyond the index sectors, there may be pockets for investors to hunt for returns. 

#1 Sector shifts

While 2021 was a year of IT, 2022 turned out to be that of banks. This apart, discretionary consumption and autos made a comeback. From a broader perspective, cyclicals and value turned out to be market favourites as opposed to compounders and growth stocks in 2022. PSUs also emerged as hot favourites, especially banks, defence, and rail PSUs. 

In 2023, segments where earnings recovery is either beginning to play out or will continue - auto and ancillaries, pharmaceutical API, cement, consumer durables and textiles - may be the ones to watch out for in 2023. These are some of the sectors that bore the brunt of commodity/ energy price inflation and are on course for earnings recovery in 2023 while some of these sectors benefit from China +1 and PLI as well. This apart, the capex boom and the continued credit growth can favour select capital goods companies and those that support infrastructure such as steel, as well as financials, in pockets where valuations still remain modest.

#2 Increasing market breadth

If the US avoids a hard recession and flows to EMs including India gains pace, mid and small cap stocks may start to catch market attention. The Nifty Smallcap 100 index is still almost at the same levels as it was in 2018 while it lost 13.80% in 2022. The Midcap 100 index just about stayed afloat with 3.5% returns in 2022 to match Nifty 50. Remember, all companies below 250^th in market cap are classified as small caps. Below is a glimpse into key valuation metrics of these indices.

Source: Nifty Small cap 100 index fact sheet, NSE

What to do with your equity exposure?

If you are investing in stocks, stick to key index sectors and stocks in the early part of 2023 while hunting for opportunities outside of index as explained above. At PrimeInvestor, we will look for stock opportunities in the pockets we mentioned earlier and will not favour stocks that appear too stretched on valuation without earnings support. You too can use our stock screeners to filter out companies from these potential sectors.

With mutual funds, continue your existing strategy and ensure you have passive fund exposure if you don’t yet. We would also prefer small-cap exposure in long-term portfolios that don’t have sufficient exposure to this segment. As we did last year, we may also play sector/thematic opportunities through funds. Do look out for our calls to play such opportunities if you are not a stock investor. 

2023 may be a year for you to consider a more balanced asset allocation between equity and debt. It is best to stick to your planned allocation rather than deviate, especially since debt as an asset class has turned attractive.