We have exited FY24 with the economy estimated at $3.4 trillion and a market cap of $4.4 trillion. The benchmark indices have delivered good double-digit returns. That's the good news. What about the bad and ugly?

India is in the midst of a multi-year bull run, which is a fact I do not really debate. We are in a very fortunate space in terms of most things. For example, the investment cycle is just starting. The real estate cycle is picking up after a 10-year downturn. People are initially shocked by the change after 10 years, but it's nowhere near crazy.

In terms of the debt cycle, there is hardly any extra leverage. You can debate about the significant growth in personal loans, but in the overall scheme of things, it's hardly alarming. Our foreign exchange reserves are robust and on the fiscal deficit, we went a bit off-track due to COVID, which was an exogenous event that happened across the world.

There's no significant complaint against India in terms of its global standing. In fact, India is in a very happy place. Added worries have arisen since the start of 2022 owing to geopolitics. If you consider any large country, India is perhaps the best placed. We are much less impacted by global conflicts. Even in the current conflicts, like those involving Iran and Israel, India doesn't necessarily have to take any side, similar is the situation with the Russia-Ukraine conflict. Our foreign relations have been managed in such a way that India could actually benefit from these conflicts, if at all. From an economic perspective, all fundamental arguments support a very positive outlook; this is why we believe we are in a multi-year bull run.

However, merely looking at the economy and investing in the stock market has not always worked because markets have their own cycles, which are also overlaid upon risk. After all, markets are dependent on the everyday emotions of investors – which is a different element of risk compared to other economic factors.

From October to now, the stock market fell and then rose, and is up almost 15%. These are things we also need to be cognizant of when overlaying that macroeconomic thought process. We are on a longer-term path, but when using the stock market to traverse this path, there will be volatility. The only complaint I have is that expectations and valuations have run ahead of themselves. Though the economy might not be as affected as some others, if geopolitical risks intensify, they might impact flows. India is still seen as part of a broader EM basket, and EM is considered a risky asset by many foreign investors.

With a vibrant domestic investor base, we should be able to offset a large part of the impact of reduced flows compared to many other markets, which will feel the brunt of it even more in terms of stock price movements. This is where the difference lies.

There’s no point in asking for an opinion on the outlook for the market without considering the duration. Though we are structurally bullish on India, there could definitely be hiccups in the near term.

Over FY20-24, the Nifty constituents' cumulative profit pool has expanded from ₹3.5 lakh crore to ₹7.7 lakh crore. Is this the best that India Inc is going to see? Are we at peak margins, peak return ratios, and peak cost efficiency, and will it only go south from here?

That may not be true because, as I explained, I have lesser worries about the profit pool.

Why is that?

It's because the whole cycle is still in its infancy. We highlighted that even this year, the expectation of consensus is that the top 100-150 companies will see a significant decline in their debt despite the fact that there is hardly any leverage in the current system. The only red flags we can imagine are more external, such as building our manufacturing base at a time when the world is deglobalising. Another concern is the impact of geopolitics on commodity prices, which could always hit margins. So, these are certain factors which can indeed be a risk.

But are there any significant worries — like what happened in 2008? The answer is no. 2008 was a culmination of multiple cycles — commodity cycle, debt cycle, real estate cycle, and a stock market cycle - at the same time. At present, my only concern is with regards to valuation, I have lesser worries about the profit. The bigger worry is about investor expectations about the profit pool, which is reflected in the valuations. Investor expectations are prone to emotional changes. If risks come to the forefront owing to certain exogenous events, expectations will fall. Normalising expectations is what I am trying to address here.

As a strategist, I do all my detailed work about the economy, corporates, companies, etc., and cycles. But when I make stock market decisions, I also try to bring in that emotional aspect and the risk aspect of investors, which matters a lot. In fact, CLSA has a proprietary India bull-bear index, which tries to measure investor sentiment. We started the year being extremely bullish. The sentiment gauge is only useful if it is at one extreme or the other; in the middle, it means sentiment is divided and is of no use. Only when it gets extreme, do I pay attention to it and that might be of use once or twice a year only. But at that point in time, you need to pay attention.

Now, finally, these extended expectations are catching up. For instance, in the first quarter of the calendar year, India was up 2.5-3% on the Nifty, while every developed market outperformed India during the quarter. That is because we started the year with such high expectations. Now, typically with such high expectations, you have pullbacks. Because everything was going up globally, we did not have a pullback. Politically, there are enough reasons for investors to believe that it's going to be an even stronger government at the Centre. But after a particular point it is not that surprising anymore. So, effectively, the Indian market has been very range-bound despite all the good news.

Is there certainty about the election outcome among foreign investors?

There's hardly anyone asking the question: “Is there a chance of the BJP not returning to power?”

Could that be a possibility?

Indeed, that would be considered an extreme bear case. The notion of political stability under the current government has significantly bolstered investor confidence. Finding such stability is rare, especially in emerging markets (EMs) or even in other regions where democratic societies face instability. In contrast, autocratic setups offer a different kind of stability, which isn't what we typically regard as genuine political stability. Among democracies, there are few EMs where you can find substantial political stability, unaffected by global geopolitics. This situation has led to a premium on Indian investments, evident in the narrowing differential between Indian and US bond yields. This is due to the lowest rupee depreciation expectations that we've seen in over a decade, all linked to our anticipation of continued political stability. However, any shift away from this stability could significantly increase the risk premium on India.

What happens in an adverse scenario?

Currently, we are starting from an extended point where the Indian bond yield minus the Indian earnings yield is quite stretched. Historically, when this differential exceeds 2 percentage points, the market struggles to generate absolute returns. For example, with India's forward PE at about 20X, this translates to a 5% earnings yield. With the 10-year Indian bond yield at about 7.2%, the difference is approximately 2.2 percentage points. Historically, when it rises above 2 points, the equity risk premium often drops to its lowest, making further multiple expansion challenging under the current yield scenario. If political stability decreases, causing disappointment, this differential could shrink to zero, which historically signals a bear case. Additionally, the India-US yield differential, tied to rupee depreciation expectations, could widen significantly. If yields rise to between 7.5% and 8%, and the equity to yield differential reaches zero, we could see the PE ratio de-rate to around 13X, indicating a potential 30-35% decline in the market. This would reflect a significant shift because the current positive sentiment around political stability and the popularity of our prime minister are highly valued by investors.

Are investors cognizant of the narrative that democratic institutions have been undermined? Do they pay a premium for that?

In the stock market, premiums are typically given to growth and the predictability of growth. If internal events start to cloud either of these factors—such as doubts about the conduciveness or predictability of growth—it could lead to de-rating. General discussion among people, if not substantiated by actual events, may not significantly impact investor perceptions.

But there is a perception among foreign media…

It might be the perception of foreign media, but it is not at the forefront of most investors' minds. They focus on numbers and company commentaries. So far, they are seeing more confidence. Therefore, unless the perception leads to events that cause people to doubt the conduciveness of growth in that environment, or their ability to predict growth, or if corporates start feeling that they are struggling with their operations…I believe these concerns are overstated and do not significantly impact investment decisions despite potential exaggerations by the foreign media.

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