The reopening of the Chinese economy is prompting foreign investors to reallocate their portfolio exposure away from India, but Sunil Koul, Executive Director (Asia Pacific Portfolio Strategy, Global Macro Research) at Goldman Sachs, tells Fortune India that the rotation is by no means an indication that investors are giving up on the India Growth Story. Despite a slow top-line growth, Koul believes India Inc will deliver better margins on improved efficiencies and lower commodity prices. As a result, the domestic markets will deliver low-teen returns in 2023, despite the lack of multiple rerating. Edited excerpts:

Will India remain out of favour with foreign investors in the current year as well?

This year, we may see a shift in investor preference from South Asia, including India, which saw strong performance in 2022, to North Asia, primarily China and Korea. This is due to the reopening of the Chinese economy and the associated growth opportunities. Although India's economic fundamentals remain robust, high relative valuations and strong past performance have led to a temporary shift in focus to China in the first half of 2023. However, Indian markets are expected to recover and regain investor attention in the latter half of the year.

Is the disconnect between the Indian and US markets likely to persist?

The decline in the US markets last year was caused by the Federal Reserve's decision to raise interest rates by over 400 basis points. This significant tightening put a strain on equity valuations, leading to a decrease in the S&P 500 from 21x to 17x, and briefly reaching 15x. The impact of the interest rate hike is expected to slow down economic growth, with projected GDP growth of 1.6% in 2023 and little to no earnings growth in the S&P 500. Our three-month and 12-month target for the S&P 500 is 4,000, which implies flat returns, assuming no recession occurs. However, if a recession does occur, there may be a 20% decrease in the index. India, on the other hand, managed to withstand market volatility in 2022, owing to its strong domestic growth and consistent retail SIP flows. In 2023, Indian markets, however, could see modest valuation pressure and low-teen returns.

What is your take on the nature of recession in the US?

Our perspective differs from that of the market consensus. We do not anticipate a recession in our projections but a 'soft landing,' with our economists forecasting a 25% probability of a recession in the next 12 months, compared to the consensus estimate of 65%, due to continued strength in the labour market, diminishing drag from fiscal and monetary policy tightening and early signs of improvement in the business surveys. We expect Core PCE inflation to have reached its peak and to moderate to 2.9% by the end of the year. The Fed's actions should stabilise the economy without leading to a sharp rise in unemployment. Unlike past recessions, the financial burden this time has shifted to the government rather than corporations and individuals, whose balance sheets are in better shape. In the event of a modest recession, we expect about 20% decrease in the S&P 500, with a 11% decrease in earnings and further multiple compression. However, this is not our base case scenario.

What are your thoughts on the potential impact of inflation and interest rate hikes on India?

The current market consensus is to buy China and trim India exposure, with Asian/EM hedge funds following this trend. Additionally, some benchmarked regional mutual funds may be more inclined to buy China and sell India, leading to weak flows into India in the short-term. However, global investors, especially with more patient capital, may maintain a long-term structural allocation in India in their portfolios. We think overall investor positioning in India is not stretched. After last year's selloff, foreign ownership of India is at multi-year lows. Although India's weightage in the benchmark has increased, overall allocations from EM and Asia fund managers remain low. EM investors currently hold about 15% of their portfolios in India, compared to the benchmark weightage of 14%, implying 100 basis points overweight. This is a decline from the peak overweight allocation of 500-600 basis points higher seen in 2014-15 after the Modi government came to power and when India’s benchmark weightage was 8-10%. As the China reopening momentum fades and the global economy recovers, with Fed pausing after two more rate hikes in March and May, flows will return to EM markets, including India.

What will be the impact on domestic retail flows?

With the rise in cash rates, it's possible that retail investors may shift some of their funds into fixed deposits. This trend has already started to take place and there has been a decrease in retail mutual fund inflows beyond systematic investment plans (SIPs). Last month, ex-SIP retail MF flows turned negative, and in December, they remained flat. Therefore, for next few months, the absence of foreign portfolio investment and any further slowdown in domestic flows may result in a moderate correction.

Do you see the current interest rate cycle peaking out in India as well?

Yes, we anticipate the rate of interest rate increases to decelerate. Our predictions include another increase in April, resulting in a terminal rate of 6.75%, after which the RBI is likely to end its monetary tightening cycle. On inflation, we forecast average CPI inflation of 5.5% year-on-year (YoY) for the year, with inflation remaining just above the RBI's target band in Q1 CY23 driven by high core services inflation and a reversal of the recent decline in vegetable prices.

What does that mean for earnings?

We anticipate mid-teens earnings growth of approximately 15% in 2023 and 2024. This is nearly six percentage points higher than the Asian region's overall projection of 9%. Our approach to forecasting differs from that of the Street, as we believe that last year, India's strong top line was driven by demand and inflation. However, margins declined due to high input costs. This year, we anticipate that top line growth will moderate due to a slowdown in growth and the impact of the US slowdown on the tech sector and exports. But margins are expected to improve as commodity prices have decreased. Many corporates, especially in the consumer sector, have reported a margin recovery starting from the December quarter. Therefore, we believe that despite the moderation in top-line growth, improved margins will drive earnings growth and contribute to our projected 12-13% return for the market. We don't anticipate a significant rerating of multiples.

Is there a material change in investor perception about India's growth prospects, or is it a market still characterised by rotational flows?

That's a great question. India has traditionally commanded a growth premium compared to the rest of the region, as investors are willing to pay more for its strong growth prospects. Historically, the premium of India versus the rest of the region has been around 30% with a peak of 60% in some years. However, during the last two years, other markets in the region such as China, Korea, and Taiwan experienced significant declines of around 30%, while India held up and was even up 4%. As a result, India became relatively expensive compared with the rest of the region, trading at 22 times when the Asia region was trading at 11 times.

It’s not that investors are abandoning their faith in India's growth potential. However, many investors in the region have a significant – one-third-- weightage of China in their benchmarks. China's strong performance, with a 50% increase since November, has made it difficult for benchmark investors to overlook this fact. The result is that some investors are adjusting their portfolios by reducing exposure to certain sectors in India to fund their investments in China. This has led to some of the well-performing and expensive sectors in India being impacted, as foreign investors adjust their portfolios. However, US-based investors such as endowments and pension funds still believe in India's longer-term growth story and are seeking diversification away from China. In summary, investors still believe in the India story and are only adjusting their portfolios in response to market movements in the region.

Where do you see value in the Indian market?

The banking sector is one of the few that remains undervalued compared to its historical range, owing to lingering concerns about non-performing loans and stress in the system. However, 2022 was a good year for banks, and this trend is expected to continue in CY23, with 20% compound earnings growth expected over the next couple of years. Despite the 10-year high in credit growth, credit momentum is still expected to remain robust at 14-15%, which should support strong margins and drive double-digit earnings growth for banks. Additionally, we are optimistic about the broader manufacturing and investment cyclical sectors, such as infrastructure, logistics, and cement, as there are increasing signs of a private investment cycle picking up, with more and more companies announcing their capital expenditure plans.

Goldman Sachs Sunil Koul

Current market consensus is to buy China and trim India exposure: Goldman Sachs