Three Headwinds That Led Nomura To Reallocate From Cyclicals To Defensives
After a strong rally driven by expectations of a cyclical recovery in growth, improved corporate earnings and foreign fund inflows, the equity markets are now dealing with three headwinds, according to Nomura, prompting it to raise its weights on defensive sectors in its India model portfolio.
First, a resurgence of Covid-19 cases has led to restrictions being imposed by the government. The vaccination drive has picked momentum, but the number of doses administered is likely to be limited by production constraints. So, the current Covid-19 spread is unlikely to be controlled through vaccination, the brokerage said in a note. And while a nationwide lockdown is unlikely, local restrictions could have a shorter and even potentially medium-term impact on growth.
Second, there is inflationary pressure with the rise in commodity prices. These are likely to adversely impact margins for commodity-consuming companies, Nomura said.
Third, a rise in yields poses headwinds to further expansion in valuation multiples. “Sectors and stocks with relatively lower Return on Equity and higher growth expectations are at a higher risk of compression in valuation multiples,” the brokerage said.
Nomura sees relatively higher risk for financials, infrastructure and cement, while sectors such as information technology, pharma and select consumer-oriented sectors have lower risk.
India’s equity market has more than doubled from its pandemic-triggered low in March 2020, owing to a pickup in economic activity as lockdown curbs lifted, foreign inflows, surplus liquidity, and hopes of a Covid-19 vaccine.
“The market now trades at 21x one-year forward earnings, which is higher than the historical average,” Nomura said. “We think a potential rise in yields could put pressure on the valuation multiples unless expectations of corporate earnings growth surprises materially on the upside.”
The strength in foreign inflows has also helped sustain valuation multiples at elevated levels, Nomura said. “Foreign holdings in Indian equity market have shot up to 27.6%, much above the long-term average of 19.6%,” it said. Foreign investors, it said, have increased their positioning in metals, cement, coal and utilities, consumer durables and industrials, while lowered it in media and real estate.
Nomura doesn’t expect any material re-rating for the market from current levels. “At the upper end, we expect the market to trade marginally above 20x, where it is currently trading.”
The brokerage’s worst-case scenario is driven by a rise in bond yields and relatively weaker earnings growth, which could imply a downside of 8-14% from the current levels. “We reckon that the risk-reward is not very favourable and recommend a bottom-up stock-specific approach.”
Nomura took a more cautious view given the emerging headwinds and increased its weight on IT and pharma and reduced active weights on financials and cement. It has retained its overweight stance on global cyclicals and metals, and lowered its overweight stance on financials.
Within the financials, it has reduced its weight in ICICI Bank Ltd. and Axis Bank Ltd., while raised for HDFC Bank Ltd. and Max Financial Services Ltd.
The brokerage also retained its underweight stance on consumers and autos.
From its model portfolio, Nomura has excluded stocks like UltraTech Cement Ltd., Voltas Ltd. and Just Dial Ltd. after the rally over the last six months. Additions to its model portfolio include AIA Engineering Ltd., PNC Infratech Ltd., Dr. Reddy’s Laboratories Ltd. and Apollo Hospitals Ltd.
Nomura’s Top Picks
Sun Pharmaceutical Industries Ltd.
Mahindra & Mahindra Ltd.
Reliance Industries Ltd.
Max Financial Services