Market rally will fade: 4 reasons why Goldman is bearish on India

The BSE Sensex is trading flat ahead of the conclusion of the two-day US Federal Reserve meeting that is expected to result in the start of a rollback of its stimulus.

Goldman Sachs remains “underweight” on Indian shares in its Asia Pacific portfolio and maintains its Nifty target at 5,700, saying the macro outlook remains challenged, which coupled with tighter financial conditions may lead to lower valuations.

According to the investment bank,the market could rally if the US Federal Reserve maintains status quo on bond purchases (QE) or reduces it by a quantum lower than what the market is expecting. “But we would expect such a rally to fade and for markets to move lower in line with the deteriorating fundamentals,” saidTimothy Moe, CFA at Goldman Sachs, in a report titled “India: Fundamentals stillchallenged, fade the rally.”

Here are 4 reasons why the investment bank is bearish on India

1**.Sharp rebound in equities, but macro remains challenged**

[caption id=“attachment_1117057” align=“alignleft” width=“380”]  Reuters[/caption]

Indian equities have seen a sharp rebound aided largely by policy, positioning andpositive global factors. After having corrected 13 percent from its July highs, the Nifty posted a10 percent snapback rally in less than a week following new RBI Governor Raghuram Rajan’s announcement of a set of measures aimed at encouraging US dollar inflows and stabilising the rupee.

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According to Goldman, a variety of global factors alsosupported the move with concerns over Fed tapering having somewhat moderated,geopolitical tensions in the Middle East easing, Brent selling off and cyclical data in China showing some improvement.

But the domestic growth outlook continues to look weak.

“We expect a continued decline in investment demand (due to funding issues and higher interest rates) and weaker consumption demand (due to rising fuel prices and weak employment outlook). The key data points regarding investment demand and consumption (like industrial and infra projects starts, personal consumption expenditure growth, consumer confidence and 2-wheeler growth) continue to remain tepid,” said Moe.

2.Corporate health, asset quality of banks to deteriorate

The investment bank says corporate profitability has been poor due to rising operating costs and declining marginsdue to weaker investment demand amid higher oil prices, higher interest rates and structural bottlenecks.

Leverage has risen significantly withdebt servicing capacity deteriorating to the lowest level in a decade. Asfunding costs rise and profits decline, the “stressed-segment” is likely to getbigger.Corporates relying on overseas borrowing could potentially come under more stress in the case of any funding crisis.

“As US rates continue to rise and funding costs rise and/or the INR currency remains weak, corporates with high foreign debt may be impacted- especially the ones with no natural hedges in terms of export revenues,” said Moe.

Capital goods, transportation, telcos and infra companies have a high proportion of foreign debt and may remain under pressure in a weaker rupee environment.

Secondly, the asset quality of banks is also likely to remain under pressure givenweaker macro conditions, deteriorating corporate balance-sheets and a weaker currency.

“Impaired assets in the banking system currently stand at 9.1 percent of loans, which is similar to the levels in 2003-04. If these impaired assets were written off, the hit to the banking system’s net worth could be significant,” it said.

3.Election uncertainties likely to linger

Election uncertainties are another hurdle for FII investment as no investor is likely to bet on a country where policies are uncertain.

India is months away from five legislative assembly and the final parliamentary elections. Hence political risk and concerns about policy paralysis are likely to linger ahead of elections.

“India needs tighter fiscal policy and sustained structural reforms to tackle the deeper macro imbalances of high inflation, twin deficits and a sharp slowdown in investment demand. But the likelihood of such reforms is low ahead of the elections,” said Mae.

4.Very little foreign selling has occurred compared to the significant foreign inflows over the past few years

And while most emerging markets/Asia active fund managers are still overweight on India, Moe cautions that that could well turn out to be a double-edged sword.

“Major EM/Asia active managers are still overweight India by roughly 300-400 basis points and any meaningful retail redemptions or decrease in allocations could put pressure on equities,” he said.

Hence, foreignselling impact could thus be much higher, if sentiment continues to worsenand other non EM-focused active managers were to sell their India holdings as well.