The Tantallon India Fund closed 3.54% lower in December, a risk-off month marked by foreign institutional investors trading out of India into China, even as the broad markets fretted over the resolve by global central bankers to continue tightening monetary policy, risking recession, in order to restore price stability.
India at 30,000 feet
Reflecting on what has been a challenging year in the markets, what stood out for us were:
(i) Prime Minister Narendra Modi government’s unwavering commitment to reforms, infrastructure investments and fiscal discipline,
(ii) the clear messaging on corporate India and domestic private risk capital embracing industrialisation, China+1, and industry consolidation as durable opportunities driving sustained earnings and cash flow growth, and
(iii) domestic savings pools continuing to underpin Indian equity market valuations.
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In the short term, we are quite mindful of the risks of heightened market volatility and potentially getting whipsawed by algorithmic and macro traders “switching” out of the outperformance in India into the laggards in China/HK/Macau.
The key risks we remain focused on are energy prices, a busy election calendar that might encourage a more populist tilt in government spending and risks to corporate earnings given continued commodity price volatility.
On markets more broadly, what stood out for us was the US yield curve inversion and whether the Fed can create a soft landing.
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The yield curve inversion seems to be signalling the rising probability of a US “hard landing” given that the Fed will likely remain data-driven (employment is still holding up) and committed to hiking rates over 5% in response to persistent wage pressures and services inflation.
We are likely on the cusp of a recession in the US. In 25 of the prior 26 instances of both ISM manufacturing and services reports falling below 50 — as it just did in December, the US economy was either in or three months removed from recession.
Our view stands that (i) the Fed will most likely raise rates by another 100 bps over the next six months, (ii) the USS is likely to have peaked, supporting strong positive flows into non-US$ risk assets for the first time since 2009, and (iii) we need to be especially cautious with regards to earnings for the more economically sensitive stocks, and in particular, with regards to companies exporting into the US.
As for Asia, is poised to surprise meaningfully on the upside on the back of (i) China reopening, (ii) structural and cyclical tailwinds in India and Indonesia, and (iii) coordinated regional monetary policy easing and policy support as headline inflation moderates, and as a buffer against recession risks in the US and Europe.
The “inflation watch” of the last 12 months may well be yesterday’s news. Global central banks have belatedly tightened monetary policy and as global supply chains, energy prices and labour markets start to “normalise”, we do expect that moderating inflationary expectations will finally allow global central banks to signal a “pause” in the second half of the year.
As for Europe, given the hardliners in Russia becoming even more assertive, and the reaffirmation of US/EU support for Ukraine, it is difficult to project a speedy resolution of the war. We remain concerned over the risk of escalating, irrational, military action by the Kremlin, and specifically over the implications for energy, agro-commodity and fertiliser prices.
Corporate India stable
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Having been on the road in India, visiting companies, local economists and bureaucrats, and a sprinkling of the media talking heads over the last month, we would explicitly make the point that domestic demand in India will continue to surprise on the upside, despite the recession risks that we worry about in the US and Europe.
It is particularly noteworthy to reflect on how much more “comfortable” corporate India is with the broad macro environment today, relative to a year ago when they were confronted with the Omicron surge, the Russian invasion of Ukraine and the resultant spike in energy and shipping prices globally, and the prospects of unprecedented central bank tightening globally as inflation expectations soared.
Weakening external demand remains the key risk. Growth will be domestic demand-driven and will continue to surprise on the upside on the back of pent-up demand, healthy labour markets and strong consumer confidence.
We are encouraged by nascent signs of a revival in discretionary consumption and rural incomes. We are especially encouraged by the sustained recovery in both residential and commercial real estate markets across the country.
The correction in energy and food prices anchors lower inflationary expectations and will likely allow the Reserve Bank of India to signal a near-term peak in interest rates, perhaps, as early as 1Q2023.
GST collections for December of INR1.49 trillion ($24 billion), +15% y-o-y, is the third highest monthly collection ever and the 10th consecutive month with collections exceeding INR1.4 trillion.
Manufacturing PMI rose to a 26-month high of 57.8 in December, while services PMI jumped to 58.5, its highest level since June 2022, and up strongly from 56.4 in November.
Credit growth has remained resilient, +17.4% y-o-y in December, reflecting sustained demand for working capital loans and consumer credit.
We remain more constructive than consensus and are looking to take advantage of any short-term volatility to build our exposure to Indian equities.
Domestic demand and a significant new capex cycle will sustain GDP growth in the +6%-7% range over the next five years.
Corporate India and domestic private risk capital have embraced industrialisation, China+1, industry consolidation, and domestic consumption as durable opportunities to drive sustained earnings and cash flow growth. Domestic savings pools will continue to underpin Indian equity market valuations.
We are invested in the highest quality financials, capital goods, and consumer-facing companies, with conviction on earnings and cash flow visibility, and where the recent market action has provided us with a compelling expectations/valuation reset.
Stock highlight of the month
The stock we would like to highlight this month is NTPC, India’s largest thermal power producer which accounts for 25% of India’s total electricity generation. NTPC is in the process of making a significant pivot to renewable that currently accounts for a mere 2.5GW of a total installed capacity of 70GW. Over the next decade, we expect NTPC to double its current generation capacity, almost entirely through renewables, with renewables accounting for 50% of its generation capacity by March 2032.
We conservatively model NTPC’s revenues to compound at 15%+ annually over the next three years relative to consensus expectations in the low teens.
We expect NTPC to deliver on 10%+ annual capacity expansion over each of the next three years through a combination of solar, hydro and wind.
NTPC’s quasi-government debt rating allows it to refinance its existing debt on attractive terms, and to bid extremely competitively on new solar projects, allowing it to benefit disproportionately from the government’s policies to encourage solar. The agri-waste blending project and the green methanol pilot projects will be revenue and margin accretive. At this point, we are not building in any contributions from the significant investments being made in carbon capture projects and the pilot programme to convert carbon dioxide into ethanol using biocatalyst reactors.
We expect NTPC to compound earnings at 20% CAGR over the next three years, well ahead of the 7% run-rate pencilled in by the Street.
With the government having fast-tracked its new plants, we expect a meaningful uptick in revenues and earnings over the next three years as projects are commissioned and finally start to earn a return on the capital that has been sunk into the projects, driving strong operating leverage and free cash flows.
The recent allocation of coal mines to NTPC backstops about 30% of its coal requirements, reducing their dependence on erratic supply from Coal India, and allowing for consistently higher plant load factors.
Strong free cash flow growth and the potential value unlocking in the green energy subsidiary (probably through a strategic stake sale) do provide a significant upside to the current 4% dividend yield anchored to a 40% payout ratio.