Industrials, financials, discretionary to gain on capex boom: Morgan Stanley

Given the perception that growth may be accelerating, led by investments, the domestic cyclical sectors could gain, the global investment bank has said

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India’s coming capital expenditure cycle implies that the country is in the midst of a strong earnings cycle with positive implications for industrial and financial stocks, global investment bank Morgan Stanley has said.

The confidence stems from an improving trend in corporate and financial sector balance sheets, along with a strong reform push by the government, Morgan Stanley said in a recent report.

The fact that India’s corporate debt-to-GDP ratio is at a 15-year low and impaired loans in the banking sector are at a 10-year low makes a strong case for a likely surge in investments to strengthen supplies.

“We believe that India will see a new capex cycle changing the growth dynamics and fostering a virtuous cycle of productive growth and we see both the supply side and demand side factors favouring the onset of a new capex cycle,” the report said.

The investment bank is also seeing nascent signs of improvement in high-frequency data.

What will drive the capex? 

Supply-side factors 

A number of factors are seen in play for the revival of private sector capex. These include cyclical improvement in demand and capacity utilisation, cleaner corporate and financial sector balance sheets, structural reforms such as corporate tax rate reduction, implementation of Production-Linked Incentive (PLI) schemes and focus on infrastructure and supply-chain diversification.

The corporate sector continues to deleverage its balance sheets with “the corporate debt to GDP ratio expected at 47 percent in FY23 from a peak of 62 percent in FY15”,  Morgan Stanley added.

It expects the corporate debt growth to surpass nominal GDP growth in FY24 after staying below it in the past nine years.

The banking sector’s balance sheet position between FY10 to FY18 was constrained as impaired loans continued to increase, peaking at 12.4 percent of bank assets in FY18.

“Impaired loans have now decelerated to a 10-year low of 7.5 percent in FY22, indicating an improving balance sheet position to fund the capex cycle,” said Morgan Stanley.

It is also seeing an inflection in credit growth with better domestic demand. Year-to-date credit is growing at one of the highest rates in 10 years. Year-on-year (YoY) credit growth was 15.3 percent as of August 22, partly because of a low base.

However, “we note that trailing three-year credit growth has accelerated to 8.7 percent as against 6.8 percent as of end March 2022 and retail/SME demand has resumed and capacity utilisation has improved which has led to normalization of loan growth at Indian banks.”

Also read: Morgan Stanley rerates banking sector, sees 41% upside in select stocks

The government has shown strong intent to push structural reforms. The policy reforms have been meaningful, starting with the significant reduction in the corporate tax rate, the introduction of fiscal incentives under the PLI schemes for the manufacturing sector, expansion of public infrastructure spending and opening up of new sectors for private businesses.

The recent spate of supply-chain disruptions in the wake of the coronavirus pandemic and geopolitical tensions have brought to the fore the vagaries of dependence on a few sources of supply. Global companies are making a shift toward a “China plus” strategy to reduce their dependence on that country and India is one of the biggest potential beneficiaries of the shift.

“Indeed, we are seeing signs of improvement in foreign direct investment (FDI) flows, multinational corporation (MNC) sentiment and more news flow suggesting India should benefit from relocation of supply chains,” the investment bank added.

It expects India’s export market share to more than double to 4.5 percent by 2030 from 2.2 percent currently.

Demand-side factors 

After the pandemic brought the global economy to a standstill, the complete reopening of the economy is enabling a strong recovery in India.

The recovery has been the strongest in almost a decade. “It is the breadth of the recovery where we are seeing growth firing on almost all cylinders, which is very encouraging,” said the report.

The strength of the economy can also be gauged from the improvement in key economic indicators like the Composite Purchasing Managers’ Index (PMI) and a surge in Goods and Services Tax collections.

Growth in car and two- wheeler sales compared to pre-COVID levels has been more than 30 percent each, new property sales and launches have reached 11- and 8-year highs respectively and capacity utilisation rose to 75.3 percent in the first quarter of the current financial year.

According to Morgan Stanley’s proprietary MNC Sentiment Index, which has a strong association with FDI inflows, corporate profits and the direction of share prices, the sentiment towards India is close to all-time highs.

“Relative to China, where we run a similar index, India took its outperformance to an all-time high,” it added.

The report stated that from a geographical perspective, the improvement in sentiment was led by the US and Japan. From a sector perspective, real estate, materials, communication services and industrials outperformed, whereas energy, utilities and consumer staples and technology were the laggards.

Also read: FPIs park record $6.5 billion in Indian equities in August, financials beat FMCG this month

Economic outlook 

The investment bank estimates that the overall investment rate will rise to 36 percent of GDP by FY27 from around 31 percent of GDP in FY22. This implies that total investment growth (nominal) will average around 16.7 percent in the next five years compared to average growth of 8.8 percent in the previous five years.

Risks to the banks’ outlook emerge from external factors such as a sharper-than-anticipated slowdown in global growth and or a sharp rise in commodity prices, particularly oil prices, which can impact business confidence.

Corporate profits still have steam left to go grow for the next few years. The most important ingredient in profits is the rate of investment. In turn, higher profits drive investments, creating a virtuous cycle of higher wages, more consumption, more investments and more profits.

“The profit cycle breaks when investments start getting unproductive or “excessive” but that point is a few years away,” said the investment bank. “As investments rise, profit share in GDP (aka profit margin) will likely go past its previous high which means Indian stocks are not as rich as they appear on a headline basis.”

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Sectors and stocks 

Given the perception that growth may be accelerating, led by investments, Morgan Stanley thinks domestic cyclical sectors could do well relative to external-facing sectors or defensive ones.

“Accordingly, we prefer industrials, financials and consumer discretionary. We are also overweight on these sectors in our sector model portfolio with a 12-18 month view,” it said.

Industrials are likely benefiting from strong capex plus inexpensive valuations, while for financials, rising interest rates support margins, low leverage levels in the economy and rising capex favour a loan boom and benign credit costs further boost earnings.

Consumer discretionary valuations look attractive, given expectations of strong growth in the coming months. Long-term fundamentals are robust, underpinned by rising incomes.

Among the stocks, the investment bank’s top picks are Hindustan Aeronautics, L&T and Bharat Electronics in the EPC (erection, procurement and construction) and capital goods segments.

It expects a few industrial goods companies like Havells, Voltas, Astral and Kajaria to benefit from improving real estate cycle and rising electrification.

In the financial space, it believes that retail deposits and competitive intensity will be high, and the ability to gain deposit market share gains will be the key. Large banks like ICICI Bank and State Bank of India are best placed to capitalize on this.

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