Fundamentals of Indian economy intact; use volatility to increase market exposure

In line with the yield curve inversion, the likelihood of a US recession would seem to have risen meaningfully over the last six weeks with the smaller regional banks under duress, and the debt refinancing schedule for US commercial real estate starting to loom ominously into the second half of the year.

• The US banking sector has little alternative but to prioritise bolstering and protecting capital and imposing lending constraints is likely to trigger a credit crunch even as the US Fed continues to shrink its balance sheet.
• The narrow breadth in year-to-date US equity market performance is telling — we should expect more job losses and be more cautious on consumer spending, demand destruction and further balance sheet stress over the next 12–18 months.
• However, given the persistent data pointing to labour market tightness and inflationary expectations, we are simply not ready yet to buy into the 80 bps of rate cuts in the 2H2023 that the front end of the US yield curve would seem to be suggesting.

The bottom line is we should expect earnings disappointments and continued underperformance in US equities broadly and a structurally weaker backdrop for the US dollar.

In contrast, India’s strong fundamentals stand out

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• Policy and infrastructure initiatives anchoring a resilient domestic capex cycle and broad-based industrialisation.
• An improving real economy given a strong balance of payments position, shrinking current account deficit, and moderating inflation allows the Reserve Bank of India to signal a potential peak in the current interest rate cycle, rising employment and recovering domestic consumption. Of note, the initial data points on April’s economic activity are robust with strong GST collections of INR1.87 trillion, strong manufacturing PMI of 57.2, even stronger services PMI of 62 and strong passenger vehicles and urban-centric two-wheeler sales.
• A strong earnings upcycle on the back of sustained top-line growth, operating leverage, lower input commodity costs, and free cash flows allowing for lower interest expense.
• A sustained bid for domestic equities from domestic investors.
• Our two key concerns remain the risk of higher energy prices that are inherently inflationary and would translate to stress on its balance of payment position and a weaker rupee, and the El Niño risk to the monsoons and rural agricultural output and consumption.

A third of the way through the earnings season in India, we would make the following points:

• Earnings growth in the March quarter for the NSE-200, ex-commodities, is tracking at +21% y-o-y (relative to consensus expectations in the low teens range).
• The positive surprises have been from banks (strong loans growth, stabilising margins and lower credit costs), industrial cyclicals (strong operating leverage and robust margins), and consumer discretionary plays (on the back of strong urban demand and pricing power).
• The negative surprises have been from the IT services companies (margin stress and tepid guidance on new order wins), building materials (competitive pricing/margin pressure), staples (weak rural demand and margin pressure), and metals (declining commodity prices).

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Indian banks are stable

Given concerns over the de-rating of financials globally, we wanted to highlight:

• The regulatory capital buffer and the counter-cyclical provisioning policies enforced by the Reserve Bank of India, internalising the lessons from the global financial crisis in 2008/2009, the taper tantrum of 2013, and the IL&FS default in 2018, have put the Indian banks and financial companies on a sound wicket.
• The Indian private sector financials are especially well positioned given abundant growth capital, strong deposit/digital franchises, well-regulated asset-liability management, and improving credit costs as the cycle turns, and are poised to put growth capital to work, taking market share from the public sector banks as corporate and infrastructure demand for loans augments strong retail loans growth.
• Over the next three to five years, we expect the well-capitalised private sector banks with adequate growth capital and strong deposit/digital franchises to meaningfully outperform the sector and the market on the bank of strong loans growth, low-cost deposits, significant cross-selling opportunities, and lower credit costs driving sustained improvement in margins, earnings, and returns on assets/equity.

Our conviction in the long runway opportunity in Indian equities remains underpinned by India’s compelling decade-plus growth window, thanks to the government’s commitment to structural reforms, infrastructure development, industrialisation, job creation and fiscal discipline; India’s demographic tailwinds and domestic demand opportunity, and the sustained bid for domestic equities from domestic investors.

Cognisant of the near-term risks of heightened market volatility, we are looking to opportunistically increase our exposure to high-quality Indian financials, industrials, infrastructure, and consumer discretionary stocks.

Stock in focus: Sun Pharmaceuticals

The stock we would like to highlight this month is Sun Pharmaceuticals, a pioneer Indian generics manufacturer with a global distribution presence, leveraging internal R&D capabilities and bolt-on acquisitions in niche therapeutics to transition to being an R&D-driven global speciality pharmaceutical manufacturer.

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Having carefully tracked the successful global launches of its first speciality products (Ilumya, Cequa, Winlevi), we believe that the market is structurally under-appreciating Sun’s ability to identify niche speciality molecules in an early development phase, the opportunity to scale market share globally, and importantly too, the domestic growth opportunity.

We believe that the recent FDA import alerts/export restrictions at the Halol and Mohali plants are providing us with a compelling risk/reward framework.

We expect Sun Pharma to compound its revenues at a 15%+ CAGR over the next three years, with consensus expectations pegged at a much more modest high single-digit CAGR.

• Sun has a strong new product pipeline in generics such as gRevlimid, gForteo and gLiraglutide as well as in speciality pharmaceuticals such as Deuruxolitinib.
• Global market share gains in the current speciality portfolio are likely to exceed market expectations; we expect speciality revenues to exceed 25% of consolidated revenues over the next three years. We are not modelling any further acquisitions at this point; however, we do expect opportunistic M&A, underpinned by its cash-rich balance sheet, to be a meaningful growth driver.
• The branded generics market in India remains a significant growth opportunity, and Sun’s well-diversified product portfolio and focused sales force will deliver sustained domestic market share gains.
• Sun’s intentionality in local product registrations and investing in local sales teams across the developing world, is now bearing fruit, sustaining double-digit constant currency growth.

We expect Sun Pharma to compound earnings at 20%+ CAGR over the next three years while the Street is pencilling in low-teens growth.

• We anticipate sustained mix improvement on the back of an expanding speciality portfolio to drive 100 bps–150 bps of annual operating margin accretion over each of the next three years.
• Having implemented the remedial measures required by the FDA, the cost rationalisation programmes that have been put in place will drive additional margin uplift.
• At this point, we are comfortable modelling an 18%–20% ROE/ROCE and a 25% dividend payout and expect that our estimates are likely to be conservative.

The Tantallon Asia Impact Fund SF is a fundamental, long-only, Asia-focused, total return opportunity fund. The fund invests with a horizon of three to five years in a concentrated portfolio (30–35 positions without leverage), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models, and data-driven analysis of sustainability, innovation, societal trends, and material environmental and governance initiatives to drive profitability. Tantallon Capital Advisors is a Singapore-based entity set up in 2003. It holds a capital markets service licence in fund management from the Monetary Authority of Singapore