Rising inflation among key risks to Indian equity market: Morgan Stanley

Morgan Stanley's base-case June 2019 target for the S&P BSE Sensex remains unchanged at 36,000 levels

A likely rise in crude oil prices that could put pressure on growth, an election cycle that brings its own set of uncertainties and an upward pressure on inflation from food price hikes that sees the Reserve Bank of India (RBI) hike rates further are among the top risks to the Indian equities, according to a recent Morgan Stanley India Equity Strategy Almanac: The Uphill Climb.

On Monday, the wholesale price inflation (WPI) for June rose to a four-and-a-half year high of 5.77 per cent, rising from 4.43 per cent recorded in May 2018. Inflation in vegetables jumped to 8.12 per cent in June, from 2.51 per cent in the previous month. 

Inflation in 'fuel and power' basket, too, rose sharply to 16.18 per cent in June from 11.22 per cent in May as prices of domestic fuel increased during the month in line with rising global crude oil rates, data showed.

Experts do feel that the central bank may hike rates further over the next few months. Manishi Raychaudhuri, BNP Paribas’ Asian Equity Strategist, for instance, expects the RBI to hike rates twice in 2018, of which, one hike already came through in June. 

“We think the market’s expectation is more benign now, but given the fact that core inflation is on a steady uptrend, consensus expectations about rates may move upwards as more data points become available,” he says.

"While the outlook for the WPI inflation would be influenced by commodity prices, rupee movement, effectiveness of MSPs and the dispersion of the monsoons, an easing of the base effect should cool the WPI inflation for July 2018 to some extent. The sharper-than-expected uptick in the WPI inflation in June 2018 reinforces our expectation of a likely repo rate hike at the next MPC meeting in August 2018," writes Aditi Nayar, Principal economist at ICRA in a note.

Besides the above-mentioned risks, relatively rich mid-cap valuations, rising equity supply and the fact that the markets may already be pricing in some part of the growth recovery are the other factors that pose a risk to the India equity story, says the report authored by Ridham Desai, head of India research and India equity strategist along with Sheela Rathi. 

Their base-case June 2019 target for the S&P BSE Sensex remains unchanged at 36,000 levels, while the bull-case scenario sees the 30-share index at 44,000.

“Indian stocks are jostling weak emerging markets, rising rates, higher oil prices, an election year and relatively rich mid-cap valuations. The large-cap index has support from an improving growth cycle, strong macro stability and local appetite for equities,” the report says.

On the flip side, the report highlights six factors - Strong macro stability evident in a positive balance of payments (BoP) and backed by a Central Bank that is committed to keeping real rates positive; a bullish steepening of yield curve; a low and falling beta, which augurs well in a weak global equity market environment; India's growth that is likely to accelerate relative to emerging markets (EM); strong domestic flows and a weaker foreign portfolio (FPI) positioning – that are currently working in favour of Indian equities.

As a portfolio strategy, Morgan Stanley prefers to stick with the large-caps as compared to their mid-cap peers. 

"We like Banks (private corporate and retail), Discretionary Consumption, Industrials and Domestic Materials, while avoiding Healthcare, Staples, Utilities, Global Materials and Energy," the report says.