UBS signals risk of India stocks trailing bonds over next 12 months

'While the economic recovery momentum is good, we believe equity markets in India are beginning to appear stretched on valuations,' says Sunil Tirumalai of UBS

Rising commodity prices and stretched valuations are posing a risk to the rally in Indian stocks, making a case for equities to underperform local bonds over the next 12 months, according to UBS Global Research.

“Equity valuations relative to bonds are at levels seldom seen,” Sunil Tirumalai, Mumbai-based head of India strategy at UBS, said referring to the gap between the yield on India’s 10-year government notes and the earnings yield of the NSE Nifty 50 Index. “On most such occasions in history, we see equities underperform in the ensuing 12 months.”

Continuing their rally from pandemic-driven lows in March 2020, Indian stocks have significantly outperformed their Asian peers so far this year, helped by sustained foreign buying of local shares. The Nifty 50 gauge has jumped almost 9% in 2021, more than triple the advance in the broader MSCI Emerging Markets Index, and is approaching a record high reached last month.

The Indian gauge is trading at 21.8 times its 12-month forward earnings, versus a five-year average multiple of 17.7 times, as investors pile into stocks on expectations that vaccine rollouts will drive a post-pandemic economic rebound and boost corporate profits.

“While the economic recovery momentum is good, we believe equity markets in India are beginning to appear stretched on valuations,” Tirumalai said. Nifty’s higher-than-average premium to emerging market equities seems vulnerable, given many of the commodity exporting EMs could see upgrades,” he said.

UBS expects these commodity cost pressures to start showing up in earnings for Indian companies in the January-March quarter and beyond, and pose a risk of downgrades for FY22 consensus estimates. Another cause for concern is that foreign institutional ownership of Indian equities is touching all time highs, according to Tirumalai.