GDP growth data masks weak domestic value creation: Dhananjay Sinha

There is a meaningful risk that inflation and input costs become bigger concerns in Q2 than they were in Q1, said Dhananjay Sinha of Systematix Group.

Despite robust growth numbers, the Indian stock market has faced intense selling pressure over the last two years. Dhananjay Sinha, CEO and co-head, Institutional Equities, Systematix Group told Saloni Goel in an email interview that there is a disconnect between reported GDP/GVA growth and the evidence from GST collections, corporate results and informal-sector surveys. Additionally, he explains why markets may stay in prolonged corrective phase, how cost pressures could mar Q2 earnings and why large private sector banks are a better bet in a higher for longer interest rate environment. Edited excerpts:

 

It was two years ago that Nifty 50 first hit 26,000 and still hasn't reclaimed that mark. Do you expect to see a turnaround, or will a prolonged consolidation continue?

 

 

The market's inability to reclaim previous highs despite supportive developments is telling us that investors are questioning the sustainability of growth rather than current conditions. The key issue is that earnings momentum has slowed sharply. While there was a strong post-pandemic earnings recovery, the last two years have seen Nifty 500 earnings growth moderate to only about 3.5 per cent CAGR, while Nifty 50 earnings have been broadly flat. At the same time, valuations have undergone significant compression, with Nifty 500 and Nifty 50 trading at nearly 30 per cent and 28 per cent discounts, respectively, to their pre-Covid average multiples.

 

My view is that the market is likely to remain in a prolonged consolidation phase until there is clearer evidence of an improvement in domestic value addition, earnings growth and demand. A sustained turnaround would require easing input-cost pressures, revival in private capex and stronger domestic demand. Until then, the market could continue to oscillate within a broad range rather than enter a strong bull phase.

 

What is the biggest disconnect you see between India's macro fundamentals and equity valuations?

 

The biggest disconnect is between reported GDP/GVA growth and the evidence from GST collections, corporate results and informal-sector surveys.

 

Official growth data suggest a robust economy, yet domestic GST collections have grown only 3.3 per cent over the last five quarters, versus 21 per cent growth in import GST. The share of import GST has risen from 18 per cent to almost 30 per cent of total collections, suggesting that growth is increasingly being driven by imported inputs and consumption rather than domestic value creation.

 

Corporate earnings tell a similar story. Rising raw-material costs have compressed gross value-added margins, and many companies have maintained profitability largely through cost rationalisation rather than genuine revenue productivity gains. The market appears to be discounting this underlying weakness, which explains why valuations have de-rated despite headline macro resilience.

 

The Q2 earnings season is almost upon us. Will inflation and input cost pressures play spoiler after a healthy Q1 show?

 

There is a meaningful risk that inflation and input costs become bigger concerns in Q2 than they were in Q1.

 

Our analysis shows that raw material costs for non-financial corporates rose nearly 40 per cent YoY in Q1, significantly higher than historical sensitivity estimates. This suggests there is still considerable "pipeline inflation" that has not been fully reflected in consumer prices or company margins.

 

A significant portion of higher-cost inventory is expected to flow through during Q2, creating further gross margin pressure. While companies will continue implementing price hikes, volume growth may suffer as consumers respond to higher prices. Therefore, Q2 may reveal a greater divergence between companies with strong pricing power and those that are unable to pass costs through effectively.

 

How do you assess the risk-reward in mid- and small-cap stocks at current valuations?

 

I would differentiate between the broader small-cap universe and selective niche opportunities.

 

In theory and in practice, larger companies possess superior pricing power, stronger balance sheets and greater ability to absorb macro shocks. In an environment characterised by slowing domestic value addition, rising input costs and tighter financial conditions, those advantages become increasingly important.

 

That said, not all small caps are equal. Businesses operating in niche markets, specialised manufacturing, differentiated products or local monopolies can continue to deliver strong earnings growth. Therefore, this is increasingly becoming a stock-picker's market. While small-cap indices have proven relatively resilient recently, I believe investors should focus on companies with clear competitive advantages, pricing power and low balance-sheet risk rather than taking broad-based small-cap exposure.

 

Do you expect the higher-rate environment to sustain for longer? What does it mean for investors and bond markets?

 

Yes. The risk is skewed toward higher rates for longer.

 

Crude oil prices remain elevated, food inflation remains relatively sticky, and there are significant pass-through effects from raw material inflation still flowing through the system. Consequently, inflation may surprise on the upside relative to consensus expectations. We believe inflation could potentially move into the 6-7 per cent range, creating pressure on the RBI to reverse its easing bias and eventually raise rates.

 

For equities, a higher-rate environment places pressure on valuations, particularly for long-duration growth sectors and companies dependent on cheap financing. Higher bond yields also raise the attractiveness of fixed-income instruments. For bond markets, the near-term risk remains higher yields and mark-to-market pressure, although longer-term investors may find value as rates adjust upward.

 

With FCNR(B) inflows crossing $130 billion, why hasn't the rupee strengthened more meaningfully? How do you see banking stocks in this backdrop?

 

The FCNR(B) inflows have acted primarily as a buffer rather than a source of structural currency appreciation.

 

India continues to run an external deficit that is being exacerbated by higher import costs and commodity prices. The FCNR(B) mobilisation strengthens reserves and allows the RBI to smooth currency volatility, but it does not change the underlying balance-of-payments dynamics. In essence, these flows are debt-like liabilities rather than autonomous capital inflows driven by productivity or export competitiveness.

 

For banks, the picture is mixed. The FCNR(B)-related deposit mobilization has increased the share of higher-cost term deposits, while lending yields have struggled to keep pace. This has compressed spreads and reduced earnings momentum. If inflation remains elevated and rates move higher, funding costs could rise further. Consequently, I would prefer banks with stronger CASA franchises, diversified fee income, longer-duration liability profiles and stronger pricing discipline. Large private-sector banks remain better positioned than the broader banking universe.

 

Disclaimer: Views and outlook shared belong to the respective brokerages/analysts and are not endorsed by Business Standard. Readers' discretion is advised.