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Ind ia St rategyInd ia St rategy

Edelweiss Securities LimitedNirav Sheth+91 22 4040 [email protected]

Kapil Gupta+91 22 4063 [email protected]

Prateek Parekh, CFA+91 22 6623 [email protected]

Rahul Veera+91 22 6623 [email protected]

State Finance

Nominal Growth

USD

EM Risk

Rural

January 4, 2016January 4, 2016

A n n u a l O u t l o o k 2 0 1 6A n n u a l O u t l o o k 2 0 1 6

E a r n i n g s t o s u p p o r t ; w i l l p o l i c i e s s u p p o r t ?E a r n i n g s t o s u p p o r t ; w i l l p o l i c i e s s u p p o r t ?

1 Edelweiss Securities Limited

Strategy

Rewind 2015 and Fast Forward 2016

This letter is neither an attempt to claim credit for our winning ideas nor provide an excuse

over failed ones in the last year. It’s an honest attempt to recount how reality held up

against our expectations set out in 2015.

First, we were deeply convinced about a big reset in monetary policy, arguing for a 125‐

150bps rate cut then. Importantly, we got it right for the right reasons. We religiously avoid

second guessing policy makers/CEOs/experts while making our own forecast—some may say

it smacks of arrogance, but we prefer it this way. We were unmoved by Mr. Rajan’s hawkish

stance as the underlying inflation trajectory was evolving on expected lines. We had also

highlighted that the changing terms of trade (ToT) will favour urban consumption,

forewarned about the impending rural distress while noting that excess capacities will delay

corporate capex. These too have played out well.

We were wrong on perhaps what mattered the most—our March 2016 Sensex target of

32,400 now seems aggressive and has been rolled over to a March 2017 target. So, it has

been a year of missed returns. In hindsight, our analysis of key macro events should have

been more multi‐dimensional. We did not fully comprehend the negative impact of weak

emerging markets demand/commodity price rout on India Inc.’s earnings. We also need to

be more mindful about asymmetric distribution of gains and losses. Hence, while benefits of

lower commodity prices were dispersed amongst various economic participants, risk popped

up in the rather concentrated producer base. Financial linkages amplify this risk. Also, the

last nail in the coffin was a rather flattish 10Y bond yield, capping any possibility of multiple

expansion.

We are approaching 2016 optimistically. We believe the economy has turned the corner, but

a sustained recovery will require more policy support. Again, without second guessing Mr.

FM, we expect relaxation of fiscal goals. Monetary easing of at least another 75bps is due.

Importantly, earnings recovery in mid double digits is very probable.

Finally, investors should now get used to incremental, but relevant, policy reforms. These

small delta changes over time will amplify and create big changes in outcome; we have

dubbed it the Nut & Bolt’s strategy. Politically, the biggest risk is these anticipated changes

take longer than usual to bear economic traction. We are worried about the series of losses

that BJP had in local civic polls in several states, especially in rural constituencies. We expect

agriculture to be a focus area in the forthcoming budget.

Overall, we expect investors to have a more rewarding year. So, Happy Investing and a

Bullish New Year!

Your’s sincerely,

Nirav Sheth


Strategy

Contents

Executive summary .................................................................................................................. 3

Introduction ............................................................................................................................. 5

“It’s the nominal economy stupid”........................................................................................... 6

Box article: Nominal and Real GDP recovery in historical perspective ............................. 8

States’ finances getting challenged; further fiscal cuts unwarranted .................................... 12

Headwinds of 2015 receding at the margin ........................................................................... 18

1. Rural demand: Can FY17 be better? ............................................................................... 18

2. Exports: Weakest link so far, but modest rebound likely ............................................... 21

Expect long pause in capex cycle; tradional sectors facing excess capacity .......................... 25

Summary and key macroeconomic forecasts ........................................................................ 32

Explaining the earnings dilemma ........................................................................................... 33

Valuations: Is India is the ultimate destination? .................................................................... 38

Risks: Mind the pegs .............................................................................................................. 40

Indian Aviation ....................................................................................................................... 44

BFSI. ....................................................................................................................................... 47

Model portfolio and top picks ................................................................................................ 49

Annexure 1: Tracking reforms ................................................................................................ 52


Strategy

Executive summary Why is the economic recovery not feeling like one? Why are earnings downgrades

persisting? To paraphrase Bill Clinton’s famous election campaign slogan, “It’s nominal

economy, stupid.” Our analysis should put to rest any disbelief around reported economic

data. We argue that further recovery demands more policy support. Our detailed work

reflects considerable strain on state finances from lower oil/property revenues &

impending Pay Commission implementation. We expect fiscal targets to be relaxed in the

forthcoming Budget and monetary easing of at least 75bps through FY17.

We have always expected a government backed capital spending, as private sector reels

under excess capacity. A bottom‐up analysis should convince disbelievers, now.

Meanwhile, earnings recovery has been marred by an unusually high leverage (50%) to

overseas geographies or commoditised by import parity prices. This was less noticeable

when global growth was in sync. Importantly, our stress case indicates a mid double digit

earnings recovery in FY17—domestically driven earnings will accelerate even as one off

impact from ex‐India factor fades. We now expect Sensex to be 30,785‐32,800 in March

2017, which is close to our March 2016 target—a year of missed returns. Our sector

preferences remain financials, consumer discretionary and government led capex plays.

Indigo is a high conviction entry in our model portfolio.

“It’s the nominal economy stupid”

The striking feature of economic activity in 2015 was the sharp slowdown in nominal GDP

growth (even though real activity stabilised) and this is well echoed in the unusually weak

earnings. We enumerate that this divergence in nominal and real trajectory is a historical

anomaly (not seen across business cycles including those where disinflation was sharp). The

prime reason, we believe, is that policy response (fiscal/monetary) this time has been much

slower and inadequate given weak aggregate demand growth (close to crisis lows; 10Y yields

are 250bps higher than crisis lows) or even the policy response across cycles (typically a two‐

handed approach of sizeable fiscal and monetary support). We maintain that inflation is

unlikely to return quickly even as demand recovers (much like 2001‐2005). Thus, a re‐think

on fiscal/monetary policy is in order. Sole reliance on supply‐side reforms (which are slow to

implement, slow to yield benefits) to revive demand may lead to disappointment.

States’ finances getting challenged; further fiscal cuts unwarranted

While the Centre was pruning spending amid downturn (procylical stance), buoyant oil taxes

(and inflation tax) fuelled states’ spending, mitigating impact of former’s austerity. However,

states’ finances are entering a tough phase: 1) tax revenues are slowing amid lower oil prices

and weak nominal GDP growth; 2) impending burden of wage revisions (7th Pay Commission:

~0.5% of GDP); and 3) power sector reform ‘UDAY’ will add to fiscal burden. And, all this at a

time when several states are close to their FRBM targets. Thus, states may be forced to

retrench development spending, which will impinge on aggregate demand. Hence, it is

critical that Centre relaxes its fiscal targets to create space for continued capital expenditure.

Drag from 2015 headwinds easing; modest recovery on track….

The recovery process will continue in FY17, albeit at a modest pace. We expect demand

drivers to churn. Tailwind from ToT shift will recede and states’ finances may pose fresh

challenges. However, we believe modest revival in exports is on cards as EMs’ business cycles

stabilise amidst stable USD and commodity prices. Domestically, improvement will be hinged


Strategy

on continued policy support. We foresee ~75bps easing by RBI in FY17 (with better

transmission) as inflation is expected to remain contained at ~5%. Similarly, we expect the

Centre to relax its fiscal targets in FY17 to sustain public capex. Finally, we anticipate better

rural output assuming normal monsoon in FY17. On balance, a slow recovery is likely with

growth accelerating ~50‐60bps to 7.8‐8.0% in FY17. We expect modest depreciation (to ~67‐

68 range) in USD/INR given RBI’s asymmetric policy intervention (weakening bias) and global

uncertainty. Otherwise, we find INR to be well supported. Risks to overall outlook arise from

event risk in EMs given sharp fall in forex and commodities amidst high level of foreign debt.

Watch out for soft/hard pegs, especially if Fed turns out to be aggressive.

But expect a long pause in capex; several sectors facing excess capacity

Investors seeking private capex rebound will be disappointed and our view has been

consistent over the past 18 months. Our argument last year was macro based, emphasizing a

sizeable out gap which needs to be closed before triggering a fresh cycle. We complement

the argument with a more bottom‐up analysis. The surprising thing is that a full blown

recovery can take a couple of years rather than quarters. Private corporate capex will be

biggest laggard, dented by excess capacities in utilities / metals and unfavourable but fair

regulatory landscape. Households, accounting for 1/3rd investments, is held back by poor

housing demand. We, however, expect this cycle to be short lived, especially if prices

readjust and monetary policy is more accommodative. Government, including central PSUs,

will accelerate capex via direct investments, regulatory framework favouring import

substitution and more viable PPP partnerships. Railways, Defence, Roads, Ports, Renewable

Energy will be focus areas.

Explaining the earnings dilemma

Earnings recovery remains mired due to 2 reasons: (i) they are levered to nominal GDP

growth (not real); and (ii) earnings are more globalised than commonly perceived—almost

2/3rd Nifty’s earnings are either driven by exposure to overseas geographies or commoditised

by import parity prices. Almost 60% of downgrades since FY15 have been driven by ex‐India

factors. We view earnings through 4 lenses—commodities, exports, domestic demand and

banks. We are fairly optimistic about earnings recovery in FY17 and beyond—while domestic

consumption will maintain pace, manufactured exports will rebound as overseas market

stabilises and one‐off currency impact fades. Even commodities will pull in growth through

volumes now. Our worst case estimates put earnings in a 12‐14% range for FY17.

Model Portfolio and Strategy

We are positioning for a mild recovery led by urban consumption and government capex in

FY17, which is likely to accelerate in FY18. Our March 2017 target for nifty is a range of 9525‐

10160 (Sensex : 30725‐32800) backed by 15/16x FY18 consensus estimates ‐ an upside of 20‐

28%. Our key OWs remain banks and consumer discretionary. We are cognizant of earnings

risk to PSU banks, but expect market to overlook a temporary dislocation. Amongst

consumer discretionary, apart from autos, we are bullish on airlines and Indigo makes it to

our model portfolio. One big limitation is lack of large‐cap plays in consumer discretion or

government facing EPC plays. Another big change is the OW stance on Reliance funded by

reducing positions in ONGC and BPCL; we see asymmetric gains in Reliance over other direct

oil plays like ONGC. Unlike consensus, we see value in DLF from a long‐ term perspective. We

expect broader markets to continue to do well given higher earnings leverage to domestic

economy. Our top 5 large‐cap picks for 2016 are Yes Bank, SBI, Reliance, Tata Motor and

Indigo. Among mid caps, new entrants in our portfolio are Jet Airways and NBCC.


Strategy

Introduction In our note, A step across the line (dated 20 July 2015) we had set a 4 factor framework to

analyse India’s short‐run (business cycle) economic performance and concluded that some of

the macro headwinds seen during 2011‐14 are receding in 2015 and, therefore, a modest

economic recovery is on the cards. In this 4 factors approach—balance of payments (BoP)

situation, inflation/terms of trade (ToT), domestic macro policies (fiscal & monetary) and

external demand (exports)—we had argued that India is entering a phase of BoP stability

(after tumultuous 2011‐13), ToT has turned decisively positive (after being adverse for

several years) thus reducing inflation and aiding real incomes and fiscal/monetary drag is

reducing at the margin after being procyclical through the downturn. However, we had

identified 2 stress points—exports and rural demand. Our policy calls of fiscal relaxation in

FY16 and RBI rate cuts of 125bps taken in January 2015 have played out well, although

monetary transmission has been painfully slow.

So, how has the macroeconomic situation evolved over the past 3‐4 quarters?

We believe the defining feature of the global economy in 2015 has been the sharp

deterioration in emerging markets’ (EM) macroeconomic prospects (in complete divergence

with western economies, especially the US). The global ToT turned adverse for EMs, China

slowdown added to the concerns and Fed’s impending tightening only deepened the woes

such that their BoP situation came under severe stress and currencies plunged.

India ducked the storm as it is net beneficiary of this ToT shift. However, benefits are not

straightforward. There are always winners and losers, leads and lags in terms of costs and

benefits and of course feedback loops. While urban households, central government, and

domestic‐oriented businesses gained; rural India, state governments and global sectors

(commodities, exporters) witnessed stress. At a broader level, while India’s macro‐

vulnerabilities receded quickly; cyclical revival has been weak, partly weighed down by

extremely weak EM world.

We under estimated the intensity of export weakness and domestically, unanticipated shock

of second poor monsoon in a row deepened the rural pain. Thus, 2 large demand centers—

exports and rural spending—were significant drags on the business cycle. Rest of the

economy, however, was stabile, much on expected lines. Urban consumption (helped by real

income gains) picked up while the favourable fiscal impulse from the central government

aided the activity more generally.

As we move into 2016, our base case of continued gradual (not a v‐shape though) recovery

remains intact, but we believe demand drivers will churn. We foresee some fresh levers of

support kicking in even as some tailwinds recede and some concerns arise. We elaborate on

these in detail. As always, we believe that while reforms are a must (and they are underway),

their benefits will manifest only over a period of time. In the near term, the economy is

facing shortfall of aggregate demand and thus, importance of macroeconomic policy support

from fiscal/monetary authorities cannot be ignored.


Strategy

“It’s the nominal economy stupid”

Favourable shift in global ToT (amounting to ~2% of GDP) since mid‐2014, along with

supportive fiscal impulse has aided economic activity over the past 4‐6 quarters. However,

recovery is still tentative and is limited to select pockets. Indeed, it is striking that nominal

GDP growth (or nominal spending) has slowed sharply and is now close to Lehman crisis

lows even as real activity is stabilising/improving. This is echoed in unusually weak

corporate earnings which are levered more to nominal spending. Historically, nominal and

real growth tend to recover concurrently (even in episodes of sharp disinflation—2008

crisis, Volcker disinflation in US in 1980s). We present historical evidence in this regard.

In our view, the weakness in nominal spending indicates that support from cyclical levers

of aggregate demand stabilisation—fiscal policy, monetary policy or even exchange rate—

remain inadequate so far: 1) fiscal impulse remains far weaker than seen historically

during weak business cycles; 2) exchange rate remains overvalued (on REER basis), thus

weighing on aggregate demand through trade channel; and 3) while monetary policy has

eased, policy rates may, at best, be at neutral levels (and not stimulative yet) and in any

case transmission remains weak.

Consider this. Nominal GDP growth is at weakest levels in the past 15 years, but 10Y yield

remain ~250bps higher than its historical lows (despite RBI’s 125bps rate cut). Further,

nominal GDP growth has slipped below 10Y yields for 2‐3 quarters now. The last time this

happened briefly was during 2002 and 2008 downturns, but massive policy response

reversed the trend. Thus, we argue that policy support needs to step up, especially when

ToT benefit may be receding in the coming year.

ToT boosted activity in FY16, but benefits should fade in FY17….

During 2011‐14, the Indian economy witnessed a stagflationary macro mix of high inflation

and slowing economic activity. While persistently high global commodity prices (energy,

metals, food) contributed to elevated inflation, tight fiscal and monetary stance eroded

aggregate demand in the economy. Not surprisingly, corporate margins and household real

incomes were squeezed amid this stagflationary macro mix. However, over the past 12‐18

months, India’s ToT has turned around with sharp decline in crude oil and industrial metal

prices. This positive shock not only helped curb inflation and current account deficit, but also

helped unwind the squeeze on corporate margins and real incomes of households.

It is this favourable shock along with positive fiscal impulse and revival in capital inflows that

ended the economic deceleration and aided modest recovery in the economy. This is

reflectd in the trend improvement in industrial activity (auto sales, CV sales, capital goods

etc), although recovery is still not broad based given headwinds from exports, rural demand

and high NPAs in the banking sector.

Broadly speaking , ToT reversal engineered a gain of ~2% of GDP over the past one and a half

year. About 0.9% of GDP has been absorbed by the fiscal through higher taxes (1.1% benefit

to Centre, 0.2% loss to states through lower oil prices). Households benefited directly

through lower fuel prices to the tune of ~0.2% of GDP, OMCs have garnered another ~0.5%

of GDP through lower under‐recoveries while the balance ~0.4% went to other corporate

through higher margins. But some of that gain may have percolated to households through

price cuts.

Favourable ToT benefit amounted

to ~2% of GDP, with Central

government capturing maximum

gain……

…..incrementally, these gains may

be receeding


Strategy

…And nominal growth turn around yet awaited

These ToT benefits perhaps will persist for another couple of quarters before fading.

Sustenance of the recovery beyond that will critically depend on support from

macroeconomic policies—fiscal and monetary. In this regard, it is pertinent to note that

while the real economy has gained some traction, nominal GDP growth has slowed

dramatically in the past 4 quarters, almost to lowest levels since the Lehman crisis period.

Such stark divergence between real and nominal growth trajectories in a recovery phase has

not been seen before, either during 2002 or 2009 recovery. Indeed, a look at US business

cycles in past 40 years indicates that there is no single recovery in which nominal and real

growth did not turn around concurrently. This holds true even for episodes of sharp

disinflation such as the great Volcker disinflation of early 1980s or even post Lehman crisis

recovery in 2009.

Chart 1: Real activity has stabilized but nominal still weakening – a historical anomaly

Source: US Federal Reserve, CMIE, Edelweiss research

Chart 2: Nominal and real recovery have always been concurrent in the US

Source: US Federal Reserve, CMIE, Edelweiss research

5.0

7.0

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15.0

Sep 12

Mar 13

Sep 13

Mar 14

Sep 14

Mar 15

Sep 15

(% YoY, 2QMA)

Real GDP Nominal GDP

Slowdown in nominal GDP growth is concerning

0.0

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Jun 97 Jun 00 Jun 03 Jun 06 Jun 09 Jun 12

(%, YoY)

Real GDP Nominal GDP

(4.0)

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Sep 70 Sep 75 Sep 80 Sep 85 Sep 90 Sep 95 Sep 00 Sep 05 Sep 10 Sep 15

(%, YoY)

Nominal GDP Real GDP

It is striking that nominal growth

has slowed considerably, also

reflected in weak earnings

Historically, nominal and real

growth turnaround concurrently


Strategy

Box article: Nominal and Real GDP recovery in historical perspective (Volcker disinflation in US) As argued above, the continued weakness in nominal GDP growth even as real activity has stabilised/improved is an historical anomaly.

A long‐term look at nominal and real economic cycles, whether in the US or in India, reveals that nominal and real economic recoveries

are invariably concurrent. Even in case of sharp decline in inflation (as is the case now), this pattern holds. Take for example the

economic collapse post the fall of Lehman Brothers in late 2008. India’s (and in several other countries) inflation declined precipitously

and yet when the turnaround happened in mid‐2009, both nominal growth and real activity rebounded concurrently.

A more appropriate analogy would be the Volcker disinflation during 1981‐83 in the US. The US economy was coming out of stagflation

(just like India which witnessed stagflationary mix during 2011‐14) and disinflation thereafter was sharp—from 10‐11% in early 1981 to

about 4% by 1983 (as in India with CPI falling from 9‐10% in January 2014 to 5% currently). But, what is notable is that once the recovery

started in the US, both nominal and real GDP growth recovered concurrently.

Thus, during episodes of sharp disinflation—2008‐09 (India) and 1981 (US)—the economic recovery that followed was in both real and

nominal basis. This is not so in the current episode of Indian economic recovery. What explains this?

In our view, strength of the policy response/stimulus differentiates the current from previous episodes. For example, during Volcker

disinflation 1981‐83, US’ fiscal deficit expanded 3.5% of GDP while Fed’s policy rates were slashed by ~700bps in a span of a year from

high of ~15%. This 2‐handed policy stimulus engineered a sharp turnaround in nominal and real growth in the US economy once

inflation started declining. The US Congressional Budget Office in its economy report in August 1983 stated, “easier monetary and credit

conditions” along with “large fiscal stimulus” triggered economic recovery.

Contrast this with the current episode of India’s recovery where policy response has been much weaker—fiscal policy has been largely

pro‐cyclical and monetary policy has pursued easing, but transmission has been extremely poor. It is this less‐than‐adequate policy

response (despite sharp fall in inflation), in our view, that explains the weakness in aggregate spending in the economy.

Chart 3: During Volcker disinflation in 1981‐83, both nominal and real GDP growth recovered simultaneously

Source: US Federal reserve, Edelweiss research

2

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12

(4)

0

4

8

12

16

Sep 70 Sep 73 Sep 76 Sep 79 Sep 82 Sep 85

(%, YoY)

(%, YoY)

Nominal GDP Real GDP GDP deflator (RHS)

Concurrent recovery in nominal GDP, despite sharp disinflation


Strategy

We believe the weakness in nominal GDP growth can be attributed to the fact that cyclical

levers of aggregate demand stabilisation—fiscal policy, monetary policy and exchange rate—

remain inadequately supportive of growth. For example, the fiscal impulse has remained

negative throughout the downturn and despite relaxation of target last year, remains weak,

in contrast to previous business cycles. As indicated in the box article above, the fiscal

stimulus was sharp in 2002 and 2009 recoveries in the Indian economy and this is true even

in the case of Volcker disinflation of 1981‐83 in the US.

Second, the exchange rate (on REER basis) has appreciated ~10% since mid 2014, which is

acting as a drag on aggregate demand through the trade channel.

More importantly, there has been monetary easing, but again it remains inadequate and in

any case transmission has been extremely poor so far. Consider the following:

Despite 125bps cut, policy rates may, at best, be neutral and not stimulative as yet. Real

rates have actually moved up ever since the easing commenced. Indeed, 10Y G‐sec yield

remains around the same level as when easing began in January 2015, indicating no

transmission across the curve. Credit impulse too remains weak.

Nominal GDP growth is the weakest in the past 15 years, but 10Y yields remain ~250bps

higher than historical lows (despite RBI’s 125bps rate cut).

Further, nominal GDP growth has slipped below 10Y yields for 2‐3 quarters now. Last

time this happened was during the 2002 and 2008 downturns, but quick and sustained

policy response reversed the trend.

Indeed, while gauging whether the monetary policy is doing enough to assist recovery,

growth in nominal spending could be a useful measure. To quote Ben Bernanke:

“As emphasized by Friedman . . . nominal interest rates are not good indicators of the stance

of policy . . . The real short‐term interest rate . . . is also imperfect . . . Ultimately, it appears,

one can check to see if an economy has a stable monetary background only by looking at

macroeconomic indicators such as nominal GDP growth and inflation.”

‐Ben Bernanke (Remarks at Federal Reserve Bank Dallas, October 2003)

The idea here is not to suggest that the RBI should look at nominal GDP targeting, but only to

point out that since we are in flexible inflation targeting, growth considerations cannot be

completely ignored and slowing nominal spending is perhaps indicating that policy support

needs to be stepped up. After all, nominal GDP data is largely free of distortions caused by

assessment error in deflator, if any.

Fiscal impulse has been negative

throughout downturn, in contrast

to previous business cycles

Nominal growth is around weakest

levels in 15 years, but 10Y yields

are ~250bps higher than historical

lows


Strategy

Chart 4: Monetary policy is behind the curve

Source: Bloomberg, CMIE, Edelweiss research

Macro‐policy support needs to step up till nominal growth turns around

The bottom line here is that aggregate nominal spending continues to remain extremely

weak, which means either broader inflation has fallen much more sharply than CPI is

reflecting or real activity continues to remain depressed. In either case, policymakers need

to take notice. This recovery differs from previous recoveries, when nominal and real activity

had turned around simultaneously, in the strength of the policy support to the slowing

aggregate demand.

Thus, we foresee another 75bps of easing by RBI during FY17 and better transmission of past

rate cuts to lending rates in the economy. Inflation is expected to remain contained around

5% (in line with RBI’s objective for March 2017), although 4% on sustainable level is a tough

ask. If we apply current weights of the CPI basket to CPI (IW) during 1999‐2005 (the most

benign best phase of CPI inflation, averaging 4%), the CPI level will be ~4.5%.

It is interesting to note that the Urjit Patel Committee report on monetary policy

framwework quotes 13 studies done over a period of past 30 years with regards to

appropriate level of inflation for India. Of these, only 1 study of 1985 argues for 4% as

appropriate level of CPI, while another of 2011 pegs appropriate level at 4.75%. Rest all

studies put CPI mid‐point target at 5% or above.

5

6

7

8

9

10

5

9

13

17

21

25

Dec 01 Dec 03 Dec 05 Dec 07 Dec 09 Dec 11 Dec 13 Dec 15

(%)

(%, YoY)

Nominal GDP 10Y bond yield (RHS)

2002 and 2009 crises: Nominal GDP growth barely slipped below 10Y yield for just one quarter

Nominal GDP: At historic crises lows10Y Bond yield: 250bps higher than crises lows

2015: Nominal GDP growth is below 10Y yield for 3‐4 quarters now

Policy support needs to step up.

Fiscal targets need to be relaxed

and RBI should deliver more

easing….we anticipate 75bps cut in

FY17


Strategy

Table 1: Only 1 out of 13 studies done on inflation target suggests a 4% target

Source: Urjit Patelcommittee report on monetary policy framework, January 2014

Study Year of studyMid point of threshold

inflation target (%)

Chakravarty Committee Report 1985 4.0

Rangarajan 1998 6.0

Kannan and Joshi 1998 6.5

Vasudevan, Bhoi and Dhal 1998 6.0

Samantaraya and Prasad 2001 6.5

Report on Currency and Finance 2001 5.0

Bhanumurthy and Alex 2010 5.3

Singh, Prakash 2010 6.0

RBI Annual Report 2010‐11 2011 5.0

Pattanaik and Nadhanael 2013 6.0

IMF 2012 5.5

Mohanty et al 2011 4.8

Subbarao 2013 5.0

Histrocially studies indicate 5% as a

more appropriate inflation target

for India


Strategy

States’ finances getting challenged; further fiscal cuts unwarranted

While the Centre’s fiscal stance was firmly pro‐cyclical during the economic downturn

(2012 onwards), states could sustain spending as oil tax (and generally inflation tax)

remained buoyant. This mitigated the impact of Centre’s fiscal austerity. We believe this is

beginning to change as states’ finances are entering a phase of rough ride: 1) states’ own

tax revenues are slowing considerably amidst lower oil prices and weak nominal GDP

growth; 2) there is an impending burden of wages and pension revisions on the lines of the

7th Pay Commission (~0.5% of GDP); and 3) power sector reform ‘UDAY’ will add to states’

fiscal pressures as they share interest burden of respective state electricity boards (SEBs).

This is happening at a time when many states are close to their FRBM targets (3% of GSDP).

Thus, they may be forced to retrench development spending (states account for 75% of

total government development spending in India) amid these fiscal strains. This will erode

demand, especially if Centre’s fiscal impulse also turns negative in FY17. In our view, given

that recovery is still nascent and nominal spending is weak, pull‐back in aggregate

government spending would be premature and ill‐suited.

Centre’s tax revenue slowed, but states’ held up well during downturn…

The Centre’s tax collection slowed as the economic downturn set in 2011‐12. From a growth

of 27%YoY in FY11, tax revenue slipped to 10%YoY in FY15 and remained static/modestly

declining as % of GDP. Largest deceleration was seen in corporate tax revenue as profitability

was squeezed amid narrowing gross margins, slowing demand and rising interest rates

(corporate tax collection declined from 3.8% of GDP in FY11 to 3.4% in FY15). As a result, the

burden of fiscal consolidation (from ~5.8% in FY11 to 4% in FY15) fell largely on expenditure

cuts even as private sector demand slowed. Thus, the Centre’s fiscal stance remained largely

pro‐cyclical, reinforcing the economic downturn.

Chart 5: State tax collection has remained robust, while centre’s has stagnated

Source: CMIE, RBI study of state finances

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FY95 FY00 FY05 FY10 FY15

(% of G

DP)

(% of G

DP)

Centre's gross tax revenue State's own Tax Revenue (RHS)

Centre’s tax collections stagnated

during the downturn….

…but, states’ taxes have held up

quite well


Strategy

In contrast, states enjoyed good tax buoyancy even during the downturn (FY12‐15) primarily

helped by the inflation tax. This is particularly evident in the oil tax revenues (fuel prices

were continuously raised 2012 onwards, providing a significant tailwind to states’ tax

collections) but even other sales tax collections (such as land revenue) have held up quite

well helped by robust spurt in nominal GDP growth rate.

Chart 6: Increase in fuel prices, relatively robust property market, high buoyancy of sales taxes resulted in surge in state taxes

Source: CMIE, Edelweiss research

….enabling states to sustain spending

The buoyancy in tax collections (even amid sharp downturn) kept the fiscal situation of

states in shape (unlike the Centre). In fact, while the Centre’s fiscal impulse was negative in

the past 4 years, states had a mild expansionary bias. Critically, states sustained

development spending all through the business cycle downturn, thus mitigating the drag

from plan expenditure cuts by the Centre. Between the Centre and states, the latter account

for 65‐70% of total development spending.

Chart 7: States account for a higher share of devp. expenditure… Chart 8: …especially in education and agriculture


Note:*From FY16 onwards, tax devolution to states from centre has further increased owing to 14th FC recommendations

0.4

0.5

0.6

0.8

0.9

1.0


(% of G

DP)

State property tax revenues

State devp. expenditur

e32%

State non‐devp.

Expenditure

19%

Centre's devp.

expenditure

14%

Centre's non‐devp. expenditur

e35%

States’development spending

partly offset the drag coming from

Centre

3.5

3.8

4.1

4.4

4.7

5.0


(%, of G

DP)

State taxes ex petroleum and land

0.5

0.7

0.9

1.1

1.3

1.5


(% of G

DP)

State petroleum tax revenues (% of GDP)

0.0

0.6

1.2

1.8

2.4

3.0

Education

Health

Urban

devp.

Agri

Roads

Railways

(% of G

DP)

FY15 State govt. spending FY15 Central govt. spending


Strategy

Thus, at aggregate government spending level, areas where spending cuts have been most visible are railways and roads—areas where the Centre is a pivotal palyer. In contrast, areas where spending held up well are agriculture, health and education—areas where states dominate.

Chart 9: Aggregate devp. spending has held up well so far Chart 10: …mainly due to states


Chart 11: Health, education spending has held up… …..but roads, railways slowed in the downturn


Now, state finances are looking stretched

The concern, however, is that states which were holding up spending so far are now

beginning to face fiscal strains. Oil tax revenues have slowed considerably (17% YoY in FY14

to 8% YoY in FY15) and likely to contract YoY given significant cuts in fuel prices. Also, even

land tax revenues are no more a tailwind to the overall fiscal position of states given the

weakness in real estate markets. Even outside, oil and land revenues, a robust trend in sales

tax collection is unlikely when nominal GDP growth has slowed considerably in FY16 so far.

Some of the high frequency data available for large states clearly indicates that there were

slippages in FY15 budgeted targets and some states have actually crossed the FRBM limit of

10.0

11.0

12.0

13.0

14.0

15.0

FY01 FY03 FY05 FY07 FY09 FY11 FY13 FY15

(% of G

DP)

Total devp. Expenditure (% of GDP)

3.5

3.8

4.1

4.4

4.7

5.0

6.5

7.0

7.5

8.0

8.5

9.0

FY01 FY03 FY05 FY07 FY09 FY11 FY13 FY15

(% of G

DP)

(% of G

DP)

State development expenditure

Centre's development expenditure (RHS)

2.4

2.6

2.8

3.0

3.2

3.4

0.5

0.7

0.9

1.1

1.3

1.5

FY00 FY03 FY06 FY09 FY12 FY15

(%, of G

DP)

(%, of G

DP)

Total govt. spending on Health

Total govt. spending on agriculture

Total govt. spending on education (RHS)

0.5

0.7

0.9

1.1

1.3

1.5

0.1

0.2

0.3

0.5

0.6

0.7

FY99 FY02 FY05 FY08 FY11 FY14

(% of G

DP)

(% of G

DP)

Railways Total govt. spending on roads (RHS)

States’ finances may be entering a

period of rough ride


Strategy

3% of GSDP. As per RBI, revised fiscal deficit estimates of 17 states available so far for FY15

are 3.1% against the budgeted 2.6%.

Table 2: States have seen fiscal slippages in FY15

Source: RBI study of state finances, 2015

As we go forward, we perceive 3 levels of stress for states’ fiscal stance:

• Tax revenue collections have come under pressure as oil prices have fallen and nominal

GDP growth has slackened considerably.

• There is an impending burden of wages and pension revisions on the lines of the 7th Pay

Commission (~0.5% of GDP).

• Many states, which have signed for UDAY, will have to take on the burden of interest

payments of SEBs.

Chart 12: Low petrol prices to dent state petroleum taxes Chart 13: 7th pay commission to dent states wage bill


Note: Nominal fuel consumption is calculated by using WPI fuel indices and volume consumption

FY17 GSDP growth is assuming 10.5% CAGR for FY15‐FY17 for each of the four states

FY15 Budget Estimates

(% of GSDP)

FY15 Revised Estimates

(% of GSDP)

Slippage from

BE (bps)

Revenue Deficit (0.5) 0.1 60

Gross Fiscal Deficit 2.6 3.1 50

Primary Deficit 0.8 1.4 60

(10)

0

10

20

30

40

FY04 FY07 FY10 FY13 FY16E

(%, YoY)

Nominal fuel consumption State petroleum taxes

Petroleum tax bill is likelyto be a significant drag on state finances

3.5

4.0

4.5

5.0

5.5

6.0 FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

(% of G

DP)

States' wages and pension bill

Impact of 6th pay commission

Lower oil prices, UDAY and higher

wage bill to impact state

finances….and several states are

close to FRBM target of 3% of

GSDP


Strategy

Table 3: SEB Debt burden is more on the fiscally constrained states


Note: These four states account for ~60% of total SEB debt.

FY17 GSDP growth is assuming 10.5% CAGR for FY15‐FY17 for each of the four states

Table 4: ~Stress of ~0.6‐0.8% of GDP likely on state finances over the next two years

Source: Edelweiss research

Such a mix of weakening revenues and extra spending burden amid slowing/low nominal

GDP growth rate poses a significant challenge for states to sustain their development

spending, especially when cushion with regards to FRBM targets is running thin.

Way forward for fiscal policy: Centre needs to step up

A look at the FY16 fiscal position of the Centre shows that while the Centre benefits from

lower than expected subsidy bill as well as higher dividends from RBI, PSUs etc; there are

stress areas such as some shortfall in tax revenues (especially direct taxes), shortfall in

disinvestment target and lower than expected nominal GDP growth. Take together, it

appears that Centre might have to scale back development spending to the tune of 0.3‐0.4%

of GDP in current fiscal itself to achieve 3.9% fiscal deficit target.

Going into FY17, achieving fiscal target of ~3.5% of GDP (~40bps consolidation) will be even

more challenging

Tax revenue gains as a % of GDP in FY17 will likely be ~0.3% of GDP helped by expected

hike in service tax, improving earnings trajectory of the corporate and some rebound in

nominal GDP growth. However, note that benefits of excise duty hikes will not be

repeated in FY17

Subsidies will also provide a tailwind of ~0.2% of GDP in FY17 (vs 0.4% benefits expected

in FY16)

However, there will be extra burden of wages/pension (under pay commission

recommendations) to the tune of 0.4% of GDP

State NameFY15 Fiscal deficit

as % of GSDP

SEB Debt transferred to

state government in FY17

(INR bn)

Estimated Interest burden

assuming 9% interest cost in

FY17 (INR bn)

Interest burden %

of FY17E GSDP

Rajasthan 3.5 649 58 0.8

Tamil Nadu 2.9 562 51 0.4

Uttar Pradesh 2.9 539 49 0.4

Haryana 2.8 234 21 0.4

Total 1984 179

FY15 to FY17

(% of GSDP)Assumptions/Calcuations

Petroleum and

property taxes

0.3 Assuming Brent to avg. $50 in FY16 and FY17

UDAY 0.2 Interest burden of 75% SEB Debt transferred

Wages and

pensions

0.2 Total Pay commission implementation to be 0.4‐0.5%

of GSDP, with FY17 burden of 0.2‐0.3% of GSDP

Total 0.7

If states are forced to retrench

development spending, Centre

should refrain from prioritising

fiscal consolidation

Stress on finances implies that

many states will have to cut

development expenditure


Strategy

Overall, this amounts to a net benefit of 0.1% of GDP. Thus, in order to achieve 3.5%, the

government has to either significantly increase its disinvestment target (to ~INR700bn‐

800bn) next year– which, history shows, will be very difficult to achieve OR the government

will have to slowdown its expenditure the brunt of which will largely be born by

development expenditure.

A ballpark assessment suggests that development expenditure growth which we expect to

be ~15‐16 % in FY16E can be scaled back to 6‐7% in FY17E. However if fiscal target is relaxed

to 3.9% (same as FY16), development expenditure can grow by 17‐18%. Thus we argue that

Centre should relax its fiscal consolidation path in the forthcoming budget especially when

states’ may also be retrenching spending. Else, nascent recovery may be jeoperdised. Chart 14: A 3.5% fiscal target in FY17 could come at the cost of devp. spending


Note: For FY16, devp. expenditure is calculated assuming FFC reco’s were not implemented

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1

7

13

19

25

FY10 FY11 FY12 FY13 FY14 FY15 FY16E FY17E

(%, YoY)

Central govt. development expenditure growth

Devp. spending likely to dip if FY17 FD target is kept at 3.5 %


Strategy

Headwinds of 2015 receding at the margin Last year, we highlighted two areas of significant drag on the aggregate demand – rural

spending and exports. As regards former, two back‐to‐back bad monsoons have certainly

added to the woes of rural India but at a more fundamental level, we highlighted that rural

India is caught on the wrong side of the global shift in terms of trade and this will weigh on

rural economy. Similarly, even exports weakness is the result of the negative feedback‐loop

coming from EMs, as several of them are commodities‐based economies. So what are the

prospects of these two demand centres going forward?

1.Rural demand: Can FY17 be better?

After the boom of 2005‐2014, rural India’s fortunes turned for the worse. MSP hikes lost

steam, international food prices declined sharply, government spending moderated too

even as construction activity in the economy struggled. As if this was not enough, rural

India saw 3 back‐to‐back poor crop seasons. It’s no surprise that rural spending took a

massive hit. The question now is, can rural consumption revive if output recovers in FY17?

In our view, if the monsoon is normal in FY17, it will certainly be a relief for rural India.

However it may not be enough. The drag coming from weak food prices continues. Further,

construction activity is, at best, modest and there is a risk that state governments may be

unable to ramp up rural spending amid fresh fiscal strains. FY02 is a good example where

farm output recovered sharply after weak FY01, but rural spending (tractor, moped sales

etc) failed to recover as other headwinds persisted. Conversely, despite FY09 and FY10

being sub‐par monsoon years back‐to‐back, rural spending was fairly robust as other

factors were supportive. On balance, we foresee stabilisation in rural spending, but not a

reversal in fortunes yet.

Rural India’s fortunes turned for the worse starting mid‐2014. Surely, back‐to‐back poor

summer crops (due to below par monsoon seasons) in 2014 and 2015 along with weak rabi

output in between eroded rural sentiments considerably. However, we believe blaming only

poor weather conditions for farm distress is not appropriate. Several other factors influence

rural prospects. We list 3:

Food prices.

Government spending in agriculture and rural development .

Trend in the construction activity (which tends to pull excess labour away from the farm

sector thus aiding per capita incomes in the farm sector).

A long‐term look at rural prospects points towards 3 distinct phases:

• FY98‐04 (high distress phase): Rural spending languished (reflected in weak moped

sales, tractor sales etc) amidst extremely subdued food prices (modest MSP hikes, weak

int’l food prices), weak government spending in rural areas and generally tepid

construction activity.

• FY05‐14 ( prosperity phase): It was a phase where several factors turned favourable for

rural India, be it government spending (Bharat Nirman, NREGA), construction activity or

even food prices (MSPs and global food prices zoomed).

Truant weather has played a role in

rural distress in past 12‐18 months,

but several other headwids were

much more constraining

We identify 3 distinct and broad

phases of rural prospects in past 15

years: FY98‐04; FY05‐14 and FY15‐

FY16


Strategy

• FY15‐16 (rural distress revisited): Rural spending slowed considerably as food prices fell

globally, MSPs slowed, government’s rural spending also took a back seat even as

construction activity languished.

Chart 15: Trends in tractor and moped sales in India as a broad gauge of rural spending: Three distinct phases


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(18)

0

18

36

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(14)

0

14

28

42

FY95

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16td

(%, YoY)

(%, YoY)

India tractor sales India mopeds sales (RHS)

FY98‐04High distress phase

FY05‐14Prosperity phase

FY15‐16Rural distress revisited

2.0

2.3

2.6

2.9

3.2

3.5

0.0

3.5

7.0

10.5

14.0

17.5

FY95

FY96

FY97

FY98

FY99

FY00

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16td

(% of GDP)

(%, YoY)

Real construction GDP growth Agri price deflator growth (%, YoY)

Govt. spending on rural as a % of GDP (RHS)

FY98‐04High distress phase

FY05‐14Prosperity phase

FY15‐16Rural distress revisited


Strategy

Note that during FY98‐04, there were years in which farm output was extremely robust

amidst good monsoon season (FY00 and FY02), but rural spending remained anemic.

Similarly, there were years during FY05‐14 (FY09, FY10) where farm output was poor for two

consecutive years, and yet rural spending was robust. Thus, though output matters, it is not

the sole factor shaping rural sentiments.

Table 5: FY08‐FY10, rural consumption was robust, despite two consecutive poor

monsoons

Table 6: In the distressed phase, rural consumption was subdued despite good

monsoon


The question now is, can rural consumption revive if output recovers next year? In our view,

with improved output, rural prospects will certainly look better, but as argued above, output

recovery alone may not be a game changer. Other headwinds such as subdued food prices

continue to persist. Indeed, currency headwind (broad‐based appreciation against several

currencies) is also biting. For example, if we look at farm exports, not only nominal exports

are declining, but even the volume of exports in several categories is waning as currency has

appreciated against several large agri‐exporters such as Brazil, Europe etc. Further, with

state finances coming under pressure (argued in previous section) it appears unlikely that

states can step up rural spending significantly.

On balance, we believe that while FY17 could see some stabilization in rural India compared

to FY16, it is unlikely to herald a reversal of fortunes.

FY08‐FY10

(CAGR, %)

FY14‐FY16

(CAGR, %)

Agri output 0.4 0.6

Tractor sales 13 (11)

Mopeds sales 17 (3)

Prices 13 3

Govt. rural spending 23 9

Construction GDP 6 5

FY00

( %, YoY)

FY02

( %, YoY)

Agri output 2.7 6.0

Tractor sales 2 (9)

Mopeds sales 3 (37)

Prices 3 2

Govt. rural spending 6 9

Construction GDP 8 4

Rural consumption is dependent

on multiple factors; normal

monsoon is just one of those

There have been cases where

output was weak, but rural

spending was robust (FY09, FY10);

converse has also been true

( )


Strategy

2.Exports: Weakest link so far, but modest rebound likely

Exports have been the weakest link in the economic recovery so far (unlike 2002 and 2009

recoveries). This is not an India specific phenomenon, but global with world trade (real

terms) slowing sharply over the course of the past several quarters. This is largely led by

weakness in EM demand with EM imports slowing from 4% YoY in December 2014 to

minor contraction. Last time EMs led the downturn in global trade was Asian Financial

Crisis in 1997‐98. Since mid‐2014, EMs are facing BoP stress (amid falling commodities and

expectations of tightening Fed), forcing central banks to tighten domestic monetary

conditions to preempt free fall in currencies. This reinforced the domestic demand

downturn in these economies, thus undermining global trade.

We believe this dynamic has largely played out for 2 reasons: 1) Fed lift‐off is behind and

incremental tightening will be extremely gradual. This will stabilise the greenback and ease

BoP stress in EMs; and 2) various asset prices, especially EM currencies and commodities,

have already adjusted considerably and so incremental reaction may be limited. If so, we

expect EM central banks to refocus on domestic business cycles and reverse the monetary

tightening. This will support EM demand and hence global trade. Thus, worst of India’s

exports may be behind, although revival is likely to be modest.

Global trade recovered sharply during mid‐2009 to mid‐2011 post the global financial crisis,

but decelerated thereafter considerably starting summer of 2011 when the European debt

crisis escalated. From a growth rate of ~8‐10% (in real terms) in mid‐2011, world trade

slowed to less than 2% by 2012 end. EM imports (real terms – reflection of EM real demand)

exhibited similar deceleration. Thereafter, global trade stabilised and recovered marginally.

But, there is clearly a fresh leg down in 2015, especially led by EM imports. India’s exports

have followed a similar pattern, contracting in every single month since December 2014.

It is noteworthy that in last 20 years, the only other period during which EM demand pulled

down the global trade was at the time of Asian Financial Crisis in 1997‐98 period.

Chart 16: Global trade has seen fresh leg down in 2015, led by EM demand


(15)

(9)

(3)

3

9

15

Oct 95 Oct 00 Oct 05 Oct 10 Oct 15

(% YoY, 12MMA)

World trade volumes EM import volumes

Weak EM demand pulled down world trade

Western worldcrises pulling down global trade

Weak EM demand is weighing on global trade

Global trade has seen a fresh leg

down led by EMs in past 4

quarters….Indian exports have

mirrored the trend

Last time the EM demand led the

global trade downturn was at the

time of Asian Financial Crisis in

1997‐98


Strategy

The fresh down leg in global trade (spearheaded by decline in EM imports) in 2015 could be

driven by extreme BoP stress in several EMs—Brazil, Russia, China, Indonesia, among

others—starting late 2014 (around the time the USD began its secular rise). As capital flows

reversed and exchange rates came under pressure, EM central banks were faced with tough

policy choices (as always happens amid capital flight)—managing the exchange rate through

monetary tightening (use of reserves or rise in policy rates) in an already weak economy.

This exaggerated the slowdown in EMs and hence in EM imports, which in turn dragged

down global trade. It is for this reason that EM forex reserves and imports enjoy a good

correlation (see chart).

While India has not witnessed BoP stress over the past one year (a benefit of ToT shift);

weakness in EM demand and also stronger INR (NEER and REER basis) weighed on Indian

exports significantly (a negative feedback of ToT shift).

Chart 17: EMs have faced severe BoP shock over the last 1.5 years

Chart 18: Adverse BoP shock forced several EMs to tighten monetary conditions in a downturn

Source: Bloomberg, Edelweiss research

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(15)

0

15 Malaysia

Russia

China

Singapore

Turkey

Mexico

Indonesia

Thailand

South Africa

Brazil

Korea

India

(Change

since

June 2014, %)

Currency movements since June 2014 Change in FX reserves since June 2014

5.0

5.4

5.7

6.1

6.4

6.8

1.0

1.3

1.6

1.9

2.2

2.5

Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 Jun 15 Dec 15

(%)

(%, YoY)

South Africa real GDP growth (2QMA)

South Africa 1M interbank rate (RHS)

4.0

5.0

6.0

7.0

8.0

9.0

4.5

4.8

5.1

5.4

5.7

6.0


(%)

(%, YoY)

Indonesia real GDP growth

Indonesia 1M interbank rate (RHS)

India ducked the EM storm

(benefit of ToT shift) but weakness

in EMs and stronger INR weighed

on exports (negative feedback of

ToT shift)


Strategy


….But, 2016 should see EM stabilising

We believe the USD is now stabilising after a sharp, sustained and secular rise since mid‐

2014. Expectations of Fed’s tightening and divergence in business cycles of US and rest of the

world fuelled the USD rally. But, now with first Fed rate hike behind us, we believe the Fed

will be extremely measured in its future moves for 3 key reasons:

• US financial conditions have already tightened considerably through stronger USD and

widening bond spreads. The impact of these channels may manifest with a lag. Certain

lead indicators in the US have already turned down.

• The Fed will be mindful that its policy choices carry asymmetric risk—slower tightening

can be ramped up later, but premature tightening can stall the recovery.

The global economy remains fragile, with many EMs facing BoP stress. Aggressive hikes

from Fed could contribute to global financial instability, which in turn will hurt US

through a feedback loop. After all, over the past 15 years, US business cycle is highly

synchronised with the EM cycle.

Thus, we do not anticipate more than 25‐50bps hike in the next one year, much lower than

FOMC’s median assessment of 100bps tightening.

If so, one can conclude that secular strength of USD is largely behind us and this will provide

the much needed relief to EMs. As the USD stabilises, pressure on EM exchange rates and

capital outflows will subside, providing leeway to EM central banks to pursue their monetary

policies with much more independence. Many EM central banks would likely reverse the

monetary tightening they were forced to undertake amidst rising USD despite domestic

slowdown. This will unwind the drag on their domestic business cycles, stabilise EM demand

and hence EM and global trade. Note that similar chain of events ensued during the EU debt

crisis when capital outflows from EMs hurt their reserves and trade, but once the situation

stabilised, global trade recovered.

0.2

0.4

0.6

0.8

1.0

1.2

1.0

2.0

3.0

4.0

5.0

6.0


(%)

(%, YoY)

Singapore real GDP growth

Singapore 1M interbank rate (RHS)

5.0

7.0

9.0

11.0

13.0

15.0

(5.0)

(3.0)

(1.0)

1.0

3.0

5.0


(%)

(%, YoY)

Brazil real GDP growth

Brazil 1M interbank rate (RHS)

US Fed to go slow on rate

hikes…we do not anticipate more

than 25‐50bps of tightening

USD strength is likely behind us...if

so, EM central banks can shift

focus from supporting currencies

to stabilising their business cycles


Strategy

Chart 19: US LEI suggests a possibly of moderation ahead Financial markets have already done Fed’s job


Chart 20: Stable FX reserves should improve EM trade volumes, which in turn should result in stable FX


As argued earlier, weakness in India’s exports was the result of poor external demand, weak

prices and strong INR (on broad basis). If the above scenario pans out, not only will prices

stabilise, but EM demand will also improve modestly. Thus, we foresee India’s exports to

recover modestly in 2016‐17 after a deep contraction in the past one year.

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(2)

0

2

4

6

Sep 95 Sep 00 Sep 05 Sep 10 Sep 15

(%, YoY)

US OECD leading indicator (%, YoY)

US real GDP growth (%, YoY)

(10)

0

10

20

30

40

50

(5)

0

5

10

15

20

Oct 03 Oct 05 Oct 07 Oct 09 Oct 11 Oct 13 Oct 15

(12MMA, %

YoY)

(12MMA, %

YoY)

EM import volumes EM FX reserves (RHS)

90

100

110

120

130

0

4

8

12

16

20

Nov 00 Nov 03 Nov 06 Nov 09 Nov 12 Nov 15

(Index,x)

(%pts)

MSCI EM ROE minus Fed funds rate

98

99

100

101

102

103

0.0

1.5

3.0

4.5

6.0

7.5

Dec 90 Dec 95 Dec 00 Dec 05 Dec 10 Dec 15

(x)

(%)

Fed funds rate

Goldman Sachs financial conditions index (RHS)

Financialconditions have already tightened


Strategy

Expect long pause in capex cycle; tradional sectors facing excess capacity Investors looking for a rebound in investment cycle will be disappointed and our view has

been consistent over the past 18 months. Our argument last year was macro based—

emphasizing a sizeable output gap which needs to be closed before triggering a fresh cycle.

We complement the argument with a more bottom‐up analysis—it’s surprising that a full

blown recovery will take a couple of years rather than quarters. Private corporate capex

will be the biggest laggard, pulled down by severe excess capacities in utilities/metals and

an unfavourable, but fair, regulatory landscape. Households accounting for another one‐

third investments is held back by poor demand for residential housing. However, we

expect this cycle to be short lived, especially if prices readjust and monetary policy is more

accommodative.

The government, including PSUs, will accelerate capex activity through direct investments,

regulatory framework favouring import substitution and through more viable PPP

partnerships. Railways, defence, roads, ports, renewable energy etc., will be focus areas.

Investment pie: All economic participants exert almost similar influence

Earlier this year, we had argued about a selective government‐led capex revival while being

bearish on corporate capex cycle. Our argument then was macro led, highlighting a rather

large output gap in the economy which needs to be filled before triggering a fresh cycle.

The chart below shows the broad break up of the capex by different economic participants.

All 3 key economic participants i.e., households, government and corporate are equally

important and account for almost similar one‐third share each.

We believe a bottom‐up analysis (though constrained by data availability) will be more

meaningful in highlighting why the corporate capex cycle will have a rather long period of

sluggishness. Also, the new GDP series offers more data points on nature of capex by the

households sector, again offering a better perspective on recovery potential.

Chart 21: Distribution of capex by economic participants

Source: CMIE, National accounts, Edelweiss research

PSU's12%

Private corporate

38%

Govt.14%

Households36%

FY14 India capex spending composition

Goverment, Househols and

Corporates contribute equally

towards capex.


Strategy

Corporate capex

Bottom‐up analysis for gauging the corporate capex trend is generally limited by granular

data availability. However, CMIE database, comprising nearly 11,000 companies, is fairly

exhaustive and accounts for nearly 40% of corporate capex. Listed entities account for just

about 50% of CMIE’s data and hence reliance on it. However, this corporate capex comprise

of PSUs as well, unlike the break‐up of the national accounts data shown above where PSUs

are classified separately. In any case, we expect investors to use this analysis more as a

framework for analysing the potential for capex revival in critical sectors, rather than point

forecasts. We have aggregated accretions to Gross Block (adjusted for CWIP capitalization)

for key sectors and over different business cycles. The results are eye popping and tabled

below. We have even corroborated these with outstanding sector‐wise credit details—these

are both timely and more reliable.

Table 7: Credit growth across sectors

Table 8: Metals and utilities have seen large capacity additions over last 4‐5 years


Breakup of Industry segment Nov‐15 Prop

YoY

growth

YTD

growth

2 yr

CAGR

5 yr

CAGR

Mining & Quarrying 354 1.3% ‐4.0% ‐0.2% 3% 12%

Food Processing 1,461 5.5% ‐2.1% ‐15.5% 6% 16%

Textiles 1,969 7.4% 0.2% ‐3.2% 2% 9%

Petroleum 441 1.7% ‐20.0% ‐21.4% ‐11% ‐5%

Chemicals 1,534 5.7% 0.4% ‐1.3% ‐1% 11%

Fertil iser 226 0.8% 1.6% ‐11.7% ‐7% 15%

Metals 3,973 14.9% 8.3% 2.7% 8% 16%

Iron & Steel 2,967 11.1% 9.5% 4.3% 8% 15%

All Engineering 1,545 5.8% 4.9% 0.3% 6% 12%

Gems & Jewellery 694 2.6% ‐3.2% ‐5.8% 1% 14%

Construction 756 2.8% 4.8% 2.7% 13% 12%

Infrastructure 9,655 36.2% 8.8% 4.4% 10% 15%

‐ Power 5,865 22.0% 10.7% 5.2% 13% 20%

‐ Telecommunications 907 3.4% 4.1% ‐1.9% 2% ‐1%

‐ Roads 1,778 6.7% 7.9% 5.9% 9% 17%

‐ Other Infrastructure 1,105 4.1% 4.4% 3.7% 6% 12%

FY98‐FY03 FY03‐FY08 FY10‐FY14

Nominal GDP (CAGR, %) 10 15 15

Total gross block outstanding (CAGR, %) 8 14 13 13

Share of capex (%)

Oil and gas 21 14 13 10

Other manufacturing 11 18 16 11

Services 20 20 19 13

Metals 4 8 14 18

Util ities 24 18 22 15

Telecom 13 13 8 8

Consumer goods including auto 5 5 4 12

Infra+real estate 2 3 3 17

Share in corporate capex (%) FY10‐FY14 outstanding gross

block+CWIP (CAGR, %)

CMIE Database is used to study the

trends in corporate capex


Strategy

First, as is evident from the table above, capex recovery was strong—clocking 14% CAGR

over FY03‐08 and at almost twice the rate posted in the downturn preceding that. What is

interesting is that the delta in capex recovery was driven by manufacturing sector share gain

of 800bps. It appears that manufacturing capex, perhaps catering largely to short cycle

consumer demand, is more responsive to business cycles. Metals too chipped in with a

400bps share gain and this was on expected lines. However, while utilities and metals have a

big earnings cycle in FY03‐08, the real investment cycle kicked in subsequently during the

bear phase of FY10‐14. Between metals and utilities, there was almost a 1000bps share gain

in capex. So, unsurprisingly, capacities in these sectors were planned at near peak of

business cycle and got commissioned progressively during the downturn. As we stand now,

metals, utilities and energy account for more than half of corporate capex. A more bottom‐

up analysis reveals the size of the problem, especially in power and metals.

Utilities: The current average PLFs of coal based power plants @~60% have been declining at

a fast pace post achieving ~77‐78% during the latter half of last decade. This is on back of

~100GW of power generation capacity being added over the last 5 years. We believe another

~45GW of capacity is expected to be commissioned over the next 3‐4 years. With falling

utilisation rates, supply growing a t faster clip than demand and energy deficit at record low

levels of 1.5%, we expect a decline in power generation capex over the next few years.

Utilities, we believe will be the biggest drag on capex recovery. However capex in the

distribution and transmission sector will continue.

Banks have stopped incremental loans to fund discom losses and all future losses will be part

of state’s fiscal deficit. Resultantly, SEBs have limited options to fund the losses going

forward. The recent UDAY scheme is not only a refinancing scheme but also lays emphasis

on individual operational elements like power purchase costs, lowering fuel costs, improving

distribution infrastructure and reducing losses to the agriculture sector. This multi‐pronged

approach should help in turning around the discoms which are undertaking to implement

these measures. Hence, with the focus of Government of India shifting to the distribution

space we expect an uptick from the recurring INR350‐400bn annual spend undertaken by

SEBs.

Table 9: Thermal PLF’s to remain low even assuming high growth


Metals: Here as well, capacity addition looks extremely unlikely, given the excess capacity

globally and large capex done over the past 3‐4 years. In fact, given the excess leverage by

these companies and lower prices there is risk of shutdown of existing capacities.

Demand CAGR (%) 6% 8% 10%

FY16E 60 62 63

FY17E 60 63 66

FY18E 61 65 69

FY19E 61 67 73

FY20E 62 69 77

FY21E 63 72 81

FY22E 64 74 86

FY23E 65 77 91

Thermal power plants PLF ‐ demand scenario

Metals, Utilities, Energy and

manufacturing ex consumers

account for ~70% of corporate

capex


Strategy

Chart 22: Excess capacity in metals globally

Source: World Steel Association, Edelweiss research

Oil and gas: Over the past couple of years, Reliance has made massive investment, which

resulted in strong growth in oil and gas capex. However, that is mostly at the final stages of

completion and its yearly capex run rate is likely to taper off sharply. Lower oil prices may

delay capex plans of upstream companies. In fact, even PSUs like ONGC have announced a

delay in capex. Overall, our oil & gas team expects capex of our coverage universe

companies to dip from INR1.7tn in FY15 to INR1tn by FY18.

Chart 23: Oil and gas capex to dip sharply over next 3 years


Other Manufacturing: Manufacturing capex will broadly encompass all other industries not

covered elsewhere. These are predominantly intermediate industries such as chemicals,

construction material etc The fact that a significant portion of this segment is global

tradables where spare capacity could be sizeable, it is unlikely that a quick revival is in the

offing. However, a few pockets, such as textiles etc may do well relative to others.

60

65

70

75

80

85

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

(MT)

World steel capacity utilization (%)

Below Lehman crisis lows

500

800

1,100

1,400

1,700

2,000

FY15 FY16E FY17E FY18E

(INR bn)

Oil and gas capex (INR trn)


Strategy

Chart 24: Excess capacity in manufacturing

Source: CMIE, RBI Survey, Edelweiss research

Household investments: Poor residential demand will weigh, but likely to be short lived

The new GDP series has a far more evolved data on the composition of residential

investments which was hitherto unavailable. So, pure investments in real estate are just

about 45% of total, contrary to our earlier hypothesis of 75‐80%. Our own estimates put the

total contribution of top 8 cities at about 40% of total residential capex. Unlike consensus,

we are not overly bearish on cycle, barring some pockets in Mumbai/Delhi. Also, there is no

structural overcapacity and price corrections with supportive monetary policy could nudge a

mild turnaround.

Investments in agriculture by households are a sizeable 18% of overall investments and we

expect this to remain subdued and co‐related to poor agri prices. Other household

investments, including in services (largely a derivative of agri economy), are likely to display

some stability. All said, it’s fair to assume that about 65% of household investments will

remain subdued over the foreseeable future.

Chart 25: Investments in 65% of household capex unlikely


70

72

74

76

78

80

Jun‐10 Jun‐11 Jun‐12 Jun‐13 Jun‐14 Jun‐15

(% )

Capacity utilisation (RBI survey)

Agriculture 18%

Real estate and other

professional services45%

Trade services25%

Others12%

High unsold inventory of houses

reflects the subdued household

sentiments


Strategy

Government capex: In the spotlight

The only area where investment push is possible is government and PSU capex (both

accounting for ~26% of total capex). The central government is already making attempts in

this regard with relaxation in fiscal targets for FY16 in order to create space for spending on

roads and railways. Setting up of National Investment Infrastructure Fund (NIIF) with

INR200bn of government equity and sourcing funding from global pension/insurance funds

and Soverieng wealth Funds (SWFs) is a critical initiative. As regards other areas of

development spending—health, education, agriculture—it is the states which lead the way,

but the concern is that finances of states are looking stretched (argued above). We argue

that given the limited scope of capex revival by the private sector, the government should

prioritise growth revival rather than fiscal consolidation.

Roads: For FY16, NHAI is targeting 5,600km of project awards against ~3,000km in FY15 and

~1,400km in FY14. With more than 15,600km of projects still to be awarded under NHDP, we

expect project award at the NHAI end to remain strong over the next couple of years. Apart

from NHAI, other schemes under the Ministry of Roads (MoRTH) including NHIDCL and the

proposed Bharatmala are also gearing up for project awards. MoRTH has set itself a target of

awarding 10,000km of projects (including NHAI award).

In line with its aim to increase the pace of road development, the central government has

approved a massive increase in the outlay for the roads space in Union Budget 2016. The

central and state plan outlay for the sector at INR856bn for FY16 catapulted a whopping

126% over the FY15 figure of INR378bn. Apart from budgetary resources, the government is

also looking at funding for the roads sector from external sources. For e.g., news reports

indicate that the government is firming up plans for an INR2,000bn financing institution that

will fund highway projects across the country. In addition, it is also looking at other avenues

to raise funds. For e.g., it is looking to auction roads built by NHAI on EPC mode. News

reports indicate that ~110 such road projects being tolled by NHAI generate ~INR30bn

revenue annually; the government is looking to raise INR500‐550bn via auction of these

projects.

Defence: In defence, with modernisation of the armed forces currently underway, the

government is looking at indigenisation to reduce India’s import dependency. The Defence

Minister aims to reverse the ratio of imports from 70% to 30% over the next 4‐5 years.

Towards this end, from the projects signed during the past one year, 70% are for domestic

manufacturing, which is part of the larger INR3tn projects cleared over the past 18 months.

On the policy front, the government has taken several measures to encourage domestic

manufacturing including: (i) FDI increased to 49% from 26%; (ii) doing away with licence

requirements for defence manufacturing for all but 16 major items; and (iii) opening up

government’s defence facilities to the private sector to conduct tests and trial for their

equipment, which were sent aboard for testing earlier.

The Make in India drive is likely to supplement domestic manufacturing with a slew of global

defence majors tying up with local players to commence manufacturing in India, not just for

the Indian market but for exports as well. This could help Indian manufacturers enter the

coveted club of their global supply chain and help develop the required eco‐system. The

total defence budget (capex) at INR946bn grew 15% for FY16, 0.7% of GDP. We expect the

government to maintain defence capex at 0.7% of GDP and cumulatively over the next 5

years spend INR5tn towards capital expenditure in defence, a large opportunity for defence

players.

Investment thurst from

government and PSU capex (both

accounting for ~26% of total

capex) is crucial

Roads, Railways and Defence capex

are the focus areas of the

goverment


Strategy

Railways

From being the largest employer in India, the Indian Railways has the potential to become

the backbone of India’s economic development. Investment in infrastructure is the need for

hour and has large potential for the economy, given its multiplier effect. Accordingly, the

Railways through its five year roadmap, plans to invest a massive INR8.5tn (up 3.3x over the

last 5 years) with focus to decongest and add more lines/ capacity to its network. At INR1tn,

FY16 already saw a 52% growth in its investment outlay. To fund this massive investment

plan over the next five years, Railways has already tied up with LIC of India (INR300bn every

year for five years) to partly fund it. The Make in India drive has seen traction as certain big

ticket projects like heavy duty locomotive manufacturing in India by GE and Alstom worth

USD5.6bn have been awarded, which will spur investment in the entire value chain.


Strategy

Summary and key macroeconomic forecasts The recovery process will continue in FY17, albeit at a modest pace. We expect demand

drivers to churn. Tailwind from ToT shift will recede and states’ finances may pose fresh

challenges. However, modest revival in exports is on cards as EMs’ business cycles stabilize

amid stable USD and commodity prices.

Domestically, improvement will be hinged on continued policy support. We foresee ~75 bps

easing by RBI in FY17 (with better transmission) as inflation is expected to remain contained

at ~5%. Similarly, we expect Centre to relax its fiscal targets in FY17 to sustain public capex.

Finally, rural output will likely be better assuming normal monsoon in FY17. On balance, a

slow recovery is likely with growth accelerating ~50‐60bps to 7.8‐8.0% in FY17.

As regards USD/INR, we expect a modest depreciation (to ~67‐68 range) given RBI’s

asymmetric policy intervention (weakening bias – intervening strong when INR tends to

appreciate but softer intervention when it weakens) and global uncertainty. Otherwise, we

find INR to be well‐supported. Inflation is looking well‐contained around 5% (FY17E) and

current account deficit – CAD is looking best in last 10 years at ~1.2‐1.3% of GDP FY17E.

Besides, net FDI flows are quite robust and are enough to fund the current account deficit,

thus providing stability to overall BoP. Finally, we see secular strength in USD largely behind

as lift‐off is behind and Fed is expected to go slow in further tightening (~25‐50bps).

The risks to overall outlook arises from event risk in EMs given sharp fall in FX, commodities

amid high level of foreign debt. Watch out for soft/hard pegs especially if Fed turns out to be

aggressive.

Table 10: Key macroeconomic forecasts


FY14 FY15E FY16E FY17E

Real GVA growth (%, YoY) 6.6 7.2 7.4 7.9

CPI Inflation (avg., % YoY) 9.4 5.8 4.8 5.0

Repo rate (%, exit rate) 8.00 7.75 6.75 6.00

USD/INR (avg.) 60.5 61.2 65.0 67.5

Current account deficit (% of GDP) 1.7 1.5 0.8 1.2

Fiscal deficit (% of GDP) 4.5 4.0 3.9 3.9

We foresee a modest depreciation

in INR (to ~67‐68 range) given RBI’s

asymmetric policy intervention


Strategy

Explaining the earnings dilemma Earnings recovery remains mired because of 2 primary reasons: (i) earnings are levered to

nominal GDP growth and not real; and (ii) earnings are also more globalised than

commonly perceived—almost two‐third Nifty’s earnings are either driven by exposure to

overseas geographies or commoditised by import parity prices. Almost 60% of

downgrades since FY15 have been driven by ex‐India factors. We view earnings through 5

lenses—commodities, exports, domestic investments and consumption and banks.

We are fairly optimistic about earnings recovery in FY17 and beyond—while domestic

consumption will maintain its pace, manufactured exports will rebound as overseas

market stabilizes and one‐off currency impact fades. Even commodities will pull in growth

through volumes now. Our worst case estimates put earnings in a 12‐14% range for FY17.

Earnings leveraged to nominal growth

While we mostly measure the pace of recovery by analysing real GDP data, earnings are

levered to nominal growth. The unusual divergence between real and nominal GDP growth

this fiscal mostly explains why earnings recovery is still lagging. To put things in perspective,

nominal GDP has slowed from 13.6% in Q2FY15 to just about 6.0% in Q2FY16 even as real

GDP has increased through this time frame. This explains why pace of earnings downgrade

continues in FY16.

Chart 26: Slower nominal GDP growth, weighs on earnings


Nifty’s earnings are far more globalised than commonly perceived

We wanted to understand the extent of downgrades driven solely by sharply collapsing

commodity prices. Hence, the attempt was to evaluate how Nifty’s earnings have globalised

over the decade. What we found was fairly surprising. However, before discussing the

sensitivity of earnings, it is important to view earnings evolution through 4 lenses—export,

commodity, domestic and financial earnings. Export earnings are leveraged to overseas

demand either through ownership of overseas businesses or via direct exports. Commodity

earnings are leveraged to internationally benchmarked prices even though volumes may be

consumed domestically (e.g., metals, upstream oil etc). Domestic earnings are ofcourse

(30.0)

(15.0)

0.0

15.0

30.0

45.0

0.0

6.0

12.0

18.0

24.0

30.0

Sep‐01

Jul‐02

May‐03

Mar‐04

Jan‐05

Nov‐05

Sep‐06

Jul‐07

May‐08

Mar‐09

Jan‐10

Nov‐10

Sep‐11

Jul‐12

May‐13

Mar‐14

Jan‐15

Nifty trailing EPS (%,YoY)

GDP (%

,YoY)

Nominal GDP (%,YoY) [LHS] Real GDP(%,YoY) [LHS]

Nifty Trailing EPS (%,YoY) [RHS]

Lower nominal GDP echoes in Nifty

earnings

Nifty earnings have a strong global

linkage


Strategy

driven solely by domestic conditions while financials actually have a pie in all, though with a

domestic bias.

It is indeed surprising that nearly two third of revenues and half of Nifty’s earnings come

from exports and commodity sectors. This intensity has increased over the past 15 years

though the ratio is pretty constant since FY05. Ofcourse, as global economies were growing

in sync then, earnings co‐relation had garnered little attention.

It’s important that within overseas earnings, export (against commodity) is improving its

share. We expect the cyclicality in these earnings to be short lived unlike commodities where

the issues are more structural.

Chart 27: Revenue break up of Nifty Chart 28: Nifty PAT break up

Source: Capitaline, Edelweiss research

Chart 29: External sector (commodities + exports) have high correlation with global

GDP

Source: Capitaline, Edelweiss research

4460

51 44

5231

3636

4 8 13 20

0.0

20.0

40.0

60.0

80.0

100.0

2001 2005 2010 2015

(YoY %)

Revenues share of Nifty

Commodity Domestic Cos Export majors

1.0

2.0

3.0

4.0

5.0

6.0

(11.0)

0.0

11.0

22.0

33.0

44.0

2011 2012 2013 2014 2015

(%)

(YoY %)

External Sector PAT growth in NIFTY cos & Global GDP

Total External PAT Global GDP

Global GDP vital for Exports and

commodities sectors

6.0

20.0

34.0

48.0

62.0

76.0

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

(YoY %)

Sectoral PAT ‐ Nifty

Domestic Commodities Exports


Strategy

Over the last year, there have been 18% cut in our FY16 Nifty EPS. 60% of the earnings

downgrades have been due to commodities and weak exports. Steep fall in commodity prices

has resulted in sharp earnings cut for metals and oil and gas sectors. Export sectors have

been hit by either weak demand (Tata Motors) or sharp fluctuations in currencies (Pharma

and IT). Going ahead, as commodities and EM currencies stabilize one should expect drag

from external sector to reduce.

Chart 30: Commodity/export earnings explain 60% of downgrades since FY16


Broader markets are better proxy to domestic economy

Given the divergence in India and EM business cycles, it is natural to look for companies

which better capture domestic demand. In this aspect, the composition of broader markets

is much better in 2 ways:

While the domestic sector’s contribution to Nifty revenue is 36%, to BSE 500 (ex‐Nifty) it

is 57%. Nifty’s strong dependency on its commodity, export sectors renders it extremely

prone to crisis abroad, while broader market (BSE 500 ex Nifty) remains relatively

insulated from external factors.

Further, within domestic sectors, consumption has a higher weight and hence it is also

likely to be relatively less impacted by delay in capex cycle recovery.

0

7

14

21

28

35

Commodities Exports Banks Domestic investment

Domestic Consumption

(% of EPS)

Nifty EPS downgrage composition


Strategy

Chart 31: Broader market more insulated from external shocks Chart 32: Also, weight of domestic consumption is higher

Source: ACE Equity, Edelweiss research

This relatively better composition is also reflected in stock performance. Over the past year,

BSE small caps have outperformed large caps, a rare phenomenon in a falling market. A

similar trend is observed in Europe as well, where the small‐cap index, which better

represents domestic economy, has outperformed the large‐cap index.

Chart 33: Small cap indices have outperformed both in Europe as well as India

Source: Bloomberg,Edelweiss research

Earnings outlook: Worst is behind us

Worst behind, even stressed scenario reveals a mid teen growth next fiscal Earnings have got

consistently downgraded since the economy peaked in 2011 ‐ compounding at just about 8%

since FY10. However, FY16 saw a near capitulation with a 18% downgrade to now what

appears to be just a low 6% growth. A stress test was critical, in our opinion to guage the risk

to earning’s estimates for FY17 ‐ finally earnings will drive stock prices. What we have

essentially done is run a status quo situation ‐ no improvement no detoriation in economic

outlook. Essentially this means that we assume the current low commodity prices, no

improvement in OB for capital good companies etc while making forecast. Importantly, we

have also assumed higher credit cost (reflecting RBI’s recent directives) and continued low

credit growth in our estimates.

36

57

20

6

44 37

0.0

20.0

40.0

60.0

80.0

100.0

Nifty BSE 500 (Ex Nifty)

(%)

FY 15 Revenues breakup

Domestic Exports Commodity

(9.0)

(4.0)

1.0

6.0

11.0

16.0

Dec‐14

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

(%)

Outperformance of broader indicies v/s benchmarks

BSE Smallcap MSCI EU Smallcap

Broader markets performance

reflecs stronger domestic sectors

Dom ‐Investm17%

Dom ‐Consump

32%

Commodity

37%

Bank8%

Exports6%

BSE 500 FY15 Revenues


Strategy

The results of the excercise are interesting ‐ so while our analysts are expecting a near 22%

jump in earnings for FY17, the stress case reveals about a 6‐7% earnings pull back. This

should still leave a robust 15‐16% growth in FY17. As expected domestic earnings are at least

risk with earnings downgrade likely in capital goods and cement. Earnings estimates for

consumer staples are already below trend.

Banks could witness about a 10% earnings downgrade driven largely by PSU banks ‐ as

argued this assumes a higher credit cost driven by recent RBI directives. However, we believe

there could be neutralising impact from lower bond yields (treasury gains) and/or gains from

monetisation of subsidiary holdings.

Most surprisingly, we expect little damage to earnings expectations from exports businesses.

IT earnings have some cushion from some revenue slowdown as our estimates still have

rupee pegged at Rs65. Pharma meanwhile will benefit as the effect of one hits in FY16 fades,

primarily in Sun Pharma.

Commodities have a higher risk of earnings downgrade at 13%, but still will post an increase

over FY16 numbers. The metal companies will fare better as volume driven earnings

accretion is likely. Do note that FY16 earnings were hit by both a sharp collapse in prices

compounded by interest/depreciation charges on plant commercialisation.

Table 11: ~6‐7% Earnings at risk to Nifty FY17 estimates


FY16 EPS

growth

FY17 EPS

growthComments/ Assumptions

Domestic demand 19 21 (3) Domestic demand earnings to be mainly driven by urban consumption

Consumer staples 8 13 Good monsoon to result in better staples earnings

Telecom 42 (14) High base and 4G launch to weigh on telecom earnings

Domestic Auto 30 27

Consumer discretionary 18 27

Power 21 16 Lower coal prices and improvement in industry demand to result in better earnings for uti lities

Engineering and capital goods 14 41 (13)

Cement 6 42 (12)

Banks 18 23 (10) Even assuming higher credit cost and single digit Loan growth, there isn't much risks to earnings

Exports 9 22 Improving EM demand and stable currencies to drive growth

Information technology 14 15 Earnings to remain in low teens as industry is maturing

Export Auto (6) 46 Better EM and China demand to result in improvement of Tata Motors earnings

Pharma 11 23 Stable EM currencies and drug approvals to drive earnings in FY17

Commodities (14) 18 (13) FY17 to be better, even after assuming current commodity prices

Metals and mining (80) 146 (54) Even after assuming the current metal prices, FY17 l ikely to be better

Energy 5 12 (9) Earnings downgrades l ikely in cairn and ONGC, assuming brent to average $40 in FY17

Nifty Index 9 22 (6)

Current Edel forecastRisks to FY17

EPS numbers

7th pay commission, OROP l ikely to ensure good growth in consumer discretionary

Delay in capex cycle to result in earnings downgrades for cement and industrials


Strategy

Valuations: Is India is the ultimate destination? We persist with our economic spread (defined as RoE minus 10Y bond yield) to nominal

growth matrix and India scores right at top. We expect the economic spread to widen as

RoEs improve from their cyclical lows while bond yields too will track policy rates lower.

This should support higher valuations. Meanwhile, India figures right at the top for its

growth characteristics; this is critical as investors’ returns are also determined by a

country’s ability to recycle its retained earnings at high economic spread.

Chart 34: India clearly stands out on the growth vs. economic spread matrix


Economic spread to nominal growth matrix: The hidden message

Our Economic spread (ES) to nominal growth (NG) matrix ranks countries on 2 parameters of:

(i) economic spread defined as difference between RoE and 10Y bond yield; and (ii) long run

nominal growth rate. Our underlying thought process in using this matrix is as follows:

The economic spread (against using only RoE) neutralises the impact of any inflation bias. If

RoEs are optically higher because of inherent inflation, the spread will discount this through

persistent higher bond yields. Needless to say, higher spread, despite low inflation, simply

reflects superior franchise value of the listed corporate.

Nominal growth, meanwhile, is a simple proxy for long‐term earnings growth. We prefer

nominal growth over near‐term earnings growth as the latter could be impacted significantly

because of one‐off systemic issues like wild currency swings. Base comparisons too can cloud

the data.

Taiwan

China

Indonesia

Korea

Thailand

Mexico

India

MalaysiaS. Africa

Turkey

USA

Japan

Hong Kong

United Kingdom

0.0

3.0

6.0

9.0

12.0

15.0

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0

Nominal GDP growth (%)

ROE‐10Y bond yeild (%)


Strategy

Viewed in a matrix format, ES to NG plot simply reflects corporate ability to reinvest its

earnings at high rates. Simply put, developed economies like the US will continue to throw

surplus cash (excess RoE over NG) which either needs to be redeployed overseas or returned

to shareholders.

India in a sweet spot

India’s ES, compared to developed economies, is about 400bps lower, but also held back

because RoEs are at their cyclical lows. Even bond yields have been generally flat, but likely

to track policy rates lower this fiscal. As economic recovery gathers pace, India Inc.’s

positioning will shift right, further pushing valuations higher. Even if it’s not a 30K feet view,

we wonder where all this excess capital will eventually find home?


Strategy

Risks: Mind the pegs India is much more integrated with the global economy than generally appreciated. All

large corrections in the Indian market in the past 15 years have had global genesis. As we

enter 2016, risks in global economy persist. When EMs in general have faced sharp decline

in commodity prices and plunge in exchange rates, servicing foreign debt certainly

becomes challenging and risks of defaults cannot be ignored. At the same time, there is a

diverging trend in business cycles (US vs EMs). The concern is that if this divergence widens

further in the near term (US data surprises on upside), market expectations of Fed rate

hikes will firm. In such a scenario, the USD rally will resume.

While EMs with fairly flexible exchange rates have already seen adjustments through fall in

currencies, certain others such as Chinese Yuan (RMB), Saudi Arabian Riyal are still in the

deeply overvalued zone given some form of nominal peg. Surely, China has increased RMB

flexibility and is allowing gradual depreciation, but the path is not risk free (it can reinforce

capital outflows and can export dis‐inflation to the global economy). Saudi’s currency is a

hard peg and we believe it is particularly vulnerable to continued tightening by Fed.

Global developments have implications on Indian markets. As enumerated in our report

Market Correct: A scare or a crisis?, dated 9 October, 2015 there has been no correction in

the Indian market in the past 15 years which has not been global in origin. If somebody was

told 12‐18 months ago that crude will correct 50%, inflation will slow down dramatically,

current account deficit will look best in past 10 years and RBI will cuts rates by 125bps, one

would have been extremely bullish on Indian equities. But, actual market performance

(nearly flat) has certainly contradicted that bullishness. This is because EM outlook

deteriorated rapidly during 2015 and they fell out of favour as an asset class (negative

feedback loop of ToT shift). India, being a pivotal member of the EM basket, also bore the

brunt of EM selling, although the country was a relative outperformer.

As in 2015, risks to India’s economic and market outlook in 2016 arise from the global milieu.

In the past 4 quarters, EM have witnessed capital flight, plunge in exchange rates as well as

commodity prices and slowing China demand at a time when their foreign debt exposure has

risen dramatically in the past 5‐6 years. This has rendered EMs fragile and vulnerable to any

further global shock. It is against this backdrop that we highlight the risk arising from

divergent business cycles of the US and EMs in general, something that has not been

observed often historically. Fed tightening cycle, therefore, assumes higher significance in

this context. If, over the coming few months, the US business cycle continues to strengthen

and wage pressures rear their head, the Fed will be forced to take further actions and

market expectations of a rate hikes will firm up. This does not augur well for EMs in general

but more so for economies which run a pegged/managed exchange rate regime—China,

Saudi Arabia, Hong Kong, among others. The more the divergence in policy stance (and

business cycles) the deeper is the challenge of impossible trinity for these economies.

Indian markets are strongly linked

to the global economy;

deterioration in EMs clearly

weighed on India’s growth and

market performance in 2015

Plunge in currencies and

commodities, economic downturn

and high foreign debt have

rendered many EMs vulnerable


Strategy

Chart 35: US and EM business cycles are now divergent


China, for now, is permiting the RMB to weaken gradually against the USD. This enables it to

pursue a tad more independent monetary policy. But, this strategy is not risk free. As PBoC

permits gradual depreciation of RMB, it may become a self‐fulfilling prophecy. Market

participants anticipating the central bank’s intentions will only bet against the RMB, thus

pressuring it even more. In such a scenario, there is always a risk of larger devaluation. In any

case, continued gradual depreciation of RMB against the USD would mean that China will

continue to export disinflation/deflation to the global economy.

Chart 36: CNY is now depreciating continuously… Chart 37: …And is in overvalued


Saudi Arabia is another example where exchange rate peg may be under pressure. The

economy has witnessed negative ToT shock in the past one year such that its large current

account surplus has vanished and its fiscal situation has deteriorated dramatically.

Government is resorting to spending cuts in a slowing economy and and the central bank will

be forced to raise rates (chasing Fed; see chart) unfortunately at a juncture when easier

monetary conditions are warranted. If this state of affirs continues, it can undermine the

USD‐Riyal peg.

(3.0)

(1.5)

0.0

1.5

3.0

4.5

0.0

2.0

4.0

6.0

8.0

10.0

Sep 00 Sep 03 Sep 06 Sep 09 Sep 12 Sep 15

(%, YoY, 4QMA)

(%, YoY, 4QMA)

EM industrial production US real GDP growth (RHS)

6.1

6.2

6.3

6.4

6.5

6.6

Jun 15

Jul 15

Jul 15

Aug 15

Aug 15

Sep 15

Sep 15

Oct 15

Oct 15

Nov 15

Nov 15

Nov 15

Dec 15

Dec 15

USD/CNY USD/CNY (offshore)

High spread suggests depreciativepressure on CNY

80

92

104

116

128

140

Nov 95 Nov 99 Nov 03 Nov 07 Nov 11 Nov 1

China REER 20Y average +1 SD ‐1SD

20% appreciation in last 1.5 years

If US business cycle continues to

strengthen, market expectations of

Fed rate may firm up and USD can

resume strenghtening


Strategy

Chart 38: US and Saudi monetary cycles are synchronus Chart 39: …but business cycle is in downturn in contrast to US


Chart 40: Economy now faces the problems of twin deficits Chart 41: Saudi Riyal is now overvalued


Hong Kong, is yet another example, where exchange rate peg can add to troubles. As

Chairman of Hong Kong Monetary Authority (HKMA) said recently,

“Be prepared for a period of capital outflows, rising interest rates and slower growth.”

‐ Norman Chan, HKMA chief executive in a speech post fed lift off.

Thus, risks in the global economy cannot be ignored. If the stress does escalate in 2016, it

will not remain contained to the EM world, but will have knock‐on effects on western

economies through the banking channel. Note that western banking sector has lent heavily

in USD to EMs over the past 5‐6 years. Thus, if the BoP stress continues in emerging

economies, the ability of businesses in EMs to service their foreign debt will be undermined

even further. This could potentially be destabilising for the global financial system.

0.0

1.5

3.0

4.5

6.0

7.5Dec 93

Dec 95

Dec 97

Dec 99

Dec 01

Dec 03

Dec 05

Dec 07

Dec 09

Dec 11

Dec 13

Dec 15

(%)

Saudi repo rate Fed funds rate

(15.0)

(9.0)

(3.0)

3.0

9.0

15.0

0.0

5.0

10.0

15.0

20.0

25.0

Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15

(% of GDP)

(% of GDP)

Saudi current account balance as % of GDP

Saudi fiscal balance % of GDP (RHS)

80

90

100

110

120

130

Dec 95 Dec 99 Dec 03 Dec 07 Dec 11

Saudi Riyal REER 20Y average

+1 SD ‐1SD

20% appreciation in last 1.5 years

0.0

2.0

4.0

6.0

8.0

10.0

Dec 11Jun 12 Dec 12Jun 13 Dec 13Jun 14 Dec 14Jun 15

(%, YoY, 4QMA)

Saudi real GDP growth (4QMA, % YoY)

If USD resumes strength, certain

soft/hard pegs can come under

pressure – China, Saudi Arabia


Strategy

Chart 42: EM FX Debt has increased sharply post Lehman crises Table 12: High debt and FX depreciation pose concern


0.0

0.8

1.6

2.4

3.2

4.0

Jun 95 Jun 99 Jun 03 Jun 07 Jun 11 Jun 15

(USD

trn)

Cross border claims on Emerging economies

Sharp surge in EM Debt post Lehman crises

Foreign banks cross

border claims as of Jun

2015 (USDbn)

FX depreciation

since June 2014

(%)

Developing countries 3,571

China 986 (4.4)

Brazil 247 (42.6)

India 206 (9.3)

Turkey 168 (27.2)

Mexico 131 (24.7)

Indonesia 111 (13.3)

Russia 108 (53.3)


Strategy

Indian aviation: Play the cycle

Chart 43: Monthly traffic growth remains healthy even as supply lags driving up the PLFs

Source:DGCA, Edelweiss research

Chart 44: Rail fare (AC‐I tier) at ~25% discount to airlines and reducing going into FY16

Source:Ministry of Rail, Edelweiss research

75.0

78.0

81.0

84.0

87.0

90.0

0.0

7.0

14.0

21.0

28.0

35.0

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov

(%)

(%)

YoY pax growth PLF (RHS)

0.0

1.2

2.4

3.6

4.8

6.0

AC‐I Exec AC‐I Firt AC‐II tier AC‐III tier IndiGo SpiceJet Jet Airways

(INR/seat KM)

Investors should approach investments in aviation, exactly the way they would commodities—it’s a cycle. Lower airfares, higher business travel and rising incomes have reset traffic growth to a higher level—25% plus YoY spurt YTD. Even a 15‐18% YoY growth henceforth will demand about 50 additional planes each year; most incumbents with their stretched balance sheets are cautious. Even plane availability (at right prices) is an issue. Industry’s profits will remain elevated over the next couple of quarters as lower fuel prices are being retained. While oil prices are a risk, it’s only beyond USD65/70/bbl that price pass through becomes difficult without hurting demand.


Strategy

These tailwinds, in conjunction with benign crude prices, will help the industry sustain the

growth momentum. Even if the industry growth moderates to 14‐15% (13.5% CAGR in

previous decade), India, with a current base of ~420 aircrafts, will need to add a net 50‐60

aircrafts every year.

Table 13: Sensitivity of aircrafts needed to pax growth and aircraft seat capacity


Given the weak balance sheets of most incumbents, capacity addition has lagged air travel

demand, pushing up PLFs across carriers. Going by Indian carriers’ current aircraft order

book, we believe capacity addition will be more measured, which augurs well for the

industry as it will translate into firm yields.

Table 14: Most of the incumbents have weak balance sheets limiting ability to scale up

sizably


* Based on FY14 available data

Chart 46: Yearend fleet size of some key private airlines based on current firm orders


32 8% 10% 15% 18% 20%100 32 41 61 73 81

120 27 34 51 61 68

150 22 27 41 49 54

160 20 25 38 46 51

180 18 23 34 41 45

Growth in domestic airline traffic

Average

seats/aircraft

Airline

O/S debt (INR mn)

FY15 end

FY15 NW (INR

mn) Comments

IndiGo 35,884 4,262 All aircraft debt

Jet Airways 119,027 (63,248) ~50% non aircraft debt

SpiceJet 16,416 (12,645) INR3bn of non aircraft debt

Go Air* 15,167 (3,930)

Air India* 483,593 (176,466)

2539

5566

77

94

111

134

154

112 115 121112 113 116 116 116

20 23

4055 53

35 4152

1929

39

0

37

74

111

148

185

FY10 FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E

(Nos.)

Indigo Jet SpiceJet Go Air


Strategy

While jet fuel prices have corrected ~45% from their peak, airlines have retained a large

portion of this benefit as yields remain firm given the robust demand for air travel amidst

measured capacity addition in the system.

Chart 47: Jet fuel prices have corrected significantly while the yields are holding up

Source: IOCL, Edelweiss research

2.0

2.8

3.6

4.4

5.2

6.0

45

51

57

63

69

75

Q2FY15 Q3FY15 Q4FY15 Q1FY16 Q2FY16

(IN R/RPKM)

(INR/Ltr)

Average Jet fuel price (LHS) Jet SpiceJet


Strategy

BFSI: Concerns overblown

Markets are grappling with prospects of incremental stress and/or higher slippages from

the existing book; while mostly ignoring valuations. Simply put, at current valuations

markets are expecting almost 60%‐70% of stressed assets to be permanently impaired.

We believe from hereon, markets will overlook temporary dislocation in earnings. Fiuther,

benefits of economic recovery and nut and bolt reforms by government on stronger

governance make us all the more bullish. We continue to prefer Yes Bank, HDFC Bank and

Axis Bank among private names; within PSU banks our preference is towards large banks

like SBI and BoB.

Problem genuine, concerns overblown, price point attractive

Post the under‐performance in CY15, prices currently seem to factor in fair bit of downside.

We have analysed fair value for banks (assigning average multiples across bull and bear

cycles) and found that 60‐80% stress (assuming 100% probability of default for restructured

book and 70% loss given default for GNPLs and restructured book) is already factored in the

price, indicating that incremental stress will not be price reactive (refer table 1 for details).

Government reforms like Indradhanush, Project UDAY, among others, and the impending

Bankruptcy Code, will go a long way in allaying investors’ concerns. As nominal inflation

returns, we expect pick up in credit growth (from a decadal low), which coupled with

stabilisation of credit cost will aid earnings recovery in H2CY16.

Table 15: Sensitivity


(INR mn) BOB PNB SBI

FY17 networth 482,781 475,452 1,625,929

Avg of cycles (bull + bear) (x) 0.9 1.0 1.1

Fair valuation 436,917 473,074 1,861,688

Current MCAP 306,831 231,705 1,465,968

Stress factored in price 130,086 241,370 395,720

Stress Analysis

GNPL (FY17) 228,772 257,804 567,253

Restructured Asset 229,304 383,150 534,520

Total Stress (GNPL + Restructured) 458,076 640,954 1,101,773

Total Stress with LGD (70%) (A) 320,653 448,668 771,241

Less: NNPL (FY17) (B) 103,387 106,706 273,496

Worst case hit possible (A‐B) 217,266 341,962 497,746

Stress factored in price (%) 59.9 70.6 79.5


Strategy

Chart 48: With likely economic recovery, slippages will ease and recoveries will pick up

Note: * GDP is taken as lead indicator


0.0

2.5

5.0

7.5

10.0

12.5

0

70

140

210

280

350

Jan‐01

Jan‐02

Jan‐03

Jan‐04

Jan‐05

Jan‐06

Jan‐07

Jan‐08

Jan‐09

Jan‐10

Jan‐11

Jan‐12

Jan‐13

Jan‐14

Jan‐15

(%)

(%)

Slippage to recovery ratio GDP (RHS)


Strategy

Key stock exits Weight deleted (bps)

Motherson Sumi 250

BPCL 170

Mahindra and Mahindra 150

HCL Technologies 150

ONGC 100Exposure reduced in existing stocks Weight added (bps)

Larsen & Toubro 150

Total 970

Model portfolio and top picks

Our key strategy theme is remaining positioned for a mild recovery ‐ led by urban

consumption and government capex this year, which will likely accelerate in FY18. Our target

for nifty is a range of 9525‐10160 backed by 15/16x FY18 consensus estimates ‐ suggesting

an upside range of 20‐28%. Similar range for Sensex is 30725‐32800. Our key OWs remain

banks and consumer discretion. We are cognizant about earnings’ risk to PSU banks, but

expect market to overlook a temporary dislocation. Amongst consumer discretionary, apart

from autos we are bullish on airlines and Indigo makes it our model portfolio. We also swap

Motherson Sumi with Eicher as the latter is a better proxy to domestic consumption. Within

EPC space, another key OW, we now include NBCC. One big limitation is lack of large cap

plays in consumer discretion or government facing EPC plays. Another big change is now an

OW stance on Reliance ‐ funded by taking monies off from ONGC and BPCL. We see

asymmetric gains in Reliance over other direct oil plays like ONGC. Unlike consensus, we see

value in DLF from a longer term perspective. Our top 5 large cap picks for 2016 are Yes Bank,

SBI, Reliance, Tata Motor, Indigo and Reliance.

We expect broader markets to continue to do well given a higher earning’s leverage to

domestic economy. Amongst consumer discretionary, new entrants to our mid‐cap picks are

Gulf Oil and Jet Airways, Suprajit Engineering and Wonderla. Astra microwave also makes it

to our mid‐cap top picks as a proxy play for defence.

Table 16: Key portfolio additions Table 17: Key stock exits


Model portfolio performance

After a near 10% outperformance in CY14, our model portfolio’s out performance was more

modest 100bps. Our OW position in banks was the biggest drag on our performance. A

significant rout in commodity prices coupled with RBI’s more recent directives weighed on

bank’s performance. Our OW on autos was bang on.

However, our key UW positions were a bigger contributor to our portfolio performance ‐ we

were largely UW or avoided some popular sectors like software (zero weight in TCS), capital

goods (UW Larsen & Toubro) and cement.

Key new stock entrants Weight added (bps)

Indigo 300

NBCC 150

Eicher Motors 250

Exposure increased in existing stocks Weight added (bps)

Reliance 270

Total 970


Strategy

(10)

(5)

0

5

10

15

Dec 14 Mar 15 Jun 15 Sep 15 Dec 15

(%)

Edelweiss model portfolio Nifty Index

Table 18: Model Portfolio

Chart 49: Model Portfolio has outperformed 10% pts in 2014 Chart 50: Though outperforming only 1% pt in 2015

Stocks Mkt Cap Price Portfolio wt Nifty wt Rel wt P/E (x) P/E (x) P/B (x) P/B (x) RoE (%) RoE (%) Div Yld (%)

(USD bn) (INR) (%) (%) (bps) FY16E FY17E FY16E FY17E FY16E FY17E FY16E

BFSI 36.6 31.0 561

Axis Bank 16.2 450 6.0 2.7 337 12.2 10.0 2.1 1.8 18.0 18.9 1.2

Bank of Baroda 5.5 159 4.6 0.5 405 7.8 5.3 0.8 0.7 10.9 14.5 3.1

HDFC Bank 41.5 1089 7.3 7.6 (30) 21.9 17.9 3.8 3.3 18.6 19.5 0.9

ICICI Bank 23.1 263 7.2 5.4 187 12.1 10.5 1.7 1.5 14.8 15.4 2.1

Punjab Nationa l Bank 3.5 118 1.4 0.3 105 5.5 4.2 0.7 0.6 10.2 12.0 3.9

State Bank of India 26.7 228 5.7 2.5 324 9.7 7.4 1.1 1.0 12.9 14.9 1.5

Yes Bank 4.6 732 4.4 0.8 360 12.2 9.8 2.3 1.9 19.9 20.9 1.5

Industrials 9.2 5.1 411

Adani Ports and Specia l Economic Zone 8.4 268 2.6 0.9 170 21.2 17.3 4.2 3.5 21.7 22.1 0.4

Bharat Electronics 5.0 1376 1.5 0.0 151 8.8 7.6 1.2 1.1 14.9 15.3 0.0

Bharat Forge 3.1 888 2.7 0.0 265 24.4 18.3 5.1 4.3 22.7 25.6 1.1

Larsen & Toubro 18.1 1289 1.0 3.7 (272) 23.6 17.3 2.7 2.4 11.0 13.6 1.1

NBCC 1.8 1004 1.5 0.0 150 34.6 26.0 7.2 5.6 23.3 24.4 0.7

Autos 13.0 9.9 305

Baja j Auto 11.0 2518 1.9 1.2 68 18.8 16.1 5.9 5.1 33.7 34.1 2.6

Maruti Suzuki India 21.2 4639 2.2 2.2 (0) 25.0 18.0 5.0 4.1 21.6 25.0 0.8

Eicher Motors 7.1 17371 2.5 0.0 250 34.3 25.4 13.3 9.5 36.6 36.8 0.0

Tata Motors (Consol idated) 19.8 402 6.4 2.7 369 10.5 7.2 1.8 1.4 19.0 21.6 0.3

Energy 12.8 10.6 221

Coal India 31.9 334 3.1 1.5 163 13.3 11.8 5.1 4.8 38.8 41.9 6.0

HPCL 4.4 854 1.4 0.0 143 11.1 9.0 1.9 1.7 17.7 19.8 3.6

Rel iance Industries 49.7 1015 8.3 5.9 238 11.9 10.8 1.2 1.1 10.7 10.8 1.3

Real estate 1.5 0.0 151

DLF 3.3 122 1.5 0.0 151 24.1 16.8 0.8 0.8 3.2 4.6 1.6

Utilities 3.4 2.6 85

NTPC 18.0 145 3.4 1.0 239 13.9 12.8 1.4 1.3 10.2 10.3 2.2

Information Technology 10.3 16.2 (589)

Infosys Technologies 38.4 1105 9.0 7.8 125 18.1 15.6 4.2 3.8 24.2 25.5 2.4

Tech Mahindra 7.6 520 1.3 1.1 15 17.3 13.3 3.6 3.0 22.1 24.2 1.4

Consumers 6.0 10.8 (489)

Indigo 7.3 1343 3.0 0.0 302 19.4 18.0 27.0 25.6 286.9 145.9 4.1

Havel l 's India 3.0 321 2.9 0.0 293 38.9 27.5 7.6 6.6 20.5 25.7 0.0

Cement 0.0 2.9 (287)

Health Care 6.0 7.3 (127)

Torrent Pharmaceutica ls 3.8 1479 2.7 0.0 267 14.2 16.3 6.1 4.7 53.6 32.6 0.7

Sun Pharma 29.7 816 3.3 3.1 18 36.4 23.1 5.8 4.8 19.5 23.6 0.3

Metals & Materials 0.0 1.3 (134)

Telecommunication Services 1.2 2.2 (107)

Bharti Airtel 20.6 341 1.2 1.7 (50) 18.5 19.0 2.0 1.8 10.0 8.9 0.0

Model Portfolio 100.0 100.0 0 14.2 11.4 2.1 1.8 15.6 17.1 1.7

Nifty 100 0 17.8 14.8 2.5 2.3 14.8 15.6 1.6

(10)

0

10

20

30

40

May 14 Sep 14 Jan 15 Apr 15 Aug 15 Dec 15

(%)

Edelweiss model portfolio Nifty


Strategy

Table 19: Model portfolio attribution analysis of 2015 performance

Source: Edelweiss research, 1 Janbuary 2016

Table 20: Top Mid cap picks for 2016

Source: Edelweiss research, 1 Janbuary 2016

Tot Attr Allocation Selection

Port Bench +/‐ (bps) Port Bench +/‐

100.00 100.00 0.0 (6.0) (7.2) 1.2 1.2 (3.0) 4.1

Key overweights

Financials 37.4 31.4 6.0 (13.6) (8.0) (5.5) (2.8) (1.1) (1.3)

Autos 13.4 9.3 4.1 5.0 (6.1) 11.0 1.2 (0.3) 1.7

Industrials 8.5 4.8 3.7 (9.3) (16.9) 7.6 0.4 0.6 0.0

Utilities 4.6 2.5 2.1 (35.6) (5.1) (30.5) (2.1) (2.1) 0.1

Telecommunication Services 3.0 2.2 0.8 (7.4) (9.5) 2.1 0.8 0.7 0.1

Real Estate 0.5 0.1 0.5 (17.7) (5.4) (12.3) (0.2) (0.2) 0.0

Health Care 6.7 7.3 (0.6) (2.3) (0.8) (1.5) 0.1 0.1 (0.1)

Key underweights

Consumer 4.4 11.2 (6.8) 16.9 (7.5) 24.4 1.0 (0.8) 1.3

Information Technology 11.8 16.1 (4.3) 9.9 (0.5) 10.4 0.8 (0.6) 1.0

Cement 0.5 2.9 (2.4) 16.4 (1.4) 17.8 (0.0) (0.2) 0.0

Metals 0.1 2.1 (1.9) 9.8 (43.7) 53.4 1.2 1.1 0.0

Energy 9.1 10.2 (1.2) 13.3 (4.1) 17.4 1.0 (0.3) 1.3

Avg. relative weights Tot Rtn

Company Current Current

market cap

Current

market

Target

price

Reco (USD Mn) Price (INR) (INR) FY16E FY17E FY16E FY17E FY16E FY17E FY16E

Financials 1100 37.8 18.1 5.1 5.1 22.5 25.6 1.1

Max India Buy 2113 524 591 83.5 NA 3.9 NA NA NA 0.0

Dewan Housing Finance Buy 1041 236 295 9.4 7.8 1.4 1.3 15.2 16.6 1.6

Repco Home Finance Buy 661 701 790 27.9 21.9 4.7 4.0 17.7 19.1 0.4

CARE Buy 584 1,333 1470 30.6 24.5 10.3 9.9 34.4 41.2 2.5

Airlines 1306 12.7 7.3 NA NA (11.6) (24.3) 0.0

Jet Airways Buy 1306 761 518 12.7 7.3 NA NA (11.6) (24.3) 0.0

Chemicals 1209 26.1 16.4 4.7 3.8 18.4 24.7 1.1

Supreme Industries Buy 1321 689 760 35.4 18.7 6.6 5.3 19.4 31.4 1.2

SRF Buy 1096 1,263 1505 16.8 14.1 2.7 2.4 17.4 18.0 1.0

Manufactured exports 1166 12.4 11.4 3.5 2.7 31.0 27.1 1.0

Welspun India Hold 1383 911 849 13.0 10.8 4.7 3.5 40.8 36.9 1.6

Balkrishna Industries Buy 949 650 705 11.7 12.0 2.3 1.9 21.2 17.3 0.4

Industrials 414 21.2 15.3 2.0 1.8 10.3 11.9 0.7

Nagarjuna Construction Co Buy 648 77 114 23.1 15.7 1.3 1.2 5.7 7.8 0.5

Ashoka Buildcon Buy 565 200 279 32.3 20.2 1.9 1.8 1.6 4.6 0.7

J Kumar Infraprojects Buy 425 372 890 11.8 7.5 1.1 1.0 11.4 13.5 0.9

KNR Construction Buy 246 580 706 18.2 17.6 2.5 2.2 14.6 13.3 0.2

Astra Microwave Products Buy 184 141 180 20.6 15.8 3.5 2.9 18.0 20.2 0.9

Consumer discretionary 391 30.7 23.7 7.4 6.0 27.1 29.1 0.7

PVR Buy 559 795 977 31.9 20.3 7.3 5.9 23.2 29.9 0.2

Gulf Oil Lubricants Buy 398 531 595 27.1 22.3 10.8 8.4 45.1 42.2 1.3

Wonderla Holidays Buy 345 405 368 36.2 32.9 5.6 5.0 16.6 16.1 0.4

Suprajit Engineering Buy 261 144 187 27.7 19.2 6.0 4.9 23.6 28.1 0.8

P/E (X) P/B (X) ROE (%)Dividend

Yield (%)


Strategy

Annexure 1: Tracking reforms

Sector Reforms Allowed PSBs to raise capital from public markets through FPO or QIP by diluting Government holding

upto 52% in a phased manner. FDI l imit in Insurance increased to 49%. Social Security Schemes; Jan Dhan to Jan Suraksha: Gold monetization schemes to reduce government borrowing cost and use latent savings in gold. RBI has issued 2 banking l icenses (Bandhan & IDFC), 11 Payment Bank and 10 Small Finance Bank (SFB)

l icences. Coal Act 2015:

Passage of the Coal Bill into an Act which allows allocation of the Coal blocks in a transparent manner

only by way of bidding/auctions.

The Act also allows commercial mining of coal to improve the availabil ity of coal in India.

MMDR Act 2015: The Act allows allocation of all the mines, for any mineral, in a transparent manner

only by way of bidding/ auctions. New allocation policy for domestically produced natural gas Direct Benefit Transfer: LPG subsidy gets directly transferred to bank accounts of beneficiaries Government notified the new domestic gas pricing guidelines which determines the price of domestically

produced gas Government has released the Draft Upstream policy which is currently open for comments and

suggestions from various stakeholders Deregulation of diesel prices was announced on 18th October, 2014.

Power Power Discom revival package UDAY (States held responsible, reducing banking sector stress, improving

power offtake) Spectrum sharing and trading guidelines were issued which would help efficient util isation of spectrum

in the country The Telecom Regulatory Authority of India (TRAI) has amended Telecom Consumers Protection

Regulations, 2015, to mandate INR1 compensation per call drop to the consumer with a cap of 3 call

drops per day Land acquisition relief: No projects to be awarded ti l l 80% land for BOT projects and 90% of land for EPC

projects has been acquired Relaxation in exit clause for pre‐2009 projects Introduction of Hybrid annuity model and Change in premium payment structure for future BOT projects Done away with l icense requirements for defence manufacturing for all but 16 items In budget for FY2014‐15, the Govt increased FDI in Defence to 49% through the automatic route, FII and

other foreign investment in defence to 24%. Allowed FDI in excess of 49% in defence on a case‐to‐case basis on approval by the CCS, wherever it is

l ikely to result in access to modern and state‐of‐the‐art technology Approval for implementation of gas pooling for Fertil izer players Announcement of New Urea Policy The government is going to allow 100% FDI in non‐news channels through the auto route Government eased FDI norms on plantation and single brand retail Implementation of OROP Seventh Pay Commision Foreign Trade Policy to complement ‘Make in India’ through measures to encourage procurement of

capital goods from indigenous manufacturers under EPCG Scheme by reducing Export obligation by 25%.

Agriculture

Consumers / Retail /

Media

Others

Banking

Metals and Mining

Oil and Gas

Telecom

Roads

Defence


Strategy

One year price charts

150

250

350

450

550

650

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Max India

500

560

620

680

740

800

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Repco Home Finance

200

320

440

560

680

800

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Jet Airways

0

400

800

1,200

1,600

2,000

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

SRF

150

180

210

240

270

300

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Dewan Housing Finance

1,000

1,200

1,400

1,600

1,800

2,000

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Credit Analysis And Research

500

560

620

680

740

800

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Supreme Industries

0

200

400

600

800

1,000

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Welspun India


Strategy

400

520

640

760

880

1,000Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Balkrishna Industries

0

50

100

150

200

250

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Ashoka Buildcon

400

600

800

1,000

1,200

1,400

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

NBCC

350

400

450

500

550

600

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Gulf Oil Lubricants

20

40

60

80

100

120

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

Nagarjuna Construction Co

0

140

280

420

560

700

Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

KNR Constructions

400

500

600

700

800

900Jan‐15

Jan‐15

Feb‐15

Mar‐15

Apr‐15

May‐15

Jun‐15

Jul‐15

Jul‐15

Aug‐15

Sep‐15

Oct‐15

Nov‐15

Dec‐15

Jan‐16

(INR)

PVR


Strategy

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Recent Research

Date Title

Nirav Sheth

Head Research

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03‐Dec‐15 Strategy Super Mario to the Emerging markets rescue? 19‐Nov‐15 Q2FY16 Result Exports, commodities continue to be Review pain spots 09‐Nov‐15 Strategy Bihar Bout – Can a knocked out BJP expedite reforms? 09‐Oct‐15 Q2FY16 Result A tepid quarter likely Preview


Strategy

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