Goldman Sachs Downgrades Indian Stock Market Over High Valuation, Slowing Growth

Goldman Sachs has downgraded its rating on Indian equities from 'overweight' to 'neutral'. Analysts warn that the Indian stock market will experience volatility in the short term due to weak corporate earnings prospects, high market valuations, and weaker external support, advising investors to shift their focus to high-quality companies with high earnings visibility.

In a research report released on October 22, Goldman Sachs analyst Sunil Koul stated that the overall valuation of the Indian stock market has reached 24 times forward earnings (24x Fwd earnings), a historical peak level. High-frequency indicators show that India's economic growth is experiencing a cyclical slowdown, which will drag down corporate earnings performance. Historical experience suggests that when company valuations are high and earnings are downgraded, the market may experience volatility in the next 3-6 months.

Based on this, Goldman Sachs downgraded the Indian stock market from overweight to neutral, with a 12-month target for the NIFTY index of 27,000 points, implying a 9% upside. The short-term targets are 24,500 points (-1%) and 25,500 points (+3%).

Public information shows that Goldman Sachs upgraded its rating on Indian equities to overweight at the end of last year, after which the MSCI India index rose by more than 35%. However, recent signs of weakness have emerged in the Indian stock market's upward momentum, with the benchmark index NSE Nifty 50 index falling by more than 5% in October, on track for its worst single-month performance in four years.

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Economic slowdown harms corporate earnings

Goldman Sachs stated that the Indian stock market has performed strongly over the past two years, with the MSCI India index rising by 43% since the beginning of last year (emerging markets grew by 21% during the same period). India's small and mid-cap stock indices have performed even more rapidly, almost doubling in the past two years.

However, in the past quarter, many countries around the world have experienced a cyclical slowdown in growth. India is no exception, with high-frequency indicators showing that economic activity in India is slowing down across the board.

In terms of investment, the Indian central government's capital expenditure contracted sharply in the second quarter, and although it rebounded in the third quarter, capital expenditure has decreased by 20% year-on-year to date (FYTD) in the current fiscal year. Contract award activity in the September 2024 quarter remains weak (down 30% year-on-year).

Apart from some bright spots such as power, private capital expenditure activity in India has not fully recovered. The residential sector has been strong in recent years, but the second derivative of growth is gradually diminishing.In terms of consumption, urban demand indicators such as car sales and gasoline consumption have shown a slowdown, while rural indicators have exhibited mixed signals. Recent survey data is also slowing down, with the Services Purchasing Managers' Index (PMI) dropping to a 10-month low of 57.7 in September.

Affected by a series of factors, Goldman Sachs economists currently expect that India's real GDP growth for the fiscal year 2024 may fall to 6.7% year-on-year (30 basis points lower than the market consensus), and for the fiscal year 2025, the year-on-year growth may drop to 6.5% (40 basis points lower than the market consensus).

Goldman Sachs warns that below-expectation economic growth could affect corporate profit expectations. Sensitivity models show that a 50 basis point decline in nominal GDP growth could lead to a 200 basis point decrease in annual earnings per share growth for MSCI India companies.

The economic slowdown is beginning to affect corporate profits.

Goldman Sachs warns that the economic slowdown has already started to impact corporate earnings. Over the past month, the earnings sentiment of the BSE 200 index on the Bombay Stock Exchange (a measure of the breadth of analyst revisions) has deteriorated sharply and is approaching a one-year low. Earnings revisions have been lagging, with earnings per share for the MSCI India index only down by 1% over the past month, but the pace of downgrades has accelerated last week.

The ongoing earnings season is also continuing this weak tone. Out of the 18 MSCI India companies that have reported earnings so far, 11 have missed expectations. Although the overall consensus expectations for the 2Q reporting season seem good, this is driven by a few industries.

Goldman Sachs India equity analysts have expectations below consensus for most industries, with the largest differences in investment cyclical industries (industrials, cement/chemicals). This suggests that earnings may be further downgraded as the earnings season progresses over the next 3-4 weeks.High valuations increase the probability of short-term pullbacks

Goldman Sachs emphasizes that overvaluation remains the most widespread concern among investors.

The current forward price-to-earnings (P/E) ratio of the MSCI India index is close to 24 times, which is 2.1 standard deviations higher than its 20-year historical average and at the previous peak valuation levels seen in 2007 and 2021.

In terms of relative valuation, compared to the Morgan Stanley Asia-Pacific ex-Japan Index (MXAPJ) in the Asian region, the current P/E premium of about 70% is also higher than the average of 55% over the past 5 years.

Although strong growth and domestic capital inflows may keep valuations high, the current risk-reward measured by the price-to-earnings growth ratio (PEG) has deteriorated since June, as growth slows and valuations rise. More importantly, historical data show that when starting valuations are high (P/E ratio greater than 20 times) and earnings expectations are downgraded, returns over the next 3-6 months will be lower.

Goldman Sachs points out that regional capital flows in the current Asian market are also increasing pressure on the Indian market. With China's strong policy deployment, there are signs of regional capital shifting to the Chinese market.

India has seen about $8 billion in foreign selling in the past two weeks, which is the fourth largest foreign institutional investor (FII) selling in Indian history in absolute dollar terms, and emerging market and Asian funds have reduced their exposure to India in the past month while increasing their exposure to China and other North Asian markets.

Regulatory and external environments also add uncertainty

Goldman Sachs believes that high oil prices and domestic regulatory actions in India also suppress the short-term rise of the Indian market.The Middle East accounts for 16% of India's merchandise exports and over half of its remittances, with service exports providing a buffer for India's external balance and enhancing the resilience of its macroeconomy. Any escalation of tensions in the Middle East and their potential impact on trade, remittances, and more importantly, oil, could put pressure on India's macroeconomic indicators.

In the meantime, compared to other markets, the Indian market tends to perform poorly during periods of significant oil price increases. Ongoing news coverage of tensions in the Middle East could keep oil price volatility high, thereby exerting short-term pressure on the Indian market.

Regulatory crackdowns in India will affect retail investors' short-term speculative sentiment.

In recent years, trading activity in Indian index derivatives has surged, with the notional total turnover of options and futures ranging between $4-5 trillion per day. This has been driven by increased retail participation, the introduction of short-term index options contracts, and an increase in speculative trading volumes at expiration.

This has raised concerns among market regulators. Earlier this month, the Securities and Exchange Board of India (SEBI) announced six new measures to regulate activities in the index derivatives market. While the effective implementation of these measures has a positive impact on mid-term market stability and investor protection, it may affect retail trading activities and sentiment, leading to market volatility in the near term.

A massive wave of IPOs is also diverting market funds.

So far this year, the total value of Indian equity issuance has already surpassed previous highs, currently reaching a record $45 billion. According to various media reports, the number of companies applying for initial public offerings in September set a record, and the issuance schedule for the remainder of the year appears substantial ($6 billion). Although strong domestic capital flows have so far helped absorb the supply of equities, a slowdown in corporate earnings and outflows of foreign capital could lead to an imbalance between supply and demand, putting pressure on the market in the short term.

In light of the above discussion, Goldman Sachs advises investors to reduce investments in cyclical stocks and shift their focus to areas with higher earnings visibility. Overweight the internet, real estate, automotive, telecommunications, and insurance sectors, and maintain a standard allocation to industries such as industrials (transportation, infrastructure), pharmaceuticals, and durable goods.