The selloff in smallcap and midcap stocks have been steep in recent days, raising questions whether it will eventually turn into a 2018-like correction in the broader market. In comparison with 2018, corporate India’s balance sheets are in a better shape. But valuations, are way higher than 2018, with softer margin improvement levers. Nuvama Institutional Equities said the Fed pivot could be delayed this time, given sticky inflation, warranting caution. It maintained its 'Underperform' rating on cyclicals and midcaps despite the recent fall.
"In the 2018 USD-UST drain, SMIDs corrected 30 per cent with cyclical sectors (autos, metals, RE) suffering larger drawdowns. So far, midcaps have corrected 15 per cent since their September-end peak. And valuations of cyclicals and midcaps are still higher than the 2018 peak while margin expansion levers are softer. The saving grace is India Inc.’s stronger balance sheets," Nuvama said.
The BSE500 trades at 4 times trailing 12-month book value against a peak of 3 times in 2017. In the midcap space, the one-year forward BSE Midcap multiple stands at 25 times, similar to 2017 peak, but higher than its long-term average of around 20 times.
To be sure, the carnage in 2018 ended when the Fed pivoted. The bar for pivot is higher this time, Nuvama said. A tactical bounce notwithstanding, caution is warranted, it added.
3 factors behind SMID selloff Nuvama said three factors have changed in last six months. The first is the slowdown in domestic demand due to moderation in HH credit and government spending. The second is the acceleration in EPS downgrades as margin tailwinds faded even as demand softened. This has reconciled Indian earnings with global peers. Third, there has been a double drain from rising dollar and US bond yields, triggering FPI outflows. This has dragged domestic liquidity into deficit, a la 2018, the first in five years.
"This has stalled India’s outperformance, particularly in SMIDs and cyclicals," Nuvama said.
The 2020s bull market in India is in isolation from emerging markets- not just in terms of aggregate returns, but also the breadth (midcap melt-up). This is unprecedented.
"The high historical correlation of Nifty with MSCI EM was due to spill-overs through trade (influencing two–thirds of BSE500 top line) and flows (lifts valuations). The trade channel correlation has held up (top line has been subdued), but margin-led earnings resulted in India’s decoupling on the flows/valuation front," Nuvama noted.
It said the lesson learnt in 2018 was that cyclicals are vulnerable to liquidity squeeze. It said high interest cost is hurting US government’s finances. Disruptions in US bonds market may cause near-term pain, but induce a much softer Fed, the brokerage said.