Market not pricing disruption beyond 2-4 weeks: Gautam Chhaochharia

Gautam Chhaochharia of UBS sexpects economic recovery to be gradual and grinding
In the aftermath of the government’s demonetisation move, GAUTAM CHHAOCHHARIA, ED & Head, India Research, UBS, India, shares his views with on the event’s implications on India’s economic growth. He believes that UBS’ conservative earnings estimates for India Inc are also at risk, and if the disruption on account of demonetisation prolongs beyond 2-4 weeks, markets could correct.

India’s demonetisation move has come as a shocker. How many such instances have happened globally, and what has been their experience? 

In the past, Europe has seen a massive currency swap when EU (European Union) was formed. But India’s scale and objective is totally different, and a unique experience. So you can’t really have past template to apply to this. There are various scenarios, both positive and negative. One part where there is no debate is that it is good for the long term. It will be another drive of formalisation of the economy. And, that will happen.

There is a lot of buzz around what will happen to the currency not returned to the system, with many seeing it as a windfall for RBI and government. What is your view? 

These theories don’t make sense to me. Firstly, no one has the clue as to what percentage of currency will be cancelled. There is no analytical basis to guess that number which various estimates peg between 15-30%. It’s a gut feel number. The primary disconnect, which we have with that theory is most of the street and investor community make the mistake of looking at RBI from the prism of a company accounting --  that is, P&L and balance sheet. It’s not a company, but a policy-making institution. Any gain from revaluation in its assets, goes directly into reserves and not through its P&L. RBI pays dividend as per the Malegam Committee (technical committee) recommendation which is basically from annual incomes, primarily in the form of interest income on the bonds, etc., after meeting all expenses. Cancelling of currency is one off gain. Should this be counted as a regular annual income or should it be used to recapitalise RBI’s balance sheet, we don’t know. In fact, some ex-RBI governors have made statements against such a move.

Any conservative central bank should not treat this as a one off surplus and pay it out as dividend but use it to improve India’s macro. It can increase dividend a little bit from last year’s level but not pay it out completely. Ultimately it is the policy imperative for RBI.

I would like to caution people that don’t judge or presume it as a windfall. Similarly, on the other extreme, there is a presumption that there could be a vicious cycle happening and economy could collapse. Here, these people are presuming that RBI and the Central government will not step in and let it collapse. Very unlikely that this will happen.

How do you see demonetisation impacting India’s economy and currency, at least over next 2-3 quarters?

It will definitely have a short term disruption, there is no debate on that. What we are seeing now is just shortage of currency. So, you are not able to transact. The situation will improve because currency will become available in 1-3 weeks. Then comes the question of informal economy; how much of their wealth is destroyed and how much they are able to replenish the old cash with the new cash and therefore get back to their business. Because their business model is around cash. This plus GST will force them into a more formalised system in longer term. For now, it is unclear whether business will be 20% lower, or 50% lower in the near-term.

How are the companies you are talking to responding to demonetisation? 

Even companies are unclear. But most companies we are talking to are saying that they do think this will stabilise, and that this is a one month phenomena.

Have they seen any cancellation or stoppage of orders from the customers in the interim? 

Yes, that’s happening across the board. Footfalls are down and so are transactions for consumer facing companies. Among non-consumer segment like construction, we are seeing some impact on pace of the activity. Cement is already impacted. Property sales have come down, particularly on the luxury side.   

When do they hope to see some normalisation of the businesses? 

The hope is that cash will come back into the system. The part which is unclear is how quickly--whether it is 1 month, 3 months or 6 months, the informal system is able to replenish cash and get back to business as usual.

Realty seems to be the biggest victim. How do you see demonetisation impacting realty and allied sectors like cement, steel, etc?

Realty sector is anyway in doldrums for the last few years. So, instead of recovering in next one year it may take 2-3 years to recover. The bottoming out process has elongated, unless the scenario turns into a vicious cycle with the economy breaking down and property prices falling sharply. But otherwise it’s similar to the rest of the economy wherein you will see a short term impact on transaction volumes. In six months, if property prices remain stable or correct by only 10%, then activity will rebound to current level. That’s also because in the last few years the element of cash in residential transactions has come down a lot.

Nevertheless, it is a risky situation given the leverage involved. So, how property prices move will be crucial. If they crack, by say 20%, which is not our base case scenario, then it would be a worrying sign for me. Not just for the property sector, but that would have repercussions for the economy. Lot of wealth is deployed there. The fall in value will also play on the individual’s psyche in terms of spend, etc.

Would you take courage and buy realty stocks now? 

Property has not been an overweight sector even when we had coverage on it till a couple of months back because in our view the cycle is still some time away for it to recover except for select companies. Only a few have a brand, property quality, and can be looked at. Office space has bottomed out, and that too is okay to consider. 

For the allied sectors, all depends on how quickly the informal economy will come back on track. We also need to see how they tweak their business model, turn more formalised, etc. 

In this backdrop and given the hopes of an earnings recovery in second half of FY17, these hopes will be belied. What is your view?

We were already more cautious on earnings growth versus consensus. Top-down, we have always said that we see much more earnings cuts because as every year street is getting overly optimistic on growth recovery in India. So, we had forecasted 10% growth for FY17. Even this number would be at risk, forget the 14% plus forecasted by consensus. It is early days, to give a new estimate for earnings growth right now. 

There are talks that RBI may cut interest rates sharply to offset the impact of demonetisation. What is your view? 

If demonetisation leads to deflationary pressures which it should, then it creates room for RBI to cut rates. But, RBI will evaluate whether this deflationary pressure is short term or a permanent event. What will definitely happen is systemic liquidity will increase and bond yields will keep facing downward pressure. So, it’s early to say whether RBI will cut rates or not. My base case is that demonetisation alone will not cause RBI to cut rates.

So, how does one place the eggs in the equity side? 

From our global investor’s perspective, we remain ‘overweight’ on India in our emerging market (EM) strategy. From absolute India equity perspective, we still think that the reward is not attractive enough because our Nifty fair value based on the earlier earnings estimate was 8000 for December 2016. I would like to start buying below that level. It’s still not a screaming buy opportunity. Having said that there’s always opportunities and if you have a longer term timeframe, the longer term India story remains very strong and powerful. In fact, demonetisation should also help improve longer term efficiency, productivity of India by driving formalisation.

The question is, is the market pricing disruption beyond two to four weeks, absolutely not. So market is pricing only the very short term impact. 

Could there be big shocks from here? 

Next 1-2 weeks are crucial. If this prolongs beyond two weeks then the markets would correct. Don’t just watch out for the queues outside banks and ATMs; that will have to come down briefly as cash becomes available. The question is how it is impacting the informal economy, and how soon will they come back to business as usual. 

There has been a bitter battle between Tatas and Mistry. What is your assessment of the situation, and possible impact on the listed companies’ growth prospects? 

If there is a change or uncertainty around the group’s companies’ business strategy and policy, it will have an impact. As long as companies are able to insulate themselves from the disruption at the board level and ensure that the rest of the organisational doesn’t feel the same uncertainty, then there shouldn’t be any disruption in their quarterly performance. But, if it starts seeping through, and if this battle continues for a year or two, my guess is that it will hurt.

US bond yields have been moving up and dollar index was also at 13 year high. In this scenario, what is the outlook for global equities and do you see a risk of fund outflow from EMs? 

 
If the yields keep moving up it will hurt. Our house view is that US 10-year bond yields will move up to 2.4 – 2.5 per cent by end 2017. For India, as long as there is reasonable differential of say 1.5 – 2 per cent between US and India’s real interest rates, I don’t see major outflows. 

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