Markets likely to slip; not the right time to bottom fish in NBFCs

JItendra Gohil, India equity research head at Credit Suisse
months. Edited excerpts:

How do you see the markets playing out from here?

In January, our view was "no major correction in Indian equities" largely driven by domestic flows which we believe is structural in nature. Despite valuation concerns, we did not recommend paring equity exposure. However, we did suggest investors trim their exposure to the mid-and small-caps in February. Since then, we have been cautious. 

The recent correction was overdue, as both the local and global factors were going against Indian equities. The interest rates are starting to firm up in India. The GDP (gross domestic product) growth will decelerate going ahead. The GDP growth is likely to fall to around 6.7 to 6.8 per cent by the fourth quarter of the current financial year 2018 – 19 (FY19) from the current 8.2 per cent in the first quarter, as per our estimates. Given the uncertainty around the state and the general elections and rising oil prices, equity market is likely to lose ground over the next few months. 

So, what’s your advice to investors in this backdrop?

Investors should also stay away from equities for the next three – four months and be very selective in case they want to buy. Holding around 20 per cent in cash will be a good strategy. A bounce-back in equities should be used to exit positions in the mid-and small-cap segments. This time around, the festive season is not looking that great to us. Cost pressures will build up and the non-bank finance (NBFC) segment is already facing headwinds. All this will impact growth and as well as the markets. 

The Reserve Bank of India (RBI) surprised everyone in its last policy review. What’s your interpretation?

Inflation, growth and currency movements are the three main factors that determine the interest rate trajectory. Earlier, the RBI used to target all these together, but has adopted a calibrated approach and is targeting inflation under the new MPC (monetary policy committee) framework. We don't expect a sharp correction in rupee from here. Crude oil prices, on the other hand, are likely to soften in 2019 as forecasted by our commodities team. This will have a positive impact on the rupee, which is likely to stabilise around the current levels, in our view.

Did you utilise the correction to buy?

We have substantially reduced our exposure to mid-caps. Within large-caps, investors should cut their beta. They should also restrict exposures to cyclicals and consider defensives instead. Within the defensive segment – information technology (IT), fast moving consumer goods (FMCG) and pharma are slightly over-valued. 

The IT sector has seen a good run and is a stock-specific story now. Pharma still has some structural pain left and the earnings estimates are still elevated. That said, we do a bottoms-up approach while investing and look at where the managements are trying to curtail expenses and where there is margin expansion. Within the IT sector, there are mid-cap companies that have niche offerings. We are looking into buying there selectively. 

In the consumer discretionary space, we were positive on autos, but the outlook is now bit challenging given cost pressures. But, there has been some correction already in the auto stocks and one can look at this space selectively. Energy and utilities is another segment one can look at. There have been significant falls in the oil marketing companies (OMCs); gas utilities is another segment that can be looked at. 

Have the markets punished banks and NBFCs more than what they deserved?

There had been a phenomenal rally in these stocks before the correction set in. Given the liquidity issues, some companies will face growth pressures going ahead. That said, there are companies in this space that have managed their assets and liabilities well. This is not the right time to bottom fish in NBFCs, in our view. The valuation in some cases is still an issue in context of margin pressure and growth deceleration. Once the earnings expectations for the next few quarters get priced in, one can selectively look at these stocks for investment. Private Banks should gain market share and are a good bet. 

Where do you see the Sensex and the Nifty a year from now?

In September, the index valuation was around 18.5x 12 months forward multiples. This has now come down to around 16x. The historical 15-year average is around 15x. Given the global developments – especially higher interest rates -, there are chances that this may slip below this historical average, in my view. While there could be some bounce after this sharp correction, we expect the broader equity market could grind lower in coming months. 

How are the foreign investors and high net worth individuals viewing these developments?

The developments – rise in oil prices amid a sliding rupee and the political uncertainty – are making foreign investors nervous with regards to India. It is the long-only long term funds that are looking at the long term macro picture that will stay back here. Hedge funds, long/short funds are looking to unwind their position in India after India's relative outperformance. EMs also have a large portion of US dollar denominated debt. If the EM currencies continue to slide further, there could be cases where investors have to face defaults or rating downgrades. 

How do you see the bond markets playing out in the US over the next six - 12 months and how will it impact fund flows into EMs and India?

We have recently neutralised our view on US yields from negative. Our three-and twelve-month forecasts for US 10-year treasury yield currently stands at 3.2 per cent and 3.3 per cent, respectively; compared to 3.15 per cent currently. The US Federal Reserve (US FED) is communicating effectively and investors have largely priced in one more rate hike this year and three more rate hikes in 2019. 

JItendra Gohil, India equity research head at Credit Suisse
EM flows are largely USD driven. Secondly, global fund managers are already underweight on EMs and we are experiencing selling fatigue especially after the sharp correction in EM equity valuations and currencies. Liquidity is still abundant despite monetary tightening and hence there is a possibility that EM assets could bounce back from this lows. Compared to other EMs, we have underperform view on India, as relative valuation is still expensive and there are too many moving parts, which dampen risk sentiments.

What are your expectations for corporate earnings?

Though there could be downgrades, we still think FY19 growth in corporate earnings should be around 18 – 19 per cent and around 15 per cent in 2019 – 20 (FY20). In case growth stabilises and the input cost pressures do not go through the roof, the foreign investors will return to India.

Given the headwinds India Inc is facing, what makes you so optimistic as regards corporate earnings growth?

One, we are coming from a low base. The commodity-related companies are doing fairly well. The IT companies, too, should do well and there should be earnings upgrades in this sector. Pharma and auto ancillaries can benefit from a weaker rupee. The consumption-related companies that took a hit on volumes post demonetisation and implementation of goods and services tax (GST) should also do well. From a level of around 10 per cent, the credit growth has also picked up to 13 per cent. These factors lend confidence to a pick-up in earnings growth. 

Do you think the next wave of selling could happen in case there is a major upset in the upcoming state polls?

There could be some selling in the scenario if the Bharatiya Janata Party (BJP) loses both Chhattisgarh and Madhya Pradesh. That said, the voting pattern changes in a state poll versus the general election. Extrapolating state poll outcome to the outcome of general election is not advisable as of now.

Are the markets prepared for worsening macros?

The current account deficit (CAD) could be around 2.7 per cent, which is in line with the markets’ expectation. Unless the oil prices hit $90 – 95 a barrel, which is not our central view, the situation is still under control. The recent measures on the import front could help rupee to some extent.

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