+ve on int rate sensitives; risk reward attractive: I-Sec

Girish Pai of ICICI Securities believes the risk reward in rate sensitives are attractive from a 12-month perspective. He is positive on interest rate sensitives. 

Going ahead, he expects some deterioration in earnings. He expects inflation to peak out at 13% and fiscal deficit to peak out in FY09 at 9% of GDP.

He expects a further 25 bps hike in repo rates and CRR. Pai believes the 10-year bond yield may not go beyond 9%.

Excerpts from CNBC-TV18's exclusive interview with Girish Pai:

Q: You are overweight in financials and real estate; tell us why.

A: From a 12-month perspective, we think the risk reward for interest rate sensitives is very attractive. While we do expect some kind of earnings deterioration to come through in these sectors, we believe it is more than adequately reflected in the stock prices at this point in time. We think that there is extreme pessimism with regard to these sectors.

Our overweight call is underpinned by two factors; one is valuation and the other is our view on the macro indicators, which people are fairly worried about at this point in time. If you look at valuations - for instance - we have a situation where public sector banks are coming at price to book multiples of anywhere between 0.5-1 times on FY09 basis with an Return on Equity (ROE) of between 15% and 20%, which we think is very attractive. From a real estate standpoint, we have a situation where our real estate analyst believes that the stock prices of the large real estate funds are below the worst case scenario that he has built. The worst case scenario situation is where he is estimating a dip of 25% from his best case price for real estate-residential and retail as well as commercial; so we think that there is value at this point in time.

I think the other point is regarding macro indicators. Inflation, fiscal deficit, current account deficit, which we think are going to peak out in FY09, we believe that inflation for is going to peak out at 13% and by the end of the year we should see a number closer to 6%-7%.

Fiscal deficit will peak at around 9.6%; this is consolidated including the state deficit, the oil bonds, the sixth pay commission, farm loan, everything put together versus a number of 6% we had in FY08. So we have taken the worst case scenario with crude at USD 130/bbl both in FY10 and FY11 and we assume a weak government to come into place next year post general elections, which does not take any kind of sound economic steps in terms of increasing petro product prices, even in that kind of a situation we think that this fiscal deficit will go down from 9.6% to 7.6%-7.8% by FY11.

In my view, current account should go to 3.5%-3.7% in FY10 and then from there it should come off. So unless the view on crude is that it will go up from current levels and go to USD 150/bbl and remain there or go to USD 200/bbl and remain there for a long period of time, I think the current macro clouds will pass. And by the end of the year we should see better numbers come through and therefore on a 12-month basis, we are positive on interest rate sensitives. I think the returns you could get there could be far more than defensive sectors at this point in time. 

Q: In the target for the Sensex that you have of 19,800 for the next 12 months, what kind of earnings have you assumed and what do the valuations work out to?

A: We have taken an earnings growth of 18% as it's bottom up based on my analyst’s estimates and this is at a 15 times PE multiple of FY010 numbers. We previously had a 17 times FY010 number, why we have reduced it to 15 times as basically assuming some kind of earnings deterioration to come through in the next few years.

Q: How much more do you see interest rates going up from here? What could that mean in terms of a risk to the kind of PE multiples that you are assuming?

A: I assume that the inflation is going to peak out at something like 13%; I am basically adding about 200 bps to the 11% number. 200 bps is basically the secondary effects of the price hikes that have come through for both petro products and metals.

If that’s the case, I would probably think we should not see more than a 25 bps increase in CRR and repo rate from here.

Q: For the PSU banks, where do you think yields might range at or range between and how that might impact their bond portfolio?

A: I think the 10-year yields definitely could go up from current levels; they could probably go to 9%, but not beyond that. But all that will get reflected in this quarter’s numbers especially for those banks who have a very large Available-For-Sale (AFS) portfolio. I think there are only a couple of PSU banks that have that kind of a portfolio at this point in time; most banks have moved their investment portfolio into Held To Maturity (HTM).

Having said that, these same banks would benefit when the inflation turns down, which is what I expect to happen by the end of FY09. So when the 10-year yields move down from 9% to maybe 7.5-8% by end of FY09, I think these very same banks will benefit.

Q: When you say you are not too keen on the defensives, what is it that you would avoid between pharmaceuticals, IT and FMCG right now?

A: I am not saying that one should be getting out of defensives. We were overweight defensive until we put out this strategy note sometime back. We were basically saying that these have outperformed over the last six-months, they have delivered on our call, but now is the time to get into sectors, which will give much higher returns over the next 9-12 months.

That’s the reason why we have taken a call to move a little bit of weight out of consumer and put it into financials at this point and we have held on to our healthcare pharmaceuticals weightage; just the sheer performance that has come through on the pharmaceuticals side has resulted in a situation where the weight has come up to our overweight stance and it's become a neutral stance right now.

Disclosure:

It is safe to assume that my clients & I may have an investment interest in the stocks/sectors discussed.