Sensex to be range bound: DSP Merill Lynch

S Naganath of DSP Merrill Lynch MF says, the Reserve Bank of India's move as well as its timing was unexpected by the equity markets although some degree of tightening was expected by money markets. With regards to the earnigns growth, he thinks it can fall to 12-13% if the rates keep rising.

He expects lacklustre performance in H1 and some improvement in H2. He expects GDP growth of 8.5%. For the market fundamentals, he sees Sensex in the ragne of 11,500-13,000 for the next six months.

Excerpts from CNBC-TV18's exclusive interview with S Naganath:

Q: How are you feeling about the market and do you think there is room now for price adjustment post the RBI move?

Naganath: The RBI move was in a sense unexpected. Although the fixed income market and many other segments of the financial sector were anticipating some degree of tightening, clearly the timing was not expected but that is the prerogative of the central bank. Even today you notice that the Chinese Central Bank has increased the reserve requirements in order to curb rapid credit creations.

I guess it is a problem that many central banks in the region are facing and therefore the tightening was expected but not its timing. The market digested it with a decline but things seem to be on an even keel now; if you look at the fixed income markets, the interest rates on short-dated money market instruments, which are quite high in late March and early April, have actually come off quite a bit and liquidity conditions appear to be improving. So I think we have gotten that behind us and now we are looking forward to the earnings season.

Q: What will happen to the earnings season because of concerns being raised on the pace at which this market might continue to perform. Do you think there might be a re-rating or a de-rating in terms of what this market can report in earnings and hence in adjustments for the price of the market itself?

Naganath: That is quite possible; in any event after four years of fairly robust growth in earnings of the order of about 25% on an annual basis and more recently for 2006-07 at about 33-35%, the expectations were that with such a high base having been created in any event the earnings for fiscal year 2008 would be of the order of about 15% if I did an average of all the consensus estimates.

That 15% may well turn out to be 12% or 13% or somewhere thereabouts depending on how hard the interest rate hikes bite into the earnings growth of sectors like banking and auto. It is not that we are expecting 20-25% earnings grwoth, which will suddenly go down to 12-15%; in any event 15-16% was the expectation and that may well end up somewhere between 12-13%.

Q: The concern seems to be that the basic premises of this market are being questioned. What might happen in terms of GDP? What might happen in terms of a tightening interest rate scenario? Do you think this market can strike out any out performance compared to its peers as it has done in the past?

Naganath: This year will be subdued. We have mentioned that earlier also that in the first half we expected to see lacklustre market performance and then any uptrend of a reasonable nature would emanate in the second half; so far we continue to maintain that stance.

On the GDP front for 2006-07 itself the expectations now are centered around 8.5% thereabouts. Therefore in that context with higher interest rates and the possibility of some degree of slow down in credit offtake, we do expect GDP to probably come down to below 8%, somewhere between 7.5-8%. Therefore, in that context earnings growth expectations too will have to be tempered. So rather than going above the 15% mark, I continue to maintain that. We would be happy if we see a 15-16% growth, but should be prepared for downgrades to earnings, that will take us somewhere between 12-13% as it appears at this point of time.

If that is the case, automatically if you apply reasonable PE multiple, it is quite possible that this market will trade in a 11,500-13,000 range or so for the next six months, in the absence of any external event risks, and then look at establishing an uptrend later in the year as people begin to focus on the next financial year.

Q: Where do you stand on the interest rate sensitive argument? Has deep value emerged in these stocks or would you stay away from these spaces?

Naganath: They are beginning to look interesting but I would still wait a while. Specifically for autos there is a double-whammy of higher interest rates because the loan rates for this segment are between 15-20%. If one wants to buy a two-wheeler or a four-wheeler, the current interest rates are pretty high for such loans and that will crimp demand to some extent. The crude oil prices too are back in the USD 60s and we think the commodity will move up, as it has the potential to revisit the old highs in the coming months and that will act as a dampener.

For the banking sector, the lending rates as well as the deposit rates have gone up. It remains to be seen as to how will the margins for this sector pan out in the next three to six months. So one will have to wait and see.

Q: Technology has not struck out an out performance this time. What do you expect to hear this time from the top tier tech companies?

Naganath: We are confident that the outlook for the tech sector remains quite robust. Their hiring has been good which signifies confidence in their revenue visibility over the medium to long-term. Rupee strength is a small part of our whole earnings estimate bit and many companies do take proactive action in terms of hedging their currency exposures. We don’t see that as a big issue in terms of determining the earnings outlook for these companies.

The hiring gives us confidence that these companies are looking at a fairly sizeable pipeline of transactions; to that extent we are confident of the tech sector as a whole.

Q: How do you read the relative lack of investor participation though and where does it leave the broader market or any sort of midcap performance from here?

Naganath: I don’t understand what you mean by relative lack of investor participation as there is always going to be some interest in the midcap sector, because there are many midcap stocks out there, as a result of which, one cannot expect basket buying of midcaps but one can pick and choose.

There are many midcap funds in the domestic market that are always going to be buyers of the midicap stocks and even among the FII investor base, there is sufficient interest for midcap stocks. Hence it is difficult to define what is huge investor participation. I sense that there is continued interest in that segment whether from domestic mutual funds or from FIIs.

Q: Would you buy any of these three commodities - cement, sugar and metals - at this point?
 
Naganath: I believe that the crop is likely to be good later this year as well as the next. So, to that extent that would weigh on the prices; so it is probably a sector that we would not want to look at actively at this time.

Cement, I think, holds merit and one should start taking a look at it. Again whatever might be the issues on pricing at this time, one should look beyond the next two quarters unless you believe that the construction boom will come to an end, which is not likely to be the case. This is a sector that one should certainly be positive on over the next year or two.

As far as metals are concerned, I will trade a little cautiously simply because any slowdown in the western world will have an impact on Japan and China as well; therefore though the prices of metals have been perking up recently, I think one should trade a little carefully on this sector. I would keep a three to six months time frame.

Q: As far as an external event driven risk, what do you think might tick the scales in this market in terms of global cues?

Naganath: There are two key things to keep an eye on - one is the continuing tensions in the Persian Gulf and although they seem to have abated a bit, the fact is that crude oil did not come off very sharply yesterday, which does suggest, one, that there is a risk premium that still continues to remain and second, that the inventories of gasoline and oil appeared to be not in the most comfortable position that they ought to be.

So I would still maintain that you could possibly see oil in the USD 70-75 price-band or even higher over the next three to four months; tensions are not abated and one should keep an eye out for further developments in that part of the world. Second, the US housing market, a lot of which has been said about has seen a meltdown on the sub prime sector and though most people think that the risks are content I would still argue that one should keep a close eye on how that develops over the next three to four months.

These are two risks that can affect the global financial as well as the global equity markets and contribute to risk aversion increasing, which will then affect pretty much all-emerging market. So that is something that one definitely needs to keep an eye out for.