The worst of current account deficit could be past, says Ridham Desai, managing director, Morgan Stanley.
The worst of current account deficit could be past, says Ridham Desai, managing director, Morgan Stanley.
In an interview with CNBC-TV18, he says the market could be under pressure near term, but will recover going forward, led by improving earnings growth a pick up in corporate investments. He does not see any currency risk to the market, and is of the view that global liquidity is in favour of the Indian market at this stage.
Desai is penciling in a 15 percent earnings growth in the broader market, comprising midcaps and small caps.
Desai is bullish on the IT sector, as he feels valuations are attractive. He expects the sector to recover in the second half of the current calendar.
Other sectors Desai is bullish on include banking and energy (oil). He expects energy companies to surprise on March quarter earnings. Desai is bearish on power utilities and pharmaceutical companies.
Below is the edited transcript of Desai's interview to CNBC-TV18.
Q: It has been a difficult phase for the market since the start of this year. Are you expecting more downside from here?
A: It could happen in the short-term. However, if I reflect back on the start of the year, we were worried about the level of Foreign Institutional Investor (FII) flows. But the extent of the fall has exceeded my expectations. I would have expected the Nifty to correct 200-300 points at any given point in time, but we are now well into 600-700 points of correction. So, the downside has certainly exceeded my expectations. We did have the risk of FII flows being too high, i.e. FIIs were over-owning this market. The leading indicators that we track for equity markets are all pointing for positive returns from equities. So, not withstanding some short-term volatility, it does look like we are back to very attractive levels and the risk reward ratio is firmly in favour of equities.
Q: How do you approach IT now in the light of what you have heard from Infosys? What would you include in your model portfolio?
A: We are marginally overweight technology and we will continue to be that way. The valuations look attractive. I do not think the environment is that bad. We may go through a soft spot in global growth this quarter, but things are looking up in the second half. So, growth in the world will be a little better. IT is not such a bad space to be in for the rest of this year.
Q: Morgan Stanley is perhaps the only brokerage that has a Rs 185 EPS for FY14 on Infosys. That is very different from what other people are talking about-Rs 160-165. How do you justify it?
A: I will not get into the specific forecast on a particular company, but as a general theme, we see that there is a fair bit of operating leverage in the IT space. The bench rates are high which means that if there is a little bit of a growth in revenues, it can lead to an outsized growth in profits.
It maybe a point that the street is missing right now because we have had one disappointment in terms of earnings. However, if the growth is stable, one may actually see surprise on the earnings front. So, I would continue to hold my moderately bullish view on IT.
Q: One of your peers is suggesting about 8 percent earnings growth for FY14 given the point you made about the market and that they should recover from here. I just want to understand how that marries in with your earnings expectations for the next couple of quarters?
A: That is another place where we are quite different from the consensus. I am actually expecting fairly strong growth in earnings from the market. If you evaluate the top-down situation, it is actually looking much better for the next 12 months. So, we have a situation where the investment rate has stabilized. It is no longer falling, both in the public domain and the private domain. Public investments are rising and if one looks at the latest data point, they are going up 20 percent year-on-year (YOY). So, that is a big change over six months ago and we still think that the government will push for projects in the next six months, so public investments will look even better.
Private investments which were in a free fall until the end of last year have stopped falling now and that is coming from a low base. Looking at the components of the GDP, the gross fixed capital formation is no longer in negative territory. So, the investment rate is stabilizing if not rising, which is good for earnings. We think that the worst for the current account is also behind us. Current account represents leakage of profits for the Indian companies. The projection that Indian companies lose to their overseas counterparts and the CAD is declining because of fiscal consolidation, will be good for profits. So, if one looks at the month-on-month trade deficit data, it is already signalling that the data that we saw for the quarter ended December was probably the worst of the cycle.
Both the investment rate as well as the CAD seemed to be stabilising and the outlook for profits therefore, in our view is actually improving specially on the margin front. Revenues may not recover in a hurry. We may still be dealing with single digit revenue growth for the trailing quarter which was particularly bad because of the amount of fiscal tightening that the government did, but it maybe a little different story this quarter. So, when one goes towards the end of June, one will see some upgrades happening, especially as the July earnings season rolls out. So, our bottom-line view is that we may get over 15 percent earnings growth for the broad market this year. So, this is definitely different from what the consensus is forecasting at this stage.
Q: What are you picking up from the foreign flows side? We have not seen large outflows, but atleast some outflows. What kind of funds could be redeeming? Where is the selling pressure coming in from and does the markets still have a bit of a technical hangover from that aspect?
A: A fair bit of technical overhang is going behind us especially in the futures markets, in the derivatives markets. If you look at the long-short ratio for FIIs it is at a multi-month low. If you look at the put-call ratio, it is at the multi-year high. So that suggests that there is a fair bit of hedging that has taken place if not shorting through the derivatives market which is a good technical sign. The overbought position that the market may have had at the end of January is certainly receding. We have not seen the same type of correction in the cash market and that may be due to the fact that there is a huge amount of liquidity in the world.
If there is anything that is pointing favourably for Indian equities, it is the state of global liquidity, whether it is the Bank of Japan (BoJ), the Fed or eurozone, there is just so much of liquidity sloshing around in the system. Right now that liquidity is gravitating towards safety of Japanese equities and SPX and Japanese Real Estate Investment Trust (REIT). Eventually as those markets tend to perform very well, some of that liquidity will again find its way into India like it did last year.
I am not so perturbed about the lack of selling in the cash markets, though it remains a bit of a risk, but the heartening feature for the markets is the correction that has happened in the derivatives market which suggests that positioning is too bearish for people who want to be short this market.
Q: The anecdotal evidence is many of these emerging market exchange-traded funds (ETF), emerging market funds also have been losing some money. Do you think there is some disenchantment that may not be very temporary on emerging markets per se?
A: Certainly there is. The world is searching for yield and it is searching for yield in quality places. Emerging markets do not offer that quality, so we have seen this change in mood for emerging markets ever since the start of the year. India is not isolated in the correction that it has seen. It is middle of the pack.
There are other emerging markets that have corrected a lot more and India is somewhere seventh or eighth on the list of 20 markets. It is kind of an emerging markets story for sure. There is a challenge in emerging markets that growth is coming off, inflation is high and it does not allow central banks to ease. This is very dissimilar to developed world, where there is no inflation and central banks can keep the foot pressed on the liquidity paddle. So, that is the challenge faced by emerging markets.
Markets that tend to show a better growth in the coming growth with tempering inflation will start to attract flows and India could be one of them. If you look at the recent data, inflation is coming off and in our view growth has bottomed, so in the coming months India may present a better picture which will then start attracting flows all over again.
Q: Contrarian buying in the market is happening in the banks, but are you bullish on that space for this year?
A: We are overweight on banks. It is one of our biggest overweight positions along with energy, so those are the two sectors that we are backing, energy more so because of the structural changes in the domestic market as well as the rising gross refining margins (GRM) globally and banks. This is because we may have seen the worst of the credit cycle and net interest margins (NIM) may not compress as rapidly, so earnings may remain quite supportive.
Q: Reliance Industries has been nothing kind of performer for the market either in terms of support or performance. You would expect to see a change led by earnings performance over the next few months?
A: There are certainly better earnings that are coming for the energy space. Our view is that in this quarter, the one that has gone by, we may actually see the energy space reporting the best earnings amongst all sectors. The earnings situation is certainly turning around. For the public sector energy companies there is an undertone of a structural change because of the shift in the subsidy burden that the government is engineering. We expect this burden to stay and if that story plays out the way we are expecting it to, one will see some of these stocks rerate quite a lot over the coming months.
Q: On the point that you made about liquidity, what have you made of these deep cuts in global commodities, the way gold has crashed over the last few days, the way oil has been suffering. Is it a sign of further disenchantment with the slightly riskier assets or are your reading it as a big positive for market like us?
A: These are assets without yields. The world is not really in favour of buying stuff that does not have yield. There is very little yield in the world. There is not much in the credit markets or bond markets. The yield is only in REITs and in equities. That is where the flows are coming in. Gold and oil do not really offer yield. So, they are really not the asset classes of the moment. This is all commentary for the short run. It may change in the next six to nine months, but for now, the world wants yield and its equities and REITs that are offering it and it wants safe yield. So, it is not preferring emerging markets, it is preferring the yield that the SPX or the Japanese Nikkei is offering.
Q: What to your mind is the biggest risk to your optimistic call on the market? What do you fear most could go wrong which can lead this market into a bear market for the next many quarters?
A: The risks are threefold. Firstly, we are in a difficult political environment. It is fairly obvious to the market that it maybe one of the reasons why India has struggled in the month of March. A lot of poor stories in the political world unfolded in that month and we may head for elections, the timing of which remains uncertain. The market will be a lot better off if the elections got over quickly. We do not know what the election results will be like, though I would think that where share prices are right now, they are not discounting any bad news, so it is a risk worth taking.
Secondly, Europe is still not fixed. It is a developing story. It is going to move from a correction into some sort of a crisis at any point in time. We saw Cyprus play out in the month of March and that created jitters. These risks remain for India, because at the end of the day, even if the CAD is going to correct, it still remains high. So, India still remains dependent on global capital flows and if those global capital flows face volatility, it will create volatility in India’s macro.
Lastly the risk is really on the government policy. My own view is that the way the government will address the emerging political uncertainty is by actually accelerating policy, because this government needs growth back before the next elections. If one looks at the evidence of the last three or four elections, Indian people are voting for development, they are voting for growth, they are not voting for free rice. So, the government needs to get growth back in order to create a good environment for itself if it wants to get reelected. But, there is always a risk that that view may change. We have seen that in the past, so we cannot rule that out. These are the three most important risk factors.
Q: If your overweight still remains banking, energy and a little bit of IT, would it be fair to say that your tactical approach still remains defensive on the market?
A: No, we are not at all defensive. Think about this. Valuations are quite attractive. The sentiment is broken. Positioning is bearish. The yield curve is nudging higher, which means the bond market growth is coming back. Expectations in India remain quite low-key. I do not think it is a market to be at all defensive about. If you want to be aggressive, you want to be cyclical. There is pain in that trade. We have seen that in the last six to seven weeks, but is pain worth taking? Because when the rewards come through, they will be quite outsized. So, we are actually massively underweight consumer staples, we are underweight healthcare, we are underweight utilities. We are not at all defensive. We are quiet aggressively positioned, if you are commenting about the cyclicality of our focus list. It is very cyclical.
Q: A lot of institutional investors point out that the big problem with investing in the market is what has happened with the currency. It is a side issue, but how do you think the currency will impact the equity market also in the context of how it impacts earnings on some of these heavyweight stocks?
A: The currency has been fairly stable, hasn’t it? If one were to put the context to the equity markets one would have argued for the currency to slip a lot lower and this reflects India’s Balance of Payments (BoP) which is improving at the margin. It is not worsening. The CAD is declining and flows are stable. India is still offering a lot of yield in fixed income and to that extent, India is attracting flows. So, the currency is range-bound. It has depreciated from where it was say 18 months ago which is good for earnings. If one looks at the net Sensex impact, it is actually positive because they are long the US dollar. So, the earnings impact is not so negative. It is positive. The low level of the rupee versus the dollar will help India to fix its macro. It makes it harder for imports to compete with domestic production and to that extent, with a lag it starts impacting the trade deficit as we are seeing now. We have usually noticed a six quarter lag between the currency and the trade account and that lag is playing out. So, the currency is actually favourably poised if anything for the equity markets.