Indian markets have been seeing strong foreign inflows for quite some time now and the New Year too has started on a positive note, with FIIs pumping in nearly USD 3 billion in January. Prashant Khemka of Goldman Sachs expects the inflows to continue if the economic momentum sustains.
According to Khemka, retail participation is likely to pick up at a later stage in the rally and he remains overweight on domestic demand focused sectors like financials, real estate, consumer discretionary including autos and retail. He also believes that the reduced turmoil in global markets is likely to lend stability to equities. Besides, the government’s reforms push has improved confidence about India, he said.
"In due course of time, we expect capital spending to come back on track and help the economy get back to its 7 percent plus growth trajectory that we have been used to for the last decade or longer. As that happens, corporate earnings is bound to pick up," Khemka explained.
Gradually as the economy picks up, Khemka sees earnings growth improving in India. He feels the decline in capital spending is mainly due to the loss of confidence. At the moment, the key risk for markets remain the political turmoil at the centre, he reiterated adding that indications of a fractured mandate are likely to hurt market prospects.
Here is the edited transcript of the interview on CNBC-TV18.
Q: We have been fed on really strong flows even in January. So far, we have sucked in nearly USD 3 billion. Do you see this pace continuing?
A: On the flows itself it is very difficult to predict. It is more a function of what the markets do, how the economy does. If the economy continues on its improving trend and markets continue to stay firm, we should see flows continue to come into the market.
Q: Why does that sit at odds with what the domestic institutions are doing?
A: I think the retail driven domestic flows are likely to follow at a later point. So far the investors are still by and large in the red as the market is still lower than where it was at its peak in 2007-08 time frame. Particularly, the midcap and small cap, some of the areas where the retail would have been most active is still well below the 2007-08 peak.
Now as the market goes beyond the prior peak and you have media all over including television and newspapers all around you and as people talk about market hitting its new high in wedding ceremonies and parties, when it goes to 21500 it will be a new high, when it goes to 22000 it will be a new high. There will be a constant barrage of news that would suggest that the market is hitting new highs all the time.
Q: Any thoughts on Hindustan Lever in general, on how defensive it should be approached this year?
A: Certainly as you know, I can’t comment on any specific stock. But, in terms of defensiveness or aggressiveness of the portfolio, we generally tend to have a very balanced portfolio for individual stocks, selected stock by stock. The idea is that this balanced portfolio should not only outperform over a cycle but, also should be able to outperform through the different legs of the cycle.
So in terms of how we are positioned, generally we tend to find a lot more attractive investment opportunities in domestic focused sectors like financials, real estate, consumer discretionary which includes autos and retail. Currently, the positioning is not so different. It just so happens that many of these sectors also tend to be disproportionate beneficiaries of the improving economic environment that we see moving ahead.
Q: Are you generally constructive on the market for 2013 or are you in the camp which believes that there might be a big correction because we haven’t had a meaningful correction for a few months now?
A: We are constructive on the market for a variety of reasons. If you see what has weighed on the market over the last two years, pretty much since the end of 2010, those can be distilled down to three key factors.
(1) The oil price led surge in commodity prices which cause heightened inflation and a tightening monetary policy consequently.
(2) The global turmoil centred around peripheral Europe.
(3) Possibly the most important has been the self inflicted pains on domestic policy uncertainty.
If you look at over the last six months, each one of these factors has either turned around or is fast improving. Inflation is increasingly becoming a rear view mirror problem. Consequently, monetary policy is turning around to be a tailwind rather than a headwind.
Global markets and European turmoil is in the best situation that we have had over the last several years as reflected in declining bond yields of European sovereigns, the peripheral sovereigns. Finally and most importantly, with the series of steps that the government has taken on the domestic policy front can be best described by the old Indian saying, 'Der aaye, durust aaye (better late than never).'
The series of steps are addressing the policy uncertainty environment that had caused a drop in confidence of business houses and had created a big confidence deficit. That confidence deficit led to a complete collapse in capital spending, on infrastructure and industrial projects. As the government addresses with the series of steps that they have taken over the last six months and I expect it to continue going forward as the government addresses this confidence deficit.
In due course of time, we expect capital spending to come back on track and help the economy get back to its 7 percent plus growth trajectory that we have been used to for the last decade or longer. As that happens, corporate earnings is bound to pick up. We have had a 5 to 10 percent kind of a high single digit earnings growth over the last five years, which is well below the long term trend line growth of Indian corporate earnings of about 15 percent.
As the economy recovers, profitability and demand environment would improve for corporate India and earnings trajectory would pick up to 15 percent quite possibly, with the momentum overshooting as the economy goes back from five percent plus to seven percent plus range. We are quite constructive on corporate earnings growth, going forward from this level. We think compared to a single digit growth this year, earnings growth can be in the mid-teens next year and that kind of level can sustain beyond next year.
Q: The big debate for 2013 and going forward is what to do with stocks which are linked to the investment cycle? On one hand there is hope that it will pick up but there is not enough evidence to suggest that. How are you approaching that entire space?
A: As we discussed, the dramatic decline in capital spending was presaged by this lack of confidence or confidence deficit amongst business leaders in India. There was an increasing policy uncertainty over the last two year period which cracked or caused a big dent in confidence of business leaders. As a consequence, the capital spending programs went for a toss. Capital spending nosedived, be it in industrial or infrastructure projects and as a consequence, the economic growth slowed down to where it is now.
It always so happens that the improvement also would come with a lag. It is like when the train slows down dramatically, you have to put a lot of fuel initially for it to start picking speed and to accelerate. Similarly, what we are seeing now over the last six months, with all the initiatives announced and a generally improving macro and policy backdrop, be it on the inflation front, policy rates front or global backdrop and the policy initiatives, all these would go a long way towards not only containing the fiscal and current account deficit but also in steadily but surely eliminating the confidence deficit.
As confidence comes back over the next few months or quarters or year or two, you should see that reflect in improving capital spending with a lag. I am not concerned on that front in terms of what it is showing today. It is not necessarily reflective of what it is going to be two years from now, just as what it was showing two years ago was not reflective of the situation 12 to 24 months hence.
In due course, as the economy improves to 7 percent plus, investment spending has to go up.
Q: You outlined the three issues on which things are improving on the margins and which makes you constructive. If you had to highlight one risk which is on top of your list of risks that can go wrong, what would that be?
A: The biggest risk between now and the end of the year is the central elections. You may say that’s a 2014 event and hopefully, it is. But before the year ends, the market will start formulating an opinion about what the likely outcome of that central election is going to be.
That opinion would be formulated based on political developments between now and the year end. If that opinion so evolves that we are going to have another stable government that would fulfil its five-year term then that would be very positive and constructive to sustain this rally. It is quite likely to take us into the next bull market if that view point evolves into one which still has considerable risk of mandate, otherwise meaning not a stable government. Then the market would like to see the outcome of the election and then take course from these.
That to me, is the single biggest risk as we move forward over the next 12 to 18 months. That’s the time specific and country specific risk I am talking about. There are the usual laundry lists of risks that you will find in any sell side report which can include a spike in global commodities or global turmoil.
I am not trying to belittle those, those are very real and valid but those are omnipresent and well understood. In my mind, the central election is a country specific and time period specific risk which we have to monitor and live through as there is very little we can do about it till the event is over.
Q: There is a global backdrop to the second half. Expectations are that the global economy in various pockets will start to recover significantly in the second half. Do you think that provides some kind of cushion for us or may even be reason for the market to continue to remain strong rather than struggle?
A: As an economy, India is one of the most insulated because exports as a proportion of GDP is one of the lowest amongst the various economies. No economy in today’s world is completely insulated but, India is one of the most insulated.
In certain ways, India benefits from a muddling global economy. We don’t want a collapse in the global economy because that hits sentiment and capital flows. But, at the same time it is not necessarily from a longer term sustainability of India’s growth and inflation outlook. It is not necessarily ideal for the global economy to synchronously have very high growth rates because it puts upward pressure on commodity prices.
As long as the global economy chugs along with a low single digit kind of growth rate, that is a very good environment for the Indian economy. With what's going on in China in terms of a very determined shift and planned shift in terms of a quality of growth perspective, that should be beneficial to India as it is a non-inflationary kind of growth.
So a positive global backdrop, without it becoming gung-ho should be positive for the economy in terms of whatever modest boost it provides to the exports front and we saw many of the comments from IT services industry to that effect and the reporting of the first quarter. It should provide some modest boost, while at the same time keep a cap on commodity prices which is very detrimental to India as we don’t have the beneficial impact of commodity exports to the same extent as other emerging markets.
Q: At Goldman Sachs, in your conversation with clients, what is the approach you are taking for the next couple of years? Is this the year where we are building a base for a big bull move or is this still a trading market one month up, one month down, one year up one year down?
A: I do think that if you were asking me this question at a point in time where we were one year after the central elections with four more years to go, I would have clearly and unhesitatingly said that it is the start of the next or we are clearly along the way of a new bull market. After five years of the last peak we are still below the last peak.
If you look back at history over the last 30 years, five years after the prior peak has been a very good time to invest and a new bull market to form. The only risk I see over the next 12-18 months is the outcome of the central elections. And if it is favourable or neutral, it would be very positive and then you can count a lot more on not only the corporate earnings momentum along with the economic recovery but also on some degree of multiple expansion which currently is at about 14 to 14.5 times. It is slightly below the very long term averages and can go above the long-term averages in the early phase of the corporate earnings cycle.
However, for the year, I think it is reasonable to expect a 15 to 20 percent kind of return which is nothing dramatic or nothing insightful in some ways because 15 to 20 percent is basically the corporate earnings growth, the underlying earnings growth trend of corporate India. Any multiple expansion or detraction can add a few percentage of 5-15 percent points to that 15-20 percent.
That expansion or detraction as I outlined before, would be a big function on how the market perceives the central election. At some point in time that is going to happen within a 12-18 months time frame.