The fourth quarter of FY12 saw the weakest GDP growth in almost nine years. It slipped 5.3% in Q4 and has suddenly thrown light on the sorry state of the Indian economy. During the Citi Conference, Aditya Narain, Managing Director and Strategist at Citi India gives his outlook on how things look like in India. According to him, the weak GDP figures were certainly a surprise.
Narain futher said that earnings growth is more gradual than lumpy and therefore, they are eyeing an earnings figure of 10 to 11% in FY13.
Below is the edited transcript of the interview on CNBC-TV18. Also watch the accompanying video.
Q: Bang in the middle of the conference we got that GDP shock. How did that go down with participants and what was the mood like?
A: I think from a number perspective, it did surprise negatively. I don’t think anyone was really expecting that number to be as weak as it was. This was in some measure because bottom-up the sense one has got from companies was that February-March had tended to be reasonably decent.
I think the number really surprised. In terms of its impact on the market, it was relatively muted because I guess in part, the market had been expecting a negative surprise of some sort or the other in any case.
Q: What does it do to your forecast? Your economist has scaled down her GDP target, but what impact will it have on earnings growth that you are projecting for FY13?
A: At this point in time our earnings projection is about 10-11% for FY13. Earnings are more gradual than lumpy as GDP data, which comes out once a quarter. In some senses, I think some of it would have got factored in any case. There could be some risk to this.
But I think you also got to look at the slight disconnect that you often see between GDP growth and earnings growth. Illustratively if you look at what’s happening in the developed markets at this point in time, earnings growth continues to be actually very robust. If you see the difference between GDP growths of emerging markets and the developed markets, it is very, very vast.
If you see the difference between earnings growth in developed markets and emerging markets, it’s actually very, very miniscule. In some senses, it need not necessarily have such a direct implication from earnings. The other part also is that for earnings, we look at the top end of the market however you split it. Whereas slower GDP growth implications are actually much more broad based.
Q: In that sense are you saying that the broader market might see more pain even if it’s not reflected in the Sensex earnings?
A: Very structurally, yes.
Q: What about consumption? A lot of economists pointed out that consumption might be slowing down now, shored up in some of the services data. Could those earnings be at risk?
A: Our view on the market and on earnings has been that the investment side, the capex side is already shown in the numbers and in market sentiments. It is on the consumption side where the numbers have continued to be good and just to support those numbers you have had valuations that have also tended to be very good.
If there is a meaningful risk that lies in the system, it potentially lies on the consumption side. That being said, consumption isn’t that binary. If there is an impact, a 10% top-line will become an 8% top-line rather than 10% top-line becoming a 2%.
Q: So not the infrastructure kind of swings in earnings?
A: Yes, it's not an institutional order flow kind of business. It is like you eat out less once a week or something like that.
Q: This ties in with the theory that you have been talking about it in times of great currency volatility or depreciation. It's actually the domestic consumer plays which do the best. Could this time be different then?
A: In some senses I think it's played out because you have had a massive currency drop off. On top of that, you had problems on the capex and investment cycle side. So you have had both, from consumption being less impacted to the market seeking safety on the consumption side. I would tend to believe the best has actually played out for that space, apart from currency reasons that just adds to this entire argument.
Q: Incrementally, the case for hiding in consumer defensives is very, very difficult?
A: Not for us. We have been propounding that view for the last couple of months. It's worked in part, it’s not worked fully. But, our sense is that there is very little downside risk on the capex side because most of that seems to be factored in or you are left with this upside risk.
Whereas on the consumption side, there is no possibility of an upside risk between valuations and the growth has been so significant. But, then you are really left with downside risks. I wouldn’t hide there.
Q: What does it mean for financials because that's the big call now? Given that the GDP number is ugly and you might go through some more economic pain, do you need to rethink what kind of asset quality worsening we could be staring at?
A: I think we clearly have to look at it. Our view on asset quality really has been that the worst incremental deterioration is done. You will continue to see deterioration for the next two quarters but the pace will tend to ease off. This number does to some extent threaten that hypothesis a little bit i.e. the pain could potentially continue a little bit further.
But between the likelihood, the rates will potentially fall a little bit more than what was expected. Our sense is the market is discounting a lot of risk. We wouldn’t tend to be so cautious. The number itself does one no good because you have to really look at it a little more closely.
But you also potentially got to be a little careful with this number. You have had plenty of occasions when GDP numbers have been revised down. With this number, you are running a little bit of a risk of that number being revised up a little bit. It just seems too extreme, given what one was hearing bottom up.
Q: You are clear about the corollary that the RBI will move more aggressively now because a lot of people disagree with the hypothesis that given what the currency has done, how inflation is, they may still not be able to move too aggressively?
A: In some senses it is a policy decision. You have to look at the disconnect between headline inflation and core inflation as it was. I think that is one aspect of it and at the end of the day, the RBI has to take a call on that. But I do believe, they will look more favourably at focusing on the manufacturing side of it.
The other bit of it is, you just simply cannot have a slowdown as you are seeing in terms of GDP numbers. The slowdown in demand that you are tending to see and money being as tight as it has tended to be over the recent past. In some senses, I think the demand for money will also tend to slacken.
The policy rate side, clearly it is more of a policy decision but I think from a pure market economics perspective, my sense is the tightness in money, the demand for money is going to effectively ease off. The argument of using monetary policy as a demand controlled measure will be even weaker.
Q: If asset quality does not worsen too much incrementally from here than what have you priced in and bond yields go down because of RBI action, do you buy the cheaper public sector banks or go to the more expensive private sector banks?
A: At this point in time, what you are getting is a trade of buying decent businesses at decent valuations rather than going down too low where you are not looking at the business and buying only valuations. To that extent, it is probably, stay with decent businesses that are available cheap rather than purely cheap businesses.
Q: The phase of buying just bombed out valuations is not arrived as yet?
A: You might make money doing that. But in some senses, for someone who tends to balance out risk and return on what you are buying, I think you would probably want to stay at the slightly higher level.
Q: You would say not be too aggressive on public sector banks yet, given valuations?
A: We would buy them but we would buy them when you get a little bit of a quality and more of an underlined franchise. As a theme we would buy them but we buy the upper segment of that.
Q: The rupee seems to be dominating mindspace for most India investors right now and in May, IT did well, pharmaceuticals did well and they are about the only sectors which did well. What are you weaving in to your portfolio as a currency hedge?
A: What we did a month back was we brought in much more of a currency hedge. Prior to that our portfolio was running an overweight on pharmaceuticals and an underweight on IT services. What we did at that point in time, we felt that the currency was potentially a little wobbly. We raised our overweight on pharmaceuticals and we moved up our IT services to a neutral. To the extent that we are looking for a currency hedge and we are keeping one, this is where we are effectively hedging ourselves.
Q: Why the relative leading towards pharmaceuticals and not IT?
A: We just think the business outlook is substantially better as far as pharmaceutical is concerned. It is more structural, it is more granular for a two-three year period. Whereas as far as IT is concerned, there are plenty of question marks in terms of what their business outlook is.
Clearly they get that currency play per say but from a pure business outlook perspective, I think it could potentially carry some challenges and in many senses that is why we were underweight on that sector and that call worked pretty well because you had a lot of these guys lose value over a couple of months and individual stocks got hit. On the back of that valuations also tended to become relatively reasonable.
Q: In the midcap universe that you track at Citi, would you look at anything in the auto ancillary, textiles which typically are currency plays as well?
A: Not at this point in time. In some sense when you go midcap, it has to be a company specific theme, it cannot be a generic theme. I think if you capture a midcap with only a P&L exposure and no balance sheet exposure to the offshore side then, it is clearly worthy of a look.
But I think what tends to happen in a lot of that segment is that you are running or the gains of the currency are potentially a little offset by the fact that they have got balance sheet liability. That doesn't mean it is a huge exposure because finally it could just be hedge borrowing. You are getting export revenues and you have got the dollar denominated debt but that tends to moderate the leverage that you get to the currency play.
Q: You just spent time with a lot of India investors. What are they doing at this point? Are they frozen in fear, are they saying too late to capitulate? What sums up what you heard from majority of them?
A: I think in some senses there is a wait and watch. There is a certain amount of caution. But I don't think it's as bearish as market sentiment would actually tend to suggest. In fact, I had gone marketing with our economist to the US about a month back and there was a fair amount of caution on India.
But we didn't sense that portfolios were all that underweight vis-à-vis India. I think people are waiting, people are tending to play the quality game. People are a little concerned about this hiding in the consumption theme that has effectively played out but I don't think people are betting big on taking a meaningfully contra call in terms of the market or stocks that haven’t been doing well.
Q: Incrementally could they start getting more bearish looking at these kind of GDP readings or something goes wrong in the west because what you say is good that people have not sold yet. But there is always that sword hanging over you if they have not sold, could they sell?
A: The way I see it is that a lot of the market's focus is on how much could those risks be to the downside? My sense is those risks downside will tend to be relatively moderate. People have lost money. Valuations at the end of the day have come off and all said and done, you have earnings growth and you do have GDP growth which is substantially better than what you are getting elsewhere.
I don't see that capitulation coming in at this point in time, unless it's a globally driven thing. What I do however believe is that if you do get upsides then people will start loosening their positions, taking profit a little sooner than you would have expected in previously strong markets, as far as India is concerned.
What they will do is moderate some of the upsides if the mood in the market reverses rather than actually endanger the market too much at this point in time.
Q: You are saying people are waiting to sell the rallies?
A: I think so. I think that is where the risks will tend to be a little higher.
Q: The other thing is commodities which have come off quite a bit. I don't see too much mention of that in your portfolio as any of the global plays. You are steering clear of them?
A: We have tended to stay clear of that. In some sense that also ties in with an upward bias on the market for the reason that it is a sore and Achilles' as far as the Indian economy and the market is concerned.
Q: Let me ask you a question on Indian valuations. They are low now, 12.5-13 times maximum. Could we get down to those 10 kind of multiples given that GDP is struggling at a 9 year low, the rupee is at an all time low. What's to stop the Indian PE bottoming out this time at the usual bear market bottoms?
A: I think domestic event or further deterioration driven is a little unlikely. I think if it comes through global weakness on equities for whatever reasons or meaningful outflows for external reasons, it could be a possibility.
But as things stand in terms of the momentum that you are seeing in the economy, it's not great but at the end of the day the economy is effectively still moving. The fact that returns are actually tending to move up for the top end of the corporate sector, my sense is that you are unlikely to see those kinds of multiples.
Q: Except in a global capitulation.
A: Yes and global capitulation then is going to be very different. Will India fall more than the others? I am not so sure. The risk of India being an underperformer in the event of a global capitulation is actually much less than it would be generally pursued.
Q: In a relative world has India's case weakened over the last many months you think? When you talk to investors are they saying "we thought it was a good market but the confidence is slipping slowly", or do you think when the risk on happens eventually, India will outperform other peers?
A: I think India will still outperform when the risk on happens but the extent of that outperformance will be relatively moderate and in line with what I earlier suggested, that people will be selling rallies. I don't think the outperformance will be on a very sustained basis.
Q: Are you changing year end targets in light with what we saw with the GDP or still sticking with that target?
A: We are sticking with our target. We had a target of about 18400 on the Sensex which we put out in December 2011. We have stuck to that. We stuck with it when the market went up to almost that much earlier in February and we will effectively stick with it right till the end of the year.
In December, our suggestion was that the market is likely to move upfront and then is basically going to wait for the economy to come through. I think that stance reverses a little bit. I think it's going to be a more gradual gain going into the end of the year and the weight for the economy gets pushed out just a little bit more.
Q: How long is this economy cycle going to take to turnaround you think, where are we relative to the trough in your eyes?
A: I think that is effectively the biggest challenge. Calling the market, if you ask me is much easier than calling the economy because markets don't have to stay low for too long. They can go down sharply, they can be in the middle, they can never go down and then bounce up.
I think calling the market is a little easier and that is why we are calling for that recovery as far as the market is concerned. The economy is typically a little bit more challenging because it takes time for a big economy like India to slow. It has taken time, but it has slowed. How fast it will get back? I think it is going to be a bit of a traditional million dollar question. My sense is, it will be closer to the end of the year when we will start seeing numbers look better.
This current quarter is going to be challenging, than next one. I would tend to believe, from a numerical perspective, I think the last quarter was potentially the worst. I think in real terms maybe this quarter will also tend to be a little slow. The next quarter should get an effective bottoming.
Beyond that, I would tend to believe, if you get some rate action, if you get some policy action and if you have had a long enough period where there has been very little activity, that will only increase as you wait given that there has been very little in the last year.
Q: Around the time that you are talking about, which is Q3 of this fiscal, have you factored in what the global situation might be because that could be a fly in the ointment. By that time maybe we would have had another quarter of a lot of pain in Europe. When you say the recovery starts there, is it hope or is there conviction in that call?
A: As I said, the economy is just simply harder to call and it is a big economy. It is no longer a small economy. It didn't go down. You have had various structural issues, you had monetary issues for a while but the numbers are cracking now. Sometime last day you started seeing them weaken, so it is a little hard to call in that context.
On the specific issue of Europe, our house call is that there is a 50-75% chance that Greece will exit from the euro. There will potentially be a certain amount of turmoil around, which is not far from now. But monetary authorities will come in and support both the markets and liquidity in the system. In some senses that argument kind of feeds in well with the fact that at the back end of the year, you will effectively have gains to be made as far as the economy is concerned.
The problem with the euro has not been so much of the direct impact. I think it has been the uncertainty that it has tended to create and it is what has distracted large constituents of this economy. It has distracted investors. Everyone has either been following the euro or been looking at it as a bit of an excuse for doing something or not doing something.
You had the corporate sector which has sat out and said we don't know what funding will be like so let us see how this pans out and to some extent you had the government which has looked at the euro and said that is the problem. I think the uncertainty around Europe has been more of a problem than the real impact.
Even for India, where it is a little exposed to fund flows. But I think the moment that is out of the way, the better it is going to be for markets in general and for India in particular. I think the constituents in India, the government, corporates and investors have to say, okay let us get on with life.