There could be significant downside risk to corporate earnings going well into FY18 because of the demonetization move, says Govindrajan Chellappa, Managing Director and Head of India Research at broking firm Jefferies.
In an interview with CNBC-TV18, Chellappa says financial services and consumer discretionary segments like auto be the worst hit as the currency move will hurt consumer sentiment as well as the wealth effect.
Chellappa now sees FY17 corporate earnings growth around 8 percent and FY18 earnings growth around 15 percent, but with significant downside risk.
He sees auto volumes getting impacted even though majority of the transactions are done through financing. According to Chellappa, even those with unaccounted wealth purchase vehicles through bank finance. However, the ‘wealth effect’, following the demonetization move could lead to a lot of purchases getting deferred.
Chellappa feels it is very likely that the government will try to stimulate the economy by putting money in the hands of rural consumers and the low income group. He feels the government has little choice because it is not possible to reflate the economy through capex at this point. He says buzz that the government may put some money in Jan Dhan accounts could be true.
He is bullish on consumer staples as he feels these companies could benefit from the government’s focus on the low income group.
Below is the verbatim transcript of Govindarajan Chellappa’s interview to Anuj Singhal, Latha Venkatesh & Sonia Shenoy on CNBC-TV18.
Latha: First thoughts on your earnings revision. How are you looking at earnings in FY17 itself how much would you shave off?
A: If you look at the consensus estimates right now, the Nifty earnings consensus estimate is about 13-14 percent growth. FY18 expectation is between 19 and 20. If I look at MSCI, it is not very different, somewhere thereabouts 13 to 15 and 18 to 20 for these two years. We have to put it into context. In the last five years we have grown at low single digits. Each year we have had a different sector with a problem but there has been no single sector leading the overall earnings growth, which could offset all the problems that the other sectors have had.
After what has happened over the last couple of weeks we now expect FY17 earnings growth to be about 8 percent. FY18 we have an estimate of 15, but that also has severe downside risk. As I mentioned we have had single digit earnings growth for last five years and to expect FY18 to be in mid-teens with all the changes that are going on, it is a bit over optimistic, so the limited point being there are significant downside risk to overall markets earnings estimate as of now.
Anuj: What explains your Nifty call of 7,500 in that case is that because of this earnings risk or do you think the Indian market valuations now need to come down below the median valuations maybe?
A: It is a combination of both. As I mentioned there is significant downside risk to earnings from where consensus is right now. If for a moment you go by our top-down earnings growth estimate for FY17 and FY18 that would mean FY18 estimates would have to come off by about 8-9 percent and that is the extent of downside that we see in the markets as we speak.
I already mentioned, I wouldn’t rollout more downsides to earnings estimates, multiples is a different point. That is a function of what happens to rate what happens to global environment especially what happens to US in terms of how the rates move etc. However, I do see certain downside to the market because of the earnings themselves coming off.
Sonia: What about your first love the auto space? We are getting so many forecasts of demand destruction in the two-wheelers, in the commercial vehicles space, have you done any kind of analysis on how earnings could be hit?
A: To start with, I would say there is no point looking at what is going on right now. There is no cash in circulation, so obviously demand will be poor. Channel checks that we have done that other people have highlighted two-wheelers are down, retail sales are down anywhere between 30 and 40 percent, commercial vehicles somewhere thereabouts, car sales are down I am told 15 to 20 percent. That will continue for the rest of the quarter. We are looking at a reasonably weak quarter for December. You could see some normalisation in the March quarter but as I mentioned that is not what is important. This is transitory.
What we need to look at is what is the permanent damage that the anti-corruption move does to demand for automobiles in FY18 and beyond and this is a view that we will have to take in various sectors. Very clearly, people who have hidden wealth and hidden income, a lot of them are participants in the car market. I do know that 80 percent of cars are financed, but that is an irrelevant data point. People with hidden wealth have white money as well. Nobody buys cars with black money. People usually use finance to buy cars even if they have hidden wealth. So, that data point that high percentage of vehicles are finances are irrelevant.
What we need to focus on is how consumer sentiment changes in FY18 which will only be for the worse. We need to focus on what the wealth affect will be in FY18 that also seems obviously to be on the worse. Risk appetite of consumers will be a lot worse, so very clearly the absolute volumes that most companies would have in FY18, would be lower than what you thought on November 7th. So, that is the point that I am making that we would see at least couple of years of slowdown in volumes. The growth rates will depend on which company we are talking about, some companies have fantastic motor cycles, some have waiting periods, but we will see demand being lower for all segments.
I see more impact on cars and tractors and there will be significant impact on commercial vehicles as well. Two-wheelers will probably be the one that will be least impacted in FY18. Though as we speak two-wheelers are the most impacted because the transaction problem is more for two-wheelers. The wealth affect problem is more for cars.
Latha: Before I come to the other sectors, another macro or rather earnings question -- demonetisation was the first leg of the policy. It is going to be followed by ameliorative policies. It is going to lead to a fairly sharp fall in the rates cycle assuming that aggregate demand has been pulled out of the market probably everybody will redraw their inflation curve for next year, so rates cuts. As well, there is a widespread expectations and buzz from Delhi that some dividend will be taken out from the Reserve Bank and we are going to see some fiscal stimulus. So, monetary plus fiscal stimulus will that change your growth forecasts for next year?
A: We have assumed both those in our base case in FY18. It is very clear; the bond market is already telling you that the rates are going to fall. Bond markets have anticipated such a move, so honestly whether Reserve Bank cuts it on December 7th or they leave it for later immaterial. Cost of capital has falling and that is what is important. Secondly, as it is we had a fairly benign forecast for inflation over the next few months and I think that forecast will become even better now that you have money supply coming off. You are absolutely right there will be very sharp rate cuts.
On the fiscal side it is almost imperative that the government does something. They have no choice but to do something to revive some kind of growth for FY18 not because of any other reason, just that you will see a lot of job losses at least for the next couple of quarters. There is only so much of public support that will remain for the anti-corruption drive, if people don’t see jobs and incomes go up. So, there has to be some kind of deflation. Whether they do it with dividend that they take out of RBI which is hugely disputed by various experts so I have nothing new to add to that or they don’t stick to their fiscal deficit target for a short-term that is immaterial but you are right there will be fiscal deflation.
The question is what form does the fiscal reflation take and I think that is where there will be change in the way the government will operate compared to what they have done so far. So, far this government has been very fiscally conservative, they have been very cautious on cutting down subsidies and transfer payments. Most of the increase in spending has been in capex. Now if you want to reflate an economy in the short-term you can’t do it with capex. Very clearly the government does not have the institutional capacity to spend more on roads and railways and whatever capex in the very short-term.
I mean look at DFC, it is fully funded it has fantastic managerial capability but every month it gets delayed by few days. So, the fact is that if they want to reflate, they will have to focus on lower end consumers, so which is why I wouldn’t rule out this rumour going around that they will transfer money to Jan Dhan accounts whether it takes that form or some other form it is very clearly to me that FY18 you would see the government spending more focused on rural consumers, focused on lower end consumers, which is part of the reason why we think that there could be acceleration in lower end consumers in FY18. That is obviously not a sector that is in vogue right now, but I think consumers staples could be beneficiary going into FY18.
Anuj: The biggest sector of course is financials, you are downgrading that. There is one thought process that low cost current account saving account (CASA) deposits are going to help banks going forward you don’t buy that argument? You are downgrading banks.
A: Let us take it in two parts, so obviously as we speak CASA goes up very sharply. So, let us say of the Rs 15 lakh crore ultimately Rs 12 lakh crore is what comes back into the system and Rs 3 lakh crore gets destroyed because it is black money. In the initial stages, that will be a combination of increased deposits and people exchanging notes. Ultimately, if you need the economy to be functioning smoothly you need that Rs 12 lakh crore of cash back in circulation. We are not going to go to e-payments and card payments in such a hurry.
In a country of 6 million retail outlets, we have a total of 1.4 million point of sales machines. This includes retail outlets that have multiple point of sales swiping machines. So, very few of the retail outlets, not to include the mandis and wholesales market are equipped in the short-term to deal with electronic payments or card payments. So, for the smooth functioning of economy, you need that cash of Rs 11-12 lakh crore to go back in to system, which have will happen by February or March. Whatever CASA comes in now a most of it will go back into the system by end of the March quarter. So, first we are looking at very short-term gains on CASA and it is not permanent.
Secondly, just an improvement on the liability side even if it were to happen is not enough to make a very positive call on the banks. We are looking at probably slightly lower credit growth in FY18 compared to what we thought earlier. There are possibilities of higher delinquencies and it depends on how long this slowdown lasts and which sector it lasts. In absence of a big reflation in global commodity prices which could boost profitability of steel companies, the non performing loan (NPL) picture will look slightly worse in FY18 compared to what you thought earlier.
We need to be careful in analysing these on time series versus analysing it on the new situation compared to what we thought earlier because the market factors in what you thought earlier. So, that is a comparison we need to make. So we are looking at little slower credit growth. We are probably looking at slightly higher NPLs and may be little better liability, but that won’t be able to offset the first two factors that I mentioned.
Sonia: A follow up on the point you made earlier about how the government spending could go up especially for the rural areas. You did mention that you have upgraded consumer staples. Even the rural beneficiaries you think are a good buy at this point the tractor makers, the Mahindra & Mahindra (M&M), Escorts of the world?
A: I wouldn’t want to comment on the individual companies, but we need to be careful on defining what is rural, what is not rural. Obviously, every business has a part of it which is exposed to rural. More than saying rural versus urban I would focus on low end consumption versus high end consumption. I would focus on consumption versus some of these are also partly investment linked which is why I had focused on staples may be to a certain extent some of the low end consumer durables, kitchen appliances etc.
As we go up the price point, the influence of wealth affect on the purchasing decision is quite high. Now you mentioned tractors, if land prices fall and ability of farmers to transact lands or their perceived wealth goes down, it is hard to see how with a little boost from the government in terms of money been transferred. How they will go ahead and buy tractor when they have seen 20-30-40 of wealth destruction, which is why we need to keep our focus on low end consumption rather than focusing on items like tractors.
Latha: Is there a danger of the Indian macros changing for the worst and therefore the discounting of 18 times, which the market has been giving for the FY17 itself changing? If you are speaking about fiscal targets being violated, the big Indian story was not macro until now. Earnings have not performed yet. But we had stable rupee, stable current account deficits, stable fiscal deficit, is that narrative likely to go and therefore will the discounting come down to 16 rather than 18 for the current year?
A: I disagree with part of your statement even though I might agree with your conclusion. India has not been that big a macro story. There has been such a huge diversion in performance across sectors that belies that statement. It is not as if when people have bought banks, they have bought all kinds of banks. They have been certain section of the financial markets that has done extraordinarily well, financial institutional stocks that have done extraordinarily well. So, it is not been that widespread a macro story.
Even if it were to be the case -- if you take a 20 year history India has always been a micro story. Its parts of the mid-2000s maybe in the last two-three years or few months in the last two-three years especially around the elections India become a single stock. Otherwise, there has been huge diversion in performance in all through the last 20 years of the market performance.
As far as valuations are concerned again there is such a huge dispersion of valuation. So, you have consumer discretionary, consumer staples, parts of the pharmaceutical sector and parts of financials that traded valuations both very high relative to their history and very high relative to what you find elsewhere in the world but that is not true for the rest of the market.
The risk that we see to valuations coming off is in consumer discretionary as well as parts of the financial market. We are fairly negative on the largecap pharma as well. So, this is a set of stocks where India’s valuations for these sectors have been so disjointed from both its own history and from what we see elsewhere that we see risk to multiples. I don’t see this risk for most other sectors.