Apr 26, 2012 12:34 PM IST | Source: CNBC-TV18

Positive surprise may trigger bull mkt: Franklin Templeton

R Sukumar, managing director and chief investment officer-Franklin Asian Equities, Franklin Templeton Investments says, there is a clear possibility of upside as bull markets are built on pessimism.

The Indian economy has had negative newflows both on domestic and international front. However, experts believe that the negative news has been digested by the market.

In an interview to CNBC-TV18, R Sukumar, managing director and chief investment officer-Franklin Asian Equities, Franklin Templeton Investments says, most of the negative newsflow has been factored in by markets.

According to him, there is a clear possibility of upside as bull markets are built on pessimism. “The pessimism is pretty high. Expectations of most of the people on economic parameters as well as corporate earnings growth are pretty low. So, any positive surprise could be a very good trigger for a bull market,” he asserts.

However, he says, rupee, stagnant interest rates remain overhangs. “If the interest rate shoots up too much or if there is going to be worse than expected depreciation of the rupee then these could be some of the risk,” he adds. 

He expects rate cuts by RBI to be lower than market expectation. But he sees some improvement in cyclical factors going forward.

Also read: India growth story still on, says Motilal Oswal

Below is the edited transcript of his interview with CNBC-TV18's Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying videos.

Q: A lot of newsflow has happened, are you still okay with the market or do you think there is a downside possibility?

A: There has been a newsflow. But I wouldn’t say there are any big surprises except maybe worse than expected uncertainty created by tax related issues. But other than that, there aren’t big negative surprises.

We all knew that there was deterioration in the fiscal situation. There was a slowdown in the growth rate etc. So, part of it is structural, part of it is cyclical. The market had digested most of the things.

Now, incrementally there are going to be some improvements, essentially cyclical improvements. I think the investment rates might recover a bit in some sectors as companies invest to increase capacities etc and also in certain infrastructure sectors because of some of the recent initiatives. There might be progress in some of the projects. So, that would be the positive.

On a negative side, if the interest rate shoots up too much or if there is going to be worse than expected depreciation of the rupee then these could be some of the risks. I still think the chance of these things happening is not very high at this point of time. But clearly the country needs to tighten its belt. If there is some reasonable progress, then I think that this would abate.

Q: There was some nervousness around the S&P rating outlook change yesterday. How much of a probability would you say there is that there is an actual downgrade coming? How might that impact flows because the fear is that come a downgrade, mandatorily some funds may have to pull out from the market like India?

A: They have stated that the chances of downgrade is something like 33% or so. I don’t want to second-guess what they are saying. But I think what is more important for us is to analyse what the implication of the downgrade would be, whether the interest rates are going to go up very significantly, whether the rupee could hit 58-60.

My view is that chances of something extreme happening in terms of borrowing costs or depreciation of the rupee are still low. I think probably less than 10% that we would see very significant deterioration in any of these parameters. So, we cannot wish away the risk, but at the same time I think we shouldn’t panic either because the probability of something wrong happening is still low.

Q: Do you see meaningful upsides to this market, given the fact that in April FII flows have also slowed down quite considerably because of the general anti-avoidance rule (GAAR) confusion and the way the currency has moved? Do you expect the market to rediscover the momentum that we saw in January and February?

A: I think it is a clear possibility. Bull markets are built on pessimism. The pessimism is pretty high at this point of time. The expectations of most people on economic parameters as well as corporate earnings growth and sales growth are pretty low. So, any positive surprises could be a very good trigger for bull market.


Q: Conversely though would you say there is a greater threat that this market is headed for a downgrade or a de-rating on the back of both the macro concerns that you talked about and the fact that money may not be as willing to commit itself to India?

A: There is some risk, but I wouldn’t say it is a greater risk compared to the upside possibility. The reason being that most people knew that the growth would slowdown and there is going to be deterioration in the fiscal deficit, but we are not Greece or Italy.

We have both real growth and good nominal gross domestic product (GDP) growth. So, strong nominal GDP growth makes the government job much easier because data as a percentage of GDP doesn’t balloon the way it could, if we didn’t have the strong growth. So that is something very important that we have to keep in mind. While there can be some deterioration, I don’t think the debt serviceability for the government is going to become such a big issue.

Second is ofcourse we have a flexible exchange rate compared to some of the European countries, which didn’t have the exchange rate flexibility. Because of all these reasons, while things could deteriorate a bit, but I don’t think it is going to become alarming. There could be positive surprise in the form of capex. With the depreciation of the rupee, I think even the exports could pick up. So, there could be some positive surprises. I would think that the chances of upside surprises are higher compared to big downside surprises.

Q: How much would you bank on in terms of rate easing to help our equity market atlong? We saw what the Reserve Bank of India (RBI) announced and how little the banks did with it. Do you think that is one peg the market can hope to move up with?

A: I think the expectations on rate decreases have to be toned down. While inflation has declined from the peak levels, it has not come to a very comfortable level. As the RBI said, they will be also monitoring deficit situation, the finances of the government. We are not seeing the type of improvement that we would like to see. So, clearly I think the rate cuts will be lower compared to earlier expectations and the pace would also probably be slower.

Q: You have tracked and invested in frontline IT for a long time. What have you made of the kind of disparate performance we have started seeing and the way these stocks have started pricing themselves?

A: My view has always been that the Indian IT industry has to consolidate. That has been happening because the differentiation is not very substantial for the type of services rendered by the Indian IT services companies. So, it is an oligopolic structure. There has to be a consolidation.

During the phase of consolidation, I think the returns would adjust to more reasonable levels. I think they have been higher than sustainable levels in the past because demand growth has been higher than the supply growth. Now, I think they are better matched and consolidation is happening. So, I would expect that the margins would go down and so would the return on capital for the IT industry as a whole. 

Obviously, there are going to be market share shifts and the gainers are in a better position to maintain growth and also maintain margins, whereas the companies, which suffer on growth during a particular period, also have their margins impacted more. So, I think that is a trend we are seeing. I would expect that would continue to be the trend for the next couple of years till the consolidation is complete and the margins and return on capital has adjusted to a long-term sustainable levels.

Q: A lot of the global investors over the last couple of weeks have started talking about regulatory risk for many sectors. It may have been triggered off by the IGL episode and more recently by the Telecom Regulatory Authority of India (TRAI) recommendations, which saw a big fall in telecom stocks. As a fund manager, have you also started becoming cautious about anything exposed to government policy whether it is PSUs or sectors prone to policy surprises?

A: We have always been. This has happened many times in last few decades. The regulatory risk in India has been higher compared to better regulated countries. But I think going forward, the regulatory risk would reduce because now there is much more transparency, things are debated, everything is now available to the public and everything is analysed. So, to that extent, I think it will bring about a regime which is going to be more stable.

My five-ten year view would be that the regulatory risk would significantly reduce from the current level. But the noise is at its peak. So, it is creating a lot of panic. How we need to act in terms of investment varies from case-to-case. So, we have to make our independent assessment of where the regulatory framework would go to and where the returns of those sectors would go to and then take a call on whether the worst is priced in or not.


Q: What the market has not been able to do, even in the first couple of months, is attract any significant retail interest. Would you say it is still a tough argument to make between equity and fixed income? Would you say fixed income still remains a very potential alternative to what has been happening with equities?

A: Looking at the past behaviour of retail investors, they have generally stepped in after a bull market has set in, not before it has set in. So, this is not a surprising thing. We would have to see a sustained rally in the market before the retail frenzy builds up and unfortunately, that is a situation.

The right thing to do for investors is to buy low and sell high. But unfortunately more people come in at closer to the peak levels. Clearly, the fact that there is very little interest shows that there is a lot of pessimism in the market and bull markets, as I mentioned, are built when there is a high level of pessimism.

Q: How do you approach the rest of the year, if your base case is that perhaps the market is building some kind of ground floor or bigger move from here? Do you still go with preferring defensives or do you think these are the prices to start looking at high beta or rate sensitives?

A: We have always believed that we have to buy specific businesses whether the stocks that we are buying offer value. It is a mix bag. So, we do find opportunities. But even at lower levels, some of the stocks are not looking good. So, I think it is a bottom-up approach for us by and large and we will continue with that.

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