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Budget may not be populist; see corporate earnings growth in '18: Deutsche Bank India

One is likely to see pick up in private sector capex in H2CY18 and recovery in corporate earnings in 2018, said Ravneet Gill, CEO, Deutsche Bank India.

January 09, 2018 / 08:26 AM IST

Ravneet Gill, CEO, Pratik Gupta, Head of Equities and Rahul Chawla, Head, Global Markets (Debt), Deutsche Bank India in an interview to CNBC-TV18 spoke about the Indian equity markets, the macros and outlook for bond yields and rupee for 2018.

Gill is of the strong belief that from a macroeconomic perspective things have never looked better for India.  According to him, the structural changes taken by the government haven't yet paid off and so, upside from that is significant.

He said the house has Indian market as its top pick even though internationally all markets look good. When one looks at headroom for growth within the large economies, there is no other economy that compares favourably with India said Gill.

Gupta said India has been one of the best performing market globally. The house has a Nifty target of 11500 for 2018. The market is not too far from current levels of 10,600 because the market has already front-loaded lot of earnings expectations, he said, adding that they have a Sensex target of 37000.

Going forward he is upbeat on pick up in private sector capex in second half of CY18, especially in sectors like cement and steel. Moreover, corporate earnings growth is also expected to return in 2018, said Gill, adding that it could be in double-digits.

Gupta said, although they are expecting strong cyclical rebound in economy and earnings, a lot of it is already priced-in and so, the return expectations have to be moderate and one should not expect the same 30 percent growth for market in 2018.

With regards to the bond markets and debt, there are two aspects to it, said Chawla. The rope is slightly tighter this time compared to a year ago. He said the RBI has to balance the whole concept of fiscal prudence that the government is going to show and not deliver. The other sensitive factor has been the rebound in oil prices.

Therefore, guidance on rates by RBI will not be straightforward, it will be a function of where the fiscal deficit is in terms of guidance of 2018-19 and oil prices, said Chawla. However, growth remains an important aspect for economy, he added.

When asked of range for 10-year bond yields, Chawla said depending on the Budget announcement, the range could be 25 basis points up and down from the current levels, for the first half.

Talking sector/stock specific, Gupta said the house is upbeat on banking and are overweight on private banks but underweight on non-banking financial companies, as well as industrials – largecap infrastructure plays, energy space selectively that is more upstream than downstream. However, they are cautious on IT and pharma.

When asked about their Budget expectations, Gill said it is unlikely that government will be populist although focus on growth and making agriculture more productive will be key for them.

Government will have to think of ways to increase revenues and job creation, said Gill.

Gupta said whatever tinkering they do in the Budget, they will not do anything anti-equity markets. He said if at all the government introduces Long-term Capital Gains tax, it won’t be substantial.

Below is the verbatim transcript of the interview.

Latha: What is the sense at Deutsche Bank, both global    and in India? Are you comfortable with valuations or do you think at the moment, it is not the time to look at valuations, it is just time to dive in if you have not dived and stay in?

Gill: As it always happens that it is very difficult to look at valuations in isolation. If you look at India in its entirety at the moment, from a macroeconomic perspective, things have never looked really better. There is a lot of stability, a lot of resilience and we think that the prospects going forward also look very good. So you could say that the markets have really run up. But a couple of things that you need to bear in mind with respect to that. First and foremost is that a lot of the structural changes that the government introduced have not really paid off yet and so the upside for that is significant.

Then you are seeing growth globally and you are seeing a lot of liquidity internationally. All markets seem to be doing exceedingly well. And when you look at the headroom for growth within the larger economies, I really do not think there is another economy out there which compares favourably with India. So whether we take the view globally or within the country, I would say that this is one of the markets that we put as one of our top picks, absolutely.

Sonia: Come in on this because the views are positive, but the Nifty target that you guys have for the full year of December, 2018 is 11,500 which is not too far away from here. Are there any concerns?

Gupta: The concern is really valuation. Markets have already frontloaded all of the earnings expectations which are coming in. Remember, we had a 30 percent return on the Nifty last year in dollar terms and India was one of the best performing emerging markets globally. But having said that, going into 2018 and looking into FY19, this is the year when we are expecting earnings recovery, corporate earnings recovery which we have not seen for the last 4-5 years, we have seen earnings growth more in the single digit range.

After a very long time, we will start seeing double digit earnings growth, but the valuations have already gone up quite a bit. Now on the bullish side, one can say that this is the phenomenon globally. Most asset classes including equity markets globally are at high valuations. But in India, we went up despite relatively weak foreign flows. It was largely driven by domestic flows which we expect will still remain strong.

So while we are expecting strong cyclical rebound in the economy as well as in corporate earnings, a lot of it is already priced in. So that is why, a return expectations have to be moderate, we cannot expect the same 30 percent kind of growth in the markets once again in 2018 in our view.

Latha: What I wanted to ask you was all through the last 3-4 years, it was the macros that was strong and it was Pratik who was not delivering, in the sense the micros were not delivering. But now, how are you looking at the bond markets? Already, we touched 7.4, chances of global inflation and domestic inflation picking up. So where is this yield for 2018?

Chawla: There are two aspects to the whole market or the debt side of the business. The rope is slightly tighter this time compared to a year ago. RBI has to balance the whole concept of fiscal prudence that the government is going to show and not deliver and the other sensitive factor that has come into play is oil. We did not anticipate oil to rebound to the levels that it has touched. We do not yet know whether it will continue to stay at 70 or rebound back to a lower level and settle at that. That is the one aspect where the government has to follow and RBI will therefore look towards that as an indicator to see whether the rates need to be hiked up or not.

And the other aspect is fiscal. Yes, in the longer scheme of things, there is growth and the macro has to be delivered. You are getting into an era where after the two shocks of demonetisation and GST, you should not potentially have another situation where growth gets impeded by a rate hike. But markets are already factoring, as you rightly said, about a 40-50 basis points over the next 15 months.

But I think it is the fiscal that will first and the oil as step two which will decide whether there is scope for a rate hike or not because effectively on a real interest rate aspect, if you look at it, with inflation expected to be in 4.5 on a 12-month basis and repo at 6 percent, you still have a 150 basis point real interest rate which is something which RBI has felt comfortable in the past with.

Latha: So you are saying that you would not pencil in a rate hike in the current year?

Chawla: No, I am not saying that. I think the guidance this time around is not that straightforward. It will be a function of where the fiscal goes in terms of the guidance for 2018-2019 and oil prices. So this time, it has to be a little bit measured from that aspect. But really, the growth is an important aspect in the economy and we are still not at the levels that we should be for inflation to become a bigger worry than from a growth point of view.

Latha: I just want to tie you down to a number. Can you give me a range for the ten-year for the first half at least?

Chawla: We think that depending on how the Budget announcement happens on February 1, you could see a range which is potentially, I would say, about 25 basis points up or down from here.

Sonia: A lot of the manufacturing sector data has been picking up lately, whether you talk about the Purchasing Managers' Index (PMI) numbers which are at five-year highs, you look at the auto sector data, commercial vehicles, cements, steel, are those signs of green shoots and do you think there could be a possible pick up in the capex cycle soon?

Gill: It is a non-consensus view as Pratik keeps telling me all the time, but my view is that you will actually see private sector capex picking up in the second half of 2018. I would say that earlier I was thinking that it will be closer to the end of the year, but I clearly see it now coming in two quarters earlier than anticipated.

If you see the order books of a lot of companies, you saw L&T now and sometime back was Siemens that they have all-time high order books, part of it is that they have recalibrated their focus. They are now government focused than they were previously. Earlier if the government was 50 percent, now it is 80-90 percent of their order books and obviously the government has been spending money across sectors.

But even away from that, I clearly see that you will see private sector capex in areas like cement, steel, automotives and a couple of the other manufacturing sectors picking up in 2018. To go back to the point that Rahul was talking about in terms of what are the cues that could drive a lot of our economic policy. So just as per the Chinese calendar, this is the year of the dog, I would say from an Indian standpoint, it should be the year of the frog and the frog would stand for, 'F 'for fisc, 'R' for rates, 'O' for oil and 'G' for geopolitics.

Sonia: Did you make that up yourself?

Gill: No, not really. Credit to the equities team for that. But having said that, I just think that the first three were of course spoken about, but as far as the geopolitics is concerned, I would also keep an eye out for that. I think investors right now and more broadly, even from a macroeconomic standpoint, we are a little more sanguine about that then potentially the situation warrants. So I would look at these factors in terms of determining what is the trajectory that we see in terms of rates, in terms of RBI's actions in 2018.

Latha: What is your Nifty and Sensex targets and more importantly, which will be the stocks or sectors that will lead you to that target in December?

Gupta: Our Nifty target is 11,500 which was at last week, it is about a 10 percent upside from here. The markets have already moved up last week or so. Generally, if you speak to investors globally, a lot of them are concerned India has already gone up 30 percent, valuations are already so high, still no signs of earnings upgrades, are you guys still positive and so on. And we are and the reason is, as Ravneet mentioned, we are going to see an economic growth rate pick up, corporate earnings will likely accelerate and if, as Ravneet is highlighting, if we start seeing private capex also coming in, we may actually see even more faster earnings acceleration than what we are assuming. We are assuming about 22 percent growth in the Nifty earnings for FY19.

It may even be greater specially going into the second half of FY19. So with that backdrop, we are positive, but also, you have got to keep in mind the valuations as well, especially some of the sectors which have run up quite a bit, they are already discounting very high growth for the next couple of years. Therefore, you have to be a bit careful. In terms of our sector preferences, it is really banking, but there also financials is now a very broad term. It is private banks, PSU banks, non-banking finance companies (NBFC) so we are overweight private banks, but underweight NBFCs.

Latha: Corporate lenders?

Gupta: Corporate lenders positive, but overweight the high current and saving account (CASA) retail banks more because of the cost of funds going up and also, obviously after the PSU bank recap, a lot of the corporate banks have already rallied quite a bit. So it is more of a relative call. Then the industrials, specially some of the largecap infrastructure plays given the amount of infrastructure spending that is likely to happen, cement is another one. Energy, selectively. This year a bit more upstream rather than downstream. So those are the broad areas and generally still cautious on IT and pharmaceuticals.

Sonia: What is the expectations on the Budget this time around? Since the fiscal slippage has increased, there is a possibility that the authorities could go in for expenditure compression, that is the worry. But what are your own expectations?

Gill: Clearly, if you want to have the fiscal discipline that we have seen so far, expenditure compression is clearly one of those things. But the point is, if we look at it from a country standpoint, the key really to India's economic prosperity and stability going forward is job creation and that will not come from expenditure compression. So I think the government will need to think of ways to increase revenues.

So whether that means higher dividends from state owned enterprises (SOE) or looking at other revenue sources, whatever else they could do potentially from divestment, etc. will become equally critical. Coming to the point with respect to growth and we have been talking mainly about industrials and manufacturing, do not forget that agriculture, rural incomes have been down in the last couple of years. There were two years when we did not have a good monsoon and then last year, the agriculture prices were not great.

One of the things that you will see is the government will look to see what can be done in terms of making agriculture more productive and agriculture incomes going up which of course will have a big impact on consumption per se. having said that, I do not see this government getting populist. So you have lots of elections coming up, state elections coming up and the n of course, you have the national elections. So I definitely see the bias towards growth, but I do not see a populist mind-set coming from this government.

Sonia: Your thoughts on the possibility of the long-term capital gains (LTCG) tax being reintroduced. Every year this talk keeps coming back. Even if it is, do you think the market would be perturbed? Latha: Do you see it as your base case and if it is what is the impact?

Gupta: You have to keep in mind that the government is now quite dependent on the equity markets for meeting its fiscal deficit targets. This year the target was about 1 lakh crore, once you take into account other strategic sales as well. So for them to do something very dramatic with the tax structure which could impact the flows and the sentiment in a very big way - that is not our base case and that is why we have a positive view on the market although it is one of the risks if they do tinker around with tax structure in a meaningful way wherein they increase the tax rate quite dramatically or whereas what I think even if it happens, it will be a relatively small tinkering wherein they might introduce a marginal tax rate or maybe they extend the tenure and keep it at a zero tax rate or perhaps ideally they should be reducing the STT and only then looking at --- (interrupted)

Latha: Is that your base case - LTCG?

Gupta: No it is not but the base case is rather that whatever they do in the Budget, it will not be something which will be anti equity markets in a very meaningful way because of the dependence of government revenues on the equity markets given the amount of disinvestments they have and especially ahead of an election year, I do not think they can tinker around with the equity flows in a big way.

Latha: If it is introduced, is that an impact then?

Gupta: It depends on how it is introduced; what the shape, form and structure is. If it is a minor change then there could be some near-term sentiment impact but it won't impact equity flows in a big way. Keep in mind the alternative investment classes like real estate, gold and even fixed income on post tax basis, the returns over there are unlikely to be as attractive versus equities.

Latha: Whenever equities melted, there were not many instances, and when they did it it was maybe 2-3 percent. It was when there was danger of fisc. What are you expecting on fiscal numbers both when the year ends, so the revised estimates for this year and the budgeted estimate for next year?

Chawla: As far as this year is concerned we know what the latest borrowing programme that there will be slippage and anticipation is about 30-40 bps slippage from 3.2 percent number. As far as next year is concerned - that is where the whole policy action has to be directed towards. Do they look at announcing a fiscal which is wider than what it was indicated for FY18-19 which is 3 percent and then run the risk of growth being impacted by an interest hike or they, for the tight line of saying, to Pratik's point and Ravneet's point that there could be anticipation of growth pick up and therefore some revenue pick up from there, find other sources of revenue and maintain the fiscal balance to keep it at that declared level of 3 percent. I think it is a tight line. Chances are that they would probably go down the path of saying we will show fiscal prudence --- (interrupted)

Latha: So 3 percent is what you expecting. If it is 3.2, will you be perturbed?

Chawla: Around 3 percent we should not be, but if the slippage is much wider then you are looking towards the fact that what the market is pricing in and then starts weighing on the central bank to look at policy action.

Sonia: What are the other domestic sources which could fund the deficit this time around?

Chawla: We know that because of goods and services tax (GST) and demonetisation earlier, the revenue receipts and also tinkering with the GST rates, the revenue receipts have come lower. Ravneet mentioned about the fact that dividend from SOEs, increasing some other forms of revenue receipts could potentially be sources but that is where the creativity has to come in, in terms of finding newer sources. You have to look for newer sources as well.

Latha: What is the global view at Deutsche Bank? It has been such a huge tailwind, the US markets, European markets. Is the base case for Deutsche Bank that that rally continues and more importantly this year what maybe the colour of the FIIs? The first four days indicates that they are positively disposed vis-à-vis last year towards India?

Gill: One of the things which we need to bear in mind going into 2018 is that even as far as global growth is concerned, the star seem to be better aligned than they were in the past and equity like we were discussing in India - to the point you made in terms of green shoots and investment picking up - I think both those things are happening. As I mentioned that you need to watch out for the Fed in terms of what their view is with regards to rates. Obviously that will have a bearing. The second to my mind is the thing around oil; given how important it is from India's standpoint and from maintaining the economic stability that we have now been able to establish. So these are the two factors which we need to keep in mind when we talk about the view of the FIIs but there are just two other factors which I would like to highlight. One is the pace of financialisation of India's savings has been terrific and that was seen also in terms of how the market went up, the secondary markets in all of 2017. The FII buying was about a billion-and-a-half. The rest of it all came from domestic sources. So right from the time we were kids, we always talked about India's high saving rate etc, but the point is those were never put to any productive use because everything was going into silver, into gold, into real estate and cash holding. So that will be a big game changer and we believe that over the next few years the part of the financial aspect of India savings will go up from 41 percent to all the way to 65 percent. So see what it could do in terms of funding infrastructure, funding growth and for the government to be able to get additional resources. The second part of it is in terms of the efficiency that will get generated through this whole digitalization effort of the government and the government needs a lot of credit for that and what is more -- if you look at India's tag, the whole digital infrastructure for the country is being paid for, being laid out by - effectively not private sector investment; it is coming from state finances. I think it will lead to a lot of efficiencies in terms of --- (interrupted)

Latha: FIIs?

Gill: Yes, I mean they all see these factors. So if you put all of these together, what it could do in terms of providing the kicker for growth in India and sustainable growth in India could be very positive.

Sonia: It is expected to be an agrarian Budget this time, more farms focused and you guys have a lot of exposure there whether it is into names like M&M, HUL, Dabur etc. Do you think that there is more money to be made here?

Gupta: In fact, not just this year, we have seen this in Budgets every time over the last 30 years and pre-election years, typically spending on rural areas goes up and this time even more so given the stress in the rural area. So all the rural facing themes and that's something we have been highlighting for the last six months; it's not a new theme for this year, so that we think continues to run and these are sectors where valuations are still not crazy valuations. We think growth will pickup, in fact the earnings will catch-up with the valuations and you will see more likely -- there risk over there however is watch out for risk of a bad monsoon but our base case there is a normal monsoon but assuming it is a normal monsoon then we think these stocks could go much-much higher even this year.

Sonia: You told us 11,500 is your upside target. What about the downside on the index?

Gupta: The risks to India are more global. You have some domestic concerns perhaps bad monsoon or something in politics playing out with the elections coming up but generally we see the risks more global especially something with North Korea or more importantly or more likely the risk of faster and anticipated Fed tightening and flows into EMs, but we do not know see that as a big risk because in India the local flows, the local economies recovering. So we think that will actually offset a lot of the global risks. So by and large we are quite comfortable with the positive view but the upside may not be as much as what we saw last year.

Latha: Ten percent higher on the Nifty from current levels. How much higher on the midcaps?

Gupta: Midcap actually less so because the valuation premium of midcaps has gone up quite dramatically. Typically as a business you may say midcaps tend to do much better in recovery but bear in mind the valuation premium versus largecaps is very significant, so less positive on the midcaps.

Latha: One word on the rupee. Where would you see it in 2018?

Chawla: Our view as a house is in the range of 63.5-65/USD.

first published: Jan 8, 2018 11:39 am