Deutsche Eq advises clients to retain low exposure to risk

Pratik Gupta of Deutsche Equities India expects markets to remain volatile in the near-term. He says the flows into Indian markets are driven by weakness in other emerging markets.

Gupta sees a sustained decline if the government doesn’t act in two weeks or so. Marketmen are keenly watching whether the government will announce policy reforms such as increase in diesel prices, allowing foreign investment in aviation and retail sectors.
"I think a sovereign downgrade is possible if the government inaction continues," he told CNBC-TV18 in an interview. 
Stock markets are likely to remain volatile this week amid concerns over deficient monsoon and a string first quarter corporate earnings, say experts. 
Gupta says the earnings outlook remains challenging for the next few months. "We are advising clients to maintain low exposure to risk," he says adding, "have seen significant inflows from long only funds."
Blue-chip companies were the worst performers in the quarter ended June 30 in a market that was hit by Eurozone, rupee and policy woes.
Commenting on sector-specific issues, Gupta says, IT companies look attractive at current levels, while he is cautious on autos given the competitive pressures. 
"We think banks, cement could deliver robust returns over 2-3 years," he says. Below is an edited transcript of the exclusive interview on CNBC-TV18. Q: How is the market looking after yesterday’s global turbulence which seems to have rattled sentiment again?
A: Right now, it’s all about several factors. In fact, one is the global macro situation, which has once again reared its head in terms of the European crisis. We have seen the Spanish bond yields crossing 7.5%. Overnight, we have had Moody’s looking at potential downgrading Germany’s sovereign outlook. Obviously, the US fiscal cliff concerns remain in addition to what’s already happening in India, firstly the monsoon and secondly, all eyes on New Delhi right now given as to what sort of reforms the government will bring in. But I think you got to put the overall outlook in context.
As far as Europe is concerned, our view is that it will remain volatile. This is a long-term problem. It will not get resolved overnight, therefore, as far as we are concerned, in India, you got to look at the real outcome one of which is you will see a sharp decline in bank lending. Therefore, economic growth in the west will be quite low. Secondly, as far as flows into emerging market equities including India are concerned, it will be fairly volatile and India will go up and down depending on that. So I think a lot depends on how it progresses from hereon. Q: Last few weeks, flows have not been very volatile though. As opposed to earlier instances when Europe news flow would worsen, we would get those periods of huge outflows. What’s different this time around in the last five or six weeks?
A: As far as India is concerned, flows have been better. Part of it is also driven by deterioration in the economic outlook in some of the other emerging markets. China, in particular, I think we have seen a fairly sharp downgrade, lot of bad data coming out and the quantum of monetary easing, policy action have not kept up with expectations.
Meanwhile, the economic growth outlook in Brazil has also been downgraded. In Brazil, we are expecting now just barely 2% GDP growth this year. So we think India is bad at 6-6.5%, Brazil has fallen off to 2%, China is slowing down to about 7-7.5% this year. So in that context, India on a relative basis is looking fairly attractive. Keep in mind the earnings downgrade, the sentiment on India, the pessimism on India has been actually carrying on for quite a while whereas in some of these other markets, things are only now beginning to turn towards the downside.
So I think that is leading to some flows into India on a relative basis. We have had relative stability until very recently in Europe in the last few weeks, which has led to flows into India. Q: Are you optimistic that the government will be able to push home this relative advantage or cemented by doing something over the next 14 days?
A: We certainly hope so. I think otherwise if they don’t I think we are in for a pretty serious sustained downturn for the next two years. The next two weeks and also the next few months are probably the only window the government has otherwise you have something like 11 state elections between now and May 2014 when the general elections are due.
The government also has to do something to prevent a sovereign rating downgrade which is a lot of the rating agencies have already warned about. So in our view, they need to do three things. Firstly, take some steps on cutting subsidies. Secondly, do something on attracting foreign investment, and most importantly, attracting or rather boosting investment, especially infrastructure which is a big bottleneck area for the economy as a whole. So we are hopeful.
_PAGEBREAK_ Q: What do you make of IT now? There have been bad reaction to Infosys and Wipro results and even TCS has not done a whole lot despite good results. Are you also cautious on this space?
A: It depends on the investment horizon. For the next quarter or so, the outlook is a bit challenging, the growth estimates unlikely to be revised up, but I think you also got to look at the valuations, and more importantly, the longer term outlook. Keep in mind that firstly the core markets in the US and Europe for these companies there is still a lot of cost pressure, there will be more offshore outsourcing.
In that context, Indian vendors will benefit, especially given the rupee depreciation which has been fairly sharp this year, so the cost advantages will come to play. Also, these stocks generally at the current levels are trading more or less at the market multiples and given their balance sheets, their free cash flows, their relatively superior corporate governance, these stocks from a longer term perspective still look pretty good. You will have quarterly variations, you will have individual stock issues here and there, but fundamentally we are actually quite bullish on the sector. Q: What about FMCG, there has been some talk that they are too expensive. If one has played the defensive game for too long, too many quarters then it’s time to slowly start switching out but HUL is not giving an opportunity to switch out?
A: Part of it is also driven by concerns about the monsoons and slowdown in the rural segments. But I think some of these valuations while they are expensive, this is also consensus view and there is also question of lack of alternatives.
Which are the sectors would you put your money in, which are equally safe and where you have earnings visibility and stability of free cash flow etc? We think that as you get closer to the general election you will start seeing more entitlement like the food security bill, perhaps the land rehabilitation bill etc, all of which should be positive for the rural sector.
In that case, these companies, from 12-24 months view, see their earnings being reasonably robust. Therefore, the premium valuations versus the other sectors may sustain. Given the overall macroeconomic uncertainty both around the globe and in India, these sectors will continue to do well. So we think it’s a bit premature to pull the trigger, to get away from these stocks. But it will be very stock selective, some stocks like the one you mentioned are doing well, others facing margin pressures because of higher raw material cost or higher ad spend. So you will have to be very stock selective in the sector. Q: What are you telling your clients to do on autos because there too a couple of them have met with accidents; Maruti and Tata Motors both have come off quite a bit and two-wheeler numbers have been weak. Are people getting circumspect on that sector?
A: Yes, we have been advising caution on the automobile sector, a) the volume growth is going to be much lower b) we think the competition is intensifying so therefore there will be margin pressure and c) the valuations are no longer as attractive given the slowdown in earnings growth.
Therefore, overall whether it’s the two-wheeler or the four-wheeler sector, we are advising a lot of caution. We had few stock specific issues lately but in general we have been advising caution. We think this won’t change in the next few months unless these stocks come off a lot more. Q: Over the last couple of months, we have heard a lot of the global investors talking about becoming very stock selective, suggesting that the Nifty might grind in a range but individual stocks might generate alpha. It has for the last couple of months. Do you see that continue?
A: Absolutely, Deutsche is one of the largest international brokers in India; the flows we have seen on our pad a lot of it has been driven by large global long only, very stock specific investments. These are not people who have gone out and bought the Nifty in a large programme trade or whatever. So it is very stock specific, they have gone after specific stocks driven by certain valuation attractions or on a long-term fundamental view. This will be the case for the market as a whole for the rest of the year unless we get a dramatic shift in the macro environment and let’s see how that pans out. But in the absence of that the stock specificity will continue, this will remain a stock pickers market for the rest of this year in our view. Q: You think this is a part of the bottoming out process for the market where individually stocks start bottoming out and the downside is restricted. We are not looking at 20% kind of waterfall declines as has happened in the last few years?
A: I would agree. I think there is so much pessimism on the market, on the macroeconomic outlook for India on the rupee, the fiscal deficit etc. Earnings growth expectations have come down dramatically. Our estimate is around 12-13% for this year. The street is sub-10% when you speak to investors. So there is a lot of pessimism already built in and the same also holds true at the stock level with a lot of the stocks. Therefore, if at all there is any positive news, positive outcomes could lead to surprise. But for the index, as a whole, you could stay range bound but individual stocks over a 12-18 month period we could see significant upside. Q: Where do you suggest the maximum absolute gains will be made from here because a lot of the institutional investors like to play the relative game?
A: In terms of returns, one has to keep in mind the risks over there. So what we are advising right now is keep risks low. Stick to companies with strong balance sheets, strong cash flows, good corporate governance and good execution track records. In such an environment where there is suddenly a risk-on or risk-off mode, you do not know which way the flows will go and also the domestic macroeconomic situation is still fairly unclear.
Within those sectors where we think absolute returns from two-three year perspective, where earnings will still be in excess of 10-15% for each of these companies that is where you will make your money even if there is no PE rerating upwards. Q: What is your global team telling you that the European situation or the global situation will remain a wall of worry which the market will be able to climb without getting into serious accident like situation?
A: The tail risk of an accident always remains. Our view is that this situation will remain volatile. I think what matter is the end economic impact as far as we in India are concerned. You will see the bank lending in particular for example, coming off that in-turn will affect underlying economic growth which in turn will hopefully as far as India is concerned lead to lower commodity prices specially oil.
At the same time, there will be ups and downs in emerging market flows for equities. There is a flight to safety with bond yields in the US and Germany, actually you have negative bond yields over there in real terms and that in-turn will determine as far as the flows to India are concerned. On relative basis, India is looking reasonably attractive compared to China, Brazil, Russia and some of the other export oriented markets in Asia. The only thing that is holding India back is our own domestic policy inaction. If we get some movement over there, we think India could be a beneficiary of fairly big flows given the amount of liquidity globally.