Market meltdown: The best & worst case for remaining of '13

It has been over sixty-five years of independence but this is the worse macro economic situation so far. India has a decade low growth due to rupee deprecation and twin deficit. 

Also Read: Why Mark Mobius is staying put even as Indian mkt bleeds

CNBC-TV18 interviews Manishi Raychaudhuri of BNP Paribas Securities and Punita Kumar Sinha of Paradigm Advisors to discuss the issue. Below is the verbatim transcript of their discussion on the channel. Q: What do you think of the way the market has shaped out over the last two weeks? The macro is bad and while the index may not reflect that, the broader market is showing that we are in one of the worst bear markets. Do you sense any opportunity going forward? Raychaudhuri: The situation around the Independence Day was not too dissimilar. Even the 2012 Independence Day and the 2011 Independence Day was not exactly euphoric. In 2011, it was brought about by the problems in Europe and by 2012 we were beginning to feel the slowdown in quite a serious manner. But around mid-September the finance minister came up with certain set of packages. Today, the broader market is not an indication of what is happening on the ground because the Sensex or the Nifty, the narrow indices, they are being held up by a certain set of stocks possibly just about 8-10 in the relatively defensive sectors like IT, pharmaceuticals and consumer staples while the cyclicals both domestic cyclicals like banking, industrials and the global cyclicals like materials are performing badly. They have got completely decimated. In the near-term, that situation may not change too much because if you look at the basic variables that are driving such forces, they are unlikely to change in the near future. You have sticky high inflation, which was quite apparent in today’s data. You have the rupee staying weak, which in the near-term is likely to remain that way and you have very little movement on investment acceleration -- that investment climate with the lack of confidence on the part of corprorates and even government sponsored infrastructure investment slowing down. That situation is not correcting itself anytime soon. In the near-term, investors preference for the quality stocks for the relative defensives is likely to continue. Within domestic cyclicals, there is certain set of stocks that were beaten down to such an extent by the market in course of last couple of months that there is some degree of entry opportunity arising in some of those particularly for the investor who genuinely have a long-term outlook, about 12-18 months or even longer. Q: A lot of blue-blooded brokerages have now started to scale down their year-end Sensex targets on the fear that a meaningful revival in growth looks illusive. Do you believe as well that this market deserves to trade at lower levels? Sinha: Given the economic environment and the challenges in India, I wouldn’t rule out the fact that there could be more correction. But you also have to look at what is happening globally. We are heading into September and September is when most of the fund managers come back from their summer vacations and look at the portfolios again and decide where to position themselves for the remaining year. In this September we are having three interesting events. First, we will look at what Ben Bernanke does with respect to the bond buying because that is something widely talked about. We may see a new central bank governor in the US and also in India. So there will be some changes and that could create volatility. Now, that could be good volatility or negative volatility. Q: Now that the rupee has not seen any recovery, there is a fear that there would be another set of measures that might tighten liquidity further, how spooked should a market watcher be with regards to what the RBI may announce next? Raychaudhuri: That is a genuine concern because the RBI’s recent measures have not been successful in stabilising or curtailing the depreciation of the rupee. The rupee continues to hover in that range of 60/USD to 62/USD. If we do have another round of depreciation, suppose it goes beyond its earlier low of 61.5/USD then the best case could be that RBI’s liquidity tightening measures could continue for longer and the worst case could be that there are even further set of measures that are announced by the RBI to do the same thing. Today, we are focusing too much as far as the policy making is concerned, we are getting too much focused on bridging the gap that has been created by the current account deficit (CAD) and the trade deficit but instead we should be looking at reducing that current account gap itself. Some part of that has come through in terms of putting curbs on gold imports, gradually increasing the import duty on gold though some part of gold imports could move over to smuggling and other non-traditional channels but maybe one should try that on even the luxury goods, the massive degree of electronics goods that India imports. Even to some extent, the electronic goods imports and the capital goods imports, these two are almost about USD 100 billion every year. Even 5-10 percent reduction in these could bridge that gap quite significantly. Q: Let us talk about the flows then because so far we have not seen long only funds give up on the Indian market, despite the relentless bad news that we have seen, do you think at some point the FIIs will run out of patience and say let me get out of this market? Do you think there is a fear that there could be a large scale exodus soon? Sinha: Looking at the flows this year, India has received decent flows compared to some other large emerging markets despite the fact that we have several economic challenges. Most of the portfolios are generally neutral to overweight on India. Most funds are not underweight but again considering valuations in India, they are beginning to get attractive until for the last six-twelve months, valuations were in the fair value range because the multiples in India were around 14 times but with some corrections and also particularly the rupee weakening on a dollar terms valuations are beginning to look a bit more appealing. We have the macro uncertainty but purely on valuation, I am not sure people want to just give up on India at this point. Q: What would convince an investor that maybe now is the time to make a shift? Raychaudhuri: When we talk about domestic cyclicals, I would like to make a distinction here between the relatively high quality domestic cyclicals and the low quality ones. The low quality ones, there were second and third tier infrastructure stocks, they deserve to trade at the valuations that they are trading at. Now, global investors have been actively trying to avoid leverage and that is where many global cyclicals like materials and these second and third tier construction names fit in. But if you look at the entire domestic cyclical space, there are quite a few relatively high quality stocks that have also declined in the near-term since this concern about liquidity tightening by RBI came about, they have declined anywhere between 15-30 percent. Even HDFC Bank and HDFC have declined about 12-15 percent till their recent bottom. So there is a very restricted set of relatively high quality domestic cyclicals. I name the HDFC and HDFC Bank family, even ICICI Bank would fit in there. Some of the larger engineering companies like Larsen and Toubro (L&T) maybe some of the auto companies like Mahindra and Mahindra (M&M), maybe a couple of power companies and even Power Finance Corporation (PFC), the regulated power companies like National Thermal Power Corporation (NTPC) or Power Grid, we are working with that set. In this manner, you can figure out about 8-10 stocks that are of relatively better quality which offer the investors some visibility about revenues and cash flows but are trading much cheaper than they historically did. _PAGEBREAK_ Q: How are you positioned on some of these auto names? On something like Tata Motors specifically, we have seen a super run on that stock. Now things seemed to be improving in Europe too. Do you suggest investors take a call there? Raychaudhuri: Despite the slowdown, the entire auto space has seen some very incipient signs of recovery, particularly on the four wheeler side. We have an overweight on the auto sector in our India model portfolio. In the near-term, we should continue with that. One beneficiary of what is being happening right now is Mahindra & Mahindra (M&M). It is likely to benefit from better than expected monsoons and the consequent support to rural consumption. Tata Motors is another stock that we like; partly because it has foreign currency earnings and with the rupee depreciation, that translation benefit accounts for significant earnings upside. Sales volumes of Jaguar Land Rover (JLR) both in Europe and United States seemed to be improving. Those are some of the core holdings in our suggested model portfolio. There were a couple of two wheeler names - Bajaj and Hero MotoCorp which also could benefit from this support to rural consumption. In case of Hero MotoCorp one could even see benefits coming in from cost cutting program that the company is currently embarking on. In an environment where stock selection in India has become relatively difficult, some of these select auto names do provide some investment opportunity. Q: So far you could just rush to some of the safe havens like Fast Moving Consumer Goods (FMCG) and pharma. For last two weeks we have started to see some signs of correction over there. Hindustan Unilever (HUL) and ITC corrected a bit. Pharma stocks have also started correcting. Are you sensing that even these sectors are now threatening to breakdown? Sinha: It is actually a tough market to be really finding and positioning yourself in for the short-term. You can position yourself for the long-term. What we are seeing globally is somewhat of an economic recovery. We are not seeing that in India, but globally, particularly whether it is US or Europe, people have started positioning themselves into cyclicals, a little bit away from the outperformers, consumers, pharma and others. There is going to be some rotation potentially into cyclicals even in India given the valuations. Hopefully things will improve going forward, because the measures are being taken. Things are unlikely to get a whole lot worse economically, at least in the short-term. I would start looking at those sectors. The rest of it has to be taking a fairly balanced approach as it is not the environment to take on a whole lot of risk. But you cannot be sticking to the expensive stocks either. India is a big market. Even in the consumer space and the FMCG and other sectors that have outperformed there are stocks that are still high quality but not so expensively valued. Q: IT and pharma have done well due to the rupee depreciation. IT has been a big support for this market, both Infosys and Tata Consultancy Services (TCS). They have rallied quite a bit. They both have big weight in the index as well. Will they continue to outperform or would you be tempted to book some profits over there? Raychaudhuri: We have an overweight on IT. Our favourites are HCL Tech, Wipro, followed by TCS and Infosys. One of the reasons is that HCL Tech has clearly demonstrated its ability to win new orders in the current environment and among the large caps it is possibility the most sensitive to rupee depreciation. On pharmaceuticals we have a neutral stance on the portfolio and while those stocks are doing better than what they did historically, particularly scrip like Sun Pharma which has demonstrated the ability to constantly get new drug approvals and launch new products in the United States, valuations in pharma are even more demanding than in IT services. In the near-term when capital preservation remains the focus investors' attention is likely to remained focused on both these sectors. Q: There are some high quality names in the capital goods space like L&T. The key problem of this economy is that there are no signs to believe that the investment cycle is reviving. In such a situation, you just want to stay away from some of these capital good names. How would you then justify your view on Larsen and Toubro (L&T)? Raychaudhuri: If you look at the last couple of results from L&T and even their commentary, what the management has talked about they are actually maintaining the guidance as far as order book growth is concerned. They are quite confident that the order booking growth of close to 15 percent or maybe slightly higher is likely to come through. It is quite clear that they are not banking purely on the domestic orders but also going out of India and that today contributes about 25-30 percent of their order backlog. The only concern seems to be on margins. It is partly a consequence of focusing outside India because those orders tend to be at slightly lower margins than the domestic orders. However, at the same time there is no alternative today and as a consequence L&T's topline or the order backlog which is a bigger driver of the stock price would possibly stay intact. Not only does it have proven expertise in most areas of engineering, construction and capital expenditure it also has a de-leveraged balance sheet. Its debt to equity ratio is hardly above 0.2-0.25 which enables it to take on more leverage on the balance sheet and bid for new projects and that is a very important differentiating factor in this sector. _PAGEBREAK_ Q: Give us a bird’s eye perspective on this market. Eventually, it is all about how much flows come into Indian market. We have seen a huge divergence in performance between developed and emerging markets (EMs) since the start of the year. Do you see the developed markets outperformance continue as we head into the end of 2013? Sinha: The developed markets are definitely showing more economic recovery than EMs. Only some of the data recently from China shows a little bit of encouraging data but broadly speaking US and Europe we are seeing good data. The key factor to watch in the US is unemployment rate. It shows that economic activity is picked up and unemployment is reducing that means that we are on track for economic growth. However, valuations in the US markets are now are not as attractive as emerging markets and their divergence is above historical averages. Off late there is some value emerging in emerging markets and so there is some shift that is happening. If the bond buying program is triggered in September then it can have two effects on emerging markets, either people will generally pull money out of equities. Or they might feel that one should be pulling money out of developed markets a little bit and adding to emerging markets which are trading at fairly significant discount to developed markets. Q: What would be your best and worst case scenario for the market as we head into the last three or four months of this year? Raychaudhuri: We have a published, formally communicated target of 21,300 on the Sensex. We arrived at this target right at the beginning of this year and haven’t changed it. It was then indicating just a very small upside of about 7-8 percent, but we anticipated some downsides to the earnings estimate and therefore we felt that was fair at that point of time. I don’t think anyone anticipated that the rupee would be at 61 or 62, as it is right now with the possibility of even further depreciation. As Punita mentioned just now that if the Fed’s bond buying programme has actually began to be tapered off, then the USD would appreciate against all other emerging market (EM) currencies as it has been over the last few days. Countries with a significant current account deficit (CAD) would suffer even more in terms of their currencies. So, if that is the eventuality, that we have faced with from September or October onwards, then the market can even stay here or even decline further and that would constitute the worst case. The best case could be a kind of a recovery which in the near-term one can’t really see any driver apart from liquidity. Some proprietary models forecast liquidity based on central bank’s balance sheet expansion, which were indicating about three months back that liquidity into EMs equities and Asian equities could recover from around November-December this year. Having said that, the guidance of Fed about bringing forward the tapering target, that wasn’t on the table at that point of time. So, it is rather difficult to talk about a best case in the current environment, but the worst case could even be another 10-15 percent down from here.