Market reversal still far away, prefer pharma, IT: Axis Cap

Indian market is in the end of capitulation stage but remains at quite a distance from the beginning of a new cycle, says Nandan Chakraborty of Axis Capital. Since valuations are not low enough and dollar hasn't started falling, markets would take time to reverse, he justifies.

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Meanwhile the rupee depreciated further to hit a fresh all-time low of 64 against the dollar. While the rupee is in the midst of currency war, it is imperative that the country's central bank takes a cautious approach in dealing the crisis, he told CNBC-TV18 in an interview. Chakraborty is certain the impending elections will prevent the government from taking any definitive steps to tame the rupee, save raising import duties; hence the onus is on the Reserve Bank to come forward.
In the current situation, his advise is to stay with both Pharma and IT stocks although pharma definitely commands better pricing power. Below is the verbatim transcript of Nandan Chakraborty's interview on CNBC-TV18 Q: A lot of your peers have scaled down their Sensex and their earnings target in the last couple of weeks, where would you be placed on the index?
A: It is impossible to view what will be the view of the index in the very short-term because obviously a lot of it is expected and we are going into things which are more of a vicious cycle. So I think this quarter should be among the worst that we have seen and we should start seeing some improvement in the next quarter. That is of course predicated that successfully that battle being fought by the Reserve Bank of India (RBI) and the harvest coming in and so on. Q: Is there adequate valuation support to this market or do you think prices could adjust way below where they are right now given the kind of confluence of negative fundamentals we are dealing with here?
A: While we are in possibly the last stage of the longer-term cycle which is the capitulation stage where people sell even their family jewels in terms of stocks, I think we have reached that point but the point where you are going to start off the first stage of the new cycle is not near.
Usually that is driven by three-four factors. One is when valuations are so low that they start climbing a wall of worries. Markets don’t climb a wall of worries when the valuations are high. While they are not high, I don’t think they are low enough.
Second trigger that usually comes is regulatory but post elections I don’t think anything is happening in the near-term because the burden is coming more on the RBI rather than the government to do things for the obvious reasons. The government itself is not in a position to do anything long-term and it is doing a lot of short-term fixes, which will hit us as time goes on. For example, things like trade agreements with China and so on are a bit biased. So in desperation it may do certain things like increase import duties but that just increases your inflation.
Coming back to the point one is valuations are not low enough, regulatory changes of a nature to start the next cycle haven’t started, the dollar has not started falling which is probably a third trigger.
The fourth is there is enough desperation to make the RBI shift to growth rather than monetary policy and therefore start decreasing interest rates. That stage is also far away.
So any of these could happen over the next few months but we are a bit away from the beginning of the next cycle while we are in the end of the previous cycle which is the capitulation of family jewels.
_PAGEBREAK_ Q: Have valuations corrected enough, if you look at the climactic phase of previous bear phases, valuations usually get down to nearly 10 times before they start moving higher. So do you think this could be the start of the capitulation phase and prices may get hurt much more from here before we end this capitulation phase?
A: We did a study of cycles in our previous strategy report and the market does get intensely polarized towards the end of the market cycle which as you have seen and it is only when – because the average P/E doesn’t have any meaning. The average has no meaning. It is obviously linked to the – earnings yield is linked to bond yields and so on but those relationships break down. The only thing that you can see at the end of the market cycle is whether the polarization is getting reduced or not. We see today that some of the polarization is indeed getting reduced as the family jewel gets sold. I think that is a stage we are in so we are in the capitulation stage, which is the last stage of the cycle but quite some distance away from the beginning of a new cycle. Q: I am not talking about the overall market, I am talking about the ones which are just beginning their correction – do you think the family jewels will need to adjust a lot more than what they have already, cases like ITC, Hindustan Unilever Ltd (HUL), HDFC, HDFC Bank, Sun Pharmaceuticals, do you think there is a lot of room for valuations to compress on the way down?
A: Yes, I think so. In the near-term they will take a little more time to compress given the fact that times are still so bad in terms of the interest rates and currency and so on. So they will take a little bit of time to compress. So the taste of the pudding is when it compresses that means that is offsetting the factors, which are making their defensive premium stay high. So they could come down far more.
But it will take time because in the near-term people will still remain consumption focused. Q: This has turned the story on its head. Did you even imagine that market bond yields would go up to 9.5 percent?
A: Not at all. We were among the first in February to predict that the rupee would depreciate and we had imputed that in the numbers of our Sensex companies and Nifty companies and so on. But we never expected it to go this high. Two things happened simultaneously. One was the US bond yields went up and the emerging market currencies went down. At the same time the government also sort of fiddled and the administrative measures as I mentioned earlier were insufficient to get capital flows in FDI, FII and debt.
The third is the globe was also not induced to put in cash in emerging markets in India at a time when they have their own problems. So as the US growth continues, what you will find is the order of things because sometimes there are so many variables around that you will get a bit confused about what to do. So my suggestion is as follows. Number two is in the midst of the battle it is very difficult to know what will be the extent and the duration of the battle. So you will get whipsawed.
So when you are in the middle of a currency war - and then the RBI has to calibrate each measure so as to not to show great desperation or defeatism, for example, in the quantum of the bonds that it will raise so that it gets oversubscribed and not undersubscribed and its intent. Those times it is important to keep your cool and not to get swung to this thing. Therefore, order of your thinking should be in number one is what will happen to US growth and QE. That is paranoid because that affects everything else.
If you are in the camp that the US growth will lead to QE tapering off and the jury is still out on that which means there will be a two-stage reaction. The first reaction is that the largest pool of wealth in the world is US bonds. So obviously the first stage is US bonds moving to US equities and therefore the dollar strengthening. It is only the second stage where this huge amount of money, which then gets into US equities then overflows into emerging markets and so on and so forth.
So if the QE does not taper off, it is again continuation of the steroids and not good for India in the long term because ultimately people are not going to put up capex even in India. You are not going to have an investment unless the world grows. It is not just regulatory policies and so on, you also need that optimism in the world. Most important factor is what happens to US growth and therefore what happens to QE.
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Second, in order you must think about whether there will be early elections or no, so whether it will be in the winter holidays or back to summer holidays. Reasons for that are obvious, I don’t want to go into it whether it is early elections or not.
The third in order is to see when inflation will be tamed because your RBI’s currency war has been successfully fought which then matches with your harvest time and demand and therefore if it happens in the October to December period that you might have – what I would call is a misleading rally because that is the time on a year-on-year (Y-o-Y) basis, you will show great consumption discretionary and so on. So I think this is the order of things in one’s mind in terms of thinking. Q: How long do you think IT holds out?
A: The thesis of the world right now is on US growth. So anybody who is obviously linked to US growth will do well in the short-term and the valuations are not very stretched still. However, remember that pricing power and bargaining power is more with pharmaceutical companies compared to IT companies. It is just that because most IT companies have such high governance levels in so much cash that people prefer IT to pharmaceuticals. In general, I would give equal importance to pharmaceutical and IT in the very short-term.
People should start thinking about time diversifying their portfolios, short-term obviously is pharmaceutical and IT because of US growth. The medium-term would be consumer discretionary as the currency battle is solved and therefore the pre-election money starts coming in and so on and liquidity comes back into the system. Obviously any new government which comes into place will have to get in capex otherwise the consumption benefit that we have been getting is doomed because the hirings in high spend industries like banking, IT, telecom, services, some of these are obvious unless capex goes up and unless we get back, your consumption is not going to take off in the long-term unless capex builds in. So any new government will get capex in, which means back to things like cement and Larsen and Toubro (L&T) and infrastructure and so on. There is some amount of time diversification which needs to be done in portfolio at this point in time. Q: I want to engage you on this last point that you made about how a new government would automatically have to trigger capex. What if the same government comes back to power, the United Progressive Alliance (UPA) government, it has been saying things about reviving capex for the last 18 months without any major dent in the investment mood, how would that miraculously change if they came back to power?
A: I am not taking a position on any particular government. What happens typically and this is something which we have read a lot of stuff on what has been happening in India over the last 20 years specifically. What happens if there is a government and it is specifically a prime minister, who has very good people skills and who is able to engage with the states then the things get done otherwise they don’t get done. I don’t want to go too much in depth but you have seen that over the last so many years. So it is not necessarily that the majority government get things done or that a particular government and its ideology gets things done.
But leaving outliers aside, all that we can hope and pray for is that we get a prime minister who can engage with the various states, engage with the opposition and then get us out of this mess and everybody knows that the basic kick starting of the economy has to happen with capex. That engine of consumption will be dead very soon and it is in the government’s interest to do so otherwise there is a sword of Damocles of the rating agencies and so on. So while it is important that the government do capex, I don’t think it is 100 percent sure it is just that things like land acquisition and stuff like that and FDI many of them which read implementation level by the state, it is important of a prime minister who engages with the state and gets it done. Q: All that you said is true even today, so why will it happen suddenly in May next year when it cannot happen now. All that you said about the need for the investment cycle to be regalvanised is true even today and the government is saying it is trying but it is unable to do anything. So how will it change in May next year after the elections? Is it just hope or is there a germ of conviction in what you are saying?
A: That is a point. I do not want to make any stand for any particular government or any particular person but we can say that while the government has had its intent, it has not been able to engage the opposition and it has not been able to engage the states so far. When you come out with a new government, it is a new complexion. You may or may not have the same people even if you have the same people, you may have different leaders, we don’t know but this is a hope. The imperative is capex, I think the path to that is somebody with good people management skills to be able to implement it.