Blame rupee fall on CAD; mkt in for deeper cut: HDFC Sec

Structural problems plaguing market have been there for sometime, only it is more visible now, says Dipen Sheth, Head-Institutional Research, HDFC Securities. Earlier it was hidden under global liquidity flows, he adds.

With signs of US tapering its bond buying programme, FIIs are pulling out and there is general mayhem in the market, Sheth told CNBC-TV18.

He says despite all the corrective actions taken by the RBI, it can only do so much, policy in governance evolution needs to move up dramatically if things were to change or improve. 

According to him, the currency weakness is completely driven by the huge current account deficit. Markets are likely to look at incremental signs of curing or corrective actions not taken by the government, which will only lead to further downward pressure, he adds. He sees very little reason for investors to flock back to India.

With the RBI-triggered liquidity tightening situation, overleveraged companies may be in for more pain, Sheth says. Along with the higher borrowing costs, lower EBITDA margins and lower cash generations of these companies, over a period of time their equity value is likely to vanish in terms of having to service the kind of mountain of debt that is sitting on them.

Below is the verbatim transcript of Dipen Sheth's interview on CNBC-TV18

Q: We were talking about this possibility last time we spoke, does it look like it could get uglier from here?

A: I would agree with you there. We have a structural problem and we have had it for a while. It is just that it is getting more visible now, our warts – if we can call them that - were hidden under global liquidity flows for a while and at the first sign of the tap closing down or even the threat of the tap being tightened a little bit, there is mayhem in the markets and I hate sounding like a bear but this is the beginning of some more pain to come, maybe a lot more pain to come in terms of where the markets are going. In terms of where the economy is going I think the first few corrective actions have been taken by the Reserve Bank of India (RBI) but the RBI can do only so much and policy in governance evolution will have to move up dramatically if things have to change meaningfully from here.

Q: Where is the latest bout of selling coming from, have you tried to analyse that? There is selling in the futures markets from global funds but not so much in the cash market, these kind of falls that you saw on Friday, where is this capitulation coming from?

A: In a tightening liquidity situation, which is what the RBI triggered and rightly so I would believe from a macroeconomic perspective sometime ago, but in a liquidity tightening kind of situation, it is the leveraged plays, whether it is the banks which are naturally leveraged and it is obviously the corporates, which are overleveraged or are overextended, which have been taken the beating and I do not think Friday was any exception to that.

In fact we saw some overleveraged names cracking on Friday and I think that is going to continue for a while because if you take higher borrowing cost for them, if you take lower EBITDA margins and lower cash generations of these companies, over a period of time you will see that their equity value will just vanish in terms of having to service the kind of mountain of debt that is sitting on them.

Q: What is the stock market more worried about right now, the fact that interest rates have hardened about a couple of percentage points, the way the yield has moved or the way the currency has been moving to fresh lows every week?

A: Unfortunately, it is a little bit of every thing. So you have yields – we are at about 10.9 on the 10-year bond right now, which is close to about 170-180 basis points (bps) higher in terms of recent lows at least and that is a dramatic movement. So any rise in the bond yield is a natural destroyer of value on the stock market. I don’t need to tell you this in more details.

The second thing is of course that the currency weakening. Barring the tightening and the capital control measures that the RBI has taken recently, there is very little that inspires on the currency front especially when you look at the fact that the currency weakness is driven entirely by the current account deficit (CAD) weakness and by the concerns on the CAD and none of those concerns are looking like they are going to go away in a hurry.

So I think the way markets will take this forward is that they will look for incremental signs of curing and so long as those incremental signs of curing or corrective actions are not taken by the government, which to my mind in an election year are absolute no-nos, so long as these signals don’t come, there will be a drift downwards, once in a while it will be a crack, once in a while it will be a slow drift but yes, the overall direction is down.

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Q: Do you see the possibility of big pullback rallies or do you think the fundamental case for these rallies are getting weaker with every passing day?

A: I would tend to go with the latter conclusion. There is very little in the market or more accurately in the economy, which would inspire investors to flock to India. The more we get into this spiral, the more difficult it becomes to make a high conviction case for investing. So we are stuck in a downward trend for now and some very strong policy actions improvements in the distortions that poor policies have inflicted on a number of markets within the country. So if some of that reverses then flows will come back and then that again will have a positive spiral effect. But we are sometime away from that given the kind of political uncertainty that lies between now and May next year.

Q: Any sense you are getting from your high networth clients on the kind of pain that is playing out in the fixed income market because bond yield is almost at 9 percent which might have meant or would have meant serious capital losses for many of the duration funds?

A: I leave that for my colleagues at the retail brokerage to address. We advise institutional investors. But yes, I would agree with you that spike in yields would obviously affect long duration or income funds with long duration bonds in them but the close-ended funds so long as the money comes back into FMPs and so on, I don’t think there would be pain there. So if you had a 12-month or a 24-month FMP, which is up for redemption, so long as the corporates redeem the papers that they had borrowed, I do not think there is an issue there. But certainly, for income funds with longer maturities, open-ended funds, there would be significant erosion of value right now.

Q: Do you think this curious situation of the market underperforming, the rupee falling but FII outflows not being significant will continue for the next few months or do you fear at some point some FIIs will throw in the towel?

A: Yet again I would go with your latter conclusion. There is a tipping point beyond which FII money will not hold back. We are in the middle of a potential tipping point of soughts. If one looks at the last 4-5-6 weeks of flows one will see negative numbers. If one looks at the last 4-5-6 months of flows one might see a positive number, a large positive number, I think their faith is getting severely tested here and on two fronts. One, in terms of markets falling down, two, in terms of currency cracks because they have to earn in dollar denominated returns so at some point of time there will be concerted FII selling and to my mind it is a little bit like the upcoming elections and what people have to say about them, the sooner we get over with it, the better.

Q: How you have read this recent fall in high quality blue chip names across sectors - do you think the part of the FII selling might have started or are these domestic investors getting out fearing that, that is inevitability?

A: I think the thing to take away from recent investor behaviour is that there is a very clear and visible sector churn of soughts playing out and the disillusionment with the financials which might still hold some 25-27-28 percent of the lead indices. That disillusionment is playing out very clearly. Initially we saw it happening in fast moving consumer goods (FMCG) over the last year or so as financials began to lose their strength over the last six months especially. Now with FMCG valuations looking stretched to put it mildly barring a few names, I think the movement towards IT and pharma and I completely agree with you that these are crowded trades, the movement towards IT and pharma are getting pronounced.

Q: What does one do now – what it comes down to? There is so much of HUL and ITC that you can buy, what is the prudent course of action?

A: Maybe the prudent course of action for domestic funds might be to switch to a little more cash and I don’t think that is as sinful as it sounds. The prudent thing might be to hold even fixed income for a while. I don’t know how the term for preference for a number of equity firms are structured but surely at times like this they can hide under some umbrellas while there is a strong blowing outside. There is no need to be compulsive about equities unless one is a complete equity junky.

I think one should look for safety. I don’t think one should completely get out of equities. There are high quality names available at attractive multiples. I am getting tired of saying now that IT is a very-very good option I have been saying it for over a couple of months now. I think barring the top one or two names they are all south of 15,000. There is no convincing case for FIIs to be selling out of IT right now. Whether it is IT or whether it is pharma, any further cracks in the currency will help them, the healing of the US economy is going to help them particularly IT and I don’t think these stocks are going to fall in a hurry. The till towards FMCG can now be tempered a bit with IT and pharma and going substantially in to cash or fixed income does not seem like a very bad idea.

Q: Is gold coming back slowing into vogue because that is what some people have written off but that has been more resilient and come back quite a bit over the last few weeks. Do you think it is coming back in the psyche of the local investor?

A: Yes. It is most certainly so and the falling rupee has helped that. The clamps down on gold imports in at least two or three different stages by the Reserve bank of India has actually added fuel to the fire so to say and while that is a natural reaction of markets, I think over a sustained period having a 10 percent import duty on gold is a terrible way of punishing domestic savers. What kind of choice do they have? If one is buying gold I don’t think they are doing something that is terribly wrong. I think for a change the Indian retail investor has got it completely right and he or she has been saving on gold for the last couple of years. I don’t think it is fair to punish them.