Market may see strong run up to Budget: BofA Merrill Lynch

The government has initiated many bold reforms over the last three months. In an interview to CNBC-TV18, Jyotivardhan Jaipuria of BofA Merrill Lynch says the market will see a strong run up to the Budget. "The expectations are that the reforms will continue in the Budget. We could get some positive announcements in the run up to the Budget," he asserts.

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According to him, the earnings will be generally weak, not very strong. "I think the key thing, in January, will not be the earning season, but the Reserve Bank of India’s (RBI) policy," he adds.

Below is the edited transcript of the interview. Q: How will the market react to the Gujarat election result? Would there be reason to celebrate if Narendra Modi wins with a fairly significant majority?
A: Past history of most Assembly elections shows that these events have not been market moving events. So to that extent, the impact on the market has been quite muted. If Narendra Modi wins, then in one way we could look at it positively is that development counts in election. Modi has fought on a development agenda for the last ten years. If he gets another term on the same agenda, then it would be a lesson to a politician that people do consider development when they vote. So, reforms are important, development is important.

Q: Do you think the government will have to go into defense mode reforms-wise and come out with more populist measures? Or can they carry on with the tact we have seen through the parliament session?
A: If we look at the Gujarat opinion polls and the exit polls which came out, it was generally expected that Modi would win. So to that extent, I think all the exit polls are showing him wining by some two-third majority. I think and even the Congress probably is expecting something like that. So I do not think it will mean a major change in reforms process for the Congress. Q: What is your prognosis for 2013 now? Do you think the market can build on such a strong performance in 2012? Or is it dangerous to extrapolate this year’s trend?
A: If you look at what happened in 2012 fundamentally, gross domestic product (GDP), earnings growth, analysts earnings, were all negative. Markets on the other hand, have given a decent return, partly on the expectation that we are bottoming out on most of these fundamentals and things will start looking better.
So, that is what we will have in 2013, where the fundamentals look better. We will have a mild recovery in GDP. We will have a mild recovery in earnings. Earnings downgrade will probably not be as severe as what we have seen in last two years. Plus, we will have rate cuts. To some extent, the market has discounted this. I still expect a positive return,  but it will be lower than what we have got this year, because we will probably end this year between 22 percent and 25 percent return on the market.
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Q: The most fundamental force has been the liquidity, foreign indirect investors (FII) activity not the domestics. What is it that you expect to see from liquidity over the next months or so?
A: Next month is the holiday season. So, things could get a little muted just because there is hardly any activity at this point of time. Markets have done badly all of last year and people were not very positive on India. We are ending the year with market having been one of the best performing markets. Most people now are no longer negative on India. Data shows that, India has probably become overweight for foreigners. The extent of overweight is not very high, but it is still the highest it has been for last six years.
The time when India was a hated market is now over. People do like India now and there are some expectations built in. If we continue with the reform process, then we should get positive flows coming in from the foreigners.
From the overall liquidity, two things get importance. One is, the domestics. We had around USD 8-9 billion of negative selling from the domestics. So, can that get into positive territory next year is the question. Secondly, supply is an issue because this year we had hardly any supply. A lot of the supply was bunched up towards the large part of December. Next year, I think the supply will be much more than what we have seen this year. Infact, lot of the companies are already looking at doing issuances in the early part of the year. So, to that extent, some part of the liquidity may get absorbed by primary supply and to that extent it may not come as much to the secondary market. Q: Given the political turf, do you expect the run upto the Budget this time around to be a strong one or a weak one?
A: The market run up will be a strong one for the market. We have seen reforms over the last three months after quite a bit of a gap and the expectations are that these reforms will continue in the Budget. We could get some positive announcements in the run up to the Budget. People would be expecting some positive things to come out. Q: What do you think January’s earning season will look like? Will it be an affirmation of the fact that the downgrade cycle is over? Or will there still be pain?
A: I think the earnings will be generally weak. The key thing in January will not be so much the earning season, but the Reserve Bank of India (RBI) policy where now consensus has built up that we will have rate cuts coming. So, I think, that probably will be more significant than the earning season. Q: For a lot of people, the big call is what happens to banks in 2013. Private sector banks have done so well this year. How would you play it next year for banks?
A: At the moment, we are still overweight the banks. We like the banks because as the economy recovers, the NPL cycle will hopefully peak out.
Also, when you get rate cuts, typically banks perform well and that is the reason we are overweight. We are still running with the private sector, as our preferred pick rather than the public sector. So, some of the winners of this year are still our top picks going into 2013. I think there probably will be a phase where public sector will do well, also because it has got beaten down quite a bit. Probably as the NPL cycle peaks off, that is where the public sector will also start to gain importance and probably do well in the market.
_PAGEBREAK_ Q: You are also overweight on telecom. What is the conviction behind that sector?
A: It is a sector, which has not done very well for the last two years. There were a lot of regulatory issues behind it. The last option of spectrum proves that the burden on the telecom companies will not be as high as it was generally getting built into the market. To that extent, we are overweight on the sector expecting things to be a little better, expecting earnings to not be downgraded as much as was the general consensus. Q: Do you see India dedicated funds coming back into play in 2013? Or do you think there is still headroom for the emerging market funds to allocate more towards India as they have done in 2012 to a large extent?
A: Yes and it is true not just about India dedicated funds, but a lot of country funds are not in fashion nowadays, because we have had lots of volatile periods even in case of countries that have performed pretty well. There has been no consistent trend.
So to that extent, I think investors have been a little hesitant to put dedicated funds into any country. A lot of the money may continue to come from emerging market funds. What may also come from it are global funds, though not necessarily emerging market dedicated. Lots of people are looking at China, an area which grew over the last 7-8-10 years. We put money in China, but China is now a question mark. So, India is getting the benefit of China not doing well.
Here is another country, which probably has the same demographic profile and it is something which over the long-term could do well. I am hoping we will get more money from the global funds which are not dedicated on emerging markets per se, but are looking for a country which can grow over the next five years. Q: As it is regional money, do you expect the market to be far less bipolar going into next year where money would basically choose performance, not so much individual stocks? Will we not have such diverse valuations on the Nifty or the Sensex spectrum?
A: What I am hoping is, that apart from the global funds, we should also start getting the domestics starting to participate in the market. So, if you get domestics participating, then they tend to buy the midcaps. Probably the midcaps would start doing better.
From valuation perspective, my view is that valuations had become extreme. The defensives were trading at a premium to rate sensitive this year, which were at 12-year high. The last time, the premiums were as high was in 2002, so my view still is that that gap will narrow. The gap between the defensive P/E ratio and the rate sensitive P/E ratio will come down which essentially means the rate sensitives will do better.

Q: What kind of appetite do you sense for the government paper? You are not very positive on largecaps like National Thermal Power Corporation (NTPC) from the government basket, but the government will try to sell a clutch of these like NTPC, Bharat Heavy Electricals Ltd (BHEL), Oil India over the next few weeks.
A: In the last couple of government supplies, what we saw is, if you price an issue well enough, then there is genuine demand for it. So, I think it is all a question of the way you price it. Once you get a decent valuation for the asset then there will be buyers for it because ultimately there is money which is coming into India which is looking to be blocked. So, if you can get a good block of an asset at a decent valuation, I think we will get demand coming for it. Q: Any sense of whether new markets are opening up because a lot of people have been talking about the Far East? How is liquidity beginning to build over there? What kind of an impact will it have on markets once that money comes pouring in?
A: If you see global liquidity, it will be easy, because most large central banks are pumping in liquidity into the market. So, to that extent, that whole liquidity is not going to go away in a hurry. The only negative is that if the global liquidity also fuels a rally in commodities. While commodity prices did not go up a lot, oil has not come down but its not gone up a lot either. So, oil has been in a narrow range. As long as those global commodities do not rally very sharply, India would be comfortable. Where we will struggle is, if burst of liquidity reaches a sudden surge in commodity prices. Q: What is the case for midcaps to out-perform in 2013?
A: Historically, midcaps generally do well in periods of GDP recovery and earnings recovery, because they are more vulnerable to the economic cycle than what the large-caps are. So, they do badly whenever the economic cycle goes down and they do well whenever the economic cycle picks up.
Consensus is generally that we will get some recovery in the economy. So, that is a period where midcaps generally do well. If you look at the valuation, discount on midcaps to largecaps is higher than the average and that is very typical of this. It happens during periods of economic downturn, when people are uncertain of the economy, that the valuation differential widens. That narrows again, as the recovery happens, because in periods of recovery, you get midcaps where earnings growth are much more sharper than what is the case for the largecaps.