The Reserve Bank of India’s surprise 40 basis point rate increase and 50 bps hike in cash reserve ratio marks the start of a rate upcycle and the gradual withdrawal of excess liquidity. It negatively impacts broader market valuations, Mayur Patel, senior executive VP, fund manager – listed equity at IIFL AMC, said in an interview to Moneycontrol.
The move would be margin accretive for banks with a larger proportion of loans linked to the repo rate and with comfortable liquidity. However, he said, a series of rate hikes could slow the recovery in credit growth.
Patel said there is a high likelihood of a 25 bps increase in the repo rate in June and more hikes in subsequent meetings until inflation comes down to the target range of 4 percent (+/- 2 percent) on a sustainable basis. Edited excerpts:
Finally, the RBI surprised the street by hiking the repo rate as well as the cash reserve ratio, well before its June policy meeting. Your thoughts...
While the sudden announcement of the 40 bps hike in the repo rate and the 50 bps hike in the cash reserve ratio (CRR) came as a surprise, it was required to arrest soaring inflation. The central bank showed a stronger intent of liquidity withdrawal by hiking the CRR.
Given the inflation print of 7 percent in March, there were expectations of a repo rate hike at the April meeting itself, but surprisingly the RBI didn’t act at that point of time. The RBI expects significant upside risks to the inflation trajectory set out in the April statement of the Monetary Policy Committee (MPC) due to prolonged war conditions and supply-side challenges.
Interestingly, this sudden announcement came just before the expected rate hike from the US Fed. Clearly, the RBI doesn’t want to stay behind the curve and let the Indian rupee weaken as the Fed raises rates.
This is the beginning of a rate upcycle and gradual withdrawal of excess liquidity. It negatively impacts broader market valuations. Specifically for banks, it seems this entire move would be margin accretive for banks having a larger proportion of loans linked to repo and sitting on comfortable liquidity. However, a series of potential rate hikes can slow down the recovery in system credit growth.
Does this mean the next repo rate hike will be in June?
There is a high likelihood of an increase of 25 bps in the repo rate in the June meeting and a few more hikes in subsequent meetings till inflation comes down to the target range of 4 percent (+/- 2 percent) on a sustainable basis.
The power sector is the real star in the current year. Is it still the right time to enter these stocks or is the rally over in these stocks?
The power sector has outperformed the broader indices in the recent past as valuations were attractive and demand was picking up from a low base. Merchant-based power companies benefitted significantly from surging spot power prices.
However, rising coal prices and the introduction of a ceiling on spot exchange power prices have reduced the windfall gains for merchant generators. Regulated power companies have limited upside in earnings, but these got rerated as investors chased good dividend yield and margin of safety amid market volatility. As demand remains resilient and valuations for most of the stocks are reasonable, the sector still offers a decent risk-reward.
Is it time to start taking gradual exposure to auto stocks that have been rangebound for several months now?
Over the past few years, the auto sector has been mired with multiple challenges, ranging from emission norm changes, NBFC challenges, higher technology investments (electric vehicles), and supply chain issues (semiconductor supplies). Also, consumer demand got impacted by a significant rise in purchase prices and operating costs. This led to industry volumes languishing far below their FY19 peaks. The same is also reflected in the underperformance of the auto index vis-à-vis the broader market (cumulative underperformance of ~17 percent over the past three years).
However, the underlying conditions are expected to gradually improve with a rise in rural income led by strong rabi and kharif output, coupled with higher levels of agri-commodity prices. This is likely to drive improvement in aggregate demand in segments aligned to the rural economy (two-wheelers and tractors).
On the cyclical side, the increase in industrial capex is likely to benefit the commercial vehicle segment while passenger vehicle demand has remained resilient in the sports utility vehicle category. Electrification is likely to be the key long-term value differentiator across original equipment manufacturers and component manufacturers. Margins are likely to remain subdued in FY23. However, operating leverage and pricing actions are likely to aid improvement in FY24.
We believe most pockets of the sector are in an early-to-mid-cycle recovery phase and offer significant earnings growth potential over the next 12-24 months. Most companies are trading at historic mean valuations or below. Hence, the risk-reward is attractive for the sector with a slightly long-term horizon.
What are your thoughts on the earnings announced so far and do you still see a major earnings downgrade for FY23?
It has been a mixed earnings season so far. IT service companies have reported a slight miss in operating performance. Leading banks have reported better-than-expected asset quality. A few auto and cement companies have reported better-than-expected margins, though sustenance of the same is questionable.
While the earnings season is still under way, we see downgrades in earnings to set in and continue even in the subsequent quarter. The negative impact of commodity price inflation on corporate margins would reflect more prominently in the first half of this financial year.
How do you approach the markets right now?
Despite significant FII (foreign institutional investor) outflows ($17 billion year-to-date), Indian equities have outperformed the broader global markets on the back of strong domestic flows. While domestic investors’ optimism on local factors has given strong support to the market, there are certainly emerging signs of worry.
We do see a downgrade risk to economic growth and corporate earnings emanating from rising inflationary pressure and slowing demand. The surge in commodity prices has led to a series of price hikes across sectors. This has already started to dent demand on the ground. While nominal revenue growth would remain supported by price hikes, volumes are likely to weaken. The combination of margin pressure and the speed-breaker in demand recovery can lead to an earnings downgrade in the short term.
The Russia-Ukraine war has led to an incessant rise in energy prices due to supply disruptions, especially when global demand is recovering. Energy has become the most critical sector in the commodity complex for our economy. In this commodity bull cycle, we are most negatively impacted by oil and gas prices. At the current oil price of around $100 a barrel, our current account deficit is likely to be around 2.8 percent in FY23 versus around 1.5 percent deficit in FY22. A $10 rise in crude negatively impacts the current account deficit by 50 bps. Also, rising fuel prices have incessantly raised inflation.
The Indian economy is becoming a victim of other nations’ war. Any further supply shock-led rise of crude prices for a long time could be quite detrimental. It not only impacts the twin deficits but also slows demand recovery.
Technology is the biggest loser in 2022. Is it the right time to pick these stocks? Should we stick to large caps or take exposure to midcaps too?
The correction in Indian IT service stocks has been largely due to a decline in valuation multiples while earnings remain largely stable. This is because of the increase in risk premium due to the Fed tightening and rising margin headwinds owing to high attrition, salary hikes and resumption of travel costs. Also, the risk of a cut in IT budgets of bulge-bracket US clients is being factored in.
Post this correction, the risk-reward has become decent as demand remains extremely robust and supply-side constraints may reduce gradually over the next few quarters. Companies across market capitalisations having strong focus on cloud, digital transformation and data analytics can deliver reasonable returns over the next few years.
What are your thoughts on the oil refining sector? How are Indian refiners placed?
We are witnessing an extremely robust upcycle in the oil refining sector. Refining margins are at decade-high levels as demand has recovered above pre-Covid levels and supply remains constrained. The Russia-Ukraine war has disrupted refined product supply by at least 2 million barrels per day and further tightened the situation.
The benchmark Singapore complex GRM (gross refining margin) is now sustaining in the range of $15-$20 as compared to the historic average of $5-$6 per barrel. Limited capacity addition in the medium term, lower product inventories and higher incremental cash cost of refineries bode well for the cycle. The higher refining margin is led by multi-year higher spreads in key products like diesel and gasoline. The diesel spread is the strongest among all products. It has bounced to $40 a barrel compared to its mean of $10-12 a barrel.
While these supernormal margins may correct a bit, they are likely to stay fairly above historic averages for a while. Based on our assessment, there is a shortfall of 5-6 million barrels per day in the global refined products market and it would take at least 4-6 quarters to bridge this gap. Hence, this upcycle is likely to sustain for the next 12-15 months.
Indian refiners are the biggest beneficiaries of this cycle as diesel forms almost half of their refinery output. Indian refiners across the private sector and public sector are poised to benefit from this uptrend in the short to medium term.
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