Deutsche calls for more patience with Indian equities

Gill: I don’t really see it that way. Frankly speaking, if you look at the challenges that India was up against, let us just try and button those down. To begin with, is there an economy in the world which has actually moved from services to manufacturing? The answer is no. All the large economies in the world have actually gone from manufacturing into services. 

So, first and foremost, a path that India is embarking upon has never been done before in that sense. So, would you put markers down there? The answer is no and to that extent people are still grappling with coming to terms with that. 

Second is that if we really do want to have Make In India succeed, then you are also talking about a significant injection of credit into the system. If you look at India right now, in terms of credit to gross domestic product (GDP), we are at 59 percent. China is at 193 percent. However, even if you look at China as an outlier, let us look at the large manufacturing economies in Asia like Malaysia, Taiwan, etc. they are all in the 130s. So, taking up the credit to GDP from 59 percent to let us say doubling at a time when the banks are facing a lot of challenges, I think is not easy. 

The final point I will make is that 18 months back whenever there was a discussion on India internationally, I think the first thing that they used to talk about was corruption. It has gone from the narrative completely. 18 months back we were talking about India is a stable economy? Potentially not. Today we do talk about India as a stable economy. So, I think lots of steps India has covered, is absolutely on the right track and I would just say that it is not a question of India underperforming, I would just say that lets temper the impatience a little bit.Anuj: You have a Sensex target of 29,000 for this year. You are underpinning hopes on earnings recovery in 2016 but what about the global risk? Do you think the global risk can take the market much lower from here? Gupta: You are absolutely right, in fact we had set this target back in early December. At that time it didn’t seem like much upside and that was as you rightly pointed out for the last couple of months, since September in fact, we have been advocating a relatively cautious stance on the markets. The main reason for that was, one, the US Fed rate hike cycle and more importantly the bigger concerns lay around China which is actually now come to the fore in the last 10 days or so. I think in our view, the China concerns or more specifically the China renminbi concerns are the more important factor to watch. In fact we have a conference going on in China right now and most investors are still extremely concerned that we will not see this gradual depreciation of another 5-7 percent. Our house view is, the renminbi goes to 7 to the dollar by the end of the year but there is still a significant concern that you will not see this gradual depreciation, you could see a big one step devaluation which is what is bothering investors that the contagion impact of the China currency decline could lead to a more broad based emerging market (EM) sell-off. Moving back to your earlier point about India underperforming in the last one-two days, actually India has been an outperformer if you look at it on a one year basis compared to say other markets like whether it is Brazil, Russia, South Africa, most of our Asian markets, China in particular in the last 10-15 days, etc on a relative basis, India still looks significantly better. Our economy is in a much better shape, we are a beneficiary of the crude oil price decline and as you rightly said the earnings outlook for next year should be much better. We will have a favourable base effect going into FY17 and hopefully we will also have a good monsoon. If you recollect, we have not had three consecutive bad monsoons in the last 100 years. So, hopefully that will also help the overall earnings cycle. Anuj: What is going to be the next trigger for this market? We have not had leadership in this market and we have not had earnings support. What do you think can lead to revival in the Nifty and the Sensex, midcaps have done well but the index has not reflected that? Gupta: You have to look at the broader global context in perspective first. I think you cannot have a sustained revival in our view until you have clarity on China. I think that is the single biggest uncertainty that is driving foreign institutional investors (FII) outflows, the FII selling which is going on and if that continues and if market cracks beyond a certain level, I am worried that you may actually even see domestic flows slow down. So, the biggest uncertainty relates to China and if we have some clarity on the Chinese policy, some confidence returning that the renminbi is not going to depreciate sharply and I repeat our base case scenario is for a gradual depreciation of the renminbi, remember, they have USD 3.3 trillion of reserves, their own FX related corporate debt is in excess of USD 1.2-1.3 trillion so even they don’t want to have very sharp depreciation suddenly. So, once you have clarity on China, then you could see the slowdown in the FII selling which we are seeing. Valuations are anyway I think beginning to come off to fairly attractive levels. However, I think the leadership as you said, I think that in our view in the short-term given the lack of earnings visibility with some of the domestic cyclicals, with some of the domestically investment oriented companies, you will see earnings visibility more from the consumer sector. So, whether it is consumer durables, the urban consumption plays, IT services, pharmaceutical, these will provide stability in the short-term until we see more policy action on let us say revival in government spending which starts filtering down to the corporate order books. That we think is still six to seven months away. Therefore in the near-term we are still advocating somewhat of a defensive stance. Latha: One of the stable performances outside the equity market has been the currency. This definitely has been boosted by a goodish amount of debt flows, USD 40 billion, will that continue even if the ceilings are raised or is it that some of that money may walk away either because fiscal deficit targets are not kept or because there is nothing much by way of rate cuts to expect? Varadarajan: I think the fundamental investment premise which kind of was there when these flows actually came which was really a credible central bank, a credible inflation targeting framework, excellent macroeconomic numbers in terms of the fiscal path with some deviations in between and the current account, that fundamental premise still remains. So you have got very high nominal rates and you have got a credible central bank who is targeting inflation at 5 percent next year and 4 percent the year after. So, where do you get such high nominal yields? So that is what basically drove a bulk of those flows. To some extent there is a pause right now. I think it is primarily driven by what is happening in the US and the monetary policy outlook in the US and some uncertainty in China. However, again, US can be a tale of story of two halves. Higher policy rates initially but on a more structural basis, I think there would be challenges in terms of raising rates. So, to a large extent the flows into India in the ensuing quarters really is driven by who gets vindicated, whether the Fed dot plot of 100 basis points gets vindicated or the market pricing of 50 basis points gets.Latha: So, there is no likely despondency with India per se that okay, there are no more rate cuts to come or not too many. So, why stay, are there incremental gains, would that argument play?Varadarajan: It is more basically a question of waiting and pausing and looking around the neighbourhood, seeing what is happening in China, what is going to be the EM fallout out of this and really in terms of where the Fed is heading and what is really the outlook to US bond yields._PAGEBREAK_Anuj: When you talk to a lot of foreign investors what is the sense you are getting about the Modi government because our market for long enjoyed Modi premium. Is that still there or are there signs or despondency that we haven't seen much action as far as reforms are concerned. They may have done some steps which could yield back dated results but in the near term is there a bit of worry on what is happening?Gill: If you talk about foreign investors let us talk about the strategic for instance. That is a constituency that India hasn't really reached out to over a period of time and the reason for that was the manufacturing was not your focus. So, you were happy to get Foreign Institutional Investors (FII) come in and put in money but you really were not looking at anything in terms of the whole concept of ease of doing business for instance. Till two years back we never heard that phrase, ease of doing business. If you were a service economy and you could work on the basis of information highways that didn't need ease of doing business but today when you need to build physical infrastructure you need to do that.So, what the foreign investors on the strategic side are liking about this particular government and the leadership of the Prime Minister is that they are taking a very composite view of growth that this whole concept was smart cities, you talk about Swachh Bharat because ultimately the environment is going to play a big role in this. The whole thing in terms of ease of doing business, taxation and then ultimately building infrastructure whether it is through railways, the privatisation that we are seeing in defence the like the fact that they believe that you need a proper eco-system for strategic investors to start investing here and I have never seen that interest higher than I see now.As far as financial investors are concerned we talked about the fact that whether the Modi premium is gone. The bigger issue is let us look at the overall risk aversion towards EM right now and we were just discussing this earlier that if you today look at the EM growth on a composite basis it is looking at about 3-3.25 and the developed world is two. So, the differential hasn't ever been as narrow as this. So, if there is risk aversion and the upside is capped then obviously people tend to turn cautious. So, this is more a view of EM than India being singled out. In all our discussions India still stands out as probably the most stable and the most promising of the large EM economies.Latha: What kind of an earnings growth are you factoring in therefore? What is this year likely to end and what is next year likely to bring?Gupta: Currently our bottom up analyst forecasts are suggesting about 4.8 percent earnings growth for the year ending FY16. For FY17 we are currently at about 14.5 percent but there are a couple of factors which could take it up or down. One is like I said what happens to the rupee forecast. Second is the monsoon is a big factor. This year monsoon hopefully would be better so, that is the one big assumption we are making that there will be a normal monsoon but also we are seeing a bit of a base effect coming in as well wherein you have had a very bad FY16. So, on the back of that FY17 with the worst of the deflationary pressures out of the way, revenue growth recovering somewhat, margin should expand, we have had a big commodity price decline in the last 6-9 months. That in turn should feed into corporate margins. So, overall therefore we think 15 percent revenue growth should be quite achievable. We may get lucky if the government steps up its public investments and the global situation improves somewhat. We could see slightly higher growth but for the time being it is about 15 percent.Anuj: I am looking at your equity strategy and your large cap stock picks. What is really intriguing me is that you don't have private sector banks, you don't have IT, you don't have Reliance there. That is a lot of market leadership which is not there. Why have you made your portfolio like this?Gupta: As I said we are advocating and we have been advocating defensive stance on the market for the near term. Private banks most of the corporate lending banks we don't like. We are more in favour of the retail focussed banks, so, that is one reason. The Public Sector Undertaking (PSU) banks unfortunately a lot of them tend to have very heavy corporate loan books. There we think things are still pretty dire and you would see more aggressive provisioning in the next two or three quarters and the earnings upgrades are unlikely to happen.IT we think the concern is while on one hand you may have benefits from a currency depreciation which will probably help to mitigate the impact of things like the higher visa fees and so on but you also have a US election year coming up. More importantly these stocks haven't corrected as much. IT has been one of the star performers in calendar 2015 and refining companies we actually like. We actually prefer the downstream Oil Marketing companies (OMCs), the gas utilities. So, those are sectors that we actually like.Anuj: What I am asking you is that are you expecting another year of big mid cap outperformance or a big broader market outperformance while the Nifty doesn't do much?Gupta: That is right. We do expect midcaps to do relatively better this year but again like with the broader market looking at the broad midcap index is somewhat misleading. You have got to look at some subsectors. So, like I said some of the gas utilities, some of the other consumer plays, they will actually do much better than some of the broader market.Latha: But what will provide leadership to the index? You said your index target is 29,000. What will provide that leadership of almost 20 percent?Gupta: There we have the consumer durables, the urban consumer plays, the pharma companies, some of these oil refining companies, select private banks, those are sort of the sectors we are underweight would be things like telecom, materials, some of the PSU banks but there weightage is actually not as much.Latha: The next thing the market will stare at for an excuse to build up will be the budget. Will it be taken very badly if the budget didn't deliver 3.6 percent but instead gave a good excuse to come to 3.9 percent fiscal deficit?Varadarajan: To a large extent it is really driven by RBI's reaction function to that and really how they balance a second year in succession really in terms of moving off the fiscal target, what is going to be the reaction function. But again we saw that last year as well they didn't meet their targets. The effect persisted for 10 or 15 days and the market kind of dusted itself up.Latha: If this is systematically a government that doesn't stick to target will it evoke negative reaction from FIIs?Varadarajan: They key question really is the discussion that is going to come into sharper relief in the ensuring days is this dramatic fall in nominal growth in the economy. So, nominal growth which was about the high teens five years back and compared to base rates of nine percent there was a positive spread of about 8-9 percent when most investment came on-stream and since then we have actually seen this nominal growth base rate flip to a negative and the rupee depreciate by close to 50 percent. So, the point is given that there are no growth levers either on the external front or in terms of the government is also constrained to some extent by the framework in place. It increasingly looks like that this could possibly be an exceptional year given what has happened globally to kind of move away from the course there would be a reaction, I am not saying that there won't but eventually the markets would kind of dust this off and progress as you get into the borrowing calendar next year. I don't think it is a show stopper yet._PAGEBREAK_Anuj: This bear market that we have seen in banks is not just an Indian factor. We have seen globally financials are in a tough spot since you head in large bank, do you see a lot of problems because of corporate books for a lot of these banks in 2016?Gill: Globally I think what you see in terms of the challenges that banks have been facing has to do a lot with regulatory as well. So in terms of the cost of compliance, how much capital you need to provide now for a lot of the businesses, the cost of globality, every jurisdiction has a different regulator and they have a different take to that. So if you look at those factors, they have impeded growth as far as the banks are concerned.As far as India is concerned, historically, if you have seen we have always said that India has had more conservative risk management, the regulator is more enlightened and the regulation is deeper but just look at what happened globally -- you look at the US, you look at Japan, you look at China, you look at Europe. At the end of the day, it wasn’t the banks that nursed the economy back to health, it was effectively bailout. So you can call it quantitative easing but what it was a bailout. So whether that was the automotive sector or that was the banks, it was the government that stepped in and revive that.That maybe the emerging model for the global economy as well where the government becomes a very important lever for bringing back economic growth or nursing economies back to health. At this point in time, what India is doing is slightly counter-intuitive. So we are seeing more aggressive provisioning, we are saying that the nexus between the government and the private sector needs to loosen etc.So India has some pain to go through and this is a transition that we are currently undergoing but I would say that there are two factors, one is the world is appreciating the fact that we are taking the painful decisions, we are addressing it on a strategic, on a structural basis rather than a tactical basis. The second is just to come back to the point I made, so let us presume that the government sticks to make in India which is what I think it will remain. You still have an economy which is at 59 percent rate of GDP. You still need that to double.Foreign capital is not coming in at this point in time so it is an Indian banks that will have to provide that capital. So do I believe that the government will go ahead and recapitalise the Indian banks to the extent to which is required? Absolutely yes, because the Indian banks are going to be critical to the Indian economy transforming from being a servicing economy to manufacturing economy. So I feel very bullish about the fact and I will go to the extent of saynig that if I see the Indian banking market, it is best years ahead of it.Just to end up on a point that you made with respect to the fiscal deficit -- first and foremost they will be able to meet the target but we talk to the rating agencies, we talk to a lot of investors, for them the concern always is the quality of spending that if you are putting into capex and you are putting into infrastructure, it is fine but if it is going to consumption subsidies then they have a problem and as long as the government can keep the spending targetted, we should be fine.Anuj: We have seen this play out once in the past where we had a lot of domestic mutual funds in the market and then we had a bad year, I think it was 2008 and retail confidence got shaken because of that. Is that a risk now because of what has happened al through last year we have seen a lot of domestic money in the market through mutual funds directly as well. Today you may have seen a big decline in midcaps too early to talk about one day as a trend but is there a risk-off something like that happens?Gupta: Yes, there is clearly a risk but I would highlight a couple of things. Firstly, if you are a retail investor, your investments in the past were real estate, gold, your fixed income. On a post tax basis, equities on a two-three year views still looks relatively attractive assuming that you will see corporate earnings growth recovering to say 10-15 percent levels at least over the next 2-3 years that is point one.Secondly, a lot of the flow that is coming in is in the form of SIP. So it is kind of most sticky, it is not lumpy, it is not on the basis of suddenly the market falls, people start coming in so it is a very sticky kind of a flow which is already there. The way the markets are coming off, anecdotally we are hearing the flow is still continuing but yes, the risk remains.I keep going back. You have a big global shock and the markets come off very sharply then you start seeing net asset value (NAV) losses in a big way. That is when you should be worried about domestic equity flows also slowing down that could take the market down. Otherwise we think that the flows will continue especially given the lack of investment alternatives versus other asset classes.Latha: What is your base case in terms of a low that the Nifty can reach and what is the bear case?Gupta: To define the base case or the bear case, you need to take a view on the global outlook. There, as I said our base case is the Chinese currency depreciates gradually. So in that scenario we would probably settle somewhere around here or maybe another 3-4-5 percent lower. So that is the base case scenario on the low side.The bear case scenario would pan out if you continue to have more rapid down move in the Chinese renminbi, which in turn reach to an EM currency decline, commodity markets come off further, the global EM confidence erodes even further then there is a complete risk off in which case you could see even more aggressive FII selling, which in that case then also leads to the domestic investors also sort of pulling back and then you see heavy midcap selling as well but that is not our scenario.However, even on that scenario yes, then you have to take a view on how much lower the flows could take us. However, from a valuation perspective we are beginning to look attractive even if you assume 15 percent growth next year, zero percent growth this year then you are looking at the Sensex trading roughly 15.5 times next year earnings. Now this is on the back of somewhat trough earnings when you are hopefully coming out of the trough and over the next two-three years you will see much better earnings growth and inflation, which is under control, the macroeconomic situation under control, India within the overall EM context looking relatively better.Historically in the last five years we have traded between 15 and 16 times. So we are almost there but a lot depends on the view on the Chinese currency where our view is that it will depreciate gradually._PAGEBREAK_Latha: What is your sense about Reserve Bank of India (RBI) rate cuts and its move on banks? Do you see them being able to force the initiative in terms of cleaning up their books?Varadarajan: In terms of our house view, we are looking at one more rate cut of 25 basis points post Budget around April and then, there will be a bit of a pause while the RBI takes in inputs in terms of really what is happening on the monsoon front and how the Fed path actually eventuates.Latha: Will that really mean lower cost of money? It has not really fallen for the borrower. Varadarajan: The key point is there is dramatic fall in nominal growth and something needs to be done. If you recollect, 2010 was the marker where this system, went into a deficit mode from a surplus mode. The point is that be as you are, constrained by the inflation targeting framework, can something more be done? Again, this point has been debated a lot and discussed but, I think a case can be made out to relook the entire liquidity framework for the banking system. Obviously, you do not want the system to go into a surplus mode with the rates hugging the lower end of the corridor, but one of the policy options that could be considered given where we are on the growth cycle and the nominal growth rate shock that we are enduring, to look at actually crashing the corridor, why not look at a corridor which has about 50 basis points compared to a corridor which is 200 basis points. The point is that banking behaviour does change depending on the change in liquidity dynamics. From being a borrower of the marginal banking reserve to being a lender of the marginal reserve, it does change behaviour.Anuj: Do we need to do anything different to come out of this gloomy scenario that we have painted for ourselves over the last three or four months or are we more pessimistic than the real situation itself?Gill: I do not think we are pessimistic. I just think we expected the whole world to turn around a lot quicker than it actually has. So, we may in some ways, us included, have underestimated the challenge that was there in terms of turning India around. That said, if you look at it from the point of view of what could the government have done more or what could we have done differently, the one area where we can do a lot more is public spending. Currently, you have a situation where the private sector has an issue of leverage as well as over capacity. So their ability to invest incrementally is limited. So, you are really looking at two forces over there. One is the public sector and the second is of course, the foreign investors. The foreign investors will take time before they can build their infrastructure, those investments get approved, their business plans gets firmed up, and their own balance sheets are repaired and level becomes stronger.  However, the government side of it on the spending, so we have seen a lot of good spend on NHAI for instance. Power sector, we have seen some good things, but if you could see a bigger push on railways and defence, we will be in much better shape in six months time. I would go back to the point which was being made earlier that the fiscal deficit is a very important parameter and we must respect that. However, at this point in time, spending is the key. As long as the spending is going towards investment, is going towards infrastructure, I do not think the world will really bolk. So, I will just say that let us spend a lot more on the public side and I really think that will give a big growth impetus to the Indian economy.Latha: I am compelled to ask a stock question because the markets are so compelling now. Ravneet made the point that the best days for the banking sector lie ahead. You do not have any, even private sector bank, in your top list. You have State bank of India (SBI), the public sector giant. What will make you buy the banks?Gupta: There the issue is more of the short-term versus the long-term. I completely agree with Ravneet that the longer term scenario is looking definitely a lot better. The RBI is cleaning up the banking system, etc.Latha: In short-term, will half the prices make you buy?Gupta: I do not think we see, already some of these PSU banks are trading at 0.3-0.4 times price to book, but the bigger issue is you need to have clarity on the extent of the NPLs which are out there. Right now, the market does not like uncertainty and the lack of clarity on how bad the books are, how much of the NPL problem is really out there, you still get surprised by a Federal Bank which reported yesterday, where the NPLs turned out to be much bigger than expected. So, that is the sort of, what the RBI is doing is actually forcing banks to come clean with the NPL problem in their books. Once you have that clarity, then you are setting the stage for significantly better performance by the banks.Latha: So, a gut wrenching provisioning this time by ICICI Bank and Axis Bank will make them attractive? You will believe that they have pulled out the poison?Gupta:  I think already some of these corporate lending banks are looking reasonably attractive, but yes, what we are seeing is lack of willingness on the part of investors to go out there and aggressively buy these banks because of the uncertainty of how big the NPL problem is.