Domestic cyclicals need to perform for uptrend to continue: JPM

Indian markets have rallied recently, along with a host other emerging markets, with the Nifty reaching JP Morgan's base case forecast of 8,600.In an interview with CNBC-TV18, the firm's Head of Research Bharat Iyer said global central banks' monetary stance and a rebalancing in investors portfolios will continue to support emerging market equities.Particularly for India, he said the domestic cyclical sector will have to perform strongly for the market to maintain its uptrend."The big delta in terms of earnings typically comes through sectors like financial sectors like resources or in sectors like infrastructure and industrials, capital goods or even consumer discretionary for that matter," he said, before outlining his views on a whole host of other sectors.Below is the verbatim transcript of Bharat Iyer’s interview to Latha Venkatesh & Sonia Shenoy on CNBC-TV18. Latha: The good news that perhaps is a little bit of worry. This gush of liquidity coming into not just India but also into emerging markets itself, is this something that we can believe will continue for some time now? A: There is no reason to believe that it doesn't continue for some time because of two reasons. Central banks all over the world are recognising that growth is anaemic and they need to do all they can to support this growth and also fund flows into emerging markets particularly on the equity side have been very weak for some time. So, I would like to believe that global investors are largely underweight emerging market equities at this point in time so there is some kind of mean reversion happening there too. Sonia: But you still have a base case of 8600 on the Nifty by the end of the year. We are already at that level, would you want to scale that up? A: We have a bull case of 9000 also as you know. So, we have been maintaining this all along from January that base case we should hit 8600, bull case we could hit 9000. The base case is coming close to fruition, but yes, if this gush in liquidity continues and if the uptick in the earnings cycle comes through as we expected to. And we have some positive surprises on the policy front, no reason to believe that the bull case is not satisfied to. Sonia: And what would take us to that level? Which are the sectors that could lead the way that could lead the way? For now one big heavyweight sector, IT is under quite a bit of cloud? A: If you want to see further upside as far as the markets are concerned the domestic cyclicals will have to play a very key role because as we know if you go back to the last four or five years the defensive sectors the intellectual exporters have typically tended to do very well and so expecting them to shift gears is a little unfair at this stage though they could continue to hold the trend. The domestic cyclicals will really have to come to the party for our bull case to be actioned. Latha: When you say domestic cyclicals what are the numbers you will watch out for? Today's Hindustan Unilever? A: Unilever yes, but again you must appreciate that that is a more defensive stream of business, the statements tend to be more defensive but yes, the big delta in terms of earnings typically comes through sectors like financial sectors like resources or in sectors like infrastructure and industrials, capital goods or even consumer discretionary for that matter. So, I guess the upside will really have to come from these areas which is where you would have to expect positive surprises at some point. Sonia: From the government standpoint how have you read into the recent reforms that the government has come out with, whether it is on the coal front, the power front any pick up in capex etc? Anything incremental that you have noticed? A: We had a very productive Budget session of parliament. We saw a lot of very legislative action there after a long time. So, full credit to all concerned there. Apart from that what we have also seen is that the government has clearly prioritised its early cycle investment priorities and they have been largely focussing on areas like highways, power transmission, railways, defence and we are seeing the numbers pick up in all these areas and that is very positive. Going forward a couple of other areas could join the party. There will be a big rural infrastructure push at some point of time over the next 12 months and we should see urban consumption getting a leg up as well because of the seventh pay commission's recommendations being implemented. So, these are four or five baskets which overall seem to be doing well. Latha: What kind of an earnings growth are you pencilling in this year? A: We are going for about 12-14 percent for the current fiscal year which is FY17. What we are likely to see is a continuation of the margin improvement story that we saw for sometime in the later part of last year, that continues. We should see financing cost come down because we have seen a meaningful change in liquidity stance of Reserve Bank of India (RBI) and we are seeing market interest rates trending lower. So, it is a reasonably positive environment for margins and with a lag of a couple of quarters we should start seeing a volume recovery. Sonia: I notice in your India strategy note that you remain overweight on IT services. Would you not be concerned about the slowdown in global discretionary spending, something we have seen reflecting in Infy and Tata Consultancy Services (TCS)? A: There are near term headwinds, I will not deny that. But the reason why we like the sector is basically it gives you are very steady income stream. It is not very volatile in terms of earnings yes, I know investors were spooked. But what was it? It was a USD 50 million miss in the revenue line in relation to revenues which are like probably 30 or 50 times that. So, it is something that one can take in one's stride and what is important to note is this is a sector which is trading at a discount to overall market valuations and which has earnings growth more or less in line with the market and with very little volatility. So, on a 12 month basis I still see money being made in the sector. Latha: I was surprised, I thought I expected you to come and give a headline and say no, IT sector is not one of our top picks now. You are not changing that at all. I don't know are you all defending a stance which you all have already taken in public. For the last three year-on-year (Y-o-Y) quarters TCS has shown lower volumes and lower margins. Infosys is guiding lower without factoring in Brexit. A: But look the overall numbers, they are still reasonable. You are looking at revenue growth of 10 percent. Latha: But the price has already discounted that? A: But the stock is trading at what 15 times forward earnings for a market which is trading at 17-18 times forward earnings, you are trading at a discount to the market and I have earnings growth which is more or less on par and as I said with very little volatility. When you are running a portfolio you have got to appreciate that you can't really bet the house on everything which is extremely volatile. You need some pockets which are largely stable. Sonia: But there is a bigger issue here, the industry as a whole is moving away from legacy businesses and into digital businesses and many of these companies are finding it unable to cope at the pace at which it is changing? A: What you need to do is give it some time because this transition to digital is something which is going take two or three years and what you need to do is bet on companies which are making the transition or are well positioned to make the transition and if you bet on the right horses I don't see why - I am not saying that the rising tide is going to lift all boats but specific companies have very credible initiatives and if you bet on them you are going to make money. Latha: Who will be the leaders to 9,000 if that happens? A: Well, from a local perspective I guess all those sectors which are going to cater to the government’s early cycle priorities will all do well. As I said the government’s priorities are clearly areas like highways, railways, power transmission, defence or urban consumption. So all the segments that cater to these areas will do very, very well and on the margin you are going to get an uplift as far as the financials are concerned also, because you have seen about 60-70 percent of the problems being recognised, so I guess that will be a sector that I think in all probability will do well to particularly those who sort out their credit cycle issues. Latha: Until now the market is only preferred to bet on the private sector banks, would you go beyond that. A: I guess we will have to get past this distinction of private sector versus public sector whether it is the public sector or the private sector and this is a discussion we have had in the past as well, I guess whether it is the private sector or the public sector there are banks that are proactively sorting out the issues, so they need to be bought into whereas there are banks some of them are lagging behind and they are going to pay the price in terms of underperformance. Secondly, you also have to look beyond the credit cycle issues, because let’s face it, the credit cycle issues will give you a tactical trade, but beyond that the nature of the industry is changing, in terms of how you maintain your liability franchise, what you are doing in terms of complex products for corporate and I have seen you being very, very concerned about some of the private sector banks in terms with how they will cope with digital and the disruption that it brings. So you need a bank which can proactively address all these areas and it doesn’t make a difference whether it’s an NBFC or it’s a private sector bank or it’s a public sector bank. Latha: Therefore will you bet more on NBFCs, in the finance space how are you and your company looking at the digitisation challenge? A: I think as far as NBFCs are concerned there is a case to be made for some of them, because let’s face it the state owned banks are still grappling at large with the credit cycle issues and lot of them currently seem to be starved for growth capital, which is really opening up a substantive market for the NBFCs which is where they disintermediate, so I guess people who have the right product offering, who have a liability franchise which can cater to that growth required, there is a case for them as well. Sonia: You continue to be overweight on the pharma space. What has happened recently is there a faster resolution of USFDA issues because of which the pharma stocks are rising? A: I guess what happened in this space really was people were spooked by the USFDA letters that some of the companies got. Our take on this has been when we talk to the companies, most of them assure us that it’s not going to cost them 4-5 percent to really meet the enhanced FDA requirements and as far as we are concerned that’s the cost that they can very well take in their stride, that’s one year rupee depreciation as I see it. So I guess those issues seems to be getting resolved on the margin and that’s really bringing the flavour back as far as the sector is concerned. Latha: From this point view will you say that some of the midcaps can give you much better gains than 9,000 on the Nifty and if that is the case that may always be true of some midcaps, which are the sectors you will concentrate. A: The way I look at it is midcap is always going to be a bottom up story, I don’t think one can make a generalisation top down, but that said at large if you were to ask me right now I think there is more value in the large caps than the midcaps at this stage. Latha: If the goods and service tax (GST) amendment bill is passed in the current session, what are your foreign guys telling you, will India get some outsized money. A: Well, I guess it is not a question of outsized money, but yes it will just completely change the perception, because there have been some concerns the country is going a little slow on the reform agenda and this will meaningfully change that perception, so I guess it will be very, very positive and let’s not look at it in terms of just what happens in the month beyond, because both of us know that to implement GST and to get the benefits will take a year or two, but yes it definitely will. Latha: If that bill is passed is August going to be seen as game changer? A: It will be in the sense that it will justify markets sustaining a higher level of valuations for some time to come, because the earnings is obviously going to take some time to come in, but it will give a leg up to valuations and which will be something which can be sustained. Sonia: When there is a new Reserve Bank of India (RBI) governor what do you think is more important for the market policy continuity or a faster rate cutting cycle? A: I would expect to see policy continuity at this stage, because let face it the last few inflation prints have been a little on the higher side, so I guess policy continuity is what the markets will be looking forward to. It doesn’t preclude rate cuts, but I think the rate cut argument will largely depend on the trajectory that inflation takes.