Valuations of the market have been expensive and the market is likely to stay richer for longer, says Deutsche Equities.
While maintaining December 2017 Sensex target at 29,000 levels, Abhay Laijawala, Head, India Research, Deutsche Equities told CNBC-TV18 that the research house is not looking to change the Sensex target given the lack of earnings pick-up.
Consensus earnings growth expectations for FY18 are pegged at 20 percent, which looks difficult, he feels.
"Our sense is that the first half of FY18 is pretty adverse; hence, there is a strong likelihood that 20 percent earnings growth is unlikely," he said.
Currently, the market is trading at 19 times one-year forward, with an assumption of 20 percent earnings growth.
Abhay said if earnings growth comes at 10 percent in the current financial year, then the market is expected to trade 21x PE.
The 50-share NSE Nifty surged more than 19 percent year-to-date (2017) and crossed another milestone of 9,800 level on Tuesday. That was majorly by short covering in sectors like technology, PSU banks and healthcare stocks, especially after market regulator SEBI modified P-Notes rules.
If rules and regulation will change, the market is likely to see this kind of impact, Laijawal feels.
Actually, there were a lot of expectations that the SEBI could enforce some modifications in P-Notes and investors may get more grace time, he said.
According to Securities and Exchange Board Of India (SEBI), now, participatory notes or offshore derivative instruments (ODIs) can be issued only for the purposes of hedging with respect to equity shares held.
Besides, the market regulator said that existing positions on unhedged P-Note derivatives have to be liquidated by end of December 2020.
Inflows from institutional investors slowed down for a month recently, which suggest that FIIs are keenly looking at events like possible Federal Reserve unwind, he said, adding the US employment is back.
Last week, the US added 2.22 lakh jobs against an expected of 1.79 lakh.
According to Laijawala, central banks will have to move towards normalisation and unwinding of Federal Reserve balance sheet is more likely.
San Francisco Federal Reserve Bank President John Williams in Sydney on Tuesday said that he expected the Fed to start unwinding its massive balance sheet in the next few months. He also said that the US Fed will be raising rates one more time this year.
Meanwhile, in India, "We are seeing a massive flow from physical savings to financial savings. We are seeing whole host of factors rebalancing the economy," Laijawala said, adding the government's recent policies have been extremely positive.
He is very bullish on India with long term perspective.
Stocks and sectors
Laijawala is positive on IT stocks. BFSI segment, which has been hurting revenue growth of IT companies, is expected to grow, he feels.
Last month, big US banks planned for share buybacks and dividend payouts, especially after the Federal Reserve approved capital plans for all 34 financial firms that took part in annual stress tests. This is an indication that these US firms may come back to pre-crisis days soon.
Hence, US financial companies' IT budgets are likely to increase, he said. Banking, financial services and insurance (BFSI) segment contributes 40 percent to Indian IT companies' revenue.
He is also positive on auto, industrials and commercial vehicle sectors.
He said in the first two months of FY18 (April-May), the government spent 50 percent of expenditure on rural economy, including Rs 1 lakh crore on fertiliser subsidy, diesel subsidy etc. Even procurement of rabbi crops increased 30 percent.
Hence, Laijawala said the research house is positive on stocks that are more reliant on agriculture economy like auto, energy (particularly refinery) IT, consumer sector.
Recently, banking & financials rallied smartly on hopes of early NPA resolution and likely normal monsoon.
He is not overweight on banking sector as a whole because he is positive only on private banks. He believes private sector banks will continue to gain market share at the expense of government banks.
Below is the verbatim transcript of the interview.
Anuj: Last time when we spoke to you the market was having a bit of a momentum, there was a bull charge and you raised some warning signs. Would you say something similar right now as well? Do you think the recent run-up is a bit too steep?
A: The run-up has to be seen in conjunction with the key transformation that is happening in the Indian savings profile. I think what we have to see right now is that with real interest rates staying sustainably in the positive zone, 1.7 percent or so and staying sustainably there, we are seeing a massive flow of savings from physical to financial savings. Within financial savings as well, we are witnessing a transformation with liquidity at the banks leading to fixed deposit rates coming down. Investors are moving from fixed income towards safer quasi equity products. So what we have seen in the last four months is a massive surge into balanced funds.
Now balanced funds are 60-65 percent invested in equity. So if you see the flows into equity funds as well as the equity component of the balanced funds, we are talking of USD 2-2.5 billion every month coming from retails investors into domestic mutual funds. So despite the fact that we are seeing a massive transformation in the economy, we are seeing rebalance of the economy, what you are seeing in the savings profile is completely independent of that. So answer to your question is, with such a backdrop, market is likely to stay richer for longer.
Reema: We just flashed your December Sensex target and it still stands at 29,000. It seems a bit out of sync now considering where the Sensex currently is. So, any chance you would look to revise it and how would you read this valuation versus liquidity conundrum that we are facing right now?
A: We have been at 29,000 and we continue to stay at 29,000. Our entire premise for the 29,000 is that we need to see earnings growth once again recovering. We waited for three years for double-digit earnings growth, we haven't seen that. We are now in the fourth consecutive year, we are waiting for that to come in. I think what we are seeing this year particularly is a whole host of factors leading to a rebalance of the economy.
At the end of the last year we had demonetisation. Now, we are going to see the impact of the Real Estate Regulation Act (RERA), we have just gone ahead and passed the Goods and Services Tax (GST). So, effectively when so many things are happening at the same time, these are all dramatic, these are all extremely positive and these all have the potential to change and transform the country including a very positive impact on the return on equity, but we will have to be patient.
Reema: So no double-digit earnings growth even this year, for the fourth year in a row?
A: Consensus is for 20 percent earnings growth. It is looking increasingly difficult like the last three years and our sense is that the hurdle in the first half of the year, the base effect in the first half of this year, is pretty adverse. So, there is a very strong likelihood that the near 20 percent earnings growth that the street is expecting looks unlikely.
So, at this point in time, the market is trading at 19 times one year forward with the assumption that the earnings will grow at 20 percent. However, if actual earnings growth is going to be only 10 percent, then we are already looking at the market trading at close to 21 times one year forward earnings.
Anuj: Let us also look at couple of recent news points and which are technical indicators for the market. Since you have a lot of foreign institutional investor (FII) clients, what did you make of the Sebi circular on p-notes having to unwind the naked positions? What are your thoughts on how that is going to impact the market, whether there is more short covering which is possible and whether that damage is the inherent structure of the market?
A: We have obviously seen the market react on Monday particularly and we had this mishap with the NSE having trading issues. So, to a large extent the short covering could not happen and we did see that continue into the next day. We think that short covering is going to continue to happen and we have seen that three particular sectors where there were likely a lot of shorts have really seen stock prices move as a result of this announcement. So I guess there is little you can do. Regulation is regulation and if regulation is going to change, we will see this kind of an impact.
Anuj: The issue here is that you cover shorts because you have been told to cover shorts. However, if stocks rally and inherently there is no strength then at higher levels do we see some of the other investors using that as an opportunity to short? For example names in pharmaceutical, IT, or PSU banks where we did see that short covering, is that then an opportunity for others to short then?
A: I did not understand.
Anuj: Let us look at couple of sectors; because of forced short covering you saw a rally of say 8-10 percent, but that was purely technical in nature. So some of these stocks then exceed their fair value. So in that case do we see fresh shorts entering from some of the other FIIs, not necessarily using the p-note route?
A: That will depend on what happens next. It is very difficult to take that call at this point in time. Let us see how this situation pans out. There is a lot of expectation in the market that Sebi could probably announce some modifications over here, probably give the investors more grace time to go ahead and make the adjustments. So, let us watch the situation. At least the market at this point in time is expecting that there will be some modification.
Anuj: In general what is the FII view because we have not seen too much participation from FIIs? Of course that is only in the recent rally. They have been staying invested in India for long now and that way they are making a lot of money. However, in the recent rally, we have not seen any participation from FIIs.
A: Yes, in the last I guess one month or so, we have seen a slowdown in terms of FIIs. It is really the locals, domestic investors who have been keeping the market going. We think that FII investors are looking at events like the possible Fed unwind. There has been a lot of talk about the Fed unwinding the balance sheet and I think we will have some indications today when Janet Yellen at Humphrey-Hawkins Testimony probably gives some kind of a guidance on the timing of this unwind including the trajectory of interest rates.
We at Deutsche, our global chief economist has been highlighting that USD 13 trillion of excess liquidity needs to be unwound and his view is that in this entire bull run, US market growth has been 4x the gross domestic product (GDP) growth. So, clearly there is a big variance between the real economy and the financial economy. With the news flow over a stablisation in the economy with US employment coming back, with a normalisation of growth in Europe, central bankers’ world over will have to move to normalisation. So, investors at this point in time, emerging market investors are basically looking at what could be the potential of this unwinding. While the Fed is likely to move conclusively, but not aggressively, it will not be without any impact.
Let me make one more point which is very important, the institute of international finance has just come out with the latest global debt numbers and global debt has risen to USD 217 trillion. This is 327 percent of GDP. When the global central bankers look at the huge increase in debt that has taken place, and the fact that normalisation is happening, it is more likely than not that the Fed balance sheet unwind is more likely than not. Therefore -- I have probably gone about the rather long winded manner, but the point is this is exactly what FIIs are watching.
As far as India is concerned, they continue to stay very bullish on the longer term prospects. However, clearly this generic worry over emerging markets and the impact of the Fed unwind is the reason for the slowdown in flows.
Reema: You also have a small overweight on IT. You turn bullish I think in the month of January or the start of the year. Are we done with the earnings downgrade cycle for IT?
A: For IT, we will have to look at what happens with the rupee. In the June quarter, the adverse currency movements had an impact on earnings and if the rupee stabilises, and shows no further appreciation and there are no adverse cross currency headwinds as well, as we head into the second quarter, it is likely that sequential growth will pick up. In addition we are enthused by the improving health of financial institutions globally. As we saw recently, the Fed gave a clean chit to US banks to go out and raise dividend payouts or pursue buybacks.
If the banks are going to pursue buybacks and if they are going to give out higher dividends, they are definitely going to go out and raise the discretionary IT spend. As we know, the financial sector constitutes close to 40 percent of the revenues of Indian IT companies. So, we continue to stay positive and we do believe that all these events including the movement of the rupee, will have a bearing on IT sector earnings. We have a small overweight on the sector.
Anuj: What about domestic economy facing sectors, we saw good numbers from Ashok Leyland for example, so, commercial vehicle (CV) cycle picking up, is the capex picking up. Is that a sector where you would put your bets on?
A: We are positive on autos, we are positive on industrials, we are positive on commercial vehicles and one point I would like to make over here is in the last two months I do not know if -- this has not really been reported as I think it should have been given how significant it is, in the first two months of the current financial year, the government has frontloaded pump priming. Total government expenditure is up 50 percent. Most importantly there has been a huge amount of pump priming to the rural economy.
We saw that close to Rs 100,000 crore has been spent between the food ministry releasing a fertiliser subsidy payments and releasing a diesel subsidy payments. We have also correspondingly seen that the procurement of the rabi crop is up 30 percent. This is likely to provide a very strong tailwind to the rural economy which has been complaining of severe stress. So, consequently we think it is time to look again very closely at the rural plays and the all the stocks that are reliant on the rural economy and the agrarian economy.
So the stocks we like right now, the sectors we like right now, are autos, energy, particularly refining, we like IT as I mentioned, we like the consumer sector. That is what we like.
Reema: It does not include financials, and being underweight financials seems a bit like a contra call right now because the rally is being led by financials.
A: It has, but in financials our preference is more towards private sector banks and therefore it is difficult to be positive on financials across the board. Our preference is very clear, we like the private sector banks and our banks analyst believes that private sector banks will continue to see market share gains at the expense of the government banks. So, as a sector, we cannot be overweight because the positivity is only on one part of the sector.
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