If capex doesn't perk up, mkts will look stretched: Eastspring

Speaking to CNBC-TV18, Krishna Kumar, Investment Director at Eastspring Investments, said that industrials and materials can make the entire industry look good. "Our economy is a large one, it is not a switch-on, switch-off economy."

Regarding earnings, he said numbers don't mean much. He indentifies two key elements. "The overall economy is recovering. We have to see how corporates respond to it." He believes that the economy has to be capex-led. "If capex doesn’t pick up, markets will look stretched."Below is the verbatim transcript of Krishna Kumar’s interview to Udayan Mukherjee on CNBC-TV18..Q: How are you feeling about where the market has reached after it stuttered earlier in the year because we have had a fairly pedestrian start to the earnings season this time around amidst hopes that we will get 17-18 percent earnings growth this year, is that a wrinkle that you think the market will be able to move over smoothly?A: It has been a bit volatile and it continues to be a bit volatile. Global markets are obviously not very helpful. India in the scheme of things is the only bit of an island where we see earnings growth. I have a fear that it is being exaggerated and possibly a bit back ended.I really hope that the fact that the delivery is more sanguine and probably real in the second half because the first quarter obviously has not been a great start. I believe that the global markets could get a little more volatile in the second quarter but I think the second half should be relatively better.Q: Why do you think global markets will get volatile in the second quarter? There have been many problem pockets which have cropped up in the last quarter or so, Brexit included, yet the S&P in the US is trading at all time highs, markets seem to be just dismissing any of the problem areas which are cropping up. Is your concern related to what the Fed might do or why do you think volatility will come back later in the year?A: It is a very awkward market. There are variety of reasons. The awkward bit is the fixed income guys are looking for capital gains and the equity guys are actually looking for yields. The fact is there are number of events which are happening globally, interest rates are at an all time low and that is not helping growth. In spite of being so low as they are you still don't have growth or any signs of any growth.So, obviously the alternate asset that you think about is equities and commodities where you have got to go and invest more money because you are not making money elsewhere.Couple of other things which are important is, China, where there is rate action which is spending. Chinese rate action will have an impact on commodities and that is where one needs to kind of keep an eye. The fact that these changes as they happen tend to become more volatile and less things which are anticipated start cropping up. The reality is we live in a world which is so uncertain and zero growth as you see. So, it will be volatile because things will settle down, people will look out for assets which are cheap, people will go out to look for materials, commodities, whatever be it and the fact that at these zero rate environments even that is not driving consumption. So, it is a very awkward kind of a market place and that is what will cause volatility.Q: You would say that the calm that we are seeing in global markets is an uneasy kind of  calm then?A: Think about it this way, even globally all brokerages are benchmarked, in a bull market you have volumes which are peaking, topping the previous highs. A classic example is the Indian markets, the foreign brokerages are running at about 30-50 percent below previous year volume levels which suggests to you that there is very little participation. The fact that it is running away or going away wherever it is, the fact that there is retail money chasing it somewhere in some form or the other and that is what is causing this kind of a bit of a turmoil.Q: Would you go as far as to say that valuations right now having reached where they are without any evidence yet though the hope is there any evidence of earnings turnaround have reached uncomfortable levels by some benchmarks even assuming 15-16 percent growth this year, you are probably trading at 19 times current year’s expected earnings. Is that stretching it a little bit in the fairly dodgy global environment that you described just now?A: India has been a hope trade and we have had several bull markets or bull phases on the basis of hope and this is one more which is kind of really, really running away. So if you break up the overall earnings estimates or expectation and go behind the numbers there are three or four key sectors which are supposed to drive the 20 percent kind of earnings growth that you will see in probably 17 which I am very doubtful about.Financials, industrials and materials are the key sectors where you will see or apparently the forecasted numbers suggest are going to be phenomenal growth numbers. In the environment that we are in, I think the bets are pretty even call I am not sure whether these numbers are achievable in the environment that we are in. What can change and what can kind of revise and is possibly a more aggressive simulated environment by the local government which is imminently possible. The fact that you could have a kind of an industrial recovery through capex of public sector enterprises is possible and that could trigger a bit of operating leverage and hence earnings could kind of a comeback.I am really worried about financials and the fact that these guys trade at valuations where everything seems to have been washed away and it is a good world to be in, I think it might be a bit of trouble spot.Q: You raised the issue with everybody would it be talking about today after the Axis Bank numbers, because every quarter we say the problem has been ring fenced, its behind us and it’s time to re-rate this banks, yet up come more slippages even in the blue blooded private banks forget the public sector banks and financials is such a big part of the market. Do you worry that the market is ahead of itself in valuing some of these names.A: If I say deeply worry I won’t exaggerate. I think some of these private sector banks are pretty late in recognising and acknowledging problems. They have been told several times that these are real issues, global commodity collapse is a real problem and they need to kind of cover themselves or acknowledge issues in terms of problems that they have.The second part is I think their growth in the last three years for whatever drama that we might kind of talk about; these guys have been growing retail loans at the rate of about 20-25 percent. The much often repeated comment that they are getting share from the public sector banks looks like a little misplaced. The fact that they have the same amount of non-performing loans (NPLs) as the public sector banks, just the public sector banks have disclosed and private sector not yet.The other bit is that loans to NBFCs that the private sector banks have been giving out and so moving away from the industrial bit where the trouble is big and second bid is the NBFC and the retail lap/mortgage and other things which have been given out to retail. I think that is one area where I think one needs to be very, very careful. It is very suspect. NBFCs are trading about 4-5 times book and those numbers are staggering and the fact that the banks have got increased exposure to NBFCs is a kind of a bit of a trick place.Q: Are you expecting a valuation compression in the financial end of the market then?A: The valuation is basically pricing in a fair bit of optimism and the optimism stems from multiple parts. The first part is obviously there is policy changes which are happening in the side. Second bit is there is monsoon which kind of invariably drives up more optimism than it should. Third bit is obviously there is expectation that the recovery will kind of play out with operating leverage. Now, all these are priced to perfection in a way that the margin of safety is clearly much more diminished in the environment that we are in.Q: You spoke about three aspects which should be able to drive 20 percent expected growth which you are circumspect about. Financial, industrials and materials. What about the other two industrials and materials, do you think they will deliver as the street is expecting leading up to that or adding up to that 20 percent growth this year?A: Yes, that is an interesting part. If you are thinking of an economic recovery which the market is pricing in. if you are thinking that the second half is going to be better than the first half if you think that the public sector capex is going to be a reality where we see early signs of capex coming through. If that comes through, if the industrials play out there is tremendous operating leverage both in industrials and materials. They are all working at about close to 60-70 percent utilisation. If the capex cycle starts which will have to start through public enterprises because the private enterprises are in a knotty corner, they just obviously can't do anything, the public sector enterprises will have to drive one.Second is operating leverage will kick in and if that happens your system is back on a roll which means that you can actually see numbers which can actually surprise pretty much. But industrials and materials can they kind of take the entire industry or the entire market to make it look good, maybe not. It is a bit worrying that this will get the system back on a roll but our economy is a large economy, it is not something which is switch on - switch off, it will take some time, it will take a few quarters to kind of build it up.Q: What is a more realistic earnings growth expectation then? After having seen how the year has started off, if you are not sure about 20 percent and if you have to stick your neck out and put your pin on a number, what would you say is more deliverable?A: There are two parts to it. First is the overall economy recovering and second part is how do the corporates respond to this economic recovery. Give or take a number it doesn't matter, I can stick my neck out but if I don't tell you I won't be wrong. So, that is the only way I will avoid the number question.The way to answer it is to think about economic recovery and where is it coming from, it has to be capex led and that is what you got to think about. Obviously we have spoken about financials which is a serious chunk of the market which is not very helpful so the other bits have to be from here and it is not impossible to kind of get to a number where you will say that this is more realistic and given that it is less than 20 or possibly could be less than 20, if the capex cycle doesn't pick up quick enough the market will look stretched.Q: The other part is IT which we have not spoken about and I know that you own many of the top IT names in your portfolio. Are you disappointed with the communication that came out from Infosys and some of the larger players suggesting that growth will not be as robust as the market might have thought earlier? A: I won’t fault them too much for a variety of reasons. The reasons being ranging from the cross border issues that one has heard, partly political which are kind of happening across the regions and the second bit is I am not every sure whether the companies are capable of grappling with the way the world is behaving. If we sometimes assign too much to their ability to understand and also communicate eloquently in terms of what is going on and what they see, so, it is a very tricky world. The way the currencies are behaving, the way the banks are trading, the important point is imagine that a good part of the IT companies have a large share from BFSI and BFSI is a key component for all these Indian IT companies. BFSI globally, take US, take Europe, take Asia, wherever you want to be, that is the soft piece in the puzzle globally. When I say soft piece in the puzzle is think of Bank of America, think about Deutsche Bank, the European Banks, the American Banks, they are struggling to figure out what the next few days are going to be and they obviously will find it extremely difficult to tell their vendors as to what they need to be prepared for. So, I am sympathetic about what the IT companies say and the management commentary is to be kind of be more --we need to be more considerate towards them because they themselves are grappling with a lot of issues. Q: Do you have a view on the commodity space, on the material space because that is not only a sizeable chunk or in terms of the delta increasingly important chunk in terms of determining earnings for us but also it sort of underscores the risk-on, risk-off moos in global markets. What is your sense of how the next six months could be for the whole commodity space? A: I don’t have a very strong view but I think the way the liquidity has been bobbing around and the way liquidity has been chasing assets which are worth investing in, there are two parts to the story. First is the currency and second is fixed income. The currency part is like anybody’s guess because everybody wants to be lower than the other. The fixed income is possibly all consumed and the yields are now being chased down to zero. The assets that are left which are where liquidity could actually go and possibly kind of see a fair amount of chase is commodities. The fact that these are the assets which are trading at possibly six to seven year lows and some of them are life lows, so, those commodities will offer some value and the fact that if the Chinese policies are favourable, there are few things which can kind of trigger a fair bit of optimism from the Chinese outlook. They have managed to curb production, managed to kind of remove some assets and they have rationalised a fair bit of their capacities. Secondly, I think their rate action will possibly trigger a bit of capex as well. I will possibly watch out for the commodity space which is still relatively a low key asset class as we see it now. Q: What do you make of some of these local triggers which seem to be driving sentiment back home which is the passage of goods and service tax (GST) or the monsoon, do you think they are priced in a) and b) do you see them as very material fundamental triggers in the near-term? A: With the risk of sounding a bit cynical, this GST Bill and the GST changes which are being talked about, we have seen several bull phases and rallies on the back of GST rumours. I think the reality is it will be done only when it is done. Even if it is passed as a bill, it has got several follow through measures which need to be taken and it is not going to be before middle of next year that you will see things actually fall in place. There are couple of concerns on the back of GST which I think people are still possibly -- we all are a little blind about is the impact on inflation and the neutral rate, how neutral is neutral and also how do you distinguish between goods and services. So, there is a whole lot of issues there. So, GST sentimentally because we all kind of do not understand the totality as to when it comes to existence what the impact is, it is a positive sentiment driver. However, the outcomes might be very different from the sentiments. The second part is monsoon. I think monsoon is important; it kind of is a key driver. These are positive triggers. What is more important is some of the initiatives that I see, power and road sector which have taken up, those are positive moves. So, the policy action and the ministerial moves are little more significant than to talk about key events. So, structurally things need to be done rather than looking for few rockets here and there.Q: You are sounding a bit cautious would it be fair on my part to suggest that you are not completely confident that we are on a multiyear uptrend or bull market at this point in time that you are prepared that given the global backdrop things could change anytime?A: I am mindful of the risks. About the risk of you having understood the way you have that I am not bullish is possibly may not be accurate. I would sum up by saying that I feel that the policy actions are positive. I think the efforts in terms of corrective measures and structural changes are positive. The global backdrop is obviously not conducive. The third bit or last bit is if the banking system was little more robust and it had the capability of pushing more than 8 percent credit to the system your GDP growth and overall structural growth would have been much stronger. It is important to understand that you can’t blow bubbles and you can’t call it growth and the fact that you need credit to support it, your banking system 60-65 percent of the banking system is reasonably crippled that’s needs to be fixed first. If you have credit supply you must assume that it is going to be for the right reasons.If you do not have credit supply it is very difficult to kind of have a robust 8-9 percent growth in the economy and I am completely mindful that these are being fixed. I am appreciative of the fact that albeit slowly but it is being done. The fact remains that these things are not fixed in a quarter. I am cautious to the extent that the valuation does not permit any margin or there is no room for error and that’s what making me a little less buoyant or you could call it a multiyear rally, it could be a multiyear rally I don’t know about it, but as I see it as a static picture as we stand here and talk is it is valuing a fair bit of the optimism and we need to be mindful that world around you is not the best place to be.