Lofty valuations, plummeting consumption, stagnating growth to play spoilsport in 2023

A: For starters, you have valuations which are fairly expensive. If you look at the multiples for the broader market, say the Nifty 50 index, it is trading at almost 20 times on a 12-month forward basis. So, the starting setup is not that great. If you look at the stocks trading in automobiles, consumers, staples, consumer discretionary sectors, IT, etc, most of the trading is happening at significantly higher multiples compared to the pre-COVID levels.

If you compare March 2019 multiples with current multiples, most of the stocks are at least 5 to 10 times higher than what they were in March 2019. Further, if you look at the interest rates, they are more or less at similar levels. The 10-year G-Sec yield in March 2019 was about 7.35%, and we are currently at the same levels. So despite whatever we are seeing globally in terms of interest rates rising and compression multiples, India doesn't seem to have gone through any of that correction in multiples.

Another thing could be the market is betting on significant improvement in growth going forward, which I am not very clear about because if you look at the last few weeks, the commentary from many of the companies has been actually quite downbeat and across the board, if you look at apparel, consumer discretionary, automobiles, QSR – pretty much every company is suddenly starting to talk about significant downshift in demand.

I am not very clear about the factors, but it could just be some amount of slowdown in hiring and in the organized sector, particularly the IT services space. It is possible that high inflation is starting to affect discretionary demand somewhere. Lastly, we've also seen fairly stiff increases in interest rates as far as mortgage rates are concerned, which will definitely impact EMIs of the households. All this put together will result in some amount of slowdown in consumption. So, I am not very clear about what the market is really excited about. Multiples are very high, clearly ignoring the macroeconomic setup… interest rates will stay higher for longer and clearly, some amount of slowdown in discretionary demand will be visible.

Q: There seems to be a contradiction in the narrative, in that, India has been receiving record foreign inflows on the back of the perception that India is set on a higher growth trajectory from here on. For this narrative to be true, the market and individual stocks will have to have higher valuations. However, we're still looking at past valuations and declaring the valuations to be fairly expensive. How do we reconcile the contradictions in these two narratives?

A: Well, if you look at growth, to start with, we have to wait and see whether that growth materialises or not. So far we are not seeing any signs.

Let's look at various other sectors. If we look at the two-wheeler sector, for example, volumes are significantly lower than what they used to be, let's say FY18 or FY19. If we look at four-wheelers, we are just about getting back to FY19 levels here. So clearly, we haven't seen any meaningful acceleration volumes to start with. What’s more, most Indian companies sit on very high levels of profitability. One of the concerns, I have, is that across sectors we are starting to see a kind of breakdown of oligopolies or monopolies, which will definitely impact the pricing power realisations and profitability of companies going forward.

As of now, growth is still a question mark, and the emerging evidence does not inspire confidence. Look at the three-year CAGR for volumes across sectors, it has been pretty disappointing. Unless and until we see a big rebound in volumes going forward, I am hard-pressed to make a case for higher multiples compared to whatever we have seen in the past.

Also, keep in mind the fact that for the last 10-12 years ever since the global financial crisis, we have seen abnormally low-interest rates globally. As far as the global markets are concerned or the larger economies are concerned, we have seen pretty much zero nominal interest rates or very negative real interest rates.

Going forward, we are looking at a situation where real interest rates would be modestly positive and central banks would now be a lot more cagey (less tolerant) about inflation. Any signs of incipient inflation, they are going to act a lot faster, and a lot harder in trying to control inflation. So all this suggests, to me, that we are looking at a shift as far as the interest rate environment is concerned. We are headed into a period of higher interest rates, which means a higher cost of capital to start with. So, to argue for higher multiples, when growth is simply not accelerating… it’s a bit doubtful at this point in time.

Q: You are talking about consumption slowdown. Do you see a demand slowdown for the next two-three quarters or do you have concerns over consumption/growth over a long period of time, let's say three to five years?

A: In the course of the coming three to five years, things will be a lot better, but before that, what we need to see is a big step up in investment. And unfortunately, we are not seeing that so far. Obviously, the government has done a lot of good things in the last three, or four years in terms of rationalisation of the taxation regime, and the change in labour laws (even though they have not been notified as yet) as well as instituting practices on the ease of doing business. Additionally, you have the PLI scheme, which will hopefully result in more investment going forward.

But, in the larger picture, it doesn't look like we are seeing a big acceleration in the investment cycle as yet. Hopefully, next year or so, some other PLI scheme-led investments actually start hitting the ground. Hopefully, you will start seeing some acceleration in investments going forward. As of now, the missing piece seems to be investment, which is happening but not at the required rate.

Q: So, how do you explain this credit growth of 18% upwards? Of course, last quarter we could have argued that because of the working-capital requirements, credit growth was perhaps buoyant. But if it continues at 18 percent, then where is the money really going to if it is not going to power capex?

A: As of now, at least the YoY growth (in credit) has been driven by growth (in lending) towards the retail consumer and NBFCs, which mostly lend to the retail segment. So most of the incremental demand has largely been driven by the retail sector, not so much as by the industrial sector. If you look at industry also, we are seeing some recovery over there. At least power and road seem to be doing okay. Steel, obviously, you are seeing some amount of decline but that is understandable because… (the steel sector) had two years of very high, free cash flows, which resulted in deleveraging. Having said that, don’t just go by the yearly numbers because you had a low base to start with. Three-year CAGR for credit growth is not that impressive, it is still sub-10%. So year-on-year everything will look good in India (because there was the advantage of low base across sectors)… also higher inflation does also result in growth numbers starting to look a bit more exciting than what it is (going by the fundamentals).

Q: What is your expectation on public investment spending? And what is the number that will satisfy you in this Budget?

A: The real problem is, you know, the government simply does not have the capacity to spend. If you are running a 9.5 percent consolidated fiscal deficit between central and state government, where there is a capacity to spend? A lot of the government revenues are actually eaten up by interest payments, salaries, wages, pension allowances, subsidies and so on. So, the ability to spend is quite constrained.

If you look at public sector investment as a percentage of GDP, that has hovered at around 7.5 percent for the last several years now. So no real change over there… in the sense, it is moving in line with the nominal GDP growth. If it has to grow further, then clearly something has to give (has to change). I don’t think India can have a model where the bulk of infrastructure is being funded by very high fiscal deficits. Eventually, India will have to go for fiscal consolidation, and unfortunately given the fixed nature of a significant portion of the expenditure, the cut will, unfortunately, come on the capital expenditure.

There are two-three ways to fix this problem. One is if growth picks up, automatically revenues pick up, tax buoyancy reasons and so forth, then maybe the ability of the government to finance incremental capital expenditure, particularly the infrastructure sector is still okay. The other option is to see how quickly you can get the private sector to invest in real infrastructure, which is in areas of, let’s say, electricity, mobility and water. As of now, most of the investment in these areas is largely done by the government sector, not really by the private sector, barring electricity generation or long-distance highways. I mean, everything else is largely in the hands of the government. Unless, the government’s fiscal position is a lot better, I am not too sure how we can fix this problem.

Q: Global markets still hold out big risks from a market perspective. Where do you see rates peaking? And how long do you think it will stay there?

A: It looks like (for) most of the global economy… (it) is more or less near peak interest rates, I would say. Maybe another 50 basis points as far as the US is concerned. Most of the other countries I think are already there as far as peak interest rates are concerned. The bigger issue is how long interest rates will stay where they are. That's where the real battle is going to be, that is, between the central banks and the market next year. The market will be probably hoping for a pivot from the central banks. As of now, if you look at the U.S. Fed fund rate, the market seems to be assuming that you would see two rate cuts by the end of calendar 2023. So, we will have to wait and see whether we will see any rate cuts in 2023 to start with and how much.

For now, the markets seem to be more focused on headline inflation, which will obviously come up very sharply going forward, as long as you don't see any negative surprises from food or fuel, both of which we really can't forecast, but, at least, based on the high base effect, you will start seeing headline inflation starting to come off really strongly. If you look at the underlying data, the problem seems to be core inflation is still very, very sticky. It is not showing any signs of coming down. If that stays high and that's what probably the central banks will focus on because that is a measure of more embedded or entrenched valuation, and that's what the central bank would like to bring down, which means that the central banks will sustain the peak rates, whatever that may be.

There is a bigger issue going forward, which is not just the level of peak interest rates, which I think, are more or less getting there, but how long will rates stay at their peaks? One could see 9-10 months of peak interest rates and then a decline or an extended period of very high-interest rates, which will definitely disappoint the markets.

Q: Where do you see Indian interest rates? Do you think we will also stop with another 50 basis point hike?

A: Well, I think as far as India is concerned, I think we are broadly there (at peak interest rates). Again, keep in mind the fact that inflation can be fairly volatile in India depending on what happens to food prices. Thankfully, we have seen a big cooling off in vegetable prices, which should help. But having said that, even in India, core inflation is still going to be on the higher side. The RBI may not be in any big hurry to reduce rates. I think it will probably stop at 6.25 or 6.5. But I suspect, it will also just keep rates (as they are for a long time).

Q: Where do you see pockets of opportunity in the markets?

A: Mostly the banks, I would say, because valuations are quite okay. In fact, they are quite cheap for some of Tier II, and Tier III banks and NBCFs. At least for the next two, or three years, it doesn't look like credit cost is an issue. Credit growth is picking up, so, hopefully, that will sustain.

In the rest of the sectors, especially the consumption sectors, which have seen a big leap in multiples, my concern is that even though growth may be fine--hopefully, we can go back to double-digits, mid-teens kind of growth for most of these companies--you could possibly see some re-ratings in the multiples, which means some of the increase in earning numbers gets offset by lower multiples. So, stock market returns will fall, in that case.

Q: You would be bearish on IT?

A: I am underweight for the time being till some clarity emerges on what is really emerging on the demand side. So, as of now, we are starting to see some slowdown on the discretionary part. We will see how much slowdown is there in the U.S. because the macroeconomic indicators are quite mixed as of now. On the one side, you will still see very strong growth in the economy in terms of labour market, consumption, demand and so on and so forth. We see some slowdown in the housing market, but clearly, it looks like the U.S. Fed will have to keep rates on the higher side for a longish period of time.

You could possibly see a far bigger slowdown in the economy than what the market is prepared for currently and that can't be good for demand for at least, especially a part of IT services. Multiples are okayish, I would say, still slightly higher compared to pre-COVID levels, but at least, you know, it will be more palatable compared to whether, let's say, in February, or March of this year.

Q: What’s your take on new tech? A lot of price destruction has already happened. Companies are also obviously talking about getting to break even and all of that, but that doesn't mean that it has changed anything dramatically in terms of business fundamentals.

A: Food delivery seems to be in a better position given the fact that we have more or less of a duopoly now. So the chances of managing cost and hopefully, getting to profitability seem to be a lot better compared to, let's say, the FinTech space, for example, where you still have way too many players. I don't know what the competitive edge for a FinTech lender is compared to, let's say, any normal bank or NBFC lender. Clearly, they don't have any real competitive advantage in terms of the cost of funding.

The problem is, if you have a higher cost of capital and lower ability of the markets to digest risk, this is the sector that will suffer the most.