Mkt fairly valued; India to react well to Fed rate hike: MS

Sonia: From last Diwali now the Nifty has not done anything for investors? What's your sense? Will we make decent headway by from this Diwali to next?

A: When I look back on Samvat last year we were optimistic on the markets, we were hoping that the markets will give returns and frankly they have disappointed us. It has not been one of the brighter calls. Earnings have lagged our expectations.

I had a much bigger call on earnings and if I look at why that has happened it has happened because export growth has been weak and that is because global growth has been weak. So, that is the prime reason.

The other reason is that producer price index (PPI) has been in deflation and that is hurting corporate revenues. So, even if you look at this quarter for example even though margins are up 500 bps on the aggregate which is a massive increase year-on-year (Y-o-Y). We still have very feeble earnings growth because revenue growth is actually down for most companies.

So, those are the two things that India needs to overcome. In fact oddly enough India needs better stability in commodity prices, it has helped our macro but it has hurt our earnings. I don't think it will do good to India if commodity prices fall much more from here and it requires a little bit of stability in global growth. And if those two things come along the earnings picture will improve. So, I am actually retaining my optimist and hoping that what we didn't make in the last Samvat we will make in the next Samvat.

So, equities look quite reasonably poised. Valuations are looking a bit more attractive than they were last year. On a relative basis India continues to have a very strong macro. In fact you make the point about India not having done well but on a six month trailing basis for example India is still the best performing emerging market in the world. So, it is more to do with what is happening in the emerging world. And the best performing emerging market in the world is actually down five percent. So, that is that problem that India has which is that equity returns have been anaemic across the world and a little bit of boost from that will do good to Indian equity returns on an absolute basis.

Anuj: There are some headwinds for the market. The Fed make hike rates, also the government after losing two states may not be able to make legislative changes. Will stocks be able to make decent returns despite these issues?

A: Of course those risks are there. There are a lot of risks on the horizon. The Fed thing I worry a little less about that. I would rather have the Fed lift off. For one, it takes the event behind us, like the Bihar elections and you can see how the market is responding. The event is behind you.

The second is actually it is a signal that US growth is okay and if the Fed is not making a mistake and it is reading this right that won't be bad for India. It is very different from the summer of 2013 when India was running a very challenging situation with a high current account deficit, high fiscal deficit and high inflation and a potential lift off then proved to be quite fatal to both the equity and the currency markets. This time around India has been for the past several months the best house in a bad neighbourhood. So, India will actually react well to a Fed lift off.

With regards to the policy making of the government, well for sure, the Bihar election can be viewed as a setback. But I can also view it the other way. I can view it that it will actually egg the government to push forward things that they may have been hesitating on because they may see the urgency to revive growth in a stronger way than what has happened so far. Nothing taking away from what has happened in the last 18 months but a lot of market participants may have hope that things would have happened faster and maybe this is the trigger point.

Legislation, that challenge doesn't go away. Even if the NDA had won the Bihar election that challenge is there with them till the end of their term. The Rajya Sabha majority position or the minority position of the NDA doesn't change in the next three years. They need to work with the opposition to get the legislation done. The good things from a stock market perspective is that the expectations are pretty low now compared to where they were six months ago. So, if the Goods and Services Tax (GST) bill does get passed in the winters session it will be a mild positive surprise rather than the other way round and hopeful it is done and that will be good for the markets if it is done. So, maybe the Bihar elections may make the government a bit more proactive in getting these things sorted out rather than the other way round.

Sonia: Those are all the macro issues but let us start talking about stocks now. If you take stock of the year gone by, the biggest gainers have been the pharma space, stocks like Lupin and the technology space, stocks like Infosys. In your assessment what will be the leaders of this rally in the next 12 months?

A: We are probably going to see a little bit of a shift there. There are a few consensus trades out there which I don't think we are abandoning. But for example we are now clearly underweight healthcare. So, we don't think healthcare is going to be at the top of the pack as it has been for the past five years. In contrast we closed out an underweight position in utilities last week and luckily for me the government announced their big state-owned enterprise (SOE) banks. It is still early days, the market doesn't buy into that story but utilities have been hammered and they seems to be priced for nothing now. So, there are a few changes that may happen.

Private banks may continue to do well over SOE banks. That may be one of the continuing trades for the last 12 months or 24 months. So, I see some positive signals for discretionary consumption whether it is in the broader auto space, not just the car manufacturers or media or for that matter other areas of discretionary consumption. There is a clear sign that job growth is back and it is being lead by the internet sector which is not something we are measuring so accurately. Therefore that may be an area of positive surprise. I am actually constructive on technology. A Fed lift off is good for tech sector and the tech sector should do well into rising or a positive interest rate environment in America.

So, there could be a few changes in say, the last year or two or three years with some of these so called low beta defensive sectors giving up their gains in favour of, say, infrastructure. I am quite positive on railways, I am very positive on the infrastructure space and maybe power utilities to some extent and discretionary consumption.

Anuj: I guess one of the triggers for growth could also be more rate cuts. We have seen already some of that but the Governor has maintained that he is open for more. By next Samvat how many rate cuts do you see?

A: Our official forecast is the year ended March and we expect one to two more rate cuts. Our economist has been pretty spot on. He started the year with 125 bps as his base case and we have got there. So, I would go by his view that we have another 25-50 bps in the next six months. I need to actually spend a couple of minutes on this. It has never happened in India's history since our opened our doors to foreign investors that we have cut interest rates in front of a Fed hike. So, this is the first time it is happening and it is underpinning the point on India's macro and our macro is in such good shape from an external perspective that we have the courage and the capacity to do that. That is a very positive signal for equities. So, rate cuts are probably going to happen, maybe slightly more than what the market is expecting and that will feed into earnings.

Sonia: Any cutting edge or sunrise stocks or sectors that you are spotting this Diwali? Something out of the ordinary? I heard you mention the railway sector but anything else you are looking at?

A: Amongst the large sectors there is very little to find as sunrise but in the smaller sectors there could be stuff like renewable energy that could do well. Smaller industrial companies, new group of industrial companies would emerge. Some of the older ones that participated in the previous cycle may not actually be there. Some of the smaller banks could find that the environment in the next 12 months actually gets better for them. So, there could be as I said in the discretionary space you could go down the cap curve there and there should be some very interesting companies which are building consumer portfolios which could do well over the next one or two years.