Politics overshadowing fundamentals; buy midcaps: Goldman

Going into  2014, two key events that would have significant impact on Indian equities are general elections at home and the likely reduction in money printing by the US Federal Reserve.

Goldman Sachs recently upgraded its India rating to equal-weight from earlier underweight citing improving macro and micro cues. The investment banking firm raised its Nifty target to 6900 citing optimism over possible political change led by Narendra Modi. (Read More) In an interview to CNBC-TV18, Asia Strategist Timothy Moe said the market is viewing Narendra Modi as a leader for change and it is trading politics over fundamentals at this point. Moe based this assumption on the feedback his firm has been getting from its clients. A weak rupee and its impact on the current account deficit were the two key concerns the Indian economy was faced with sometime back. While Finance Minister P Chidambaram is now confident that India’s FY14 current account deficit (CAD) will be contained below USD 60 billion against the estimated USD 70 billion, Moe also agrees that CAD concerns have lowered significantly. Also, the recent measures taken by the Reserve Bank of India (RBI) to protect the Indian currency have been effective in stabilising it, he noted. Moe does not see a big downside to the Indian market in near-term and feels that Indian market will not react severely when the Fed actually rolls back stimulus because external factors for India have moderated. He is overweight on IT, pharma and energy stocks and is underweight on consumer staples given its high valuations. The US based broking firm has also raised its outlook on cyclicals to equalweight from underweight. Midcaps have been performing well in the last couple of session; he points out that midcaps are currently trading at a 30 percent discount and sees it as good opportunity to invest. The ongoing second quarter earnings season has been in line-with expectations and financial companies have reported earnings better than estimates, Moe said. He expects 5 percent earnings growth in FY14 and raised its FY15 earnings estimate to 11 percent from 8 percent. Below is the edited transcript of Timothy Moe’s interview with CNBC-TV18 Q: You have pointed to a lot of positives that probably are emerging in the Indian economy. Do you see the capex cycle picking up? We have seen the currency stabilise and things like that but we haven’t seen any growth numbers coming in. Are you confident that growth will return? A: With regard to the cycle, I would say that the growth environment is still very constrained. But there are some glimmers of hope that we have picked up particularly in some recent visits that we are doing in India last week. Looking at the data which suggests that at least the downturn that we have been seeing maybe stabilising and there maybe some green shoots of improvement in a couple of select areas. We noted two things in the piece that we wrote earlier this week. One, if you look at some of the indicators, one of which would be activity levels for industries associated with infrastructure, it seems to be picking up. Additionally, if you look at some lead indicators like raw material inventory to sales ratios, it looks like there are some signs of picking up. In terms of number of projects that are stalled, those have been on a steadily rising trend and appear to have at least stabilised in the last few months. _PAGEBREAK_ One encouraging development from the recent reporting season for the recent quarterly results is that it has come inline with expectations. In fact, for financial areas, some are above expectations and that is against the backdrop of people concerned that we might have a lot of misses of earnings because the economic environment has been a lot more sluggish otherwise. So, we are seeing some signs of the micro level that corporate India is delivering results that are commendable in the context of a more suppressed growth environment. We are seeing some signs that we are getting some traction on the capex side and particularly infrastructure and those are certainly things which should take note of and have a more constructive view on. Q: To what extent upgrading of the Nifty to 6,900 based on the hope that Narendra Modi comes to head the next government and if that indeed were not to happen then would you want to drastically change your forecast of the Nifty? A: We are not expressing view for any political parties nor are we expressing view on what might happen in the general elections, which have to happen not later than May of next year. What we are observing and this is the case in terms of how the market is trading and also the very large number of investors we speak to both externally as well as domestically is that Mr. Modi is viewed as nation of change. The market has been trading or reflecting various opinion polls and has been responding to those. We observed in our piece that if the political dimension is one that is currently in focus and valued by the market and we have at least or likely we have up to six months of the timeframe between now and when the actual national general elections happen, then that’s the environment which the market maybe expressing a more confident view on the political developments. That needs to be considered into one’s overall perspective in terms of how the market can trade. Our view has been that the market is trading politics. To me to understand that and reflect that in terms of overall assessment and when we combine that with the fundamental and structural change, for example the announcements on some progress been made and things like the Mumbai-Delhi industrial corridor, that leads to a much more balanced appraise of the risk versus award of the market. It is also very important in the current context to note that the actions that have been taken by the Reserve Bank of India (RBI) to assuage concerns about capital outflows during the pressure that many emerging markets including India faced particularly during August that the RBI has done an effective job in terms of stabilizing those expectations. We have seen how that has happened with regard to the way the rupee has traded and now to 62-61/USD level. The idea that there have been quite a lot of buffers put in place with regard to capital flows, for example USD 50 billion swap facility with Japan. So, in conversations we had with RBI in terms of RBI’s specific communication in terms of its press statements and analyst briefing, it is quite clear that the concerns on the current account external side have come down significantly and that is been reflected. If we look at the situation in the middle of this year when growth was coming down and there were tremendous external pressure and the situation now, where external pressures have moderated.There is a welcome window of respite that the Federal Reserves has given us in terms of delay in the timing tapering, evidence at the corporate levels that their profits have been coming in and the fact that the market is trading the political development in its own perception in a positive way, all that adds up to or taking a more balanced view on the Indian equity market.

Q: You spoke about the upside for the Nifty at 6900 level. What about the downside? When the Fed decides to taper which in all likelihood could be in the month of March do you see that as a big deterrent for the Indian equity markets which could take it back to those August lows of 5100-5200 or have we put that firmly behind us? A: That is a great question and I am really glad you asked it, because there is an important concept that people need to understand at this juncture. We have had this sort of windfall opportunity or windfall grace period that has been delivered by the fact that the Federal Reserve has delayed its tapering from an expected September period to sometime in March. There might be some risk around whether it is earlier or later, but let us just for argument say we have a six month window or this respite of tapering. What is important about this is how that window of time is actually used. If. for example nothing was done during that period then it would only be effectively a stay of execution. We have been given six months more time but when tapering happens and the global liquidity tide changes, if India is still as vulnerable as it was in September then arguably the market's reaction would also be similarly adverse. If on the other hand, India shows some progress, there is some moderation of external imbalances, the arguably the market's reaction to the Fed's tapering will be much more attenuated when it finally comes. There seems to be some empirical evidence that the external pressures have moderated. The trade account has been improving. It looks like the current account will begin to moderate and I am sure there are various details we can go into in terms of gold, oil and trade and so forth. But there are specific granular and factual evidence one can sight with regard to some improvements that are made in that direction. The funding of the CAD looks as though is more secured now and in place. So, the level of concern with regard to the magnitude of the CAD and the funding of it through the capital account clearly would have moderated. Our expectation is that as and when Fed does begin to taper, say in next March, the Indian equity market's response and currency's response would be much less severe than it was as we saw in August. _PAGEBREAK_ Q: I just wanted to pull up one point that you spoke about earlier which is with respect to the earnings situation -  Historically every bull market hinges on a sustainable improvement in earnings. Have you seen atleast a little bit of evidence which could suggest that the worst of the earnings performance is behind the Indian markets and there could be perhaps upgrades as well? A: Let's divide that into two components -there is sort of a global aspect and there is an India specific aspect. From a global perspective our expectation is that we will have the United States economy improve next year to about 2.9 percent growth for full year 2014 over 2013. We are expecting a moderate improvement in Europe's growth; low in absolute terms but an improvement from the previous year. So, we are looking at about 1 percent growth in the EU area next year, may be a tad below that but better than the flat growth that we have seen this year, the slight recessionary conditions. Japan, we think is also having moderate growth and some of the effects of the Abe programme will be flowing through into growth there. For China, we feel that they are in a sort of a roughly stable momentum phase and this weekend we are going to have some important developments about the impact and the overall profile for their reform measures but our rough forecast next year is for about the mid 7 percent range of GDP growth - all that is reasonably good. It is not ultra-fantastic but a reasonably good global backdrop, which obviously should be helpful for the external section and portion of the Indian economy. For the domestic side of things as we were just discussing earlier on – a lot will hinge upon whether the industrial production cycle does actually begin to gain some traction and improve. I think there some of the lead indicators we are looking at are this issue of capital investment and infrastructure development both in terms of the actual contribution to growth but also in terms of its beginning over a longer-term period to address some of the supply side constraints to growth, which are still pretty significant in India's case.       I think there are some reasons for moderate amount of confidence. In fact even on our numbers which are slightly below what consensus is for growth, we are still looking at a moderate improvement in overall growth momentum next year. So, that should also accrue to the benefit of the corporate sector. Also for the corporate sector, we are looking for earnings growth momentum to improve. Our top down numbers for this year are about 5 percent, we are tad below consensus which is at about 8 percent right now. Next year we are looking for an improvement as we have mentioned in our piece to about 11 percent, that may even be a little bit on the conservative side – consensus is a bit higher to about 13-14 percent right now. However, the overall profile is one of a moderate acceleration in earnings per share growth and as we go through the full year of 2014, the market particularly in the later part of the year wills start to focus on the outlook for 2015. I think the further out we go, the more generous we can be in terms of expecting and hoping that India's economy can approach further an approximate trend growth to a better degree and that should also allow corporate earnings growth to begin to firm as well. Ofcourse against that backdrop there are some continuing real time challenges and just to mention two of them very briefly, one is that inflation is still very high and it looks as though monetary policy will remain quite firm and restrictive. It looks as though the Reserve Bank of India is focused on curtailing inflationary expectations. I don’t think we are going to have any near-term respite in terms of a difficult monetary policy backdrop. Over the longer term that is probably very good for the overall economic health of India but obviously it is going to be a challenge for corporate India operating under a regime of still high interest rates. One of the ramifications of that for the banking sector is that there may be some lagged effect on NPL provisioning in the next couple of quarters for the fact that the economy has slowed in the last several quarters. That is why we need to take the financial results of this quarter with perhaps a pinch of salt because there may be a little bit of a lagged effect in the next one or two quarters in terms of loan loss provisioning ratios. Overall to simplify things, we think that the overall outlook is one where cyclically we are getting somewhat better and we think obviously the market has been sniffing that out and we think appropriately so. Q: This 6900, which stocks could take India there? What are your preferred stocks? A: I prefer not to mention specific names on the show just for regulatory and compliance reasons but I can talk about some themes that we are focused on. As we said in our piece, we have been overweight n our sectoral allocations, we have been overweight areas which have been beneficiaries of a weak rupee and that would include the software-info tech sector, We have liked healthcare which is a continuing good structural theme and a beneficiary of external pressures, and we also like the energy sector. We are little bit less optimistic about what we think are the more richly valued consumer stable sector. We think a lot of the good domestic growth has been pretty well factored into valuations. One of the changes we made in our recent report was to become more constructive on the industrial cyclicals and that really is a reflection of the expectation that we might get little bit better news from a cyclical standpoint particularly on the infrastructure side as we go forward. So, we raised them from underweight to market weight in overall sector allocation. From a thematic standpoint we think that there is opportunity within the middle cap part of the market. A number of the investors that we spoke with domestically in Mumbai last week were also noting this that there is a significant valuation disparity between the large caps and the midcaps, with midcaps currently trading around about 30 percent discount valuationwise. There may be some better risk versus reward or some of the earnings versus valuation opportunity recognising you have to take some liquidity risks when you go down the market capitalisation spectrum. So, one of the things we did in our piece was we did a screen of some of the infrastructure related companies that are in the midcap space, which have some attractive valuations. Some of which are as low as sort of 8-9-10 times earnings against a market that is currently trading around 14-15 times. So, there is a significant valuation benefit that you can get if you are willing to take a little bit of liquidity risk and go down the cap spectrum. That is one of the ideas that we surfaced in the report which we wrote earlier this week.