Daily Voice | Rate hike peak, subsequent easing may trigger risk-on environment, says Julius Baer's Unmesh Kulkarni

Financials looks promising over medium-to-long term, says Unmesh Kulkarni of Julius Baer India

"A 10x return at a sector level may be a tough task, but broadly speaking, one sector that looks promising over the medium-to-long term is Financials," said Unmesh Kulkarni, Managing Director Senior Advisor at Julius Baer India in an interview with Moneycontrol.

In the case of pharma, he says while the valuation poses a near-term risk, especially in case of a market correction or sector rotation, the worst is behind for healthcare companies, and the sector presents a longer-term structural play.

On the market mood, Unmesh, who has over 25 years of experience in the wealth management industry, believes that the peaking of the rate hike cycle and easing of rates in the subsequent quarters could trigger a risk-on environment.

He further says India, with its relatively superior economic and corporate earnings growth, remains an attractive destination for global flows. Indian markets are on a good wicket for the next few years, he believes.

Midcaps and small caps have run up sharply over the past four months; while the Nifty50 index has returned 13.8 percent (April-July), the Nifty Midcap 100 index has delivered 25.6 percent return, whereas the Nifty Smallcap index has even more handsomely out-performed with 30.1 percent return.

Midcaps and smallcaps are now outperforming largecaps over 3 years. On valuations, midcaps are now trading at a premium of over 30 percent versus largecaps.

While the longer-term outperformance potential of mid and small caps holds, especially in a buoyant economic cycle, the recent sharp outperformance calls for a bit of caution in the near-term, as any disappointment on the global front (e.g., a sharper slowdown than expected mild recession, or excessive hawkishness by Fed) could impact sentiment and flows and induce volatility, and more so for mid/small caps which suffer from low liquidity in market downtrends.

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Equity market sentiment has been improving over the past one year, as evident from the flows and new high created, aided by healthy economic momentum and corporate earnings. Small caps had underperformed massively in 2022, and with the improving sentiment and market breadth, smallcaps started catching-up with the broader market.

While the earlier part of the rally was concentrated around fewer stocks, the recent leg has seen all-round participation and recovery, including in midcaps and smallcaps. Investors’ risk appetite has improved and domestic flows into equities have been very resilient, which has also helped in improved sentiment for smallcaps.

Besides direct participation in equities, flows from equity mutual funds have been robust and equity PMS/AIF schemes have also garnered healthy inflows from investors, which have found their way into smallcaps as well.

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As of August 1, revenues (up 8 percent YoY) and EBIDTA (earnings before interest, tax, depreciation and amortisation up 29 percent YoY) met expectations, while PAT (up 43 percent YoY) was slightly above expectations.

The earnings growth is being driven primarily by domestic cyclicals - BFSI, Auto and Industrials. BFSI is witnessing healthy credit growth and lower credit costs, while Auto and Industrials are seeing improvement in sales and profitability with benign input costs. OMCs (oil marketing companies) have witnessed a surge in profitability in Q1FY24 on strong marketing margins, while Pharma companies have started reporting better numbers with improvement in pricing in US generics.

On the negative side, Metals sector continues to drag, and IT sector remains marred by an uncertain global macro environment and delays/reprioritisation of projects.

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While most companies remain hopeful of a recovery in rural consumption, it remains a key monitorable. The rainfall activity, especially the temporal and spatial distribution, can have implications for food inflation and rural demand.

Pharma sector had been a big underperformer over the past eight years, marred by multiple issues including US generic pricing erosion, regulatory actions by the USFDA and a long resolution cycle, and heavy investments by companies in various new areas which were weighing on their profitability.

The sector finally seems to be coming out of the various headwinds. The US generic pricing erosion has recently eased out significantly, the various investments are seeing monetization and companies are witnessing a steady resolution of the regulatory issues. Further, drug shortages are enabling the scope for better business for companies having requisite approvals and manufacturing capacity/capability.

Results have been encouraging so far, particularly companies having exposure to US generics. Apart from improved traction in niche opportunities, the base portfolio is witnessing reduced price erosion as well as market share gains. Domestic formulations are witnessing robust growth in key therapies, fueled by new launches/price hikes.

The sector has run up this year, with Nifty Healthcare index posting a robust 20 percent+ appreciation. The sector valuation is now at a slight premium to its 10-year average versus the 10 percent discount in the earlier part of the year.

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While this poses a near-term risk, especially in case of a market correction or sector rotation, we believe that the worst is behind for healthcare companies, and the sector presents a longer-term structural play.

A 10x return at a sector level may be a tough task, but broadly speaking, one sector that looks promising over the medium-to-long term is Financials. India is among the fastest growing economies, and with the nominal GDP expected to grow in double digits, credit growth should also grow commensurately, which augurs well for the banking sector and select NBFCs/HFCs.

Loan growth remains healthy, led by sustained traction in Retail and SME, while the corporate segment has also started picking up with revival in the capex cycle and higher working capital requirements. Consolidation within the financial sector provides scope for additional growth and improved efficiency.

Digital lending is picking up and likely to grow in the coming years, and this will provide additional impetus to the growth and penetration of lending by banks, NBFCs and HFCs. Improved penetration, aided by higher digitization, provides additional opportunities for other financial services and cross-selling opportunities.

Indian equity markets have run up recently, and since April 2023 have played catch-up and outperformed global markets. The market breadth has been strong and volatility has been low.

In the near-term, global factors rather than domestic factors will likely drive the market sentiment and outlook. The evolving global landscape (hard / soft landing) and central bank actions (pause / continued rate hikes) will set the tone for the broader equity market sentiment and flows in the near term.

US equity markets have run up handsomely this year and are vulnerable to corrections / volatility, as just witnessed with the credit downgrade of the US. However, the earnings momentum of US companies is still healthy, labour markets are still strong and unemployment levels are low, which suggests that US might just be able to stave off a recession. And this provides some more upside potential for the US equity indices.

Indian equity markets too have moved up sharply recently after consolidating for almost 20 months; however, valuations are only slightly above historical averages. A healthy economic activity and steady corporate earnings momentum with about 13-14 percent earnings CAGR can help the markets sustain the valuations.

The peaking of the rate cycle and easing of rates in the subsequent quarters could trigger a risk-on environment. India, with its relatively superior economic and corporate earnings growth, remains an attractive destination for global flows. Indian markets are on a good wicket for the next few years.

Oil prices have rallied more than 20 percent over the past couple of months. The most recent leg up ($85 a barrel) comes from Saudi Arabia’s decision to extend its production cut by at least another month.

However, the current oil politics and artificial supply tightening are not in a stable equilibrium, as there are diverging interests among producers and unhappiness about artificially inflated oil prices among buyers.

Key oil buyer countries (China, India) will likely increase their efforts to import ‘grey market’ oil at discounts. The bounce in oil prices could also prolong the US shale growth phase.

Overall, the continued output cuts result in less supply tightness than perceived. China’s economy continues to struggle, and Asian oil storage seems well filled anecdotally.

While the oil market mood has shifted from bearish to neutral, oil prices will most likely trade at the upper end of a range; however, a break above $87-89 could unleash further upside.