Markets seem to have taken the RBIs tightening measures in their stride.
Contrary to immediate reaction on the RBIs actions on short-term rates, the inflows have remained healthy. Today, India is a preferred destination amongst emerging markets because of its relatively strong consumption theme. Foreign investors mainly consider two criteria to manage their investments: the size of the market; and the economic activity.
While some markets may be more attractive than India, their size may be such that they cant take a large amount of capital. What works for India is that it is a large country and it needs large capital to fund its growth. Investors biggest concern at this point is the currency, and actions taken by the policymakers in defending the rupee are well received by investors. The GDP growth has already come down to the lower side of its range and a further marginal deceleration may not create huge incremental damage.
Despite higher volatility the market has stayed in a range for quite some time, but it is difficult to justify a large upside in the market. The market needs triggers like a turnaround in GDP and earnings growth to move up. As long as the money does not leave the market, it may trade at healthy levels. The money may get churned between sectors or stocks depending on sentiments on growth.
What is your outlook on the rupee given the way it has bounced back
The recent fall in the rupee was more sentiment-led than fundamentals. There were two concerns i.e. absolute value of the current account deficit and means to fund it. The recent measures taken by the government, particularly on the gold import side, has resulted in substantial reduction in trade deficit. To fund the deficit, the government and the RBI have announced measures to attract foreign capital in India. As market recognises this, the rupee will stabilise.
Do you think the correction in market was an overreaction to interest rate concerns
The markets were surprised by the RBI move on short-term rates as they were focused towards RBIs stand on inflation-growth dynamics. RBI's action was a text book way of raising the interest rates and controlling liquidity. The last time RBI resorted to this strategy was back in 1998 during the Asian financial crisis. While the street did not expect the central bank to cut rates, nobody expected the RBI to raise short-term rates. The message it gave out was that the RBI and the government are here to defend the currency, not at a particular level but to defend it against the speculative attack. That caught the street by surprise.
Higher interest rates badly impact the balance sheets that are leveraged. Indirectly, it sips into the banking sector. Just a few months back, it was expected that as the interest rates come down, the asset quality would improve. However, in the worsening scenario, even large-cap companies can also default, which is turning out to be a big worry. Given that the economy is slowing amidst high interest rates any company with high operating or financial expenses gets impacted irrespective of which sector it belongs to.
Export-oriented sectors do get a boost from the weaker rupee. Fortunately, it is not a small portion of the overall market, with IT and pharma becoming a reasonable part of the index, as also RIL. Further, as the currency depreciation takes place, consumption theme again tends to strengthen. In effect, almost 40-45% of the market is likely to weather the rupee depreciation.
Till the currency stabilises, the concerns related to markets may sustain. That in turn depends on CPI inflation. The RBI may not consider any loosening at all. Over the next few quarters, the asset quality problems may get much more intense and would be clearly reflected in the September quarter results.
What is your outlook on the banking sector given the return of asset quality concerns
In the banking space, two key issues have emerged in the recent past. In an environment where rates are expected to go up, banks position themselves to control the risk. Small-sized banks with lower CASA ratio were not ready for the rates to move up and to that extent may be hurt with any increase in the interest rates. Some of these private sector banks were given a higher value, based on growth and margin expectations. However, that premise is challenged now. Secondly, if the pain in the system continues for long then you may see the asset quality issues affecting even the larger private sector banks.
We believe that over the next two quarters market would want to see how a few dynamics play out for the private sector banks in addition to the asset quality concerns. Banks may turn conservative in lending, so their growth may come down. If one gives a high multiple to a bank, it is based on expectations of a certain rate of growth. Because of the short-term rates going up, if a bank does not efficiently manage its funding, the margins can be impacted. Together, these factors can affect the return on asset of the banks, which were near 1.8-1.9 levels for quite some time. Even if this measure reverts towards its mean value of 1.5-1.6, the market would take a serious note of it. The street may require time till January 2014 for fundamental clarity to emerge on the earnings and book value impact even as valuation may start looking attractive.
Do you think the recent bout of GDP downgrades is yet to affect the earnings expectations for FY14
In a way, earnings growth is not relevant because it may not be coming from a stronger revenue. At this point, I would like to give more importance to top-line growth than margins, because the currency fluctuations may impact the latter. Since the currency outlook is not certain, it may me more prudent to build in lower multiple into the estimates. What is relevant for us to know is that the long-term story of India is attractive and as far as money continues to remain in emerging markets, we would continue to benefit from that. It is logical to argue that as an impact of QE3 winding down, money may move out of bonds, specifically US bonds. By September-end we may get clarity on the extent of impact on equities if the Fed actually starts curtailing its market operations. Indian market may face the pressure than given that it is not attractive on an absolute basis but is on a relative basis.