Most investors not pricing in a sustained moderation in inflation

Written by Devangi Gandhi | Updated: Apr 14 2014, 08:14am hrs
As both macro and micro factors impacting the inflation taper, the CPI number may post a positive surprise that the street is not discounting yet says Gautam Chhaochharia, head, of India Research at UBS. In an interview with Devangi Gandhi, Chhaochharia discusses investors expectations from the election outcome, market valuations and outlook on various sectors. Excerpts..

What are the key positives the street expects from a favourable election outcome

Our discussions with investors imply their hopes that in case a BJP led government comes to power, because of his pro-business image, Narendra Modi will help in accelerating recovery in Indias economy in various parts, primarily the investment cycle. It could lead to an improved sentiment amongst corporates, and positive sentiment is critical for giving a boost to the investment cycle.

Investors also hope that fiscal prudence will be maintained. The social spending will always remain but the question is as a country how we spend within our means. The problem is not that we have various social spending schemes but that the current government continued with them for the last five years despite the fiscal deficit running high. While during the global financial crisis it made sense for the government to increase stimulus to revive the economy, the problem was that it continued for too long despite not having the means. When it was launched in 08-09, Indias deficit was quite low; inflation was quite low so we could afford to have a high fiscal deficit. But clearly it continued for longer than required. Given that the current government has also made efforts to rectify this, the course correction would continue no matter which government comes into power. This reflects the changed political economy now vs 2009.

Do you think market valuations are already factoring in the positives that could immediately come out of a favourable election outcome

The long-term average multiple for the Nifty is 15 times forward earnings while currently it is trading at somewhere around 14 times so there is still some room for it to converge. However it is important to understand that the market composition keeps changing. The second thing is that within the Nifty itself, there is a huge discrepancy in performance within various sectors with consumers, pharma at near all-time high valuations, the IT pack trading at rich multiples while the rest of the market is trading below average valuations. Cyclicals which will benefit from local economic cycle recovery are also witnessing a lot of interest.

Despite various opinion polls, it is very difficult to take a call on which way the election results can go and hence our base case scenario is built on expectations that economic recovery will continue irrespective of which government comes into power. The reason we say this is that in the last three-four quarters even the current government has been doing the right things like fiscal consolidation, policy stability and administrative support for stuck projects. In that context, we expect current policy approach to continue and growth recovery to happen any which way.

The sentiment does play a crucial role and can drive the pace of the recovery. But our base case scenario is that a bottom is developing. And investors who take a two to three years view, should be investing now. For a shorter time period if the election gives a negative surprise than what the investors are hoping for, some correction will definitely take place. Although building blocks are being put in place, recovery in the capex cycle will take time. For a market like India with unique problems with respect to land and project clearances, capex recovery is likely to take two to three years minimum. So impact being felt in terms of improved order books, or actual, capex spending would take time for sure. In that context it may be early to get overtly bullish on capital goods and cyclical companies for shorter time-period of six-months to one year post the election results.

Amidst the election-led euphoria, focus on earnings expectations seems to have taken a back seat. Where do you see FY15 earnings growth at

From our base case of economic recovery the earnings growth for FY15 is more likely to be 10% to 12% top down. We dont see a negative surprise on this number. For positive upgrades to this, we would look out for more clarity on the state of the recovery. Our base case also accounts for a positive surprise from inflation (CPI) because both, the macro and the micro factors that are driving high CPI from the last two years, are likely to moderate. As a result, the near-term GDP impulse may be negative due to fiscal consolidation, less monetary stimulus and reduced stimulus to rural India in terms of minimum support price (MSPs) and NREGA. This is what we have observed happening in the last two to three quarters already. From our discussions with investors, we see that a majority are not pricing in a sustained moderation in inflation.

Our bottom-up forecasts based on analysts projections are higher. Obviously things are more positive in terms of sentiment and election excitement and that could add a small delta. Consensus earnings is somewhere around 14-15% of growth which is obviously building in some kind of recovery.

Export-driven sectors were the most preferred theme not so long ago. What is your view on these companies

We are bifurcating exporters into those companies which benefit from the currency move and those that are impacted by more sustainable factors. From a strategy perspective we are neutral on pharmaceuticals since the valuations have turned expensive. They are primarily beneficiaries of currency depreciation but with not structural improvement in business model, etc. Also, they are not necessarily big beneficiaries of the cyclical recovery in the US.

On the other hand, IT service providers are still better off because the recovery in the US and Europe will help them. Secondly, the visibility of earnings for IT companies is improving in the medium-term, in our view. These companies have been able to add areas of businesses beyond the traditional application development. From valuations perspective, despite their run up which has come from earnings surprise, the sector has not re-rated to expensive levels. Currently the IT services pack is trading at 10-20% discount to their peak valuations which we saw in 2010. So there is room for them to re-rate to those highs. So, we maintain an overweight on IT services and neutral stance on Pharma.

Metals are more like a trading sector so we need to be tactical about it. From a strategy perspective, Tata Motors is a buy for us from a stock recommendation perspective. The stock used to be a top pick for us but after the rally and stretched valuations we think that the risk-reward at these levels does not justify it to be a preferred pick.

What is your outlook on the banking space

We are still positive on private banks from a sector as well as a strategy perspective. But obviously as the stocks have run-up one turns more conservative in terms of the risk-reward and the bias towards better quality names increases. Broadly we are positive on the sector. Although we do acknowledge that the NPL issues are real those are much bigger issues for the public sector banks. The PSBs are also under capitalised so in case of a growth recovery , they would have to raise significant capital in order to participate in that revival. That is a key overhang on these banks.

Midcap stocks have lately participated in the pre-election rally. Do you think the pack can sustain pace

Midcap is a much diversified pack, so it would be difficult to take a simplistic view on the universe alltogether. However, ignoring this fact one big difference now vs 2009 and 2004 is the nature of the money. We still see domestic institutional investors which are big holders and drivers of mid-cap companies, being the net sellers unlike the previous instances. That is a negative overhang on the space. Secondly, from a foreign institutional flow perspective India and Asiadedicated funds are generally more inclined to invest in mid-caps. However, a lot of the fund flow coming in now is from ETFs, GEM funds or global macro funds which not necessarily invest in mid-caps. That's the simplistic way to look at it. Good quality smaller companies have done well even in the last two years, especially from the consumer space. We would continue to advocate a more bottom-up approach for mid-caps but yes, given valuation gaps, they would overall still do well if market does well.

The concerns regarding QE3 tapering have been put in the back burner.

When the US Fed started withdrawing the liquidity there was a big surprise move in the US 10-year treasury that impacted the global flows. However, now the negative surprise element is lower. India is less vulnerable compared to other high current account deficit countries despite a high CAD number on an absolute basis. There are two reasons for it; For India it is arguably easier to control the CAD compared to some other emerging countries, as seen recently, albeit affecting growth adversely. A large part of this comes from flexibility in managing gold imports. More importantly, from a tapering perspective, Indias CAD funding is significantly less dependent on bond flows versus any other high CAD countries.

When you look at tapering from a global perspective the biggest implication of tapering is for the bond markets and lesser for equity market flows. The cumulative bond inflows to India which is some $20 billion odd is nothing in the context of India's FX reserves or the size of the economy. On the other hand, it is significantly higher for a lot of high CAD countries and that is what is hurting those markets.