Deutsche equities has the most aggressive Sensex target for the year. It is expecting it to touch 22,000 by end of March 2010. And Sensex after the pull up has also been sliding over the last two days. Against this backdrop, Muthukumar K and Samie Modak spoke to Abhay Laijawala, head of research, Deutsche Equities, who was bullish on the fact that gross capital formation will go back to its double-digit levels. He believes the commodity markets wouldnt play the party-pooper as steel prices are more important for Sensex and that would hold on.

You have the most aggressive target for the Sensex on the Street. Do you still hold on to that target?

We see no reason to change the target. This year when we came out with our Sensex target, our view was largely based on the domestic macro situation. And at that time, earnings growth for Sensex companies was at 23%, but today it has risen to 30% and the domestic macro situation is also much stronger.

For the January-March quarter, the GDP grew 8.5% in 2010, now there is an indication that the June quarter GDP growth?according to all government?s advance estimates?will be 8.9%. Advance tax collections are also up for corporates, and so are indirect tax collections (49% year-on-year in April-May). Even the 3G and wireless auction proceeds are three times the budgeted number.

All of which leads us to believe that the fiscal situation is in better shape that it was. In addition, we are also enthused by acceleration in gross domestic capital formation, which seems to be showing signs of moving back into double-digit growth in FY11. It is moving back to levels of 2004 and 2008 when GDP grew by 9%. The macro situation has just got better, which gives us conviction. We have the highest BSE Sensex EPS (earnings per share) target of Rs 1,095 for FY11, whereas the Street is still looking at Rs 1,050.

But non-food inflation has gone up. Isn’t that a worry?

There is concern with regards to inflation. Food inflation should wear off if there is a normal monsoon this year. But then, the base effect will also come into play. We are not worried so much about double-digit inflation. In addition, we are also enthused by how the oil prices are moving. Oil was expected to run up to $85-90 per barrel, but is contained at $80 or so at the moment.

How do you see interest rates in the overall context?

We have had higher rates coupled with higher GDP growth in the past. Our estimate is a rise of another 50 basis points from here, which will not dent economic recovery. The economic recovery is very strong and we are drawing a lot of confidence from the recent hiring intent expectations. Corporate India is very confident and the hiring intent also has gone to the pre-crisis level. At this point of time, there is a lot of public sector capex happening and private sector capex will follow.

How important are FII inflows in achieving your Sensex targets? Could FIIs play the party-poopers?

The Indian equity market will continue to be dependent on FII inflows. Even if domestic institutional investors grow in size, the determining factor will always be FIIs. So, if there is another chilly macro global headwind, significant flows into India will be impacted. But inflows is also a function of relative attractiveness of equity markets. In currency-adjusted terms, India has been amongst the best performing emerging markets this year relative to Brazil, China and Taiwan, which have seen negative returns in local currency terms. We will have to live with global macro. Investors will have to be prepared for air pockets.

What if institutional inflows don?t come at all?

You are probably bringing in the worst case scenario?if the world is headed into double dips scenario. It would happen if the euro is showing signs of breaking down, which is a massive risk akin to the Lehman event. We don’t expect it to happen.

Yes, the Indian economy is massively dependent on foreign flows, as it is capital constrained. If the crowding out of private sector (through government borrowings) is to be avoided, the country has to remain open to foreign flows.

And India?s domestic fundamentals will stand out. Globally, we are seeing a shift in funds from the developed markets to the emerging markets.

The bulk of earnings growth are expected to come from commodity companies of the Sensex. And metals prices are down now?

We are still bullish because the risks are primarily with regard to non-ferrous metals (copper, aluminium, zinc). We are not seeing similar risks for ferrous metals like steel. Our earnings forecast for steel companies are conservative. The contribution of non-ferrous metal companies into Sensex earnings is not as significant.

Even steel prices are going down with excess inventory and lot of Sensex companies also consume steel. How does it affect the Sensex as a whole?

We don’t expect steel prices to come down. Steel prices are determined by global raw material prices (iron ore and coal). For the next two to three years, the world resources is going to be extremely supply constrained. So, we believe iron ore and coking coal prices globally will remain above trend with tightness in those markets. Consequently, it is difficult to expect steel prices to come off as long as iron ore and coking coal prices remain strong.

Interestingly, the Japanese automakers have grudgingly agreed to steelmakers’ demand for a quarterly price hike that legitimises the entire quarterly contractual pricing for raw materials. The only way steel prices can go down is either its raw material prices come down or if demand comes down in the developed market. But that could be a generic risk for the world markets.

Where are commodity prices headed?

We are expecting incremental world GDP growth from here on to come from non-OECD markets. While the world would move back to similar levels of GDP growth of the past, its drivers will be the emerging markets. When emerging markets are the engines of the global GDP growth, you cannot become negative on materials because the emerging markets are highly material-intense. So, this, in fact, increases our conviction that the world resources industry, be it iron ore or coking coal or thermal coal, are going to be intensely tight, which will keep commodity prices stronger.

The world is looking at what will come out of the Obama administration, after the financial reforms Bill. If that Bill has some (adverse) provision for speculative limits or position limits in exchange traded commodities, then it will impact the medium-term investment in commodities . To that extent, fund flows into the exchange-traded metals might take a hit.

We favour non-ferrous metals over ferrous metals right now, primarily because the risk is low as they are not exchange traded.

What are you advising your clients at this point?

We are advising investors to stay away from global sectors. And go overweight on domestic consumption names. We like the power utilities sector, particularly those companies which are into the merchant market and which have access to coal as well. Then infrastructure companies, Indian private sector financials, automotives.

Why are you overweight on financials?

We are very confident of loan growth because the domestic macro situation is strengthening. There is generally a multiplier impact, loan growth-to-GDP is roughly 2.5 to 3 times. Our conservative estimates put loan growth at 20% this year. But one would not be surprised if it is higher.

Which sectors from which investors should stay away?

We are underweight on pharmaceuticals, cement and telecom; neutral on real estate and oil and gas sectors.

What are the headwinds or key risks for the Indian markets at this juncture?

For India, it is concern on the supply side. If supply side bottlenecks in the form resource constraints become severe, then it has the potential to hit growth. The Indian industry is already complaining about land acquisition and delayed environmental approvals. If investment doesn?t come up as fast as demand, then there is a serious worry about supply-side bottlenecks.

We should also be looking at the oil prices. If oil prices start moving up, then I think there could be certain headwinds as far as India?s macro is concerned.

What are the next big events that you are keeping an eye on?

The most immediate one is the Q1 earnings as well as the GDP growth numbers. Then, reforms. Clearly, the window of reforms has been a little slow to open. Plus, the market is looking at further visibility on the direct taxes code. The markets is largely looking for something to be announced on the clear distinction between short-term and long-term gains tax.

Do you think the market will be able to absorb the flood of new paper that will come into the market once the 25% shareholding norm comes in place?

I think it is purely academic to expect that much paper to hit the market. The government has, to some extent, made it clear.

In the long-term basis, we view this as a positive as in the long-term, the weightage of India in global indices will go up on a free-float basis. If you get more weightage more inflows will come.