Earnings growth needs to improve for investors to gain further confidence in the Indian market, says Manishi Raychaudhuri, Asia-Pacific Strategist, BNP Paribas Securities, in an interview with Devangi Gandhi. Excerpts:

Do you expect a lot of turmoil in the Indian market when the US Fed starts raising rates?

We are not in the camp that believes that there will be a premature rate hike. The base-case scenario that our economists have highlighted is that it will possibly happen somewhere in September 2015. Even as US economic and jobs data have surprised of late, the quality of employment generation still leaves a lot to be desired. And, therefore, the trend of healthy fund flow into emerging markets that we have seen since February will possibly prevail until the Fed actually starts raising rates. Having said that, as and when it starts increasing the rates, I don’t think that the impact will be as sharp as the taper tantrum crisis of 2013.

After the last couple of months’ tremendous outperformance, the Indian market witnessed a natural process of correction in March. But if you look at the longer term, India has quite a few distinct advantages over emerging market peers. While interest rates are coming down everywhere — China, Korea, Thailand, Indonesia have all reduced rates — India has the unique advantage of declining interest rates and improving economic growth, which is rare in the EM universe.

There have been steep downgrades to consensus earnings estimates in the last three months…

One element of worry is that this increase in optimism is not quite translating into earnings delivery. It looks like FY15 will end with single-digit earnings growth for the Indian market. This is, no doubt, disappointment and I think earnings growth needs to improve for investors to gain further confidence in the Indian market. One hurdle that the market needs to cross is earnings delivery.

For FY16, we are expecting low-teen earnings growth (13-14%), which is, no doubt, an improvement form the last 3-4 years when benchmark companies reported single-digit growth. One of the reasons why we are optimistic on FY16 is the possibility of margin improvement on the back of sharp correction in commodity prices. We also think that the decline in rates may lead to reduced interest costs and, consequently, for public sector banks, asset quality concerns may decline. It may not happen immediately; it may take 2-3 quarters for this to be reflected.

Do you think India’s current valuations are justified?

Indian markets are fully valued right now in comparison with Asia ex-Japan. India is currently trading at a significant premium — more than one standard deviation higher than its long-term average. The average itself is brought down by other north-Asian markets like China or South Korea. In fact, the relative valuation premium that India enjoys is possibly preventing significant re-rating of the market. Having said that, I don’t think that the Indian market will correct severely from current levels, because, fundamentally, India remains a better investment destination than its EM peers.

In absolute terms, India’s current valuations are about 8-9% higher than the longer-term average forward P/E multiples of 15-15.2x. This is not very expensive. India has always commanded higher valuations than its peers. Investors are willing to pay a premium for growth and earnings visibility.

Does the recent correction reflect a growing concern among investors around the pace of reforms?

It is too early to say that they are disappointed, but I think investors, both domestic and overseas, are watching the Parliament session very keenly. They are keeping track of whether the many ordinances that the government has promulgated will be passed and converted into Acts. The focus will be on how policy unfolds and, more importantly, how much action takes place.