Earnings disappointment and Chinese stimulus has seen foreign investors taking out money from India. But Sankaran Naren is also worried about investors’ overenthusiasm in the derivatives market. He tells FE that the RBI is unlikely to cut rates in December if growth rates don’t go down materially. Excerpts:
After a wonderful run of almost five years, we have seen some correction in recent weeks. What is your assessment of the market at this juncture?
Given the high market valuations, we have been tempering investor expectations for a while now. So, you had some euphoria, and on top of that, there was a fair amount of IPO activity, accelerating fundraising. Additionally, there was a situation where FIIs wanted to sell in India to invest in China. The combination of these factors led to this outcome. If you look at it, the biggest reason was what China did with its stimulus. FIIs were significantly underinvested in China; they assumed China wasn’t a place to invest for the next 5 to 10 years. Valuation-wise, China was at a 9 P/E, but people were hesitant to invest due to China’s deep structural problems. However, when the stimulus was announced, most hedge funds and foreign investors were caught off guard. They saw India as the best place where valuations were high, making it easier to sell in the Indian market. They could execute their sell trades here, which might not have been possible in some other markets, so they went ahead and executed those sell trades.
If there is a correction, do you see a prolonged one or a quick sharp fall before recovery?
The challenge is that if there were a fundamental problem along with high valuations, it would be easy to say what might happen next. Today, India doesn’t have any fundamental problems, but markets are richly valued, and domestic retail sentiment is a problem. A valuation and sentiment problem can mean that high valuations can last for an extended period. We aim to reduce investor expectations, encouraging people to moderate their expectations and invest across asset classes, not just take on risk with equities. Are valuations cheap today? I think, aside from banks, where valuations are reasonable, most other sectors are still not cheap.
Had the markets already reached a level where things had become cheap, we would have shifted our stance. We would move away from emphasizing asset allocation, multi-asset, and so on, and focus on equity. But that hasn’t happened yet. If you look at where the markets are or even consider one-year returns in small-cap, mid-cap, or large-cap, they’re not low—they’re still high. The markets may have corrected in the last month, but if you take the one-year returns, they’re still high, and valuations are not cheap in any sense of the word. That’s why it’s still not a situation where we can advise people to invest aggressively in equity at this point; that phase hasn’t started yet.
What could be the main triggers for the correction? While earnings and China are the main ones, what are the other pain points?
Clearly, the US election is one major factor. We don’t know what policies will be implemented depending on who takes office, but it will have some impact. The good news is that right now, India’s macro environment is fantastic. If you look at the most important indicators—the current account deficit, the fiscal deficit (particularly for the central government), and inflation—India has managed to keep these very stable. That’s why Indian government yields haven’t risen in the last 3 to 5 years. But in the US, it’s quite possible that after the election, the fiscal deficit will increase, which could impact US yields. In fact, U.S. 10-year and 30-year yields have already been rising. The macroeconomic impact of the U.S. election is something that hasn’t received much discussion, even just 10-15 days before the election, but it could have significant implications for India. It’s possible that FIIs have sold in India just to keep cash ready for any uncertainty surrounding the U.S. election, and they may return after the election if there’s no negative impact on emerging markets. So, that’s one clear factor.
The second is geopolitical. We’ve seen two conflicts recently, and the second one is almost like a full-scale war if you look at the situation. Could this escalate after the U.S. election? Has the U.S. government tried to persuade Israel not to escalate before the election? We don’t know. Oil has been stable, but if it spikes substantially, it would have a negative macroeconomic impact. That’s the second concern.
The third factor is the enthusiasm for the derivatives market among local investors, which SEBI has repeatedly pointed out as a concern. The high level of leverage in the derivatives market is significant; while people talk about SIPs supporting the Indian market, the amount of leverage in derivatives is actually much larger than the SIP inflows. So, that’s the third concern.
These are the key factors that really worry me at this point. The third is something SEBI has been highlighting through research papers and interviews, so these would be the key issues to watch.
FIIs have largely been sellers in this market while DIIs have been holding it up, quite similar to some of the earlier years. How long do you see DIIs being able to pump in money if this trend continues?
I don’t think there is any connection between FIIs and DIIs in this. DIIs have been continuously getting inflows. The only challenge is that valuations are high and domestic investors have been positive on equities despite valuations being high.
Do you see a rate cut coming in December or later?
Basically, the thought behind the rate cut is that it will largely depend on how growth will pan out. If growth doesn’t slow materially, then we don’t think RBI will want to cut interest rates, and what RBI has been doing more of is to contain risks which they see in different parts of the financial sector, including NBFCs or micro-finance. So, they are acting more as a risk manager. Growth has slowed down a bit, but there are various reasons why it has slowed down. Actually, it hasn’t slowed down as much. If growth remains normal, then RBI won’t cut rates.
Banks have generally been slow in raising rates despite RBI’s push. Now if there is a turn in the interest rate cycle, banks could suddenly find themselves under further pressure. How do you see the situation?
A rate cut doesn’t seem likely. Even if it happens, it will be shallow, so from that, there is not much of an impact on banks. Hence, pressure will not be significant on them.