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Earnings recovery will support market rally: Kotak Institutional Securities’s Sanjeev Prasad

LiveMint logoLiveMint 08-05-2017 Livemint

Indian markets are at record highs. What is driving this rally? Is there more steam left, or will the party be over soon?

The markets are rallying on expectations that (1) the ongoing global economic recovery will be positive for India and other emerging markets and (2) the incipient signs of improvement in the domestic economy will result in strong earnings recovery over the next few quarters. Both domestic and foreign institutional investors are positive on India’s economic prospects.

Among emerging markets, India stands out given its strong macroeconomic position, ongoing economic reforms and political stability. India has seen remarkable improvement in its macroeconomic position in the past 2-2.5 years in the form of lower inflation (and interest rates) and current account deficit, which has boosted investment sentiment. At the same time, the government has delivered significant fiscal, investment and governance reforms, which have been well-received by investors, even though a few areas such as labour and land reforms have seen limited progress.

However, I don’t see further improvement in India’s macroeconomic parameters with (1) likely increase in inflation and possibly interest rates and (2) higher current account deficit on likely higher global crude oil prices. Given the limited scope for a further improvement in the macroeconomic situation and meaningful reforms (the government has already completed a large part of reforms expected from it at the beginning of its term), the market rally will sustain only if it is supported by earnings recovery.

Are Indian markets expensive at this point? Why or why not?

Yes, especially if one looks at automobiles, cement, consume staple and discretionary stocks. The broader market valuations have very little meaning, given the wide range of multiples from 10-11X FY18 net profits for the metals and mining and oil and gas and utilities to over 35X for the consumer and media stocks. In fact, there are very few sectors and stocks in the Nifty-50 Index that trade at average market multiples. Also, the high contribution of low P/E (price-to-earnings) PSU (public sector unit) banks, commodity stocks and utilities to profits of the broader market indices pulls down the overall valuations and makes the markets look optically cheaper. However, the broader market and several stocks are trading 25-50% higher than their long-term multiples and even arguing for lower cost of equity given (1) an improved macroeconomic position and (2) improved fundamentals of India, it is hard to justify the valuations of several sectors, especially in the banking/NBFC (non-banking financial company), consumption and industrial space. I am not sure what is left after that!

When and by how much do you see an earnings recovery?

FY17 has already seen some recovery, given our expected profit growth of 15% for the Nifty-50 Index. However, 50% of the incremental profits for FY17 comes from the oil and gas sector and 25% from one stock (Indian Oil Co.) alone. So, it is not a broad-based earnings recovery led by an economic recovery. For FY18, We expect 16% growth in net profits for the Nifty-50 Index on the back of (1) lower loan-loss provisions in the case of banks, (2) higher commodity prices and (3) moderate recovery in the Indian economy, which will result in higher volumes/realizations in the domestic sectors.

Where does India stand in EM/Asia preference? Why?

Investors are quite comfortable with India, given its strong growth prospects, political stability and delivery of economic reforms while certain other emerging markets face political uncertainty and economic challenges. Most overseas investors continue to be overweight India, but this already reflects their positive views about a domestic economic recovery and continued macroeconomic stability. Thus, disappointment in earnings or economic recovery may result in overseas investors changing their favourable view on India.

Will Donald Trump’s tax cut plans impact emerging markets in a big way? How much impact do you see on Indian information technology and pharma sectors from US visa restrictions and protectionist policies?

Both the US dollar and US bond yields have fallen from end-December which, of course, has aided the current rally in the emerging markets. Global investors, in general, had started losing faith in the new administration’s ability to deliver on its pre-election promises, including taxation reforms. However, if the Trump administration was to implement taxation reforms, including cutting the corporate tax rate to 15% over the next few weeks, we could see a rally in US dollar and yields, which may impact EMs negatively.

There is a fairly strong inverse correlation between the US dollar/yields and EM performance/inflows; at least, that has been the case historically.

IT companies may benefit moderately on lower taxation rates in the US on their US (on-shore) profits, but the sector has far bigger issues of low demand for traditional IT services and related pricing pressures.

The pharma sector is also facing pricing pressures, apart from USFDA (US Food and Drug Administration)-related compliance issues. However, a stronger US dollar may result in the current negative sentiment for IT and pharma companies being partly allayed as their revenues and profits will improve on a weaker rupee.

Are geopolitical risks being ignored by global investors?

Yes, but investors can do very little about it. We can only hope that the tensions in the Korean peninsula do not escalate into any form of conflict.

Also, the elections in certain large European countries pose political risks. While we do not expect any negative surprises in the French presidential election on May 7 and the German general election in September, the outcome of the parliamentary elections in Italy could throw a huge negative surprise if the Five Star Movement party was to come to power.

That may even result in Italy leaving the EU, which could create huge uncertainty around the future of the EU.

What are the key risks to this rally in emerging markets, particularly India?

We have discussed some of the factors above. These include—(1) escalation of tensions in the Korean peninsula, (2) unexpected outcome of elections in one or more major economies in Europe and (3) restoration of the market’s faith in ‘Trumponomics’ that may result in a strengthening of US bond yields and the US dollar. In India, weaker-than-expected earnings in the fancied sectors and stocks may lead to some sort of a reset in expectations about the medium-term earnings growth of the sectors and stocks leading to a sharp correction in their multiples, which are at quite high levels.

Which sectors in India are you overweight and underweight on, and why?

We like the banking space, but more so the wholesale banks at this point in time as the private retail banks are looking somewhat pricey at over 3X FY2019E book. We expect a re-rating in the multiples of the wholesale banks on the back of higher returns on assets, resulting from a decline in loan-loss provisions over the next few quarters. However, this is predicated on favourable resolutions (of bad loans) in the power and steel sectors. We also like the private retail banks based on their strong growth prospects. I am also comfortable with certain oil and gas, metals and mining and power utilities stocks.

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