While many brokerages have trimmed their Sensex/Nifty expectations with disappointing Q1, bad monsoon, no rate cuts by the RBI and now the pressure on the Indian currency due to China currency devaluation, UBS has maintained its Nifty target of 8,600. It says the estimate is based on already modest earnings growth expectations.
Gautam Chhaochharia, head of research at UBS Securities, admits that there are several headwinds to the Indian economy and markets in the short to medium term, but things are better here than elsewhere and in the past. He believes risk to reward ratio is favourable for Indian equity market after the recent crash and is overweight on financials, oil and gas, telecom, media and pharmaceuticals. Edited excerpts from Chhaochharia’s exclusive interview with BusinessLine .
Our year-end target for the Nifty remains 8,600 based on 17x one-year forward price to earnings multiple. We already expect a modest growth of 10 per cent and 18 per cent growth in Nifty earnings for FY16 and FY17 respectively compared to consensus expectations of 17 per cent and 21 per cent. We expect further cuts to consensus Nifty earnings estimates. Growth recovery will continue to be slow and grinding, likely disappointing against street expectations.
Markets are behaving crazy since China devalued its currency on August 11. While investing long term is indeed a good strategy, what should one who is entering or wanting to exit do? Or one who is with a one year horizon?
Our Nifty target of 8,600 for the 2015 year-end implies better risk-reward post recent correction. We remain positive in the medium term given our aggressive and long-held view on inflation / interest rates, supportive policy/reforms environment and India's sustained relative attractiveness.
Many think there will be more pain—Do you think whatever crash had to happen has happened or we are mid-way or almost done with the crisis? Has the recent crash factored in the worst scenario?
Emerging market funds have seen $38.2bn of outflows this year till date which is close to the full-year record of 2008. Less than one-fourth of MSCI global emerging market stocks are trading above their 200-day moving averages recently. At the recent market trough, they trade at 9.8 times one year forward despite very weak earnings, and 1.27 times price to book value, which is just 15 per cent above the 2008 low.
“ India seems better prepared for Fed rate hike compared to two years ago, with inflation under control and current account deficit at much better levels. ”
Growth in the US remains solid and in the Euro area, it is improving, while China is still expected to grow at 6.8 per cent this year (albeit with some downside risk to our forecast).
The recent panic over global growth looks overdone.
Recent US data strengthens the hope of a rate hike? Do you see another bout of sell off in the emerging market? Do you think Indian markets will again face a jolt?
Fed rate hike should be a less negative event for emerging market equities than at times in the past. Liquidity conditions in EM would be more favourable this year than normally associated with a period of Fed tightening. We believe that India appears much less vulnerable than two years ago.
How do you find India valuation after the crash?
Though recent market correction has improved the risk-reward for India, the Nifty is still trading at 5-10 year average valuations of 16x 1-yr forward PE. Our end-2015 Nifty target of 8600 (which is based on 17x 1-yr forward PE) implies reasonable upside.
There are various events which are actually against India like a rate hike in the US, no or delay in corporate recovery, rupee decline, bad monsoon uncertainty and timing of implementation of goods and services tax, outcome of Bihar elections. What is your view on each of these headwinds for markets?
India seems better prepared for Fed rate hike compared to two years ago, with inflation under control and current account deficit at much better levels. The sharp fall in inflation levels does leave room for rate cuts in India even in a scenario of rate hikes in the US.
Our forecast for the rupee is 66 and 68 against the dollar for 2015 and 2016 respect, which suggest we do not expect the rupee to cross earlier all time low levels. Given the weightage of exporting sectors (such as information technology and pharmaceuticals), the rupee decline does not really impact Nifty earnings negatively.
“ Results of Bihar state elections may become an important driver of political capital momentum ahead and thus for the fate of pending reforms. ”
As regards timing of GST implementation, my view is that, post FY16 Budget, macro and micro data points, including earnings, would matter more than reforms and act as the key market catalyst. However, reforms remain a hygiene factor, key for both investor and corporate sentiment. GST is anyway more important for India in the medium-term, and any short-term delay should not be a cause of worry in our view.
Results of Bihar state elections may become an important driver of political capital momentum ahead and thus for the fate of pending reforms.
We still have one month with monsoons. Do you see an upside risk to inflation if monsoons are bad indeed?
We do not expect possible short term inflationary pressure to derail the underlying disinflationary trend driven by sub-potential GDP growth, excess capacity, a depressed credit cycle and anti-inflationary policy. High foodgrain stock levels (above average at the start of the monsoon season), have helped tame inflationary pressures previously.
What are your expectations in the September RBI policy? Lower inflation has raised hopes of a cut. Do you think rates should be cut? If yes, why and to what extent?
We continue to expect another 75bps of repo rate cuts in FY16 and 10 year G-sec yields to decline to 6.5 per cent by end-FY16, based on our long-held view that inflation in India is not structural and the strong disinflation process under way will keep surprising positively in inflation data prints ahead. Unless the RBI cuts in between meetings, our forecast implies a cut in the September policy. We expect another 50 bps of cuts in FY17.
In the recent market crash, DIIs were a big support. Now with reforms like EPFO investment allowed in equities, do you think Indian markets have reached a stage where FIIs' dominance can reduce say after 5-10 years?
As of June15 quarter end, FIIs owned over 25 per cent in MSCI India stocks (over 50 per cent of free float) while DIIs owned about 10 per cent - FIIs dominance remains for now. Moreover, India remains relatively attractive for FIIs – based on the end-July EPFR Global data (as analyzed by our GEM strategy team), India remains the biggest OW held by GEM investors relative to the MSCI GEMs benchmark (although the size of this Overweight has fallen from an all-time high earlier this year).
Our meetings with investors also indicate that nearly all the FIIs remain positive on outlook for Indian markets, in both absolute and relative terms, though their time frames may differ. Thus, it is difficult to say whether FII dominance can reduce – we can only wait and watch.
Q2 was considered to be critical for any recovery in the second half or FY17? Do you think that has happened? What does your interaction apart from Q1 management comments say?
High frequency data (business activity, consumption, surveys, economic) continues to indicate a slow gradual growth recovery. There are a few green shoots, but these reflect the dynamics of the particular industry/sector or changing preferences/mix, rather than indicating a broad-based economic recovery. Overall demand recovery remains elusive as yet and we are not hopeful of a meaningful second half recovery.
You have pegged an 18 per cent earnings growth in FY17? What all have you considered?
Our FY17 earnings growth forecast of 18 per cent reflects underlying view of gradual economic and corporate recovery. This 18 per cent is on the back of only 10 per cent growth in FY16. We believe that the growth recovery will to be slow and grinding, with only a 20 basis points expansion in real GDP growth in FY16 and acceleration at best in FY17. In FY17, the positive impact of lower interest rates should start coming through, and we are also hopeful of benefits from the reforms process, which are aimed at medium-term recovery (and not short-term fixes).
Do you think the recent currency depreciation will stalk the revival?
While some stocks/sectors are negatively impacted by the rupee decline (including due to forex debt), other exporting sectors (e.g. pharma) actually benefit from a rupee decline. Rupee decline should not prevent the RBI policy rate cuts in coming meetings, in our view, and lower interest rates can help drive a recovery in the medium-term.
What is your current market strategy in terms of sectors and stocks (if any)?
We are overweight on financials, as strong disinflation process under way will keep surprising positively in inflation data points ahead and in turn lower interest rates may be a bigger driver than growth at this stage of the cycle.
We are also bullish on oil and gas and petrochemical space due to benefits of benign crude oil prices (lower subsidies) and stock-specific drivers. We also like coal as government initiatives to clear regulatory/transportation hurdles will result into increase in coal production. We prefer pharma over IT.
We are overweight on telecom as we believe it will benefit from rapid data growth. Improving fundamentals are likely to drive operating leverage and sector earnings.
“ Overall demand recovery remains elusive as yet and we are not hopeful of a meaningful second half recovery. ”
Improving coal supply should support utilisation, but lack of industrial demand implies only gradual improvement and I expect overcapacity in the power market to continue.
We are underweight on two-wheelers, infrastructure, capital goods, information technology and real estate. Muted growth recovery, rural slowdown and competition act as headwinds for two wheelers.
We are cautious about infrastructure and capital goods as I believe capacity expansion in the economy may not happen in a hurry with low capacity utilisation currently and lack of promising projects for driving private corporate capex. Also stock prices reflect heightened expectations.
Do you think the substantial rise in stock prices of oil marketing companies could reverse with rupee depreciation?
We remain cautious on this space with expectation of increased risk to state-owned oil marketing companies’ earnings on account of weak rupee and stocks already near 8-10-year peak EV/EBITDA and price to book value.
Earnings of state-owned oil marketing enterprises are very vulnerable to a weak rupee given large crude oil imports, and about 80-85 per cent of debt is in foreign currencies. We think the adverse impact of the weak rupee on LPG and kerosene under-recovery is likely to more than offset the benefit of currently low oil prices. The weak rupee could also reverse part of the interest savings from easing working capital needs evident in the past few quarters.
Since the diesel-price deregulation, SOEs' diesel and petrol marketing margins have improved. However, we believe it is unlikely that India SOEs can match global retailers' fuel margins of 5-6 per cent on a sustainable basis as the government's fuel subsidy compensation is an overhang on SOE profits and as private competition intensifies.
Do you think banking especially PSU will be a game changer with Indradhanush and now the payment banks? Are you looking at PSU banks as an opportunity or still treading with caution? Do you think by now NPA issues are factored in?
We believe SOE bank reforms are gathering momentum. We believe that large SOE banks are better placed on capital and will grow faster than other SOEs. While asset quality and low return on equity remains a near term challenge, we have Buy rating on select SOE banks given inexpensive valuations and likely reforms.
We also note that non-banking companies has gained significant market share in online transactions in India (particularly low value transactions) and new payment banks could increase competition for current account and savings account and transactions related fees (particularly debit cards).
However, large Indian private sector banks are investing heavily in digital offering in anticipation of higher competition. Pace of SOE Banks’ (which are not investing in digital channels) losing float market share would accelerate, in our view with so many new players.