A correction relative to Asian peers could be on the cards: Raychaudhuri

Interview with Manishi Raychaudhuri, Asia Pacific equity strategist at BNP Paribas

Emerging market flows face a risk of sharp appreciation of the dollar, or severe global political uncertainty ignited by European election outcomes or potential trade restrictions, says Hong Kong-based Manishi Raychaudhuri, Asia Pacific equity strategist at BNP Paribas, in an interview with Puneet Wadhwa. Edited excerpts:

How are the market valuations looking at this stage?

On consensus earnings estimates, the frontline indices like the S&P BSE Sensex or MSCI India are trading at PE multiples of 19x 12-month forward earnings per share (EPS). That’s about a 50 per cent premium to the weighted average PE of India’s peers in Asia. India has always traded at a premium but the usual premium is 30-35 per cent. That’s why we think a short-term correction relative to Asian peers could be on the cards.

Are the current levels sustainable?

The recent rally in the Indian market, in conjunction with that in Asia and emerging markets (EMs), is essentially driven by liquidity. In the near term, the Indian market could correct, driven by earnings estimate downgrades, steep valuation premium compared to peers, and potential political uncertainties. Over the long term, however, we remain positive on India, owing to the ease of stock selections, superior return ratios and likely growth recovery, combined with benign liquidity.

What are the chances of a crash / hard landing in the mid- and small-caps over the next few months?

The rally in mid- and small-caps has been sharper than the one in frontline stocks. Consequently, mid-caps are, on average, more expensive than large-caps now. On consensus estimates of the 2017 earnings, price-to-earnings (PE) of the mid-cap indices are now seven-eight per cent higher than those of the large-cap indices. We don’t think the Indian market could face a “crash” or a deep correction, but some underperformance relative to its peers could be on the cards.

What is the outlook on foreign portfolio investor flows into India?

It should be better in 2017 than in 2016 because the growth outlook across advanced and emerging economies has improved considerably. The only risk, we think, EM flows face is a sharp appreciation of the dollar, or severe global political uncertainty ignited by European election outcomes or potential trade restrictions. 

Which Asian regions are you overweight and underweight on?

We are overweight China, India, Thailand and Indonesia. China’s growth and currency – the twin concerns – have stabilised remarkably due to pro-active Government policies. The theme of “New China” that we like offers an excellent investment universe of growth stocks to investors. 

India, despite the valuation premium, offers a large array of high quality stocks with good corporate governance, and the return ratios – return on equity (ROE) and return on capital employed (ROCE) remain significantly higher than the Asian average. 

Thailand has the most stable currency in Asia owing to a large current account surplus (11-12 per cent of GDP), is benefitting from increasing stream of Chinese tourists, and the Government has embarked on a serious infrastructure enhancement program. Government’s infrastructure focus is a theme in Indonesia as well, and the country’s fiscal and current accounts are benefitting from commodity price buoyancy. 

How has the December earnings season played out for you thus far, especially after demonetisation?

The earnings growth was impressive, in excess of 20 per cent, though driven largely by materials and treasury gains in some public sector banks. Stripping out these sectors, earnings actually declined marginally year-on-year (y-o-y). However, we think the decline was driven more by companies with large international revenue than by the after-effects of demonetisation. 

What are your estimates of corporate earnings growth in FY18 and FY19, in the backdrop of the recent gross domestic product (GDP) numbers?

The GDP data for the December quarter seem to indicate that the impact of demonetisation was short-lived. For FY18, we expect about 15 per cent earnings growth for the BSE Sensex.

You were overweight on the Indian consumption basket pre-note ban. How has this strategy played out?

Some of the consumption-orientated sectors, like two-wheelers, have suffered a sharp growth slowdown. Some other sectors, passenger cars being an example, recovered sharply after a temporary decline. Share prices of frontline consumer staples companies also recovered sharply since late December. 

In our model portfolio, we were not positioned in the sectors like two-wheelers, which have suffered a relatively long-drawn-out pressure on sales volumes. Consequently, the strategy of overweighting the Indian consumption basket has played out well for us.

Which sectors are you overweight and underweight on in the Indian context given the road ahead for the economy and corporate earnings? 

Our preference in Indian equities are concentrated mainly in three silos – retail-focused private banks, consumer discretionary, and potential investment beneficiaries – particularly those which are under-leveraged. We also maintain exposure to the information technology (IT) sector despite the concerns about restrictions on H1-B visas, as the valuations have corrected sharply and the companies are large cash generators – enabling them to return excess cash to shareholders through the buyback route.

How are the markets likely to react to unfavourable assembly election outcome verdict in March?

Favourable result for the ruling party in the State assembly elections would obviously be taken positively by the market. An unfavourable result, on the other hand, could ignite concerns about the feasibility of further reforms and of the path of fiscal consolidation that the Government has adopted. 

In the backdrop of the recent rally, an unfavourable election outcome could lead to a short-term correction. However, the long-term economic fundamentals seem durable – companies are clearly generating more cash than earlier, and the ongoing reflationary trends could lead to enhancement in pricing power.