'Earnings upgrade cycle seen over the last two-three quarters may end'

A severe third wave of the Covid pandemic, he says, is not priced into investor expectations at this time

As India Inc remains watchful of growth amid uncertainty due to the third wave of Covid-19, UNMESH SHARMA, head of institutional equities at HDFC Securities, tells Nikita Vashisht that it will be a stock pickers’ market in fiscal 2021-22 (FY22), with bottom-up positive risk-reward investment ideas available across most sectors. Edited excerpts:

Markets seem to be indecisive of direction amid rising Covid-19 cases but ample liquidity. What is your short-to-medium term outlook?

The market is caught in a tug-of-war of counter pressures. While on one hand we have concerns on inflation, Covid 19 – possibility of a third wave in India and movement of the epicenter across countries, geopolitical pressure- US versus China and oil; on the other hand, global liquidity continues to be under-written by the central banks and the market has clearly taken a view that inflation concerns are transitory.

Given this, there is going to be no decisive move on the index in the short-to-medium term. We believe it will remain a stock pickers’ market in fiscal 2021-22 (FY22) with bottom-up positive risk-reward investment ideas available across most sectors.

How should investors tweak their portfolios in case of a third Covid-19 wave? 

While the steps taken by the government towards localised lockdowns, vaccination and lessons learnt in healthcare preparedness from the second wave will lead to more benign outcomes in the future, a severe third wave is not priced into investor expectations at this time. At this moment, investors should look for relative value within sectors and clear visibility (third-wave-or-not) on earnings delivery.

What are bond markets suggesting about the market rally and economic growth?

Bond yields clearly indicate that the market sees the inflation concerns as transitory. The markets did turn volatile when inflation concern raised its head. However, we seem to have reverted to the expectation that technology driven global deflation is a multi-year if not multi-decadal theme. Importantly, central banks have not been able to deliver a globally-coordinated aggregate demand pulse like we saw in 2003-2007. This will keep bond yields capped till we see real movement in rates and bond-buying in CY 2022 and beyond.

June 2021 quarter earnings have been a mixed bag. Do you think markets have been too optimistic about recovery?

There have been no positive surprises in the ongoing results season. Indeed, some banks, autos, technology companies which have reported seem to have missed forecasts on aggregate. Needless to say, it’s too early to make conclusions at this time. It feels like the earnings upgrade cycle, seen over the last two-three quarters, may end. At the same time, forecasts are not very optimistic, due to the hit from the second wave during Q1FY22. From that perspective, we reiterate that the overall index upside may be capped in the short-to-medium term. It will remain a stock pickers market.

Are foreign investors doubtful of India's growth?

In the context of the stock of listed equities owned by foreign portfolio investors (FPIs) in India and the buying in the last 12-18 months, the quantum of selling is not a major concern. It has, in fact, been easily absorbed by buying by domestic investors. Our conversations do not suggest that there is a structural change in view by FPIs on India. Indeed, the participation in the recent primary market deals shows the long term conviction. A bit of profit booking post the rally, rally in the US dollar against the rupee in the last 6-8 weeks, oil / commodity prices and some concerns regarding Covid seem to have driven this move. There is also a minor technical matter of muted expectations in the financial sector, especially large lenders, where generally FPIs hold more weight in their portfolios as compared to the domestic institutions.

Overweight and underweight sectors? Any contra bets?

We prefer economy-facing sectors, like cement, infrastructure and gas, which will benefit as markets start looking at FY23 and beyond. Within financials, we hold an equal weight within the overall BFSI segment with an overweight on non-lending financials notably insurance and capital markets and a net underweight in lending financials (with a bias towards large banks and select real estate stocks). We remain underweight on consumption (staples, discretionary and autos), NBFCs, and small banks. While our sector preference has remained largely unchanged in the past six months, within the sectors, we look at mean reversion / valuation convergence plays.

Have you been trimming weights in any sectors?

We have consistently been cutting weights and asking clients to book profits in a staggered manner in small-mid caps, IT, Pharma and Chemicals. Our contrarian views are our underweight stance on Consumer Staples and Discretionary, which face PE derating risks, given stretched expectations and hence valuations. We hold a similar view on mid-cap IT names. We were early in moving into infrastructure and real estate names and see more legs to the rally in these sectors.