GST can be positive for fiscal deficit; help lower rates: Neelkanth Mishra

Interview with managing director, equity research at Credit Suisse

In conversation with Puneet Wadhwa, NEELKANTH MISHRA, managing director, equity research at Credit Suisse says that though India's medium-term prospects are very strong, the near-term economic momentum is quite weak. He expects the pace of flows into the emerging markets, including India, to slow going ahead. Edited excerpts: 

The government unveiled the goods and services tax (GST) rates last week. What are your views?

The 40-plus days of advance notice should be a relief for corporates and enterprises, as not only does it allow them to assess the impact on their profitability and operations, it also allows for some to-and-fro and clarifications before the clock starts. The release of rates therefore was a welcome move. What is important is the weight of the items in the consumption basket, and how the new rates compare to existing rates. We are still working through the numbers, but it would seem that the government's tax take would be higher than it is now, assuming the economic momentum stays unaffected. If so, it would be positive for fiscal deficits, lower bond yields and interest rates. READ HIS FULL VIEWS HERE

What is your interpretation of the way markets have run up thus far in calendar year 2017 (CY17)? Are these levels sustainable?

While the Indian market has done very well YTD in comparison to global markets, the outperformance is exaggerated because the market bottomed near the end of last year. The YTD outperformance over global equities of 16% drops to less than 6% if you take early November levels as the base. Most of the move has been related to multiples, as forward earnings have improved only slightly, and the pace of earnings cuts to both FY18 and FY19 continues to be quite high. 

We continue to believe that India's medium-term prospects are very strong, but near-term economic momentum is quite weak, and we fear the weakness could last longer than the market can have patience for.

How do you see the fund flows – FII and domestic institutions – playing out over the next 6 – 12 months?

We are at a stage in the market when flows beget flows. On the domestic front, we have been highlighting for a while that financial savings have been rising for two years now. As demand for funds remains weak – central government borrowing is more or less what it was five years back, and banking system loan growth is at multi-decade lows – the cost of capital is likely to fall. 

There is an increase in state government borrowing, and corporate funding through the bond market, but even that growth in this financial year is coming down. So flows into Mutual Funds should persist. Though extrapolating that into stock market strength would be unwise – over three to six months P/E multiples can drive the market, but over longer periods these moves have to be supported by changes to underlying earnings.

FPI inflows should be a bit more muted going forward – the flows into Emerging Market (EM) funds were quite strong earlier this year, and India got a fair share of those. But going forward, with concerns arising again in some of the EMs, such flows may slow.

What’s your advice to investors at this stage? What are the key risks for the financial markets that one needs to be mindful of?

Equity investment is very much a bottom-up exercise – looking at index levels is not very useful. Of the 232 stocks in the BSE500 for which forward earnings are available, 6% traded at above 30x P/E five years ago, but that is now 24%. P/E re-rating is a global phenomenon, but whenever one buys a high P/E stock, the underlying assumption is that future growth will be high. We find that very few categories grow meaningfully faster than nominal GDP growth unless they innovate, or are benefiting from some strong enablers. Even under-penetrated categories like cars struggled to grow revenues faster than nominal GDP growth between 2002 and 2016.

If one buys stocks that have high P/E ratios, it would be better to be in sectors that can see such growth, and avoid stocks and sectors where such growth is difficult. In India it appears the market expects a tidal lift – unfortunately growth going forward is likely to be more selective.

On the risks for financial markets – there are several geopolitical risks still, and yet global volatility indicators are trading at very low levels.

How comfortable are you with the valuations? Which sectors, according to you, could possibly lead the next leg of the market rally from here on over the next 6 – 12 months?

Our research shows that value as a strategy has started to work starting last year, after underperforming for nearly five years. That is, if you bought low P/E stocks, which people earlier bought because they thought buying cheap was better, you would have underperformed for nearly five years. But given some of the underlying changes in the economy like prospects of lower interest rates, a pick-up in infrastructure order books, and global GDP seeing the strongest growth in more than five years, we would rather be overweight sectors that have been historically low P/E. Some of our preferred sectors like metals and housing finance companies have done well. On the other hand sectors like IT have continued to de-rate – we expect that to reverse. 

What are your key takeaways from the March quarter results season?

There is another week of earnings to go. We take stock after all companies have reported, but so far one can see that the pace of earnings cuts has not slowed. This contrasts to other countries in Asia where earnings are being revised upwards.

In any case, FY18 is likely to be a year where the market continues to feel disoriented. The weakness in the December and March quarters was ascribed to the disruption due to demonetisation, and it is difficult indeed to separate out structural trends from what was affected by several weeks of cash shortages. In the June and September quarters, there is likely to be disruption due to GST, and there is a good possibility of that lasting through the December and March quarters too. If the markets are bullishly positioned, as they are now, they tend to look through this uncertainty; but when sentiment turns they panic equally easily. 

What has been your investment strategy over the last 6 – 12 months? Which sectors are you overweight and underweight on? Any contrarian bets?

In March/April 2016, we upgraded metals to outperform after nearly five years of underweight calls, starting with Aluminium, and then on Steel; we also went overweight private sector banks that have corporate exposure after having advised caution for several years, as metals were a large source of non-performing assets (NPAs). This call has worked very well, and we continue to be overweight the sector – the upturn is lasting longer than we had earlier anticipated.

In May 2016, we wrote on how a good monsoon would not revive agricultural incomes, and also that it would bring down food inflation. And then, in September, just about when the monsoon was getting over and had turned out to be normal, we wrote about how food inflation would fall sharply downward, and that by April of 2017 interest rates could be meaningfully lower. We accordingly advised investors to take profits on Staples, which we downgraded to Neutral after nearly five years of overweight stance. We added weight to Construction, as a large part of their costs come from labour and interest costs, and went further overweight on Housing Finance companies as mortgage demand is inversely correlated to interest rates.

In November, we flagged lasting disruption from very structural policy changes happening in India, and that rising global bond yields would pressure the high P/E stocks. In any case, our research was showing that value was starting to rebound nicely. We went underweight cement and consumer discretionary, and added weights to IT.

So far this year, some of our sector calls have not worked – the underweight in cement and the overweight on IT in particular. The IT call is best played selectively though, as some of the larger companies have internal issues. While fundamentally things are playing around as expected, market momentum has clearly not been in our favour. However, we continue to hold on to these calls, and IT would be the contrarian bet for this year.

Banking sector has seen a lot of policy initiatives by the government. What is your assessment of the measures and the outlook for the PSU banks in this backdrop?

We continue to interpret government actions over the past few years as indicative of a policy where they just want to keep alive the PSU banks, but don't want them to grow. This is privatisation of the banking system through the private sector gaining share – not just private sector banks, but also NBFCs. Nearly 100% of incremental loan growth till December last year came from private sector banks – and this is not something that appears to be troubling the government. 

Some of the really weak PSU banks – even though their market capitalisation is not very high, they have large loan and deposit books – are now at risk of being pulled up by the Reserve Bank of India (RBI) for corrective action. Despite much excitement around PSU banks in the markets, we are advising investors to stay cautious on the names. In the last five years, and two years in particular, we have seen the market chatter swing to "NPAs have bottomed" every few quarters, and we believe the current wave of optimism is also misplaced.

Modi government completes three years in office this May. What are your expectations in the remaining tenure as far as policy measures are concerned?

Goods and Services Tax (GST) is one of the biggest reforms India has ever undertaken, and its implementation is likely to be bumpy – something that government must be anticipating as well. It will likely require several months to be understood by the economic entities that get affected by it, and supply chains will require a while to settle down around it.