Hard to make a case for a material upside in this market: Saion Mukherjee

As the pandemic recedes and growth recovers, we may see inflationary pressures, says Mukherjee

It has been a roller-coaster ride for the markets over the past few weeks. SAION MUKHERJEE, India Equity Strategist at Nomura, tells Puneet Wadhwa in an interview that the markets are not factoring in any material deterioration in macros at the moment, as there is high confidence in growth and favorable external environment with portfolio flows and high forex reserves. Edited excerpts:

Are the risks of a downside more for the markets now than upside triggers? Have they run ahead of fundamentals?

We expect high volatility in the markets in 2021. The economic recovery in India and the rest of the world has been strong. Hopefully, with the rollout of vaccines globally, the Covid-19 pandemic will be largely behind in the coming quarters. In the base case for India, we are assuming the economic growth momentum to improve over time, given easy monetary conditions for long and the fiscal support from the government. More importantly, corporate earnings have recorded an uptrend after extreme pessimism in the April-June quarter of FY21. However, we acknowledge the risk of inflation and higher bond yield. The surge in commodity prices can adversely impact earnings in certain pockets and higher bond yields will limit any material expansion in valuation multiples. Therefore, despite improving fundamentals, it is hard to make a case for a material upside in the market.

Are 'taper tantrum' fears firmly back on the table?

Central Banks have responded to the pandemic with unprecedented monetary stimulus. So as the pandemic recedes and growth recovers, we may see inflationary pressures. That is what the bond markets are indicating. Central banks, however, continue to remain supportive at the moment given the uncertainty on the extent and sustainability of the growth recovery. Therefore, in the very short term, liquidity conditions may remain supportive. That said, the risk of a taper at some point in the future does exist. India’s macros now are better compared to the taper tantrum period, as there is stronger policy support for growth and strong foreign flows (reflecting in significant rise in forex reserves). To that extent, the impact may be less than what we saw in 2013.

What are the top risks for the markets hereon?

Factors that we see as a risk are: a) increasing Covid-19 cases stalling the current recovery; b) higher commodity prices adversely impacting near-term margins for companies; c) rising of trade and current account deficit and potential concern of twin deficits; and d) rising bond yields impacting equity valuations. Market valuations, to a large extent, have started to factor in sustained earnings recovery and, hence, any disappointment there will be a meaningful negative for the market. A rise in bond yield will have a greater impact on long-duration equities.

Are they factoring in a possible deterioration in macros given the rising commodity prices?

We don’t think the market is factoring in any material deterioration in macros at the moment as there is higher confidence on growth (both monetary and fiscal support) and favorable external environment with portfolio flows and high forex reserves.

Strategy for commodity-related stocks?

We have been constructive on commodity-related stocks as higher demand for certain commodities -- both on account of cyclical and structural factors -- might keep prices elevated.

How much can the rising commodity prices dent corporate earnings by over the next few quarters?

In certain pockets like large commodity consuming sectors, su­ch as auto and consumer, there are downside risks to earnings due to higher commodity prices. A steep rise in commodity prices is unlikely to be passed on completely. We note that for ex-financials and ex-oil & gas universe, the market is factoring in the highest earnings before interest, tax, depreciation and amortisation (Ebitda) margin in a decade in FY22/23.

Are listed public sector stocks likely to draw greater investor attention in FY22?

The disinvestment target, in general, has not been achieved in the past. Slippage in FY22 as such can’t be ruled out. However, given the government's intent and supporting market conditions, it is possible to deliver a better disinvestment number than in the past years. We have already seen good traction in listed public sector space and that may continue in FY22 as the stocks provide valuation comfort. 

Investing strategy at the current levels?

Given expected volatility, we prefer a bottoms-up stock specific approach. We can’t say as a basket mid-small cap segment will necessarily outperform large-caps. We are constructive on financials. We have private, public banks, and insurance represented in our model portfolio. With sustained recovery in the growth rate and adequate provisioning, the risk of higher credit cost has receded to an extent. We are more comfortable with larger banks. We are also overweight on infrastructure/construction, metals, and information technology (IT) services, and underweight on auto and consumer.