Prospects for India good, but expensive valuations limit upside: KIE

"Even after a 7 per cent correction from the top, India is still not cheap," said Kotak Institutional Equities' Pratik Gupta.

Stocks will remain volatile until there is clarity on Russia-Ukraine situation and oil prices, says Pratik Gupta, CEO & Co-Head, Kotak Institutional Equities (KIE). In an interview with Samie Modak, Gupta says markets could enter a phase of consolidation as interest rates go up globally. Edited excerpts:

Markets are yo-yoing too much? Is this the new normal?

Two event risks are out of the way - one was the state election results and second was the Fed rate hike. However, markets will remain volatile till we get clarity on the Russia-Ukraine situation and oil prices. Incidentally, China has been even more volatile (it went down about 10% last week and almost fully recovered in a few days) and some of that volatility impacts India as well. Global investors have mixed views - one is that the Chinese market has become more attractive, so let’s move money from India to China. The second view is that China has significantly underperformed India over the last six months, so some investors prefer to just stay invested in India. The latter view has prevailed in the last few days as we’ve seen foreign selling slow down, but whenever China moves up and down so much, it has a contagion impact on portfolio weights within an emerging market portfolio which in turn impacts foreign flows into India.

How do you see India’s valuations right now? And what are the key risks?

Even after a 7 per cent correction from the top, India is still not cheap. Nifty is trading at about 20 times FY23 earnings. Also, India’s valuation premium to the MSCI EM index is almost 70 per cent. There's always been a premium and it ranges between 15 per cent and 90 per cent. So now we are again towards the upper end of the range. The longer term prospects for India are good but relatively expensive valuations limit the upside this year, especially given a rising interest rate environment, with the increasing risk of an economic slowdown in the US that may adversely impact global equities as an asset class. Another risk is the geopolitical and oil related uncertainty as it can depress economic and corporate earnings growth. Also, the COVID risk is very much out there with China and South Korea reporting huge increases in cases once again. The last one is the monsoon risk – India has had three successive good monsoons and it remains to be seen if we will have a good monsoon in 2022 also. Most risks are global in nature, there is no significant India-specific risk other than the monsoon risk.

How do you see the market trajectory?

We expect India’s equity market to be range bound for most of this year assuming no further deterioration in the geopolitical situation and in oil prices. Globally, interest rates are going up and there is a risk that economic growth may not be as strong, so it's tough to see equity markets globally doing well like last year. Earnings growth is like the accelerator, but this is also slowing down a bit. On the other hand, higher interest rates act like a brake on the equity markets, and we’re seeing the Fed hitting the brakes finally with more rate hikes planned this year along with its balance sheet reduction. As we get past this consolidation phase and market valuations become more reasonable, we should see Indian equities performing in line with the corporate earnings growth trajectory.

What are the earnings growth expectations?

For FY22, we are largely on track to achieve 35 per cent earnings growth for the Nifty, and for FY23 and FY24, we expect about 15 per cent earnings growth for each year. However, while our overall Nifty earnings growth estimates haven’t changed too much, we have seen a change in the mix of earnings growth - we have seen cuts in earnings estimates for the auto sector, consumer goods and the cement sector. On the flip side, all commodity-linked sectors have seen upgrades to earnings. So the quality of earnings has deteriorated to some extent as it’s become more vulnerable to a global commodity sell-off, but India’s longer term earnings outlook still appears very strong versus most other global EMs.

What are the reasons for the massive FPI selloff since October?

The first driver was the turn in the US interest rate cycle which investors began to anticipate as inflation started going up. The second was the fact that India had performed extremely well compared to other EMs, and was looking quite expensive on a relative basis. Then in February, we had the Russia-Ukraine war, commodity price disruption and oil prices shooting up. For India, which imports about 85 per cent of oil, that has a huge impact on the economy. However, the one good thing this time has been the buying by local investors that offset the  selling from FPIs.

Will strong local flows into the market continue?

Yes, we believe they will. The alternatives for local capital don’t appear very attractive – bank deposits are not even covering for inflation on a post-tax basis, other fixed income products don’t appear very appealing in a rising interest rate environment, and price appreciation in real estate is likely to be muted as the upcycle is being driven mainly by genuine buyers and not by investors, Also, there are many millenials who are now investing in equities which is being facilitated by easier online access, and overall share of financial savings in household savings is still low in India. So local flows should continue unless there is some global event which scares away retail investors.

Which are the sectors you like?

Private banks, life insurance and capital goods. We are also positive on certain other areas like chemicals and some of the large real estate companies. Within sectors, we recommend focusing on stronger players in general. So within financials, for example, we prefer the better quality large private banks rather than most PSU banks or NBFCs. Also, we suggest sticking to the large caps rather than small caps, or companies with weak balance sheets and/or governance. This is not the time to take undue risk in our view.

The Street is bullish on private banks for quite some time, yet the sector has not performed.

The main reason was sustained selling by FPIs as most would typically have a 35-40 per cent weightage in financials and some even more. So when FPIs start selling India, banks are hit the hardest. The second is that we've not seen earnings upgrades for the banks and as of now, credit growth is still weak with downside risk if economic growth forecasts are trimmed further. We expect loan growth to pick up in the second half. Most banks have also cleaned up their books, and leading private banks have a very strong deposit franchise with significant investments in technology. They are well positioned to capitalise on India's higher economic growth as and when that materialises.