Risk-reward is unfavourable for investing at current levels: Chhaochharia

Mr Modi's reform agenda has aided investors in ignoring earnings disappointments over the past four years, Chhaochharia says

The Karnataka election outcome, crude oil prices and the rupee kept investors on the edge last week. GAUTAM CHHAOCHHARIA, head of India research, UBS Securities, tells Puneet Wadhwa that foreign investors’ concerns now revolve around the banking sector’s non-performing loans and fraud cases, inflation and rising oil prices. Edited excerpts:
 
How do you see the markets play out for the rest of 2018?
 
Our end-2018 Nifty base, upside and downside scenarios of 10,500, 11,900 and 8,800 (respectively) imply unattractive risk-reward from current levels for rest of the year. The Karnataka assembly election result may add to expectations of a Modi win in 2019. Our discussions with investors suggest that they presume Modi will win 2019 national elections. Market's recent performance and valuation multiples also suggest that this is priced in. Any opinion poll in the next few months would drive market sentiment. Towards end-2018, results of three big state elections will also be a key.

 

What is the downside in case the Modi government loses general elections?
 
Mr Modi's reform agenda has aided investors in ignoring earnings disappointments over the past four years. Thus, his re-election as Prime Minister with a single-party majority underpins the market's hopes, reflected in rich multiples. Markets are pricing in a Modi win, and a loss would hurt sentiment and could result in lower multiples. Depending on where the market is trading at the time of results, a loss could see markets dip 5–10 per cent in the near-term. Market performance beyond that would depend on the policy/reforms outlook of the new government, the course of growth pick-up, earnings expectations, etc.

 
What are the risks to watch out for?
 
Some of the global risks include monetary policy normalisation in the US curbing flows into emerging markets (EMs), which may be a damper for India. Any development on the trade tariff front which impacts Indian exports to the US, on the lines of what is happening with other countries, may also be somewhat negative. That apart, any associated currency volatility and depreciation and a 'risk-off' positioning will also be sentiment dampers.
 
Is it a good time to start buying?
 
Nifty is trading at 18 times the 12-month forward price-to-earnings (on earnings that are likely to be cut around 10 per cent in FY19), and we believe the risk-reward is unattractive currently. However, rural-exposed stocks should do well (regardless whether a rural stimulus is real or remains just rhetoric). We also continue to like property, information technology services, retail and corporate private banks with strong retail deposit franchises and niche non-bank financials. Stocks levered to goods and services tax-led formalisation should also do well if e-way bill implementation is successful.

 
What are the key takeaways from March quarter results and the outlook for FY19?
 
Until the beginning of May, considering 20 of Nifty's 50 companies that had reported (57 per cent by index weight), Q4FY18 broad earnings were okay considering the low base, but growth excluding financials was ahead of expectations. Revenue and Ebitda (earnings before interest, tax, depreciation and amortisation) growth trends were better, driven by global commodity-linked sectors but margins were lower year-on-year. Our base case forecast for FY19 is of 13 per cent growth in Nifty earnings (consensus estimate is 23 per cent), which along with expectations of 15 per cent growth in FY20 and 18 times the 12-month forward PE multiples, forms the basis of our end-2018 Nifty base value of 10,500.

 
Where do you see the oil and rupee headed over the next 6–12 months?
 
UBS' global oil team forecasts Brent at $63/65 per barrel (bbl) in CY18/19. But, it now exceeds $75/bbl. If current oil prices sustain, our economist expects the MPC (Reserve Bank of India’s Monetary Policy Committee) to hike rates by 50 basis points in FY19 to ensure macro stability risks are contained. Oil sustaining $75-85/bbl could undermine macro fundamentals and in such a scenario, our economist sees a risk of 3-6 per cent rupee depreciation.
 
What are your views on liquidity flow towards equities?

 
Foreign institutional investor’s (FII) net buying of equities at $7 billion in 2017 was moderate, higher than 2015-16 levels but lower than 2012-14. This has slowed further in 2018, especially in the context of record inflows in emerging markets’ equities. Key concerns of foreign investors are around banking sector non-performing loans /fraud, rising inflation and rising oil prices. Local mutual fund flows will moderate from the 2017 levels, though a material slowdown will depend on the market performance —retail flows follow the performance, not the other way.