Risk-reward ratio not favourable for markets: Vibhav Kapoor

Interview with Vibhav Kapoor, Group chief investment officer, IL&FS

Vibhav Kapoor, group chief investment officer, IL&FS, explains to Rajesh Bhayani the many risks for equity markets. He also warns that valuations are high, and if earnings growth doesn't follow, markets could fall. The rising rupee is another risk. Edited excerpts:

Price-to-earnings (PE) valuations are around 2008 highs. In 2008, markets had seen a sharp fall. Are we in a similar situation?

I would say valuations are very high, but they have not reached 2008 highs yet. In mid-caps and small-caps, PE valuations of many companies are quite high, maybe resembling 2008 high, and indicating danger. But, in large-caps, PE levels are not so high in all companies. Also, in 2008, due to global financial crisis and global recession that followed, the potential for earnings growth vanished. That is not the case now. In last few years, earnings have not expanded, but valuations have gone up on hopes of earnings revival, resulting in high PEs. Now, earnings have to start to grow in next two quarters, else there could be a sharp correction. However, I don't see a 2008-type correction.

Liquidity is a key factor driving valuations. Can the trend sustain, and what could be the warning signals?

Globally, there is a lot of liquidity, with Quantitative Easing continuing in Europe and Japan. The US is doing well and now some growth is returning. This is a conducive situation for equities. Domestic market has seen a very big change and in my career so far, I haven't seen so much money coming to domestic institutions like mutual funds, insurance companies, that are together getting $20 billion per year, equalling foreign portfolio investments. This money is driving valuations, particularly of mid-caps.
 

A sharp rise in US interest rates could see withdrawal of liquidity and emerging markets underperforming. If the 10-year US treasury yields rise from 2.2-2.3 per cent currently to 3 per cent, it could be another dangerous signal. Domestic liquidity partly depends upon interest rate and when it rises, money could dry up and go to bank deposits.

Defensive bets of yesterday, such as information technology (IT), pharma, are not doing well. Can they provide support when market starts falling? 

As I said, earnings growth must come back. Good monsoon can help earnings growth revival, especially in FMCG (fast-moving consumer goods), two-wheelers, consumer durables, tractors, fertilisers, and others, which can help sustain the market. Investment cycle must move on, which is not happening. There are two reasons for that. Private-sector balance sheets are too stretched, particularly capital-intensive sectors like infrastructure and steel. Banks are also still not out of woes. Both are also integrated issues and hence hope is on the government, which should make investments but it has its own issues like fiscal deficit and now new FRBM (Fiscal Responsibility and Budget Management) recommendations, which make it further difficult. We have to largely depend upon resumption of consumption cycle, which is monsoon-dependent. With respect to IT and pharma, I don't see them recovering soon.

Do you see any kind of bubble building up in markets?

At the moment, no. But certainly, the risk-reward situation is not good in the current market. On the whole, equity markets globally are expected to remain benign, at least for some more time. Low domestic interest rates and good monsoon projections are also positives. GST (goods and services tax) also, after a couple of quarters, will start to benefit companies and hence markets. If market gets a reasonable correction, there is reasonable potential on the upside. In the immediate short term, risk-reward is not favourable. If markets rise in the immediate future by 10 per cent, then it's a bubble. 

Should investors looking to put fresh money wait?

On a general basis, it could be the advice for people who are not looking at a very long term. Long-term investors can use systematic investment plans (SIPs). Corrections cannot be timed, nor one can chase markets and hence a balance is required. I believe markets could go up three to four per cent from here in the next couple of months. If that happens, the second half of the financial year could see some correction. FMCG, consumer durables, two-wheelers, some private banks (though their valuations are high) and NBFCs (non-banking financial companies) can be considered.