We prefer large-caps that could gain from govt initiatives: Manish Kumar

The blip in the earnings growth due to demonetisation and GST implementation is expected to yield tangible benefits in the medium term, says Kumar

The past year’s rally in the markets has taken valuations to the higher end of the historical band. In an interview, MANISH KUMAR, chief investment officer (CIO), ICICI Prudential Life Insurance Company, tells Vishal Chhabria and Ashley Coutinho the mid- and small-cap space looks frothy. So, one has to be prudent in investment decisions. Edited excerpts:

The markets have rallied sharply in the past year, despite significant headwinds. At the same time, we observe the global equation is not encouraging. Does this worry you?  

The current rally has been gradual and fairly widespread across sectors and we are cautiously optimistic. Many companies have concluded their fundraising programmes and the markets have taken this into account, and rallied. We believe there is strength in the current rally, backed by strong inflows.

With price-earnings at 24-25 times, are valuations expensive?

These are on the higher side of the historical band. To sustain the current valuations and support the markets, companies need to deliver strong earnings growth. Unlike in large-cap companies, where valuations are close to their higher end of the historical zone, the mid- and small-cap space looks frothy. So, one has to be prudent in making investment decisions. 

The blip in the earnings growth due to demonetisation and Goods and Services Tax (GST) implementation is expected to yield tangible benefits in the medium term. We are expecting earnings to improve from the third quarter of FY18, partly due to the low base effect. In fact, second quarter earnings were better than the first one.

In the past three years, investors expected earnings growth to be in mid-teens and each year earnings disappointed. In FY19, too, earnings is estimated to grow by 15-20 per cent. Do you subscribe to this view?

We believe earnings growth in FY19 will improve over FY18. In FY20, it will be healthier than FY19. Banking, telecom and the pharmaceutical sector could witness improved earnings in the next two years, and play an important role in improving overall earnings.

In FY18, earnings growth in the banking space was impacted due to slippage and high provisioning cost. We expect earnings growth to improve in Q2 of FY19 and in FY20, due to the steps taken by the government to reform the sector.  

In telecom, earnings growth remained muted due to competitive dynamics but we expect it to improve from FY19. The pharma sector, on the other hand, was on the wrong side of the US regulator, due to which earnings growth remained weak. 

So, when we analyse earnings at a micro level, there are sectors and companies where profits were impacted due to certain headwinds. So, we expect earnings to improve in FY19 and FY20. 

What is your view on the rally in bond yields in the past few months?

We expect the 10-year bond yields to be range-bound from here and peak at 7.5 per cent in 2018. In the past six months, we have cut our duration to 3.5 years against the benchmark rate of 4.5-5 years, anticipating a reversal in the interest rate cycle.

How are you structuring your equity portfolio?

We prefer large-caps over mid- and small-caps. We are also aligning our portfolio to replicate the initiatives taken by the government. For instance, the government is likely to take measures to boost the rural economy in the next 18 months and our portfolio will reflect that. We also have our crosshairs on telecom and banks, mainly private players with a high CASA (current account and savings account) franchise and better growth paradigm.

Globally, central banks are tightening their balance sheets. What could that mean for India?

We are seeing gradual improvement in the US economy and signs of economic growth in Europe. Hence, we will see a phase of tightening and gradual uptrend in interest rates in the US and Europe. These developments will result in moderate fund flows into Indian equities. The US 10-year bond yields are at 2.2-2.3 per cent and could touch three per cent by the end of 2018. Even then, the spread between US and Indian 10-year bond yields will remain about 4.5 per cent, which is fairly healthy. So, we don’t see any outflow of foreign capital from the Indian debt market.

Crude oil prices are going up and the government’s fiscal math is being questioned. How will markets take it?

Despite challenges on the fiscal side, in our opinion, the government won’t deviate completely from fiscal prudence. The 3.2 per cent fiscal deficit target for FY18 might inch up marginally to 3.5 per cent but we believe the government will stick to its stated glide path. A significant deviation will become a cause for worry. Given the structural changes in the oil market globally, a rally in prices beyond $70 per barrel might not be sustainable. If there is any rise in prices globally, we believe the government, too, will hike diesel and petrol prices. So, the impact on oil marketing companies will remain minimal.