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The sharp fall in inflation has cheered the markets, as it implies that sharp cuts in interest rates would follow. The euphoria overlooks the fact that a fall in inflation comes with low growth. Gautam Chhaochharia, executive director and head of India research at UBS, the Swiss global financial services company, tells Malini Bhupta that although the Reserve Bank (RBI) is expected to cut rates by another 75 basis points, FY16 will not be very different from FY15. He expects earnings growth to just about hit double-digits. Edited excerpts:
Where does India stand, in absolute and relative terms?
India is in good shape, from a fundamentals' perspective. From the markets' perspective, what has happened (the decline in growth) is that reality has finally dawned that recovery will be gradual. Our view has not changed since last year, that India's macro will improve gradually and inflation will surprise everyone. When you say inflation will come down sharply, what you are also saying is that growth recovery will be slow. We also said that rates will come down as inflation declines, which surprised the markets positively. Growth has surprised negatively in the past two quarters but it was ignored. Now, it (the impact on stock valuations) is finally catching up.
What is your earnings estimate for FY15 and FY16?
We will exit FY15 with earnings growth of seven-eight per cent. The Street is still looking at 16-17 per cent growth for FY16, after cutting estimates. More earnings cuts are likely. We estimate earnings growth to just about make it to double digits.
In that case, are the valuations justified?
The valuations are rich but justifiably so.
By when do you expect corporate India to deliver double-digit earnings growth?
If you look at India's nominal gross domestic product (GDP), it has been growing at 12-13 per cent, which should make double-digit earnings growth possible, as the private sector is supposed to be more efficient. But that was not the case in the past three-four years. As growth starts slowing, earnings tend to fall below nominal GDP rates and when growth accelerates, the earnings trajectory moves towards nominal GDP rates and then surpasses it.
The second driver of corporate earnings is the mix between real and nominal. When nominal growth is driven more by real growth than inflation, then earnings improve.
Do you expect GDP growth to accelerate in FY16?
We expect it to be higher by 20 basis points (bps) in FY16, year on year. Under the new series (data), we expect GDP growth to be 7.5 per cent. Growth acceleration will be gradual and it is still early days for a sharp recovery.
Which sectors will drive earnings?
Banks will play a big role. We believe non-performing loans and net interest margins are bigger drivers of earnings than credit growth. If credit growth is slow, it won't impact profitability too much. But if interest rates come down, the impact on non-performing assets, bond-book and margins will be higher.
What is your forecast on interest rates?
We continue to expect 10-year bond yields to touch 6.5 per cent by the end of FY16
The government has been criticised for not doing enough to improve the business environment. How are investors viewing the Modi government?
The government is taking steps to improve the ease of doing business. If you look at the policy direction, steps have been taken across sectors. If you see telecom, the regulatory uncertainty is behind us. Similarly, if the Supreme Court had cancelled coal blocks two or three years earlier, who would have expected the re-auction to happen in three months? But, the government has done it. The coal, mines and insurance Bills have been passed by Parliament. The delta in the coal Bill is that it allows merchant mining, a big reform. The only area the government is lagging is the land Bill.
Do you expect coal output to improve to one billion tonnes (annual) by 2020 and will the power sector benefit?
Theoretically, it is possible but will be a staggering challenge. At the margin, coal availability will improve because of the more concrete plans Coal India has and infrastructure will improve for specific mines. The auction of cancelled blocks will also help. Additionally, prices of imported coal have come down, which will also benefit the sector.
When do you expect the power sector to come out of the current situation?
Lower coal prices will help the sector. Now, specific reforms for state electricity boards (SEBs) are required to ring-fence the state regulators, meant to become independent in 2003. The crux of the (SEB) reform is that the state-level regulator is independent.
Where do you see interest rates in the coming financial year?
We expect the 10-year government bond yield at 6.5 per cent by March 2016. We expect RBI to cut another 75 bps by March 2016.
Will RBI's decision be influenced by what the US Federal Reserve does?
RBI will track inflation data. The rate differential reflects inflation differentials and risk premia that bond investors would want for the local economy's credit metrics. India's fiscal deficit and current account deficit is improving, the risk premia is anyway improving. India's premium or risk to the US Fed is improving. India's rate cuts will be driven by inflation and the interest differential with the US is not coming down on a real basis. We expect the US Fed to cut rates in September.
Where do you expect the Indian currency to be?
On an absolute basis, on the depreciating side, as we expect the dollar to remain strong.
Is the currency a risk to corporate earnings?
Too early to say. Export growth has come down, due to global conditions. Currency is only one driver of exports. A move of five to 10 per cent in currency does not impact exports in a major way, the experience shows.
But cross-currency moves do impact earnings?
That is an accounting move and not a fundamental one from a long-term perspective.
What is your view on Indian IT (information technology)?
We are cautious on Indian IT, as we do not see much room for positive surprises.
Is the sector's valuation, versus its growth trajectory, justified?
When you say growth, is it one year or five years? In the near term, it is a matter of expectations versus delivery. But a five-year call is trickier, as there are newer growth opportunities beyond traditional application & maintenance. On the other hand, SMAC (social, mobile, analytics and cloud services) can even be potentially deflationary.
