 "Neelkanth Mishra")
With the second quarter earnings season under way, Neelkanth Mishra, managing director for equity research at Credit Suisse, discusses the road ahead for the markets and his sector preferences with Puneet Wadhwa. Edited excerpts:
What is your analysis of how global economy and markets have panned out over the last few months?
The global economy seems to be doing better than was expected four – five months ago. The US employment data continues to show stability, the impact of Brexit on the United Kingdom, or even the European Union, has been much milder than expected. And two months ago, for the first time in many years, we saw an upgrade to our Chinese GDP (gross domestic product) forecasts.
With the exception of the EU/Brexit situation, where the next year brings significant political uncertainty, in the form of the start of Brexit negotiations and a slew of EU elections (including major economies like France and Germany), these trends should continue. In this situation, the volatility in global markets could come from two sources – a sharper than expected rise in bond yields, and a pick up in the pace of decline in the Chinese currency (the Renminbi, or the CNY).
How are the policymakers and the markets likely to react to this situation?
With policymakers in all three major developed economies – the US, EU, and Japan now starting to move from monetary to fiscal stimulation, bond yields are now expected to rise, but at a slow pace. The assumption that many in the market have made that bond yields would stay low forever will be challenged. This has important implications for pricing of securities.
The market has been surprisingly nonchalant about the CNY’s decline so far, likely because it’s been better managed/timed this time. They don’t want a steep fall any more than the rest of the world. As the US Fed raises rates, this should be another fault line one should carefully monitor. That said, it must be noted that the knee-jerk reaction of selling Emerging Markets (EMs) when the dollar strengthened is missing this time. And, for a good reason. A painful external account rebalancing in many economies like India, Brazil and Indonesia has already happened. With the outlook on oil now better, even Russia appears stable.
How big is the global geopolitical situation right now to the stability in financial markets?
Some news flow emerges periodically about various flash points in the world. But unless it breaks out into a major conflagration, which at this stage seems unlikely, I doubt it would have a major impact on financial markets.
What is the outlook for emerging markets (EM) in the remaining half of FY17?
The conventional and time-tested view that dollar strength would mean EM crisis is not playing out this time. EM bonds are now being viewed as yield plays, and five years of underperformance, as well as better medium-term trend growth due to demographics and reform is also making their equities see more interest. EM equity funds are therefore seeing inflows. Expectations of a switch from monetary to fiscal stimulation in developed markets, and stability in China is also supporting global hard commodity prices. This is supportive of EMs too.
How does India look given the run up and valuations?
India has been time correcting the last few months, as forward earnings continue to climb but the market stays range-bound. Since May/June, indicators of economic activity haven’t been very encouraging. Demand growth for oil, power, and cement - which are very widely used in the economy - has been particularly anaemic. Till these signs improve, the indices may not break out of the current range.
Could GST (goods and services tax) Bill implementation be the next trigger for the markets?
As the GST implementation deadline approaches, we believe the market may also start to worry about the disruptions it would cause in the economy. GST is a great step forward over the medium-term, but the adjustment process won’t be easy or smooth. With so many details yet to be sketched out, it’s a bit early to assess how intense and how long the disruption could be, but it’s an important risk to the market.
Is there more money to be made in the mid-cap and small-cap segments given the run up?
Some interesting things are starting to happen in the indices. MSCI India, the most popular benchmark for FIIs, has barely moved in US dollar (USD) terms in the last twelve months. However, the BSE 500 index has appreciated by nearly 6.5%. So how “India” is doing depends on which index one tracks.
Last year we coined this term “Next400”, i.e. the stocks that are in the BSE500 but not in the BSE100. This set of stocks has delivered 13% return in USD over the same period. So the small/mid-cap story has already been playing out.
What are your sector preferences in this backdrop?
As with anything that involves a large and diverse economy and hundreds of companies, it’s difficult and I would say unwise to paint everything with the same brush. What’s clear is that many if not most of the large-cap stocks are global proxies – linked more to global growth than domestic growth.
In the Next400, the sector composition is such that they are more levered to domestic growth. So their outperformance as a group may continue, with one important caveat, that some of the small/mid-cap stocks are trading at “theme” valuations, and we are advising investors to sell those. Some of these are even in sectors like micro-finance and non-banking finance companies (NBFCs) where we are very constructive on structural trends and the transformative impact of technology.
What are your earnings expectations from the recently concluded quarter, and FY17 and FY18 EPS estimates?
We have had a mixed earnings season so far, with some disappointing results/guidance changes and some good results. The domestic economy was in the second quarter, and may be still is, going through a soft patch. I suspect the market isn’t prepared for that update, though many would want to look through this weakness.
As for FY17 and FY18 earnings estimates - we’ve often said that what matters is not if cuts are happening (they seem to always happen!) but the pace of cuts. As the starting estimates for any year are generally at 15 – 20 per cent, if the pace of cuts slows, over time the one year forward earnings starts to pick up. That is exactly what has happened in the last four months.
After a torrid pace of cuts from the beginning of the year, when index EPS for both years fell at six –nine per cent over three months, the pace has slowed to less than one per cent. That has driven the time correction discussed before.
Going forward, conviction in FY18 earnings would be dependent on the signs of economic pick-up that we expect to emerge by end of this calendar year, and some concerns around the near-term disruption caused in the economy next year due to the GST implementation.
Given the trajectory of oil prices, do you see a threat to RBI’s inflation estimates / targets going ahead? How should one deal with the interest rate sensitives – autos, banks and real estate – sectors in this backdrop?
I don’t think oil at $50-55 really affects the Indian consumer price inflation (CPI). It has some impact on wholesale price inflation (WPI), but that’s not a policy target anymore. If oil stays below $60, I don’t think there will be a meaningful impact on CPI. But it would give some reasons for caution to the Monetary Policy Committee (MPC).
We expect another 75 basis points (bps) interest rate cut in the next three quarters. Therefore, in mid-September, for the first time in more than six years, we cut our overweight stance on staples, and also for the first time, went overweight construction. We raised our overweight stance on housing finance companies, and also on metals, and went deeper underweight on IT and Healthcare.
Oil & gas and metals sectors have done exceptionally well with their respective indices hitting a 52-week high recently. What is your advice to investors regarding these two segments?
These have different dynamics. On metals, we had been negative till last year, but this year we turned positive early in the year. We continue to stay constructive. As the markets start to price in infrastructure spending by the developed economies in the coming years, the outlook for hard commodities will not be as negative as it was last year. This sector is still under-held.
We are not constructive on the upstream names. We have been strongly recommending the oil marketing companies for nearly a year, given cheap valuations, widely held cynicism about price de-control continuing, and good volume growth in India. The last part of the argument has weakened a bit in recent months, but the outlook remains stable, and we continue to be positive. On pipelines and utilities in this space, the falling price of gas opens up opportunities in some of the names, particularly as the government is trying hard to increase gas usage in the economy.
What about FMCG and telecom sectors? Are they a good contrarian bet?
We have had a counter-consensus underweight on Telecom for more than two years. If you plot the Herfindahl-Hirschman index for Telecom over time (HHI is a measure of competitiveness of an industry - the sum of squares of market shares of each participant - the lower it is, the more intense the competition), you can see a visible correlation with EBITDA margins. Before Reliance Jio’s (RJio) entry, the market was consolidating as the smaller players were getting weeded out, and that was showing up in expanding margins. But the RJio entry pushes HHI down sharply, and the turmoil may last quite a while, with significant industry restructuring, and balance sheet activity. We would continue to be on the side-line, unless of course some stocks fall sharply.
As regards staples, Patanjali is not as big a threat, and at least for now the momentum has slowed. Unlike in Telecom, where a generational transition (i.e. 4G) and massive amounts of capital provided an opportunity, FMCG is a much harder industry to disrupt quickly. Patanjali did a great job in using their branding advantage to leverage the rising trend of naturals/ayurved in FMCG, and have played an important role in formalizing markets like ghee. But building a nation-wide distribution network, and a complex organisation, takes time. In Staples, our primary concern is volume growth.
