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One Sector Will Rescue Q3 Earnings, Strong Recovery Ingredients Still Missing: UBS

BloombergQuintOpinion

The street expects Nifty earnings growth of 9 percent year-on-year for this quarter. Financials are expected to be the big driver, excluding which earnings will decline by 5 percent year-on-year. In previous quarters, global commodities supported Nifty earnings growth, however this time around they are likely to be a drag. To meet the full-year consensus expectations of 18 percent earnings growth, the asking rate for Q4FY19—assuming Q3FY19 pans out as expected—will remain steep, at 45 percent year-on-year.

This implies sharp cuts ahead.

Volatile crude/currency movements and liquidity issues will likely result in divergent sectoral trends this quarter.

How Each Sector Will Fare In Q3

  • Autos will have negative operating leverage due to weak volumes.
  • We expect normalising of volumes in consumer companies.
  • Earnings for pharmaceuticals will remain weak this quarter as well.
  • Information technology will face currency headwinds but we expect stable demand commentary despite macro headwinds.
  • For banks, we expect loan growth to accelerate, but margin improvement will be only in some cases. Mark-to-market gains on bonds can provide room for extra provisioning.
  • The top line might look healthy for industrials, led by a few lumpy projects; however, order-inflows will remain sluggish.
  • Cement can report a strong quarter-on-quarter recovery from a weak Q2 despite flattish prices.
  • Oil and gas: State-owned oil marketing companies may bear the brunt of lower refining margins and inventory losses, despite resilient marketing margins. City gas distribution growth should remain resilient.

In The Medium-Term

For an outlook beyond this quarter and politics, a broad-based earnings recovery is still unlikely, though growth will be back in double-digits. But that’s more due to a normalisation in financial firms’ earnings.

We expect earnings growth of 16 percent in FY20 and 14 percent in FY21, versus a consensus forecast of 25 percent in FY20 and 18 percent in FY21.

Our analysis suggests three out of four key elements for India’s macro growth will be missing.

  1. Monetary/fiscal impulse will be less supportive.
  2. The capex recovery is still elusive.
  3. Export growth will remain muted, with an overhang from slowing global growth.
  4. The only silver lining will be the credit cycle, as the clean-up in the banking system boosts credit flow.

The last will support the recovery, but sustainability depends on the other three too.

The easy liquidity conditions which have supported rich valuations—as seen in past three years—is unlikely to be back in a hurry. The support from local equity flows will also be less, compared to the past two years.

Flows follow the return, and not the other way round. The one-year Nifty return is in low single digits and is negative for mid caps.

Policy And Politics

Beyond earnings, what will drive markets in 2019 will be policy, reforms and the populist narrative. 10 states have waived farm loans in the last two years, in states run by both the BJP and the Congress. As a percentage of GDP, it is similar to the pan-India waiver of 2008. The Congress is calling for a nation-wide farm loan waiver if it wins, whereas Finance Minister Arun Jaitley has commented on the possible use of the RBI surplus reserves for poverty alleviation.

All these suggest pre-election populism—defined by us as direct doles with fiscal expansion—may be picking up.

Every government everywhere in the world has social welfare programmes, including India, which is needed from a socio-economic perspective. Populism ahead of an election is not something new and there are two relevant questions here.

Does Populism Yield Any Political Advantage?

Our analysis of data from past elections indicates an unclear role of populism in an election victory. The political impact of the pan-India farm loan waiver in 2008 may not be that obvious.

A look at data in key states where loan waivers were dominant indicates no clear improved results for the Congress in the 2009 elections, vis-à-vis other states which did not have any material waivers.

The same was the case for states with high spending on the National Rural Employment Guarantee Scheme then.

Can Populism Continue Post-May 2019?

This is a difficult question to answer conclusively, but worth keeping in mind for investors. Excluding credit support, agricultural growth has been weak and terms of trade have not been positive, except for periods of strong policy support like in 2009-12 (loan waivers, NREGA, aggressive price, and procurement support). The current government policy focus has been towards improving market access for farmers, food storage/processing infrastructure and insurance. These should help over the long term.

However, the reality of the challenges of farm economics in the near-term did push the government to increase minimum support prices by more than witnessed in recent history. This is something we would keep an eye out for now, but our base case remains that of policy trajectory discipline and stability post-elections. A positive narrative on reforms/policy supported rich valuations over the last four years despite earnings cuts. Policy action after May 2019 will be the key for the market multiples in 2019.

2019 Nifty Outlook

Our base case Nifty target by end-2019 is 10,000, whereas the upside scenario has a Nifty fair-value of 11,800 by end-2019 and the downside scenario has a Nifty fair value of 8,700 by end-2019. 

Our probability/comfort for the base case is lower than it has been historically and our upside/downside scenarios also suggest unattractive risk-reward. We believe 2019 will be more about stock-specific calls rather than sector-specific calls.

Gautam Chhaochharia is Executive Director and Head of India Research at UBS Securities.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.