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Upgrading Construction Stocks: A First For Neelkanth Mishra

GST may be an epochal event in Indian history says Neelkanth Mishra.

Upgrading Construction Stocks: A First For Neelkanth Mishra
A highway construction site in Delhi (Photographer: Qilai Shen/Bloomberg)

Samvat 2072, was a mixed year for the Indian markets, this despite the passage of the Goods and Services Tax (GST) bill, that aims to reform the country’s tax structure. And the volatility may exist in the near-term said Neelkanth Mishra, India Equity Strategist at Credit Suisse. But the silver lining for him is the significant uptick once the landmark tax structure has been implemented.

In this conversation with BloombergQuint, Mishra said that interest rates may fall more than what most people expect. This is one factor behind the decision to upgrade the construction sector for the first time in his career as a strategist.

Many believe we are at the beginning of a long-term bull market cycle. Interest rates have started to come off. But what factors, macro-economic or otherwise, still need to improve to take equity markets to new highs?

Since May this year there has been a very visible slowdown in the economy. Many of the high frequency indicators that we track, like oil volume growth, power volume growth and commercial vehicle sales, have been very weak year on year. Till the trend starts to improve, there will be no confidence in FY17 and FY18 projections.Till then, our view is that the broader market stays range bound, in FY18 in particular, as it will see the start of GST implementation. GST is a very epochal event in Indian history. As it gets implemented it could disrupt the economy quite meaningfully. The market hates uncertainty, hence in the coming years we could see some volatility but the shape of the markets could be very different from what they are right now.

What will prompt the return of capital expenditure?

The challenge in India is that sectors with private participation have meaningful overcapacity. The utilization level is very low. Whereas the sectors where India needs capacity, say power distribution, roads, railways and urban infrastructure, have not been fully opened to private participation. In my view it will have to be the government using various creative forms of financing to kickstart capex. As sectors open up, you’ll see more private sector capex happening. Over the next two-three years, as utilization in corporate sectors improves, you’ll see capex automatically coming back.

With respect to consumption, what is your reading on festive demand? How are you viewing consumer discretionary sectors like auto and consumer durables? You are also now neutral on consumer staples. Is that because the stocks are relatively expensive?

Demand on the staple side has been quite weak. Our expectation for the September-ended quarter is that the combined volume growth for the sector could be half of what it was last year, and perhaps the lowest in the last 2-3 years. The problem with staples is that the bottom of the pyramid is really struggling. Agricultural income growth, which saw a compounded annual growth of 14 percent between 2005 and 2014, was at only 5 percent in FY15 and only 3 percent in FY16.

Following a good monsoon, people expect that incomes will revive. We expect good volumes to drive prices down and hence the overall income growth may not be significant. There is also a fear that farmers are greatly indebted after two weak monsoons. Whatever income they may get might end up going as repayment of the loans and not consumption. Staples, which is far more geared to the bottom of the pyramid in terms of new adoption and upgrading, has that problem.

On the discretionary side, the numbers look quite decent. They are not as strong as we would’ve liked but there is the advantage of better leverage. There is a lot of financing now available. If you take two wheelers for example, a year back, only 35 percent of two wheelers were financed, now 55 percent are financed. The threshold of income at which you can afford a two wheeler has come down and is showing up in some solid numbers. So I think availability of credit and meaningful changes in terms of power and road availability across the states, should help the top half of the economy.

On discretionary we remain overweight. We are not very positive on staples.

I understand you will not give us stock recommendations but can you leave us with two ideas – thematic or sectoral that you think could play out well over the next one year?

Our consensus call over the past few months has been that interest rates will fall much much more sharply than people think. We think that rates could be cut by 100 basis points, and this was before the RBI cut rates recently. We could see interest rates reaching a level we haven’t seen for close to a decade. And that means that there will be new opportunities in the stock market. That was about the time when we cut staples to neutral. We went deeper underweight in IT and healthcare.

We also upgraded construction companies for the first time in my role as a strategist. The whole sector has 40-50 percent of their costs coming through interest and labour costs. If interest costs fall and labour costs don’t appreciate as much (because of the stress on the bottom of the market) and order flows from the government side remain steady, this sector can actually do very well.