India is undergoing many structural changes but the hope is that it’s all in the right direction, said Neelkanth Mishra, managing director and India Equity Strategist at Credit Suisse on BloombergQuint’s weekly series Thank God It’s Friday.
While analysts and forecasters see most of these changes as disruptive only in the short term, Mishra himself is more cautious as he expects meaningful earnings downgrades for the financial year 2018-19 and not just FY17.
He is not worried about the slowdown seen in the latest economic growth data but only because, according to him, India does not generate enough data to make accurate quarterly GDP estimates.
Here are edited excerpts from the conversation.
We have seen lot of money coming from domestic institutions. Will these flows continue given the fact that we may see some amount of revision in earnings as well?
Let’s look at it in two parts. One is earnings estimates, and the second is fund flows. I think the drivers for both are very different. Fund flows are a reflection of the fact that there is rise in financial savings and a lack of demand for them. In the sense that the aggregate of state and central government borrowings is not rising as fast. The loan growth in the system is not very strong and financial savings are rising. Now that we have seen, which was impossible to say or predict two months back, savings rates are now down below 4 percent. It is something that one never thought will be touched but it has been, which shows that there is a liquidity surplus. In the absence of any avenues to invest that, a lot of money comes to the stock market. That money may or may not generate good returns. It is unwise to think that it is smart money which is going in the right direction. In any commodity, if there is excess supply and lack of demand, prices will fall. So, cost of capital comes down which means lower interest rates but also high price-to-earnings ratio. That is one aspect.
Second is the earnings expectations. India is like a house under renovation. There is a lot of structural change happening which is disrupting in the near term but the hope is that it is all in the right direction. So, people are leaving FY19 numbers untouched. Even for first quarter GDP, to the extent it can be trusted, the FY18 GDP numbers were brought down from close to 7 percent to 6.4-6.5 percent. But FY19 was largely left untouched. People think that as the economy goes through these adjustments, it will revive very strongly.
My fear is that it may not happen. At this stage, the visibility is very limited. That’s why people are being a bit cautious. My view is we will see meaningful downgrades in FY19 as well. I would not trust flows to keep holding up the market because the pricing is driven by what’s happening to earnings.
The Job Creation Challenge
Yet another emerging issue seems to be the lack of job creation and that will have implications for all consumption-related stocks.
That’s right. One big problem is that agriculture-linked growth is slowing down and agricultural is the biggest employer. We have too many people in agriculture and at some point, they will get fed up with the low income growth and start moving out. But the question is where? The first output and the first port of call for them, for unskilled labour, is construction. Eighty percent of construction is real estate construction or the house construction. Because of the transitional impact of RERA (Real Estate Regulatory Act) about the clampdown on black money and the expectation that land prices will come down. Therefore, real estate prices will start correcting with a lag. No one wants to invest there. And because of RERA, new launches have slowed very sharply. So, there are not even construction jobs being created.
The hope is that as the cost of capital goes down, it encourages investment. For that, I think, the visibility on rates has to be improved. Then at least some of the future investments start happening, which drives some job creation. As of now, that is a big concern.
Rural Economy: Tale Of Two Halves
What is your assessment of the rural economy?
To say the rural economy is doing well or not is too broad a brush to be paint with. For example, if you see two-wheeler demand growth, it has now picked up. It could be because of Pay Commission implementation, arrears have been paid; electricity availability, rural road connectivity, cellphone data access, etc. improved dramatically. So, there is a pocket of the rural economy, about 15-20 percent of the rural economy is doing well. They have seen better infrastructure, they have seen opportunity. It is the farmers and the farm dependent part of the rural economy which is currently badly affected. While it’s about 45-46 percent of the workforce nationwide, in rural India it’s about 65 percent. So, if you don’t get farming right, if farm income growth is not good, then the rural economy on a broad base could not do well. You will still find, at the top end of the rural economy, 4 crore out of 18-19 crore households will have access to two wheelers. But two-wheeler demand growth doesn’t mean that rural economy is doing very well. We have to define the economy very appropriately.
Our view is that broad based consumption, like the staples, cement should continue to be weak. At the higher end, some of discretionary items and with better power availability, we can see better discretionary sales.
If a village only has 6 hours of power, then there is no need to have a TV or a refrigerator. When it starts getting 20-22 hours of power, with an inverter you can actually afford a TV or a refrigerator. The point is, sale of those items may still do well.
Growth Slowdown Worries
You mentioned that there is very little visibility in GDP. We have seen April-June numbers which was not very pleasant. How great is the concern here?
For quarterly GDP, we used to criticise it when the numbers were really strong. I have equal doubts about the weakness as well. India doesn’t generate enough data for an accurate quarterly GDP estimate. We only do it because the IMF wants it. So, I am not bothered about Q1 GDP slowdown. I track it because people ask questions but I don’t think it’s very important. I am more worried about the fact that while oil volumes are weak or power demand growth is weak or cement volume growth is weak and the question is when do they start to revive. There was a destocking-led element in the June quarter. There has been some restocking in August, not as quickly as people thought. July was still weak. I think we will see some normalisation by November-December. But the overarching theme of uncertainty is going to prevent new investments. There is also uncertainty on the banking side. Long held problems which should have been corrected, may be 3-4 years back, are now starting to get resolved. As that happens, the banks are distracted with solving those problems. The promoter groups that are affected are busy solving those problems. Other promoter groups are now eyeing if there is an opportunity for acquisitions. So, no one is thinking about fresh investments and money on the ground. But that’s again a correctional phase. But I don’t think that it will get over in 6 months.
GST: Impact On Fisc
We have seen tax compliance go up because of GST. But this has also brought some amount of uncertainty when it comes to India’s fiscal situation.
GST subsumes 40 percent of India’s taxes, Rs 10.6 trillion was the estimate for FY18e for states and Centre put together. And we don’t know how much the rates have been moved around. The assumption is that the rates has been set close to where the previous rates where. But if you see the actual incidence - we have plotted this for items in the CPI - a lot of moving around has happened. I don’t think even the government knows whether there will be revenue neutrality or not. The challenge is, if you collect too much tax in GST, you act as a drag on the economy. Imagine in a normal Budget if you had suddenly jacked up tax rates, you are slowing down the economy. This is exactly what is going to happen if you have set the rates too high combined with the improvement in compliance that you are pointing out. And yes, there is lot of anecdotal evidence that there is improvement in compliance. Now the point is, you will not get to know how much excess you have till you are well into the year. So, for July the headline number looks good, but half of it is IGST and you are not clear if input tax credit has been claimed sufficiently. You also don’t know how much of it was just the GST build-up in the inventories. There will always been some inventory in the economy and that inventory will always have some tax due. It will be credited back when you sell it eventually. It is a consumption tax. So, that could be adding up to the July numbers. I think it will be September-October when you will start to get a broad sense of what the actual tax collection is going to be. Which you will get to know only by the end of November. By then, the year is over. Then the GST Council needs to decide by December 15, as to what needs to happen because the state governments and central government will start preparing Budgets for next year. So, you can’t be tweaking tax rates for 2-3 months. You have to do it for next year.
View On Metals, Energy
What is driving your overweight stance on metals and energy?
These are sectors which underperformed for many years. In the last one and half years they have done very well. But one big change that has happened is that global growth estimates were being continuously revised down. If you look back last 5-6 years, every year you would see the next year’s growth numbers being revised down. In the last one and quarter year, that is, 15 months or so, we have seen that those downgrades have stopped. In fact, we are seeing that European GDP has been revised up, the Japanese full-year GDP numbers has been revised up. China, to the extent that you can trust any of those numbers, have been revised up even by few decimal points. So, global growth seems to be stable which is why central banks, after historic amount of easing, are starting to think about tightening.
And what has happened is that especially in metals, there have been years and years of under-investment. So, after record high capex in 2010-2011 when China was really booming, we have seen the last 3-4 years no capex happening. That’s what we saw in steel recently. With one demand spike suddenly everything moves out. Steel smelting margins have moved up, iron ore and coking coal had moved up by 40-45 percent in 3 months. I don’t think it’ll last, seasonally it’ll correct. But it shows that there is a lack of slack in the system. That gives me comfort. And these are also under-held stocks, though they have done very well, they are still under-held. People don’t expect this upturn to last and which is an opportunity.
In energy, we have been mostly positive on the refining side because similar dynamics are happening. As China curtails supply, they had curtailed it on steel and aluminum already, and even on refining they are trying to consolidate capacity. So as demand stays stable and supply growth addition not happen, refining margins should hold up. So everyone expects that refining margins could decline in the next two years. If they don’t then there is meaningful upside. And the low PE gives you comfort.
There also been debate over how inflation targets globally are falling short of expectations and that could have implications for growth and the policies of some of these larger central banks.
That is why many have called it a Goldilocks phase where you have stable growth but inflation numbers are still low. There is no urgency for central banks to react. That is one of the reasons why emerging market funds are seeing strong inflows. The resilience of commodity prices is also bringing some growth back to, say, the Latin American economy or an economy like Australia. Those inflows again are supportive of what’s happening in India.
From the broader market perspective, despite our cautious stance on the economy, I think there are pockets of growth in India which still should deliver returns.
There is 15-20 percent economy which seems to be having a good time like airline traffic, car sales which are doing very well. In those pockets, perhaps the stocks and sectors can still hold up. The overall market may not correct meaningfully if the fund flow keep supporting it.
From an allocation perspective, we are overweight IT. We think it’s cheap enough and if global growth stays stable then at least the downside surprises should be taken off.
I understand all the structural issues but I think it’s more or less priced in. I think there is some value there. On metals, energy we remain positive. We are also positive on the private sector banks and some NBFCs because that’s one sector where you can afford to see 3-5 years out. Even if the economy does very badly, even if retail credits starts to slow down which it may in a while. There is so much market share to be gained from the PSU banks. You have very weak competition. I personally think that some of the largest private sector banks in India have terrible service. But the alternative is so much worse that you keep banking with them. So, it gives you good visibility for growth 3-5 years out. Even if they correct, people will jump in and start buying. They may not do very well for the next 6-9 months but over 2-3 years they will.
You just mentioned that you are overweight IT. Is this more to do with large caps or are you looking at mid-sized companies as well?
The characteristic of the IT sector right now is that the 95 percent of the market cap of the sector is in six stocks. If you really want to deploy capital, you have to take a call on the big caps. You can’t avoid it. You can’t say ‘I am talking about the last 5 percent and I don’t have view on the top 6’. Of these, we think that the large caps also have stopped underperforming. That’s generally the first sign of bottoming out. We cut our underweight in November which may have been too early. We went overweight a month and a half back. Now even private equity firms are staring to sniff around. It says that there are buyout options. If you have free cash flow, yields go to 6-8 percent. If your price discount to overall markets goes to record lows, that shows that there is an opportunity. So some signs of pick-up in revenue momentum and there could be a very sharp rerating.