Earnings Will Have To Do Most Of Heavy Lifting Next Year, JPMorgan Says

It depends on what you define as the party. Our base case is you can make another 10 percent in Indian equities next year. Can we repeat the show of 2017? We will like it to happen but difficult to predict that at this stage.

Correction at any point is good because markets build up some kind of froth and it is good to get rid of it sooner rather than later. I don’t think we are in obscenely valued territory. Valuations are stretched. We are at the higher end of the historic trading spectrum - one standard deviation higher than the mean at 19 times. We have touched 24 times in the past on two or three occasions. So, 19 better than 24.

We are trading at 19 times. I don’t think that there is further scope of re-rating on the valuation front. Valuations were driven by two factors. One was the easy global liquidity and monetary policy by central banks in the developed world. That seems to be largely coming to an end. We have seen some kind of normalisation with some central banks. So, that variable is out of the way.

Secondly, if you see in local context, we saw meaningful improvements in local variables, including the fiscal account,the current account, and inflation. Most of that improvement has peaked and, in the near term, we could see some reversion. Also, here we are largely done with monetary easing. So, hereafter the heavy lifting has to be done by earnings rather than valuations.

On earnings, we think that street earnings expectations are a little frothy. For FY18, the street was expecting about 13-14 percent growth. For the first half, we ended flat. So, second half we have to do 25 percent plus growth which is unlikely. So, 8-10 percent growth is more likely. Next year the street is expecting 23-24 percent growth. We think it could be more like 14-15 percent.

It is combination of factors. Central bankers in developed world were just wetting their feet in terms of normalisation this year. Next year, we think that this process will gain momentum. We have seen 2-3 rate hikes in the U.S. over a period of two years. Next year, we expect that there will be four rate hikes, though the market is pricing in only two. The pace of balance sheet normalisation is gathering momentum. The European Central Bank will join the same stance next year and Bank of England is already there. We are seeing something similar from People’s Bank of China. With the exception of Bank of Japan, everyone seems to be moving the other way. The key data to watch out for is how core inflation pans out. Because we know that inflation is a hockey stick phenomenon.

This year, we still got $8-10 billion. If you compare it to last year when we were averaging only to $4-5 billion. It’s lower than the $20 billion we were getting in 2014 but it is still not bad. But we definitely need to watch out for fund flows and it is an important variable.

It is always difficult to predict flows so take my view with a lot of skepticism. We do have an internal model that throws up numbers. The base case is that we continue to get $8-10 billion in Indian equities next year. The global macro situation will get more challenging as we go into the year but the initial part of the year should be healthy and reasonable. Fund flows are a function of bottom-up stories too. Even this year we have seen it. We had a spate of outflows for 3-4 months and then we had a very high-profile IPO which attracted a lot of attention. So, you have to make allowances for that. The base case is $8-10 billion, more front ended rather than back ended but let’s see.

This (increased local flows into equity markets) is a very positive development. Indian households are under-invested in equities and it is a structural trend and not a cyclical trend. You will see more and more money coming in which is good because we want households to make more returns than what the debt markets can give them. There is a tax advantage too. It is positive for the markets and economy because it enables us to de-risk a little from global happenings. But does this make us immune to global sell-offs? it is unlikely. The FIIs are 22 percent of the Indian equity markets. The locals and life insurance are about 12 percent, where LIC is half of it. Keeping aside LIC, it is 6 percent versus 22 percent.

If you are getting $2 billion in equities every month, all of it is not structural. You may argue that $8 billion is structural and about $1.2 billion is cyclical. But its not that the local investor will keep investing in equities at all levels. This is a very smart investor. Between 2012-2014, the local investor stayed away from equities and financial markets at large, invested in debt, real estate, property and gold when inflation went up. They did very well. At the right minute, they switch into the debt markets and equity markets. The relative attraction of debt is on the margin going up. The ten-year bond yield has gone up by 80 basis point in the last four months. So, there is a structural and cyclical component to it. The structural endures and stays, while the cyclical components will have its ups and downs.

On the margin, growth will go up a little bit. Will it go beyond 7.5 or 8 percent? I don’t think so. We are averaging 6.3-6.5 percent and can that extend to 7 percent? Yes. We have had two serious supply side disruptions over last 12-13 months and both of them will make their way out of the system. Initially, there will be some kind of mean reversion. In terms of future, it depends on what kind of fiscal space these exercises throw up. At some point, you would expect to throw up some fiscal space which can be used to pump the economy, but timing is uncertain at this point.

At this point, there is limited degree of freedom to pump up the economy. On the monetary side, there would not be much happening, given the way the inflation trajectory is panning out. On the fiscal side, there is limited space to do much. To be fair to the government, they have not spread themselves thin.

They are focusing on 3-4 areas like roads and highways, power transmission, affordable housing. Do we see them continuing to push initiatives here and does that give a leg up to growth? Yes. It could be limited recovery. We don’t see a broad base recovery because overall utilisation levels in the economy are still at 75 percent. Until you cross 85 percent, I don’t think anyone is going to be in a hurry. We will see a selective recovery but it’s still not time.

Selectively. I don’t think there are opportunities where you can pick up something cheap, where a recovery is six months down the line. Given the amount of liquidity we have, those stories are priced in. If you see anything which will recover in six months’ time, it is priced in. What is not priced in is where the recovery is 18 months away, perhaps select infrastructure developers.

You have large state-owned infrastructure developers. Most of them are trading at very reasonable multiples. When you look at some private sector infrastructure developers, there could be some where balance sheet problems gets alleviated or some kind of value initiative strategies get implemented. If you are looking at an 18 month horizon, then there is value.

That is always going to be the case in India. You have to look at investment strategy in couple of buckets. First, there is the ‘value’ bucket. In India, we have an advantage that these stories may be overtly expensive in terms of valuation multiples. The good part is that they will be compounding at 20-25 percent over the next 3-5 years because either there is market opportunity, or they have ability to gain share from a weak system. It is like the retail private sector banks. When you look at them in terms of valuations and say they are trading at 3-4 times book, 15-18 times earnings, then you say aren’t they expensive? But they have the compounding opportunity.

Selectively, we are willing to take that bet. What we have to appreciate is recapitalisation sorts out the issue of resolution capital. For them to be competitive in the market place, they still need to get more capital. When they go to investors asking for growth capital, they will ask the right questions. How are you going to sort out processes and systems so that this kind of mess doesn’t happen again? How are you going to compete in the new market place in terms of digital banking for retail customers, sophisticated derivative products for corporate customers? And so on.

All of them may not be able to give the right answers. Some will, some will not be able to. For those who will give right answers, there is an investment opportunity. But I wouldn’t say it is a broad based opportunity. It is a selective opportunity for those who can get that pick right. You need to spend time assessing the managements as you would in most companies and figuring out who has the ability to make it to next level.

They had a very good opportunity on asset and liability side. Most of them tend to be wholesale borrowers. So, a falling interest regime was very favorable for them. You had state owned banks, in particular, completely distracted with credit quality issues. So, there was huge intermediation opportunity. Both these drivers are receding. Interest rates are going back up and state-owned banks will start pushing back. So this was the rising tide which lifted all boats. What’s going to happen from here should be able to differentiate the men from the boys.

For more than two years, we have been sounding like a stuck record on this saying that don’t get carried away by the cycle of broad-based recovery. The government is focusing on these 4-5 areas and this will do well. The data is trending in the right direction. We are believers in that story.

Consumption in India will do well, given the demographics you have. Urban more than rural because urbanisation will keep gathering. There is a case to be made that consumption will grow 7-8 percent every year in volume terms. If that happens then earnings can compound at 12-15 percent. There is no reason to believe that it will not happen. The challenge investing in the sector is valuations.

Globally, there was this chase for yield. In India, this thesis manifested itself in money-chasing consumption stocks because we don’t have a technology sector which has done well in the last 2 years. It is a question of valuations. Where do you find pockets where there is still value. It is more bottom-up because top-down everyone knows the story and it is priced-in.

The bigger risks to the markets are global rather than local. While we do need to focus on the local story, in 2017 the run-up in markets was largely global. Emerging markets went up 30 percent. India was more or less in line. This was underpinned by easy liquidity and easy monetary policy. That has been the key driver for markets. Earnings growth has averaged in the mid-single digits in the last five years. So, that (global liquidity) is the key risk to watch.

From a local risk viewpoint, I will be worried about the discord that we are seeing increasingly over the last 3-4 months between the bond markets and the equity markets. Bond market seem to be suggesting that there are domestic stresses building up,either on the inflation or the fiscal front, or a combination. Equity markets have stayed immune to that. We do appreciate that equity markets are more driven by global factors given that they are relatively more open whereas the bond markets are more locally driven because they are not so open. But this discord can’t go on forever. At some point, either the bond market gives up its worries and you see a big rally there or equity markets play ball. If the higher levels of interest rates are sustained, it will also have an impact on growth. This is the one aspect you need to focus on.

Equity markets have been sensible in the way they have gone about looking at this whole issue. They have been concerned about it on a structural basis, which explains the under-performance of the corporate and state-owned banks vis-a-vis private sector banks.

When the resolution capital was provided,then that was priced in very swiftly. After that the markets has cooled of and the froth has come down and the markets are saying that lets go through the resolution process.

There could be. Steel is a global business. The reason that steel stocks have done well is because globally they have had a very good run. It is difficult to start pricing in consolidation gains beyond a point.

We still need to go through the process and it will be a long winding process. Even if you have consolidation, you have to focus on global picture rather than local picture.

I don’t have a strong view on that. I have never looked at that asset class.