Abhay Laijawala, managing director and head of research at Deutsche Bank India (Source: BloombergQuint)

GST Implementation May Trigger A Cut In Earnings Estimates: Abhay Laijawala

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  • This week on Thank God It’s Friday, Abhay Laijawala, managing director and head of research at Deutsche Bank India talks about the next big trigger for the market, the impact of the Trump administration’s polices on India, and earnings growth expectations for this financial year and the next.

    Here are edited excerpts from the interview.

    We have seen given some indication of what the Trump administration’s intent is with respect to trade. Based on that there is a lot of flip-flop. We have dollar strengthen to an extent, barring in last 10 days or so. What is your outlook on the dollar, and based on that, what is your outlook on fund flows?

    We are extremely positive on U.S. economic growth. Our sense is that U.S. economic growth will exceed 3-3.5 percent this year. The economy was already seeing strong tailwinds which will probably get stronger as a result of many articulated policies of President Trump. Here I am primarily referring to the tax cuts, deregulation that he’s promised, coupled with the possibility of a fiscal stimulus. As and when the articulation of the economic plan takes place, including the tax cuts, we will probably see a resumption in the movement of the dollar. We have seen the DXY come off from 105 to 100 in the last couple of weeks. One would think that as he articulates his economic plan, it is likely that the DXY will start to appreciate once again. We have seen that with the DXY having come off from 105 to 100 we saw some sort of return of emerging market inflows. With the dollar strengthening, with the expectations of these policies buoying up U.S. bond yields, we may see flows start to dry up once again.

    State elections in India could be a test of sorts for the Prime Minister after the cash ban. Will the outcome have any implications for the market? Do you think this can be used as an opportunity to take some profits off the table?

    That could happen. We still do not know the outcome. The opinion polls seem to be suggesting that the BJP has a very good chance, though some opinion polls are also suggesting that it is a very close fight..But let’s look back, let’s see what happened in Bihar. In Bihar, too, everyone was of the view if the BJP loses the markets would come off; the markets will worry that the Prime Minister is losing people’s support, etc. But nothing of that sort happened. I think investors will realise that there are state elections and there is a national election and even if the ruling party does not win the state elections that does not necessarily mean that it does not have the chance to come back to power in the national election because there are state-level issues...and this is a state election. So my sense is that even if the market is disappointed in the event of an outcome where the BJP is not doing well, it will be short-lived. It should not be an indication that popularity levels are going down. In fact, a recent poll showed that the Prime Minister’s popularity ranking are at an all-time high. So I would imagine that if all of that popularity remains intact, there is, at this point of time, no risk in terms of them forming the next government.

    So we could conclude that the outcome of the state elections may not be of great significance for the market?

    That’s right..But we also have to realise what levels are the markets at. Given that markets have moved up so much, some investors could use this as an excuse to take some money off the table. We’ve seen a literal one-way rise in the market in the last couple of weeks fuelled by domestic liquidity.

    Now the GST isn’t far away and that’s going to create some negative implications for the economy. How do you think it could impact FY18 earnings? Will double-digit earnings growth get pushed back by a year?

    That’s a very safe assumption; it looks likely. Currently consensus estimates for FY18 are at around 20 -22 percent earnings growth for FY18. With the GST coming in, there will be disruption and therefore we will probably see a scale-back or downgrade to consensus earnings. The jury is still out on how much they go down. We will have to see what the modalities of the GST are, what the rates of GST are, what are the GST rates in different areas within services etc. So it is difficult to take a call on what will be the scale of the earnings cuts but nonetheless consensus earnings will be cut in the second half of the year.

    The RBI in its last policy changed its stance to neutral from accommodative. The commentary seemed relatively hawkish. Where do you see interest rates headed going forward and what will be the implications for the market?

    When we had written our outlook for this year, we had said that monetary policy accommodation in India is coming to a close. We were obviously not so sure about the timing and we hadn’t really expected it to happen in January-February itself. But we were also of the view that it was likely that, at best, there could have been one more rate cut which could have led to a 200 basis point total cut in the repo over the cycle. With what’s happening in the U.S.,with the return of inflation, with Chinese fixed asset investment moving up, with deflators all over the world moving up led by commodity prices. I think this writing was on the wall. Our view was, however, that we could probably see the transfer of the baton from monetary policy to the fiscal policy but that did not come through. However, the government has spoken on fiscal consolidation which is very good; this is something the world will notice. But this does mean that the scope for GDP expansion or the return back to 8 percent in the next 12 months looks difficult.

    What does the end of the easing cycle mean for interest rate sensitives going ahead?

    Liquidity is abundant and just because policy rates are not going to be cut further doesn’t necessarily mean that the banks cannot still cut more rates. In fact, with the banks are sitting at 32 percent SLR relative to statutory requirement of 21 percent. The banks are flush with cash and therefore monetary transmission will probably be the way forward. I don’t think there has been a change in the expectation that interest rates are going to remain low. It may not be the RBI but it will be the banks doing it.

    Within the gamut of listed financial companies – private banks , PSU banks, housing finance companies, microfinance companies and consumer lending companies – where is that you are still seeing some value left? In which of these are you convinced of a recovery from the demonetisation hit?

    Our bank analyst believes that wholesale funded banks should be the beneficiaries. What we are looking out for is two key characteristics in banks – 1) banks that are wholesale funded, and 2) smaller banks. Because in an environment of slow loan growth, the market is going to pay a premium for whoever can go the fastest. And smaller the bank, faster the growth. So, therefore our preferences are for relatively smaller private sector banks, private sector banks which are wholesale funded. One year ago the market would have been excited over NIMs or asset quality but with loan growth slowing to 5 percent, the market is now looking at growth over asset quality.

    We have seen a run up in prices of iron, aluminium and zinc, and along with that we have seen metal stocks rise. Is there any upside left and what is your view on the metal sector?

    We remain positive on metals; we like aluminium, zinc and steel. Within steel, we think that the government’s measures have been proactive. The measures on initially imposing a minimum import price and now transitioning towards anti-dumping duty. This is going to be important for the domestic steel industry because in the last 5 years, we have seen a very significant expansions in the domestic steel industry but in the last 2 years up until the government’s proactive moves, the domestic producers were not able to sell in the market because imports were coming in from China, Russia, CIS, they were putting a lot of steel into India, therefore the domestic steel producers weren’t even able to cover their fixed overhead. With what the government has done, domestic sales are back and that is being reflected in return to the normal EBITDA margins and normal EBITDA for many of the steel companies. We believe with these proactive measures continuing, these companies would continue to report good numbers over the next couple of quarters. With China maintaining its fixed asset investments, metals remain an attractive investment. We like aluminium and steel.

    You are overweight consumer staples. But the management commentary and volume growth numbers in the third quarter reflected the impact of demonetisation. How are you picking up stocks there? Is it purely valuation based or a choice between rural versus urban focus?

    The reason why we like staples selectively is because we believe that the impact of demonetisation, once it wears out, the return of rural demand following a very good monsoon last year will come back. All of last year or up until between the second quarter and the third quarter of last year, FMCG value sales were moving up, but in the December quarter FMCG value sales went to the lowest in terms of year-on-year growth because of demonetisation. Our sense is, as the effect of demonetisation wears out, as the government gets the cash back into the system, the very drivers that we were all expecting in terms of return of rural demand will come back. Therefore on a selective basis we do like the consumer staples sector because the rural economy is doing very well and will do very well because that’s where government is focusing on.

    There are a lot of concerns surrounding the technology sector, about the possible hit because of H-1B on their margins. You’ve said that deregulation in the long run is something that could benefit the sector. Can you tell us more about that?

    We’re contrarian, we’ve turn positive on IT after having been negative all of last year. We turned positive in November of last year and one of the reasons is deregulation, but I think the biggest reason is, and what everyone seems to be missing out on, is the revenue part of the equation. The global banking and financial services sector constitutes close to 40-45 percent of the revenues of Indian IT companies. We should not ignore what’s happening in the global banking space. Interest rates are rising so yield curves are steepening. NIMs will come back, loan growth is beginning to come back and you have the prospect of lower regulation. Trump is already talking about abolishing or working on the Dodd-Frank Act. This is something that the global banking industry has been waiting for. So, a lot of the discretionary IT spending which has been held back will potentially come back. In fact, our analyst believes that constant currency growth for the sector, which was around 5-6 percent last year can be 10-11 percent in the next fiscal year. And look at valuations. On a PE relative basis – we do it on MSCI – IT PE relative to MSCI India it’s trading at valuations you last saw in 2009. You have valuation support, you have catalysts. I agree that the concerns on H-1B are legitimate, we do need to worry about that, but if the rupee were to go a 70/$, part of those concerns would also get mitigated and if we do believe that as a result of Trump’s policies the DXY is going to appreciate then I guess rupee has to depreciate towards 70/$. In fact, that what’s our economist thinks will happen by the end of this year. So, contrarian, but don’t ignore the IT services sector.

    BloombergQuint