The market could trade weaker going into the general elections next year, as it contends with the possibility that the current majority government at the Centre may get a weaker mandate in 2019.
That’s according to Ridham Desai, managing director and India equity strategist at Morgan Stanley. “Every time the market has traded into elections, it had the hope that the next government will have a stronger mandate than the previous one. Now for the first time since then, you have a situation where you know that the current government would emerge as the winner but uncertain of it getting a clear majority,” he told BloombergQuint in an interview.
Unless it gets some signals that these assumptions are wrong, the market is likely to stay subdued till the election next year, he said, adding that it would be the key headwind from a 6-12 month view.
Here are the edited excerpts from the interview:
There has been a 20 percent correction for small-cap stocks year-to-date, and we are not even halfway through the year. This was not envisaged by anyone. While we may talk about Nifty and Sensex clinging on to near all-time high levels, there is carnage on the streets.
Nobody had also expected the 62 percent rise that small caps witnessed last year. So, if one considers the 62 percent rise, and then the 20 percent fall, you are still up about 30 percent over 18 month, which is not a bad number. But yes, the liquidity in small- and mid-cap stocks is gone. Psychologically, there has been lot of damage. Probably, it started with the correction at the end of January, which at that time seemed like just another correction. Large caps recovered from there, but mid caps didn’t.
We may be approaching some sort of capitulation and are unlikely to see a V-shape recovery in these stocks. Small- and mid-cap might bounce back after a few months but in the meantime, large caps will probably continue to do better.
Would the carnage in small and mid caps worsen if in an unlikely scenario large-cap stocks fell?
The Sensex, which was at 9,000 in March 2009, is around four times up over 8-9 years. There have been few corrections along the way. Bull market corrections can go as deep as 20-25 percent. At any point stocks can fall due to some concern,which could lead to such corrections. And if such a correction happens, which I am not expecting, it may cause mid caps and small caps go down a bit more, but the fall would not be as much as it would be for large caps.
You had earlier said that this year’s budget was inflation targeting. One thing which has changed that could impact inflation now is the oil price rally. It is difficult to call what could happen to oil but how do you see this playing out in the next six months and its impact on the markets?
The oil dynamics in India today represents a fundamental shift in our macros. Earlier when oil prices went up, it immediately brought inflation or slippage in fiscal deficit because government did not let retail prices go up. The currency got hit, the Reserve Bank of India had to hike rates and growth slowed down. But the dynamics have now shifted for India. Our macro stability is different from what it used to be and oil does not have the same impact on it. India’s current account deficit funding has changed from portfolio flows to foreign direct investment. But when you get a shift in terms of trade which is what the oil price represents, then there can be some problem.
There are two responses to this. One is that oil’s retail price is allowed to go up which has been our response so far. This brings a little bit of inflation to the forefront which would eventually lead to the RBI hike the rates by a small margin to keep inflation down*.
The second response is that if the government decides to cut taxes on oil as it’s the election year, then it would limit its ability on the fiscal deficit front. The government is bound on its fiscal target. They will not let it slip a lot, and therefore, they would have to cut the expenditure too, which is likely to impact growth. And that’s what the market is factoring in right now and reacting to as it expects that growth may get delayed again.
We have had a few setbacks to growth. An earnings recovery was expected two years ago but it hasn’t yet happened. One can give excuses of GST, demonetisation, global trade slowdown, etc,. but the fact is that growth didn’t come. Now, due to elections next year, we might have to wait until then for oil prices to fall. That has been the growing suspicion in the market which is why since April, growth stocks have taken the most beating. So, one can see mid caps and small caps taking a beating, but if you have to describe the cohorts in style like growth, value, or quality, then growth stocks are the ones which are taking the beating. Thus, the market has got suspicious about growth.
Have you become suspicious about growth as well?
There was some good news from this earnings season: revenue growth hit another multi-quarter high. Revenue growth depending on which group of stocks you take was something between 12-15 percent, which is decent number. This shows we are on a recovery path. The trough was made six quarters ago. What has not recovered meaningfully is operating margins. Within that if you look from sectoral perspective, it’s the private sector banks which have suffered the most. Sans this sector, earnings are not so bad. I believe that we may have seen a trough in earnings and things should start improving.
Rising oil prices is not bad for earnings but what matters is why these are going up, which is due to strong global demand. It becomes a problem when oil rallies because of supply shorts or an outage. That’s because then there is no accompanying balancing capital flow that India receives. So, the current scenario is not bad, but there can be a shift in terms of trade which is causing nervousness among investors. Foreign investors have been persistently pulling out of India and they have found new reasons to sell. But the underlying cause is same that our growth has underperformed other emerging markets. Until that goes away, foreign investors are unlikely to comeback. We expect India to outperform peers and see earnings recovery.
Can then India’s strong micros, referring to the earnings, battle the rising inflation over the next 12 months?
Our Sensex target at the beginning of this year was 35,500, but we have rolled it forward to June 2019 to 36,000. So, there is not much upside expected in Sensex, as is our view for equities globally. Emerging market strategists think that these markets will rise by 1-2 percent in U.S. dollar terms over the next 12 months. India is a large market and can’t perform in a different manner. It is likely to grow 7-8 percent and that’s not an attractive return for somebody who is looking at equities from a 12-month perspective on the large-cap index. But the challenge arises from the country’s political situation and deteriorating trade.
It is the first time in over 30 years that markets are dealing with prospects of a government having lesser mandate than they had in the previous term. Since 1985, all successive governments in India have been in coalition. Every time the market has traded into elections, it had the hope that the next government will have a stronger mandate than the previous one. Now for the first time since then, you have a situation where you know that the current government would emerge as the winner but uncertain of it getting a clear majority.
The market may have started pricing in that situation and, therefore, could trade weak into elections, unless it gets some signals that these assumptions are wrong and that an absolute majority is possible. Those are the headwinds from a 6-12-month view. Things will get clearer as the year ends and then the market may trade differently. Because earnings notwithstanding, the growth environment would be quite strong, as government capital expenditure hits all-time highs. Consumption is strong which can be seen in a slew of consumer companies’ results. Exports are good because global growth is good.
Our report shows that even private capex is going to recover in the next 12 months. So, all the four legs on which an economy sits: government investment, consumption, export and private capex, are all looking good. So, we are entering a good-growth environment but there are other factors, purely psychological in nature and define liquidity, which don’t look so much good right now. For that to change, may be the price points have to change and valuations need to become cheaper for investors to be willing to take risks.
In your survey, does it suggest that capex in private green fields might comeback? Corporate conversations are only talking about brownfield capex which may not trigger a big lending cycle.
Companies were simply not interested in capacity expansion, not even brown-field projects. Their focus for the past five years was improving productivity and they were trying to get more out of their existing capacities. But now the focus has shifted to greenfield projects. Productivity related capex has lost share in their total capex plan and green and brown field projects are gaining share. It takes 2-3 years for a new capacity to start production. If you don’t start now or in next six months, then it is possible that you will not have capacity and you will lose market share to somebody else. Once that psychology gets ingrained, companies will come and spend. That moment is 2-3 quarters away with one caveat. The caveat is that if the corporate sector starts believing that the election mandate will be fragmented or fractured, then there is a possibility that they may delay things for two quarters. So, keeping that in mind, everything points towards the new private capex cycle. Coming to lending growth, that happens with a 12-month lag. So, it will not immediately reflect in lending growth. So, if capex starts in January next year then lending growth will be visible at the end of 2019.
Do you sense substantially renewed free cash flow generation by corporate India which may be used in capex? Is that coming meaningfully in the next 12-24 months?
Free cash flows are already at all-time highs. What companies have done with their free cash flow, which is now sitting at 10-11 percent of sales, is either use it for pay outs or reduced debt. So, pay outs are also at all-time highs. The Sensex payout ratio hit 40 percent last year. It will only decline from here because now companies will get that free cash flow to invest and it will decline. Rising free cash flows is not necessarily good for share prices. It tends to suggest that companies are postponing investments. Unless you invest, you cannot ensure future growth. So, the fact that companies were not spending money was a big question mark on future growth. The companies in India had become bearish about the prospects of growth. When the free cash flow starts declining, it is good news, as far as the operating cash does not decline because of capex going up.
If you become a part of the Monetary Policy Committee, will you propagate a rate hike immediately or push it down the line?
We will have it sometime later this year as we are still dealing with a nascent growth cycle. As growth signals pick up, we will approach it. RBI, unlike the past, has an inflation mandate now. So, its tolerance for inflation will be low. If inflation touches 5.5 percent and above, the MPC will worry about it crossing 6 percent, and then the governor becomes answerable to the floor of the house. Hence, a preemptive rate hike will take place but we are not there as yet. So, there is no way to react now. But in six months, we will get closer to that situation where RBI may act. Our base case is a 25-basis point hike in the fourth quarter this year.
So, you are not expecting a hike tomorrow?
If the Sensex doesn’t fall too much, can the recovery in small- and mid-cap stocks come back?
Yes, it will in the next few months. It all depends on trailing price damage. The rate at which it is going it will bottom out faster than I would have thought a couple of weeks ago. The template to think about this is different. You must define whether you are a trader or investor. If you are an investor, then there has been enough damage to share prices and you can keep cash in the bag to react to further falls. But if you are a trader, then you need to time this much more accurately. Therefore, you need to come in after you have seen the bottom because a trader doesn’t have an appetite for a loss and it is okay for him to miss the bottom.
Is the investor happy with this correction?
Cheaper share prices give better opportunities for everybody to make money. You may lose money, but you must think why you lost it. It’s fine if it’s an irrational price movement, but if you lost because you bought something which was fundamentally a bad stock or was expensive, then you must wonder whether you can do it on your own or should take professional help.
The market has surprisingly become very divided, which we wouldn’t have bet on at the start of this year. The stock that is expensive is becoming more expensive and the stock that is cheap is becoming cheaper. This should have have narrowed this year because we are already dealing with highly disbursed market, but it has widened and that is worrisome. Did the disbursing narrow because of high quality sell offs or lesser than high quality goes back up? If it is the former, then we have more pain coming but if it is the latter, then we have seen the bottom.
What is your instinct about this phenomenon?
It will take time for whatever is going to happen and it won’t be instantaneous. As an investor, look for companies which might not be of high quality but doing reasonable business and are trading cheap. But be careful, as you are a sleeping partner in the business once you invest in ti and have no say in it. I am not saying go for companies with poor reputation, as reputation is non-negotiable. But businesses which may not be of highest quality but are trading at reasonable quality at good valuations are worth looking at this stage for an investor.
(*This interview was done before the Monetary Policy Committee’s repo rate hike on June 6.)