A man holds a flag of Bharatiya Janata Party (BJP) at the courtyard of the party’s headquarters in New Delhi, India. (Photographer: Anindito Mukherjee/Bloomberg)

A Stable Government Will Be The Key Factor For Indian Markets, Says Nomura’s Prabhat Awasthi

Indian markets this year will be heavily dependent on the outcome of the upcoming general election and that could have an impact on earnings growth, according to Nomura.

“There is a cloth kept on (the crystal ball) and it will lift only after the election,” Prabhat Awasthi, Nomura’s country head, told BloombergQuint in an interaction. “We need to get a stable government, which is the key.”

Awasthi said the situation has improved fundamentally and structurally in the second half of 2019 and that the growth trajectory is on “the mend”. “A number of sectors which were in distress over five years have seen some sort of resolution, be it metals, power, infrastructure,” he said, pointing to softer inflation, lower rates and improved situation in the banking system.

Emerging markets have rallied but India is lagging, Awasthi said, adding that a stable government would push the market higher and improve corporate earnings. “If you get an unstable government, then your fiscal bets are off.”

The uncertainty over the general election is also keeping foreign investments away, Awasthi said, and is also weighing on asset prices.

Watch the full interaction here:

Here’s the edited transcript of the interview here:

How are you reading into the current volatilities like domestic cues, geopolitical tensions, trade talks or crude oil prices shaping the markets?

Macro environment has been uncertain. Crude oil prices have been extremely volatile. For a country like India, especially where crude is such an important import item, looking at the future becomes more uncertain. Overall, there is a brief slowdown. It might be for various factors and these factors might be applicable to various economies, for example, fading dividends of fiscal stimulus in the U.S. or the trade friction between the U.S and China. India had a liquidity shock. We had rising interest rates in the U.S. initially, which had put pressure on the emerging markets.

We are in the midst of a synchronous slowdown in growth globally and that is the implication of how you look at the markets. You started from reasonably good growth environment and slowly transitioned into a slow growth environment. This has got priced, not only in terms of growth going forward, but also because of the fact that the monetary policy views have changed now. Fed has changed from being much more hawkish to comparatively dovish, same with Reserve Bank of India. People are hoping that China will also have a stimulus. Globally, except India, some of that pricing in will be bounced back in markets, especially equity assets because of the pricing in of growth-risk and the positivity surrounding the dovish monetary environment compared to before.

Also read: India Will Catch Up With Emerging Market Peers, Says Enam’s Sridhar Sivaram

The overall earnings growth hasn’t been as great as expected against the valuations that India attracts. How will you position yourself?

Earnings growth have slowed down incrementally. You had a good quarter and the slowdown has emerged post that. In the broader market, equity asset prices have done much worse than the headline index, be it mid-cap or if you take out five to seven large stocks. Index has done quite badly. The broader market has taken it on board that the growth is slowing down. For this, you have to ask how transitory it is to be. You will have a slowdown and it will continue for three to four months. I think growth will start to pick up again in India because of the impact of liquidity shortages, which will start to gain at some point. The fact that we had a rate cut and we are not seeing so much balance of payments pressure now. Oil prices have gone up from bottom. Rupee depreciation impact will also start to wither away from consumption slowly. What you are seeing will probably continue, which is worst of it, and see the economy starting to bounce back.

There is election uncertainty, which is a separate topic away from economy. In the next three months, we’ll be at least over it, whichever way we go. This is risky and is also weighing on asset prices.

Broad market valuations have come down a lot. Bulk of the stocks and asset prices in equity markets are much cheaper than what the headline will suggest.

Bulk of the stocks are much cheaper than what the headline will suggest.

Do you think the headline number, which is at around 10,800, would be trading at lower levels if we remove three to four heavyweight stocks? Would it be a lucrative proposition?

Valuation wise for sure. Stock prices have come down and there is no decline in earnings, so they are much cheaper. Interest rates have fallen. In uncertainty, you have priced in slow growth and election to some extent. I won’t say you can ever price in election fully. But, it could be lucrative. There are still uncertainties going ahead—election being one of them. Market outside of those stocks is probably cheaper.

What is the right barometer to invest in a company? And from what aspect will you look at the market? Will it be earnings or companies that are providing good returns or companies with healthy balance sheet/strong managements?

Style of investing changes depending on the macro environment. Pre-2007, the balance sheet-heavy companies were doing well. Post 2007, it changed, and the management and allied businesses started doing well.

It is largely to do with the macro environment. For example, the growth is slowing down, the stress in the economy is increasing, balance sheet-heavy businesses tend to do badly, including financials. When the growth is bottomed out and is improving, the heavy balance sheets do better because the utilisation of balance sheet starts to yield higher returns. The incremental changes on return parameter is important.

It is hard to forecast because of a bunch of things. You need to get the growth right. Growth is uncertain. Companies which do the best are the companies which are looking to improve momentum on their return ratios. When the momentum declines, the companies which tend to get return ratios get priced up in India. If growth continues to improve slowly—not in the next three months but in a longer period—then it will become a broader market compared to a narrow market, which we have seen in the past. It will be a process and not happen immediately.

For a market, you have to look like a stock. When you look at markets, it is a conglomerate of its own kind with so many listed components. On an aggregate basis,  if markets are improving, their return on equity is improving and cost is falling as a bullish case. We are not in the bullish case because right now there is a slowdown in the short term. But the fact that you had rising yields seems to have been corrected. We are looking at the next phase. If growth comes back and the political uncertainty lifts, then that could be very good for the broader markets.

Is the foreign institutional investor also waiting for the political uncertainties to clear before making investments in India?

Politics is an important factor. And that will continue and you cannot wish it away till May. It will keep investment in India on the sidelines, unless the perception changes that you will have a stable government. Opinion polls can help, but they also have been wishy-washy and don’t indicate certain outcome to be strong.

Unless something goes really wrong and if nothing escalates in India, the country is not that much impacted by trade friction issues. Somewhat they are, but it is a domestically self-driven economy and not dependent that much on Chinese exports. So India’s own politics and geopolitics is important. If we don’t witness escalation in tensions at the border, this will pass. But the politics of it will remain. Either the perception of results or the actual results, one of those things need to  change. For results, we know when it will happen. But the perception will change the asset prices. You could start seeing risk money flow back in the market.

While there are signs of non-banking financial institutions being able to raise funds and liquidity seems to be slightly improving, the full impact is still not visible across sectors. What is your take on this?

As long as systemic risks can be contained, that is the key. If you look at the size of the problem, compared to the size of banking non-performing assets problem, it is a smaller problem. Banking NPAs in absolute aggregate amount, which got recognised over two to three years, are multiples of what we have seen in the current NBFC fear.

The problem with NBFCs is that lenders to NBFC—which are the mutual funds—have to recognise a problem right away on net asset value. Their ability to take defaults is comparatively lower because outflows have started to happen immediately. Unlike banks, which can take capital and take those risks. It is sentiment liquidity issue which deepens the problem.

As long as support from financial regulators, the government and the system-wide issues can be managed, even companies which face issues in the second half, we should be okay. The size of the problem is not large, it is the nature of the problem. A lot of these NBFCs are funded by mutual funds. If they don’t lend to them, then they can’t do anything as their source of fund has completely gone and the problem of balance sheet gets amplified. It is like there is no grease in the system. But overall, we should be fine. Macro liquidity will get better, regulators seem to be committed to sort out the issues. It will save the shock, that could be election shock or anything. Shocks can still come. We will likely skip through these problems.

Also read: Financial “WMDs” And Mutual Funds’ “Agnipariksha” - With Nilesh Shah, Anil Singhvi

Because of the risk aversion, a bank which has larger retail book seems to be garnering favour. Is that the mindset? Are the risks on retail books higher?

I don’t think the risk on retail book has been higher. The nature of lending in retail has gone up. Infrastructure around retail lending, be it credit bureaus, information sharing, etc., make sure that if you are defaulting then your access to credit stops. That’s something which is going to be brought in the corporate world. Evergreening was much more easier in the corporate world and not in the retail world. Credit behaviour in retail has therefore been better. The retail lending to gross domestic product ratio in India is comparatively small compared with all economies in size, even neighboring and global economies. It’s not heavily levered in retail. There’s been a lot of growth in retail, but it doesn’t mean that your overall retail lending is too heavy. The overall ecosystem of retail lending is very strong.

There might be a slowdown happening in consumption space. But I don’t think it will be systemic problem. Ecosystem of retail lending is very strong.

Would you prefer corporate facing banks to have big retail books at this juncture?

There’s a cycle. In last 10 years, retail has not seen a cycle. It will see a slowdown but not an NPA cycle on corporate lending. Corporate lending will see a cyclical pick up. It has seen the worst days of the NPA problem and it will see a pick up there. The economy at the margins is picking up slightly. Investment cycle, to whatever extent it got destroyed, there is marginal pick up. But it will mend slowly. The growth prospects and NPA prospects of corporate banks have gotten better. It doesn’t mean that the nature of corporate lending isn’t risky. It’s just that you are at the right part of the cycle now and you might see higher growth in profits.

There were banks which were pure retail and pure corporate. It has now become hybrid. The corporate banks have gone to retail and retail banks have gone somewhat to corporate. The corporate-heavy banks will see a better pick up because their valuations have come down and they’re at the right side of the cycle. In the next three to four years, they might do better because it’s cheaper. They will not see the problems they had in the past and it will be able to grow reasonably well. There will be rising ROE (return on equity) trend. In that sense, over the next few years, you might see slightly better performance because valuations go up.

Also read: Private Banks Continue To Gain Deposit Share At Cost Of Public Sector Peers

How do you view the approach the government is taking in order to resolve some of these issues within different pockets?

Micro issues have been addressed. Broadly speaking, this is a pre-election budget and it sort of lives up to it. They have not blown the fiscal completely but there is a fiscal stimulus which is given to consumer in micro markets like agriculture, because of distress and political compulsions. This is to be expected ahead of elections. We have seen food security bill before the last election. Even before that, there was massive fiscal stimulus. This happens in Indian democracy. The question is, will it lead to a massive macro-problem going forward? So long as they can contain the overall fiscal deficit in a reasonable manner, we shouldn’t worry too much about the impact of government policies. You will have more fillip to consumption, especially rural consumption. I am circumspect that staples will do well just because of the stimulus. In 2009 elections, I don’t think the growth in staples picked up dramatically just because there was a massive stimulus—National Rural Employment Guarantee Act and so many things happened. We have to wait and see whether these impact discretionary or consumer staples, where does the growth pick up because of this. Consumption will benefit in some form. Usually, we have seen that increase in discretionary incomes are largely more beneficial, if you are doing a sector selection for markets. Discretionary will do better than staples because staples are expensive sector. The growth has been robust and visible in the last couple of years and it got priced in.

What is the trajectory or roadmap for Indian markets in 2019? What do you think is the biggest risk for markets?

On a crystal ball, there is a cloth kept on it and it will lift only after elections and that is the biggest problem for forecasting. There is 1-0 risk which exists in India. We need to get a stable government, which is the key.

What is that one factor, which seems to be uncertain?

If you get an unstable government, then your fiscal bets are off. If you get an unstable government, then the government might just blow up the fisc. That’s the problem or bear case for India.

That is why I am harping on the fact that you should have a stable government. Beyond that, if political compulsions are very different then you will start worrying about fiscal, interest rates, inflation, after government formation.

Otherwise, the overall construct is this. You are waiting for growth to pick up. You have seen slowdown. But fundamentally and structurally, growth is on the mend. A number of banking systems have cleaned up. A number of sectors which were in distress over five years have seen some sort of resolution of problems, be it metals, power, infrastructure. Your inflation is down, and so are interest rates. Earnings was very anaemic for last five years. It’s on the mend and might not be as strong as you like. Broad market multiples aren’t expensive. At the minimum, growth in earnings should be delivered in market returns, which is not happening. Globally year-to-date, emerging markets have rallied, and India is lagging simply because of this. If the unstable government is a 20 percent probability, you should be well poised in 2019. If the earnings growth is 15, it is a 15 percent minimum from the market, if not more, because the rates have fallen and inflation is lower.

I’m not a specialist in politics. Things change quickly in the political world. We have to keep an eye on it.