Oversold Indian Equities Set For A Strong Rally, Says Franklin Templeton’s S Naganath

Volatility and more volatility. 2017 was the year where you have bull market in equities across the world had a fantastic year. In February-March, I told that volatility can reemerge, and it did. We forget about it in April-July and August we got to see it in September-October, not just here but across the world.

Investors are waking up to the possibility globally that growth could slow down in next one-two years. There are reasons for it. One is the trade tariff issues. Initially, people did not pay enough attention to it. For some time, I thought people should be focusing on it because this has ability to slow down the global trade, disrupt supply chain if trade tariff issue intensifies and all of it will have a chilling effect on global growth. I am seeing mainstream media articles suggesting that it could be a potential cause for concern, unless it is resolved in near term.

The other is trade tariff issue did lead to some currency volatility and you could see more of it as some countries are affected by it, look at potential of some degree of currency depreciation to blunt the impact of higher trade tariffs. Often currency volatility can spill over into equity and bond markets which has its own set of variable and other factors which come into play once you have higher currency volatility then affecting bond yields and stock price valuation. If I look at the next 6-12 months, trade tariff issue will continue to be a leading factor contributing to this elevated volatility in markets.

Markets in the U.S. have discounted the benefits of the tax cuts. Many experts are of the view that positive impacts of tax cuts will start fading out by middle of next year to late next year. Also, you have potential for wage inflation. The unemployment rate is now very low. Potentially, by the second half of 2019 and 2020, growth could slow down relative to what we are seeing now. If trade tariff issue continues to rumble on, then the potential for growth slowdown elsewhere also is equally high. Financial markets tend to anticipate all growth slowdown many months in advance, sometime a year in advance. In that respect 2019 could be the year, if I am correct about growth slowdown across the globe in 2020, then 2019 will be the year where you have markets reacting to it. Maybe they have already started doing so. Therefore, from a financial markets point of view, the time period to look and watch out for in terms of the higher volatility, potential drift in prices of equities and bonds could be effectively 2019.

Nobody can predict recession. You will know it when you are in one. From March 2009 until recently, you have had the longest bull market which many market watchers haven’t seen in a long time. The contributors to this bull market were the immense quantitative easing, ultra-low rate, zero rates. Both have moved in opposite direction. You have retraction of liquidity.

You have rates moving up. If QE and zero rates were good for equity markets, then you must logically argue that retraction of QE and higher rates or non-zero rates are not that favorable for equities. On top of it, you have trade tariff issues, which given its recency, can cause slowdown in growth, higher inflation, higher rates. If you are a corporation you must deal with higher interest rates, higher wages because of tightened employment situation. You may have to deal with higher cost of intermediates because of tariff issues. You may have to deal with lower demand because of higher prices of goods. So, there is a potential squeeze in profitability that was not on the horizon may be even 6-9 months ago.

Therefore, that has a potential to crimp. PE multiple, meanwhile, is moving up nicely in last many years. Even if we do not have a clear fix on earnings trajectory, the fact is given elevated PEs in last many years, you could see a sharp contraction in it with response to one and more of this factors that which causes a downside in equity prices across the world.

Let’s see what we see in near term and what we see over medium term. September-October sell off has been very significant, very severe with many markets losing 7-15 percent in the course of two months. Many markets including Indian equities are looking very oversold right now. Therefore, I do expect a strong rally. I expect markets to rebound now and this could be a short covering driven rally or could be a relief rally. This will manifest over the next month or so. After which there could be re-assessment of economic conditions. If the tariff issue is resolved in interim period, then the rally will continue for longer. On the other hand, if it comes back and it is unresolved and there is more friction than we have seen before then equities can again face some weakness.

There is potential to be relatively more competitive. But that is from a supply point of view. The issue is what happens to demand if you have higher priced goods because of tariffs or you have inflation due to other issues. For example, oil prices which were at $60 per barrel are now close to $80 per barrel. Some argue it will go to 90 and some say it will go back to 70. The picture on oil is not that clear. For the moment, even if it is where it is, then it is much higher than where it was six months ago. Does that crimp demand? So, we must look at demand picture too. The sense is if that the demand begins to look weaker, then your competitiveness on supply front will help you in terms of market share gains relative to other countries. But at the end demand also has to improve. If that doesn’t look likely then overall trade volumes could remain subdued.

We are talking about India’s oil imports. It could be highly beneficial for us. But all this will settle down in next six-nine months. If there is likely to be a growth slowdown, as I anticipate in 2020, reflected in markets in 2019 or even from now, then may be the spike in oil prices is flash in pan and eventually oil settles down much lower and it is hugely beneficial for India. But that may not help you in terms of export growth if global demand is subdued but at least one will benefit hugely from lower oil prices. Likewise, it will help the currency, which has been depreciating recently, to start appreciating again.

Lot of mainstream analysts don’t focus on gold. We have lots of gold in the household sector as an investment, not marked to market. It is held as a long-term asset. We have spent lots of dollars buying this year after year. If, over the next 3-10 years, there is a feeling that inflation is back and in the aftermath of global financial crisis in 2008, people say that there is so much QE and where is inflation. Inflation never came because much of the extra liquidity went not into the real economy but into financial markets. Inflation was in financial assets. Bond prices went up, bond yield fell. Equity prices went up, PE multiple went up. So, inflation wasn’t financial asset prices and not in real economy. The real inflation is going to come back because of tariff issues on one hand, temporarily higher oil prices, wage pressure, etc. You may have supply disruptions because of supply chains getting impacted. All of this contributes to price increases. If at all you have, hypothetically, another round of QE in 2020 and beyond because there is recessionary situation, then bond market may not take too kindly to QE. Yields may go up as opposed to going down. If gold prices move up in response to what the market perceive around the world as higher inflation, the latent holdings of gold in households in India will see a significant wealth impact which is under appreciated today by markets.

Sentiment will be good. The fact that you have assets which are not marked to market and held by millions of households suddenly have a much higher wealth impact which can influence consumption, deleveraging if they have, so on and so forth. It is hugely under-appreciated asset in the hands of every household in India.

Earnings growth has been okay. Every year we start with expectation of 15 percent or higher earnings growth and we slide back to single digit of 6-8 percent. I thought April-May-June earnings were okay. July-August-September were not as good as anticipated. For the remainder of this financial year, it will be okay. I don’t think it will be vastly different either on the positive or negative side. Not more surprises on the earnings front.

We had to deal with with higher oil prices, a weaker rupee, issues of twin deficit in the interim. Everything is in the price right now. In the near term, I am anticipating strong rally in Indian equities. I wouldn’t be surprised if we get 10,800 or 11,000 within the next couple of months. The resolution process for the companies that are in financial stress is also working well. If we do have moderate oil prices in the coming months plus you have resolution of trade issues globally, all that will contribute to this positive sentiment. All that will augurs well for stock markets at least in near term in the next couple of months. After which if I look at 2019, then we have to see how the global cues play out, be it potential for slow growth or west trade issue still simmering,not simmering. And where oil prices eventually settle.

Like pharmaceutical sector, people will start looking at individual names more keenly than the sectors as a whole. Don’t forget that these sectors have done extremely well in last many years highly weighted by most institutional investors. That was the right trade as they got full benefit of the nice uptick in prices across the sectors. But given the recent issues in some pockets, there is revaluation. Today some banks moved sharply and some banks which were held, declined mildly in value. So, that tells you there is bit of rotation in within the holdings. My sense is this sector is largest weight in any benchmark index. It will continue to be so. It has some excellent institutions represented in it. They will continue to have a high degree of investor interest. If the resolution process continues to work nicely, state-run banks will also benefit from this uptick.

Both will do well. There is nothing to suggest that consumption will slow down meaningfully. At the margin, there could be ups and downs as far as consumption demand, and growth of consumption related stocks is concerned. That will be enduring part of this country’s bullish uptrend over many years. If you see the large technology companies in west that are investing here, the attraction is the huge market which has taken to technology very fast. If you see e-commerce sales here and you have representations by many large companies here and that points to the importance of this market for them at the fact that the online buying has picked up very nicely.

So, consumption as a trend here will continue to be strong one. Within the sector, one may have to see which one is overvalued and which stock is undervalued and then decide. But that theme will be an enduring theme in minds of most investors including me. In quarter you may like one stock versus other, but you will not say I don’t like consumption stocks. I don’t think that will ever happen. Industries have been neglected in last many years rightfully so because there was no real uptick in capital expenditure. Much of the spending was happening from government side. That cycle will start. Maybe it will start after a year in 2020 or second half of 2019. But markets, as soon as they sense it, may be the uptick of stocks in industrials will begin anytime from now into first half of 2019. So, if you are an astute investor you might want to focus on those in next few months than wait for the actual cycle to pick up which will happen in second half of 2019 and 2020.

The business that I am in now and alternative investment funds, it is long/short investment strategy which is helpful in times like this where the markets are volatile but equally the expectations are that you deliver absolute returns regardless whether the market is up or down and try to downside the risk. So, investment horizons are much shorter. One has to be a much more agile trader in stocks. So, our investment horizon is from few days to few months.Typically, our positions are based on how we see the markets and individual sectors or stocks over the next 30-60 days.

Short covering is one which drives it because the decline also happens over a two-month period. Financial is the sector which got hurt. They have rallied today, and I think they will continue to do so. For autos, if the festive season numbers surprise, you will see an uptick there again. Initially lead by short covering and followed by buying. Metals and other spaces which haven’t done that well. There are many that have not had a great run in the last two months. Couple of them will start showing some uptick. There are trade issues some appreciation in currency because of oil prices.

The oil prices went up and they now seem to be settling down and not moving in this and that way in any volatile fashion. Beneficial impact of that will show up in the appreciation of currency which will in turn trigger foreign inflows as opposed to outflows which we saw in last month. So, we will have a series of potentially positive factors that contribute to sustenance of this uptick beyond the initial round of short covering. Once we get back to 10,800 or 11,200 level, there could be revaluation at that point based on earnings for the December quarter.And the state of factors are alluded to earlier in the international context.If the view is that nothing much has changed, then you have range bound market for a period. On the other hand, if those issues again come back to the fore, you could have another round of correction.

Every investor is on the same boat. We have to look at data on more continuous basis than before. Because many trends have been interrupted,given the market correction globally in last two months or so.

Logically, one would argue that should be the case that you have ability now to be more competitive. In many businesses, the buyer also then wants due to lower prices as he wants to share some benefit of currency depreciation. It is not that only the rupee has depreciated, but other currencies have also depreciated. So, it is a relative depreciation versus other EM currencies. The state of the end demand is the end demand is robust or is it slowing down in which case the volume growth may not be as robust as initially anticipated. If you look at tech companies, they have also corrected.Once should have expected that given the depreciation of the currency, they should have held on to the gains they made. Although they did well in 2018.

It is partly a valuation call and partly the fact that you made so much money that when the markets correct you want to crystalize the gains and therefore you book those gains. So, selling to book profits could have been one reason.

Many of them are sporting PE multiples which are very expensive relative to long term average. Because they have not done as much in terms of returns as the tech sector, holders of the assets are of the view that lets keep it for longer term. If one or other large holder were to sell, prices were to fall then may be all the other holders will start reevaluating their options. Sometimes it is a trigger to initiate fresh thinking of the subject.

We launched the Franklin India long/short equity Alternative Investment Fund last month. The initial launch was successful. We raised close to Rs 539 crore. The fund focuses on trying to generate absolute return with minimizing downside risk. We can go long stocks, short stocks, we can use derivatives futures and options.When I went around to meet prospective investors and distributors, the view was in this elevated volatility environment, perhaps a strategy like this is interesting. Over the next 12-24 months, if this volatility were to continue. It considered some allocation out of an investor’s portfolio into a strategy like this. So, there is lot of interest among HNIs and family offices in particular that has been interesting.

Technical analyst who follow this do make the point that there could be a comeback. To assume that all midcaps and small caps will bounce back with equal vigor and gusto may not be the case. Each one has their financial prospects that has to be considered.

We are limiting our focus to large cap companies because that is where the liquidity is. We take short term trading views, so you need liquidity. So, we will rather like to focus on those stocks where there is ample liquidity and that is in large cap segment.