'Earnings expectations still unrealistically high in India'

Q&A with Herald Van Der Linde, head equity strategy - Asia-Pacific, HSBC

The ongoing rally may have little more legs, but will soon hit a wall as earnings growth remains a challenge, says Herald Van Der Linde, head equity strategy — Asia-Pacific, HSBC. In an interview to Samie Modak, Van Der Linde says there could be more downgrades in the Indian market as earnings expectations are unrealistically high. Edited excerpts: 

What has led to the upsurge in the market this month? 

There are a number of factors that have helped equities, not just India but the rest of the world too. I would say there are four key reasons for this. One is the weakness in the US dollar and the prospects of no further rate increases in 2016. 

The second reason is that commodity prices have bounced back, not only oil, but soft commodities like soya bean. 

Thirdly, it is the more pro-active policy making initiatives towards growth, particularly in China. The monetary policies in Indonesia and China have entered looser territory. 

Lastly, valuations had become quite low. 

The emerging markets have entered bull market territory. Do you think the rally is overdone? 

There could be a little bit more steam left. Policy makers in the variety of emerging markets were in hard landing scenarios, not only China but some of the other countries as well. Most of that is avoided. For this rally to sustain for months and quarters, we need to see stronger growth particularly in China, pick up in margins and profitability in emerging markets in general. That is difficult to come by. 
 

Therefore, I think this rally has little bit further to go. But there are also limits to this rally. To sustain beyond those limits we need to see profitability in Asia improving, but I don’t see any signs of that at the moment. So, we have to be careful in saying that this rally in the emerging market is a DM (developed market) to EM rotation that will continue throughout 2016. We will see limits to what EMs can do in equity performance. 

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What is your view on the Indian market in particular? 

The Indian market has bounced quite strongly. There is one overriding worry for the Indian market, which is not so much the politics but the high earnings expectations. The earnings expectations in India are still unrealistically high. The Indian market has come down quite considerably over the last 12 months and looks cheaper. 

However, as we go into the next reporting season, there could be more earnings downgrade. In the December quarter, India was the country with largest earnings downgrade. 

In the upcoming result season, there could be more downgrades. The valuations at this particular time are still not attractive enough to say we need to go into Indian equities. 

What’s your take on the Indian valuations and earnings growth projections? 

For valuations to become attractive, either the Indian markets have to come down or earnings have to move higher. My suspicion is that it will be difficult to see the earnings moving higher. The existing expectations are too high. 

Secondly, we have problems with the monetary transition mechanism in India. The banking system is clogged up with bad loans, demand for credit is not very high. The government and the central bank are trying to resolve this through a variety of ways. But that doesn’t give much confidence that it will lead to earnings growth. It is not only up to the monetary side to deal with this, you can do it through the fiscal side too. The market has been quite positive on the Indian budget. It is commendable that the government has chosen fiscal discipline instead of growth initiatives. However, the Indian budget is contingent on asset sales both of spectrum and enterprise divestments. In the past at least we have seen that every government has wanted to sell assets but has struggled to do so. It is not that India is an exception to that rule but markets would prefer to see proof of that. Therefore, although all the initiatives taken are positive, it may not resolve growth issues. 

Past few years, India was the most attractive market in the region. According to you, where does India stand on a relative basis? 

India has been the largest overweight position for global funds that invests in Asia and EMs. That is already on its way down and it may continue. We are seeing growing appetite for Korea and also ASEAN. But ASEAN itself is smaller, so you cannot say that people rotate out of India and put all the money there. But the combination of Korea and ASEAN together could well pick up what’s coming out of India. It doesn’t mean investors start selling India but it could get a relatively small portion of incremental flows coming into emerging markets. They might board into markets where their exposure is lower. Korea and ASEAN may benefit in that regard. 

Have you set any target for the Indian market? 

For the Sensex, we have a target of little over 26,000. We have been telling people there may not be much upside in India. Other markets offer more upside, where we see earnings upgrades coming through, where valuations are lower and implementation of policy is much better. What the market expects to see in Indonesia this year is what the market was hoping to see in India 12 months ago--implementation of reforms, higher growth and better valuations. That may unfold in Indonesia this year but has not yet been realized in India. 

What’s the downside for the Indian market? 

If we look at price to earnings (P/E) levels it starts to look attractive for India. The problem, however, lies in earnings. If that comes down, the P/E goes up. I think we need to wait till the earnings downgrade. What we would like to see is investors’ holding in India coming down so that from overweight, they become more cautious on India. Also, the earnings growth expectations have to be much more realistic. At the moment, consensus is looking at 17 per cent earnings growth in 2016-17. For us, 5 or 6% looks more reasonable. So, if we see significant downgrades, that could be a time to take a relook at the Indian market. 

What’s the outlook on crude oil prices? 

Oil prices have come down, supplies have been cut and consumers are increasing consumption. There is a rebalancing in the market. However, inventory levels across are high and that provides structurally downward pressure on prices. So there is still downside risk to oil prices. Our house forecasts though looks at oil to finish at $55 (a barrel) at the end of this year. But that’s really contingent on rebalancing where supply comes down and prices start to increase.