India may see more de-rating if growth expectations reduce: Saion Mukherjee

Rising interest rates will have a negative impact on equity markets, as this is being driven by inflationary pressures, higher deficit and not so much from growth, says Mukherjee

The sharp rebound in the markets is being fuelled by strong domestic liquidity and expectations of strong earnings growth, says Saion Mukherjee, managing director and head of equity research, India, Nomura. In an interview to Samie Modak, he says India’s valuation premium to other emerging markets (EMs) will reduce as liquidity conditions tighten. Edited excerpts:

How do you see rising bond yields impacting the equity market?

Rising interest rates will have a negative impact on equity markets, as this is being driven by inflationary pressures, higher deficit and not so much from growth. The tightening of liquidity and rates are more of a normalisation as the impact of the pandemic recedes. The unprecedented monetary stimulus after the pandemic’s outbreak led to an increase in asset prices and when that is reversed, it will have a negative impact.

How will headwinds such as inflation, policy normalisation, Omicron play out on equity markets?

There is a correlation between the rate of expansion of central banks’ balance sheets and the foreign institutional investor (FII) flows. As balance sheet expansion slows, we have witnessed FII selling in India. As part of the normalisation process central banks will slow asset purchases further and eventually reduce the balance sheet. This is likely to continue in 2022 and 2023. Hence, support from global liquidity will wane.

The Omicron wave’s impact is limited by the fact that the restrictions are limited and the disease is relatively not as severe as in earlier waves. Nonetheless, there is likely to be some negative impact as it pushes out the recovery of certain segments like services. Our economics team cut the gross domestic product (GDP) estimate for the first quarter of calendar year 2022 (Q1CY22) from 5.2 per cent to 3.2 per cent recently. For CY22, we have reduced our growth estimate from 8.5 per cent to 7.4 per cent.

Indian markets are off to a good start this year. What are the factors underpinning this?
 

We think one factor is strong domestic liquidity. Inflows into mutual funds have remained robust with strong pickup in SIPs. Direct retail participation is also strong. This is supported by a slowdown in FII selling. Besides flows, fundamentally, the expectations from corporate earnings remain high.

What should the return expectations be for the year?

Our Nifty December 2022 target is 18,150, implying that we don’t expect a material upside from current levels. The market is up 53 per cent from the pre-pandemic levels of February 2020. The valua¬tion multiple at about 22 times one-year forward earnings is higher than the historical average of about 16-17 times.

We think with increased liquidity tightening the flow support will wane. Also, after the significant improvement in profitability of corporate India on the back of market share gains, lower overhead costs, commodity linked earnings, the medium-term earnings will increasingly depend on broader economic growth. In that context, our view of slower economic growth versus Street expectations makes us cautious. Hence, rise in yields and slowdown in earnings growth could lead to some fall in valuation multiples.

Will India be able to outperform the EM pack again this year?

India has significantly outperformed EMs from the middle of last year. India’s valuation premium to FTSE EM was about 38 per cent historically, which is now at 72 per cent. Growth expectations in India were better than other EMs and easy liquidity conditions tend to raise valuation gap a lot in response to change in growth expectations. With tighter liquidity, that gap should reduce, assuming no change in growth outlook. However, if growth expectations reduce, there will be further de-rating. Given India’s outperformance, from a regional perspective we have reduced our weight on India to ‘neutral’ from ‘overweight’.

What is your view on new-age companies?

New-age companies are growing fast with cash flows in the very distant future. These are, in a sense, extre¬mely long-dated equities. In cases where the market believes in the business idea, the founders/management and unit economics are established, the valuation can be lofty, particularly in the backdrop of current liquidity conditions. Therefore, we would not like to generalise stating that the valuations are high. Investors can selectively participate in the space from a long-term perspective.

What are the earnings growth estimates for FY23? Which sectors will drive growth?

For FY22 and FY23 the earnings growth is expected at about 40 per cent and 18 per cent year-on-year. The sectors that will drive earnings in FY23 are banks/financial, IT services, oil and gas and autos (on a low base of FY22).

Any sector or theme that looks poised to do well?

We have a selective bottom-up approach to construct the portfolio. We are ‘overweight’ on IT services as we expect the growth momentum to sustain with potential upside to earnings estimates. We like the infra/construction/industrial space as valuation here is not expensive and there is policy support for investment-led growth and new emerging opportunities in digitisation and automation. We also like pharma and telecom as we see these as turnaround stories with potential upgrades to current earnings estimates. At the margin, liquidity support will decline, but it is still likely to remain higher than the pre-pandemic period. Hence, sensitivity of valuation to growth expectations will remain high and we prefer stocks/sectors with potential upgrade in growth expectations.