Mkt hasn't adequately factored in risks to growth: Nomura's Saion Mukherjee

If inflation-related issues get more structural and last longer, rates can continue to surprise further on the upside, leading to contraction in valuation multiples: Saion Mukherjee

As the markets adjust to the possibility of a faster-than-expected hike in interest rates, Saion Mukherjee, managing director and head of equity research, India at Nomura, tells Puneet Wadhwa in an interview that if inflation-related issues get relatively structural and last longer, interest rates can continue to surprise further on the upside, leading to contraction in valuation multiples. Edited excerpts:

Have the markets digested the worst-possible macroeconomic scenarios, or is it just a temporary pullback until the LIC IPO sails through?

The Indian market is largely flat year-to-date (YTD). However, there is a divergence in sector performance. Value has outperformed growth or a richly valued segment of the market. There is outperformance in power/utilities, metals, and oil & gas. Consumption-related, IT services, and cement stocks have underperformed. We have been concerned about higher interest rates and growth. There is a negative surprise on both fronts.

The market movement suggests that the impact on valuations due to the rise in the cost of capital is factored in to an extent. However, if inflation-related issues get more structural and last longer, rates can continue to surprise further on the upside, leading to contraction in valuation multiples. The market has not adequately factored in risks to growth. Earnings growth can get impacted due to lower-than-estimated demand and compression in margins in certain segments due to inflationary pressures.

Is risk-reward still favourable for equities as an asset class in 2022?

The commentary by central banks has dramatically changed over the past three-four months. Fighting inflation is a priority. Even the Reserve Bank of India (RBI) has now prioritised controlling inflation over growth. We now expect the US Fed to tighten by 200 basis points (bps) in 2022 versus the expectation of 100 bps tightening in December 2021. The key question is how disruptive the rise in inflation and higher rates will be for growth. Currently, market concerns about growth are rather limited. There are risks to growth disappointing, in which case there can be an impact on account of both earnings cut and compression in valuation multiples.

What policy response do you expect from the government that may address the markets’ and India Inc’s inflation-related worries?

Inflation in India is more driven by the rise in commodity prices, rather than by higher demand. So far, higher costs are largely passed on to consumers. For instance, in the recent past, there has been a rise in the prices of fuel and there is no additional cut in excise duty after November 2021. The government’s action will largely depend on the extent of the price increase and how long it sustains. In case the prices rise further, we can expect a policy response that could lead to a higher fiscal deficit.

How does one approach the domestic economy facing sectors against this backdrop?

From a long-term perspective, one can be positive about the domestic economy-facing sectors. The corporate and bank balance sheet is strong, which can support growth over time. We see opportunities across sectors, particularly in financials, industrials/construction, and new-age companies.

How comfortable are you with the market valuation at this stage?

The Indian market is trading at 19.7x one-year forward earnings. This is still 5.4 per cent higher than the last five years’ historical average. India’s narrative on both macro front and corporate earnings has been strong. India’s market valuation premium versus emerging market peers is at 65 per cent versus the historical average of around 40 per cent.

In the current context, India’s valuation premium may remain elevated. However, there can be an absolute correction in valuation multiples, given the rise in the cost of capital and earnings risk. We remain underweight on the consumption sector as there are risks to earnings and valuation multiples. We have a bottom-up approach currently and prefer select banks, pharma firms, and IT services.

Do you see earnings downgrades over the next couple of quarters as input costs bite?

There are multiple moving parts that impact the aggregate earnings of the market. Clearly, there is likely to be pressure on margins in the commodity-consuming sectors like consumer, cement, and industrials. The consensus is to factor in the Ebitda margin expansion of around 200 bps over FY22-24 in such sectors.

If commodity prices remain elevated and slower growth limits companies’ ability to pass on the price increase, there are downside risks to the current margin estimates. This impact is negated to an extent by higher earnings by commodity and refining companies as prices and spreads remain high. Also large, listed players can continue to gain market share from smaller/unorganised players in the near term and, hence, can deliver growth despite a slowdown in segment growth. Factoring in the positives and negatives, there is still a downside risk to aggregate earnings over the next few quarters.


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Twitter: @Pun_ditry