We're still in a phase of sell the rally rather than buy dips: Chhaochharia

Don't take too much of sector bets as we will continue to see a lot of dispersion within sectors, says Gautam Chhaochharia, head of India Research, UBS

The markets have rallied from recent lows, but Gautam Chhaochharia, head of India Research, UBS, tells Vishal Chhabria that macros have still not turned favourable, earnings estimates will see more cuts and retail flows have decelerated sharply. He says elections will be the biggest driver for markets. Edited excerpts:

What do you make of the latest rally or rebound in markets, after a steep fall? Is it is a Dead Cat bounce or you see more legs to the rally?
 

We see it as a Dead Cat bounce. We’re still in a phase of ‘sell the rally’ rather than ‘buy the dips’. In a tightened liquidity environment, markets will de-rate. Indian markets peaked at about 20 times forward price-earnings (PE) multiple. It has de-rated back to around 16 times. This figure will change to 18 times if we realistically look at earnings, where we see estimates being revised lower. The last five-year average PE is 16 times. At those levels with realistic earnings, fair value of Nifty would be 9,500 in March ’19, which is our base case. 

Leave alone global factors such as US-China trade issues, a strong dollar, etc, there are various local issues such as slowing of retail flows into mutual funds. The non-SIP flows into equities have come down very sharply from a monthly average of $2 billion last year, to near zero now. 
 

While earnings cuts will again happen, the bigger driver will be politics; elections. The markets and global investors have been presuming and pricing in that Mr. Modi will come back. If that view gets tested into the elections by May, markets will correct further. The results of State elections on 11th December will be an indication. 
 

Tight liquidity means growth in second half fiscal ’19 will underwhelm expectations, both for GDP and earnings, and means more downsides.

But, isn’t that global oil prices are down, rupee is stabilising, bond yields have come off. These were the factors which actually shook markets?
 

It could help in the short term. But these are still not at levels seen about a year back. In the last 3-4 years, bond yields came down, oil remained low and Balance Payments was in surplus, liquidity was strong. This turned in reverse gear for last six months. Markets ignored, then suddenly took notice in last two months and then we’ve seen some moderation recently. Oil is still not below $50 where it turns India’s Balance of Payments into surplus. Bond yields are down to 7.8 per cent, but not below 7 per cent. So, it’s some moderation but not showing underlying variables which suggest a big rally ahead. 

In the environment where liquidity will be tight, the uncertainty around local politics will become bigger over the next few months, local retail flows in our thesis are vulnerable, and oil is steady, and you will see continuous earnings cuts, our fair value of 9,500 for Nifty should be more in line with last five year averages multiple which is about 16 times, rather than being premium. We have bull and bear case scenarios, too, but the skew shows that there is more downside than upside from here. A Bull case is if oil comes down below $60 sustainably. There’s no US-China trade war, and they have a deal. And Mr. Modi comes back. And Bear case is the reverse. Nifty target in Bull case is 11,100 for March ’19, which is a few hundred points from current levels, and the Bear case number is 8,300. Therefore we would advise investors from a tactical one year perspective, still a ‘sell on rally’ and ‘buy on dips’ if you have a 3-5 years perspective.

Corporate earnings are still under pressure. What kind of growth are you expecting? 
 

India has seen earnings cut for last six years broadly. And every year the cuts have been quite broad based. Our forecast of 13 per cent earnings growth for Sensex/Nifty for FY19 has not changed since January. We have seen some earnings cuts, and we estimate a further cut of 6 per cent to consensus estimates. For FY20, we see 17 per cent growth assuming boost from banks’ provisioning cycle. 

How would you place your investments given market conditions and expectations? 
 

Don’t take too much of sector bets as we will continue to see is a lot of dispersion within sectors. The only sector bets we recommend is to be overweight retail liability-driven private banks, and IT services. For the latter, there is currency tailwind, investor positioning is still quite light, still a lot of scepticism around the long term growth but lot of the Indian IT incumbents are also reinvesting the dollar gains into the business.

We are underweight Capex. We underweight small mid-caps as the valuation gap are still froth. Consumer staples and discretionary are still very expensive, with earnings growth growing in sub-teens and there will be likely impact of tightening liquidity too. But that’s also a place where investors hide in a falling market. So look at individual stocks with potential earnings beat, and don’t be aggressively underweight. 

What about Pharma?
 

Pharma is again a neutral, and a stock specific call. The negative drags are behind such as US generic pricing pressure, FDA inspections, etc. But where’s the upside? Are we going to see US pricing increase, the US generics model be as profitable as they used to be earlier? Doesn’t look like. So, worst maybe behind but the big upcycle is still not too clear.

What is your view on NBFCs? Are they getting back to normalisation?

I’m not too worried about NBFCs (non-banking finance companies) and liquidity stress per se as this is unlikely to be a prolonged systemic credit crunch. None of the NBFCs individually are so big to cause a systemic issue and the larger ones are backed by strong parents. Policy makers have to watch out for potential defaults even from a small NBFC causing a vicious cycle in itself, as confidence gets shaken. 

Are NBFCs getting enough money?
 

It is much better than a month back, but not yet 100 per cent normal. But, it’s less about quantum of money, and more about confidence. To put things in perspective, in past crisis periods in India or globally, when it really becomes a systemic issue, yields go through the roof. NBFCs are currently borrowing at 50–100 basis points more, and not 500–1,000 basis points more. In last 4-5 years, the Indian banking system could digest Rs 12-14 trillion as stressed without causing any defaults though it has a cost on its growth. NBFCs together are about twice of the above amount. And many like HDFC, Mahindras, Tatas have strong parentage. They might face margin pressure, but not a solvency issue. A very small percentage of NBFCs, maybe 2 –3 per cent without strong parentage and could theoretically be facing stress and be vulnerable to default. 

In this backdrop, how would you play the financials space? 
 

Last 3-4 years, India had an era of easy money, which changed six months back when liquidity started tightening. But, markets woke up when the IL&FS issue cropped up. Earlier there was no credit growth due to lack of demand for credit. Now credit is picking up, in double digits already.

Secondly, demonetisation helped in created a lot of liquidity in the banking system. These benefits are behind us. The biggest delta always comes from Balance of Payments, which was in surplus for last 3-4 years; it’s now running deficit for the last few months. 

What can reverse the situation is if crude oil goes below $50 sustainably. But even then it will not be a repeat of the easy money like last 3-4 years. The benefit of having low-cost retail deposits is not there for NBFCs. Over last 3-4 years the market was shifting away from retail liability-driven banks to wholesale-funded banks and NBFCs. That is reversing. In an environment of tight liquidity, NBFCs and wholesale funded banks will struggle to grow and will face margin pressure. So, we are still under-weight NBFCs and wholesale-funded corporate banks. Retail liability driven private banks are compelling. PSU Banks we’re sticking to neutral, because the underlying earnings power is still not visible.

In terms of proportion, how much of money would you place on mid-caps and small-caps?
 

We are underweight mid-caps because their relative premium valuation to large-caps on a trailing PE basis, has come down from peak of 100 per cent to now 60-70 per cent. The long term average is zero to 20 per cent premium. So, we wouldn’t recommend getting into midcaps, small-caps, as an asset class. There are individual mid-caps which can do well.

We have seen some FII buying recent after a long period of selling. Do you think their view has turned bullish towards India?

We haven’t seen any big buying per se. The way I would put it is that at an aggregate level global investors were anyways overweight India. So, they trimmed a bit of the overweight over the last few months in 2018 and still trimming. India is still the biggest overweight emerging market for them even now. What would have helped is oil. A lot of investors had also looked at India as an oil proxy on both sides. So, oil coming off sharply has helped India. But otherwise there’s no dramatic change in the stance. Sentiment near-term appears to be bearish though, as suggested by UBS Evidence Lab Market Thinking Game and from our conference.

How do you see global markets moving ahead, and the kind of headwinds or tailwinds?
 

The big thing is US-China trade friction and its impact on growth. If the friction becomes a war, which is not our base case, it would surprise negatively as markets are still complacent on that. Our base case is that market should be fine, though it won’t be like a roaring bull market like last few years. 

On US interest rates, we do expect US data to also start showing up the impact of China-US trade friction. So, for next year, we expect the US Fed to miss a rate hike in March, but growth resumes in second quarter of CY2019 and the Fed resumes hiking.

It’s been over four years now and we’re getting into elections in next six months. How would you rate the Modi government?

We don’t have a formal expectation or an opinion. But I can tell you from investors’ perspective, they have been reasonably happy. In fact, that’s one of the reasons why investors have remained overweight India despite earnings disappointments. Mr. Modi has really brought a lot of reforms- the GST (goods and services tax), Aadhaar and banking sector issues, deregulation of coal, power etc. They are hoping he comes back given his ability to deliver reforms, and at the same time focus on macro stability. 

Does the recent spat between RBI-Government worry your investors?
 

When you talk about India being a good market for them to invest, having an independent RBI does matter. I won’t speculate how it plays out. There’s always a tussle between RBI and Central Government, most of our ex-governors of RBI have said that. The two debating and having disagreement is fairly common. But for it to come out in the public domain is a bit of a surprise. Most global investors have been closely following this for last few weeks. As of now there is no reason to believe that RBI is not independent. 

Are investors worried over the fiscal math worsening? 
 

They have been worried. The bond markets spiking up through this year is also reflecting that. It’s still looking tough. But here you’ve to look at three elements- Government’s revenues, expenditure and most importantly its intent. Looking at various statements, data points, our meetings in Delhi with policy makers, RBI dividend issue, etc., tells you that the intent is definitely to make sure fiscal discipline is intact. On revenue side, GST has been a bit below expectations but non-GST direct taxes are doing okay. Disinvestment also looks like muted. So is there a possibility of a revenue slippage? But there’s a third point- if the government’s intent is there, can it make it up by cutting expenditure. You’ve seen that earlier governments do it. So, the headline fiscal deficit number can slip by 10-20 basis points, but unlikely by 50 basis points. I won’t overly worry about that issue per se.