India’s good prospects, but expensive valuations limit upside: KIE

Stocks will remain volatile until the situation between Russia, Ukraine and oil prices clears up, says Prateik Gupta, CEO and co-chairman of Kotak Institutional Equities (KIE). In an interview with Sami ModakGupta says the markets could enter a phase of consolidation as interest rates rise globally. Edited excerpts:

Yueyoung markets too much? Is this the new normal?

Two dangers are out of the way – one was the outcome of the state election and the other was the Fed’s rate hike. However, markets will remain volatile until we get clarity on the situation between Russia and Ukraine and oil prices. By the way, China has been more volatile (it fell about 10% last week and almost fully recovered in a few days) and some of that volatility is affecting India as well. Global investors have divergent views – one is that the Chinese market is becoming more attractive, so let’s move the money from India to China. The second view is that China’s performance has been significantly underperforming India over the past six months, so some investors prefer to continue investing in India. The latter view has prevailed in the past few days as we have seen the slowdown in foreign sales, but the more China moves up and down a lot, it has a contagion effect on portfolio weights within the emerging market portfolio which in turn affects the foreign flows to India.

How do you see India’s ratings now? And what are the main risks?

Even after a 7 percent correction from the top, India is still not cheap. Nifty is trading around 20 times its FY23 earnings. Also, India’s valuation premium to the MSCI Emerging Markets Index is around 70 percent. There has always been a premium of between 15 percent and 90 percent. So now we’re approaching the upper end of the range again. India’s long-term prospects are good but relatively expensive valuations are limiting the upside this year, particularly in a rising interest rate environment, with growing risks of an economic slowdown in the US that could negatively impact global equities as an asset class. Another risk is geopolitical and oil uncertainty as it could lead to lower economic growth and corporate profits. Also, the risk of COVID is very present with China and South Korea reporting massive increases in cases again. The last one is the monsoon dangers – India has had three good monsoons in a row and it remains to be seen if we will have a good monsoon in 2022 as well. Most of the risks are global in nature, and there are no major risks specific to India other than that of the monsoons.

How do you see the path of the market?

We expect the Indian stock market to be range bound for most of this year assuming no further deterioration in the geopolitical situation and oil prices. Globally, interest rates are rising and there is a risk that economic growth may not be as strong, so it’s hard to see stock markets globally doing as well as last year. Earnings growth is like an accelerator, but this also slows down a bit. On the other hand, higher interest rates act as a brake to the stock markets and we are seeing the Fed finally slam the brakes with more rate increases planned this year along with a reduction in its balance sheet. As we pass this consolidation phase and market valuations make more sense, we should see Indian stocks perform in line with their corporate earnings growth trajectory.

What are the earnings growth expectations?

For fiscal year 22, we’re pretty much on track for Nifty’s earnings growth of 35 percent, and for fiscal years 23 and 24, we expect earnings growth of 15 percent each year. However, while Nifty’s overall earnings growth estimates haven’t changed much, we’ve seen a change in the mix of earnings growth — we’ve seen cuts in earnings estimates for the Autos, FMCG and Cement sectors. On the flip side, all commodity related sectors saw earnings improvements. So earnings quality has deteriorated somewhat as it becomes more vulnerable to global commodity sell-offs, but India’s long-term earnings outlook still looks very strong versus most other global emerging markets.

What are the reasons for the massive sell-off of the foreign investment index since October?

The first trigger was the shift in the US interest rate cycle that investors began to anticipate as inflation started to rise. The second was the fact that India did very well compared to other emerging markets, and it looked relatively expensive. Then in February, war broke out between Russia and Ukraine, commodity prices turbulent and oil prices soared. For India, which imports about 85 percent of oil, this has a significant impact on the economy. However, the only good thing this time is the buying by local investors that offset the selling from FPIs.

Will the strong domestic inflows into the market continue?

Yes, we think they will. Domestic capital alternatives don’t look very attractive – bank deposits don’t even cover inflation on a post-tax basis, other fixed income products don’t look very attractive in a high interest rate environment, and price hikes in real estate are likely to be muted as the recycling cycle Mainly driven by real buyers rather than investors, as there are many millennials now investing in stocks facilitated by easy online access, overall share of financial savings in family savings is still low in India. So domestic inflows should continue unless there is a global event that frightens retail investors.

What sectors do you like?

Private banking, life insurance and capital goods. We are also positive in some other areas like chemicals and some big real estate companies. In sectors, we recommend focusing on stronger players in general. So, in the financial field, for example, we prefer the big, better quality private banks rather than most PSUs or NBFCs. We also suggest sticking with big stocks rather than smaller companies or companies with balance sheets and/or poor governance. This is not the time to take unnecessary risks in our view.

The street has been bullish in private banks for some time, however the sector has not performed.

The main reason was the sustainable selling by FPIs because most of them usually have 35-40 percent weighting in the financial statements and some more. So when the foreign investment institutions start selling in India, the banks are the hardest hit. The second is that we haven’t seen upgrades in bank earnings and so far, credit growth remains subdued with downside risks if economic growth forecasts are further slashed. We expect loan growth to pick up in the second half. Most of the banks have also cleaned their books, and the leading private banks have a strong deposit franchise with significant investments in technology. They are well positioned to benefit from India’s high economic growth when this materializes.

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