Election outcome could take markets higher by 5-10%, primary via multiple expansion, believes Rakesh Arora, MD & Head of Research with Macquarie. In an interaction with Devangi Gandhi, Arora discusses investor expectations from a favourable election results, possibility of expansion in market multiples and his outlook on various sectors. Excerpts:
How do you see the market behaving hereon?
It all depends on the expectations of the recovery process and how fast it is going to be. Historically markets tend to discount it ahead of the actual numbers. The average multiple for the market (Nifty) for the last 17 years is 14.5 times and currently the market is trading at multiples of 13.8-14 times, so there is still a 5% discount to the long-term valuation. We have observed that amidst strong positive expectations, the multiple goes beyond that average, for example, a stable government in 2009 re-rated markets by 27% and the markets sustained an average 16.5x multiple for the next 18 months. So, considering the strength of expectations currently, we think the market should trade anywhere between 15 and 17 times and that’s why we have talked of a likelihood of 15% gains. Our target price for the Nifty is 7200 which equals a multiple of 15 times but there is a chance that it can get extended if we get a strong government and people start to believe that it would start taking action fast enough. In this case, post-elections, the rally may continue to build on by about 5%-10% primarily via multiple expansion. Opinion polls from January through April suggest steady gains for the BJP-led NDA and we think markets are pricing in around 230 seats, which is also our base case.
What are the key positives the street expects from a favourable election outcome?
It is difficult to quantify how things will move and that is why post-elections, the first crucial event would be the Union budget, which would come out in early July and give us a clear indication as to how the government wants to take short-term and long-term measures to tackle the fiscal situation.
On the inflation side, we expect that it would remain benign for the next two to three months due to the base effect. Beyond that, the large part of food inflation is because of food grain prices. What will set the expectation on the food side is whether or not the new government would sell some of the excess storage in the public distribution system?three- four times the reserves country normally need to keep. The second possibility is that the rupee is likely to appreciate on expectations that the economy is starting to do better. In that case oil prices in Indian rupee may come down, which could further reduce the under-recoveries. If the oil prices come down, even the diesel prices could be cut which would have a cascading effect on inflation.
Investments is the key parameter on which everyone is hopeful. The current government has given clearances for investments worth $35 billion and there is a chance that things would pick up further. Although there would be a lag of about a year for corporate investments to actually start, the announcements could start coming in before that. What we are banking on is the big infrastructure projects that the government agencies are doing, like freight corridors, or ultra mega power projects. By late FY15 you will see activity in terms of ordering picking up. We expect actual construction work to start only from FY16.
So the current rally is overlooking the pace of earnings recovery?
Earnings estimates are not very high at this juncture and hence we think they are achievable. I think even the street is now slowly concentrating on FY16 numbers more closely. The GDP forecast for FY15 is around 5.4-5.5% which can be missed by around 100-200 basis points in case of a bad monsoon. However, people are more concerned about whether FY16 GDP growth be higher than 6%. That is the question which will get an answers post-elections when we gauge how the new government is moving in terms of policy, etc. So till that time it is a little bit of hope. As people get more confident on the policies, the market can go up further.
Can we expect a spurt in FII flow post the election results even as QE3 tapering is likely to intensify?
In the last two years, we have been getting $20 billion-odd inflows and for the year so far we are seeing a similar trend building up. Some people are trying to figure out if any election-linked money is coming back to India. QE3 is coming to an end in September and we expect the first rate hike in the US in the first quarter of 2015. That would definitely have an impact on the rupee by keeping it near 60 against the dollar. Currently the money is shifting from developed markets towards emerging markets because the US Fed has set a GDP growth expectation of 2-2.5%, which earlier people anticipated to be around 3-3.5%. For India, the flows will depend on what kind of reforms the government is able to push.
A shift towards cyclicals seems to be in place. Is it sustainable given the fundamentals of some of the cyclical sectors?
Cyclicals are looking cheap as compared to defensives. The best way to look at the comparison is through the price-to-book ratio (PB) since earnings tend to lag. In terms of PB, these stocks are trading at around a 69% discount to defensives which is normally around 55%. So even after the recent run-up there is still 14-15% gap in valuations, which means that cyclicals could see further gains. Largely what we are pushing in cyclicals is banks and industrials. Amongst banks we have been preferring private banks and some of the PSU banks which have started to look good. Amongst industrials we have been pushing large-caps. After the elections, the focus will come back on mid-caps and it will become a stock pickers? market.
Many analysts have turned positive on PSU banks…
There are two major worries with respect to PSU banks, the first being the NPLS issue. Now, if there is a possibility of revival in economy the NPL would come down and lot of forums have been talking about NPLs peaking. The second problem and much bigger one is that of funding because the capital requirement is huge and people are not sure how the government would manage to infuse so much capital. So the expectations were that these banks will have to expand at a much slower growth rate. However, one of the changes that have recently happened is that the RBI has pushed back the deadline for meeting the basel III norms which is pushed back to FY18. So a part of the rally is because of easing concerns on capital requirement. There are also talks that the RBI is likely to allow pre-booking of profits in some of the NPLs sold out to the restructuring companies and may support banks on the capital front. These are the reasons why you see these stocks coming back in favour right now.
How do you think the export oriented sectors like IT would perform now?
Now they are starting to correct. We are hoping that the recovery in economy in FY15 will be driven by exports. But now there is a chance that the rupee might strengthen. So the export-oriented companies may face a downgrade cycle. Given that data points from the US suggest a recovery in the BFSI orders, I don’t think that IT companies will correct a lot but they could underperform the market.
Certain metal stocks have also seen good buying interest. What is your view on the space?
Metal companies are doing reasonably good because apart from China rest of the world is starting to see better demand outlook. In case of China we are expecting an easing monetary policy and and a ?V? shape recovery in the second half of 2014. So we are kind of hopeful that the metal stocks would be well supported. Indian companies have also finished their capex activities and are going into a deleveraging mode in FY15 so that should also aid re-rating. A recovery in the domestic demand could add 2-3% to realisation and neutralise the impact of rupee appreciation through increased premiums. These expectations combined with reasonable valuations indicate there is still a decent upside in the metal space hereon. We have an outperformer rating on the sector.
