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Overweight on banks, staples and cement: Sanjay Mookim, BofA Merrill Lynch

We expect domestic equity flows to remain strong because there are no other asset classes where savings can be parked, says the India Equity Strategist.

ET Now|
Updated: Jan 06, 2017, 12.37 PM IST
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'Conditions in place for revival in realty, household capex'

In a chat with ET Now, Sanjay Mookim, India Equity Strategist, BofA Merrill Lynch, says the conditions are falling in place for a real estate cycle capex recovery in India and an economic upcycle subsequently.

Edited excerpts:

The tone of most of the research reports is that earnings recovery in FY18 is coming. The general communication is do not lose heart, earnings are coming. My challenge with this communication is there has been a standard assumption by all of us that earnings will revive. However, that assumption is getting challenged every year. Why do you think this year it will not get challenged?

There are reasons why it may not be as bad. If you look at last the last two years, earnings have disappointed largely because of the contraction in commodity prices. All our materials companies did very poorly and very recently the decline in the aggregate was largely because of the banks. If you look at FY18, then these two factors are very unlikely to recur.

Hopefully, the commodity prices remain where they are and banks are unlikely to continue to book the sort of provisioning costs that they have booking for the last four or five quarters. So from an arithmetical composition, the index total should do better in FY18. There is, of course, uncertainty around the consumption oriented and domestic-facing businesses.

Consumer discretionary is under a cloud because of demonetisation but that is only small part of the bucket and most strategists would have told you that the index does not fully represent the Indian economy. That is partly the explanation why we think the total earnings might not do that badly.

For the index, last two years have been flat. Now markets have got much more than what they actually wanted. Interest rates have come down, commodity prices have come down. There is a good monsoon. There is OROP. There is the entire pay commission things which will be at par. Also government spending in key sectors has improved. But the index has been flat. Do you think 2017 could be a decent year for the index?

We have said as much. After two years of bonds outperforming equity in India, this does seem like a year where equities can finally match up or deliver as much return as bonds. Even if you get 100 bps correction in bond yields from here on which is probably as much as you probably expect, you could still get equities keeping up with bonds through 2017.

In order to answer your other question, why have equities not done better so far? That is because the economic cycle has not fully set in and we have been highlighting in many notes that capex needs to be revived. People look at the wrong place when they expect the government to be able to revive capex in a big way.

What you need initially is household capex to start with, which is real estate formation and with the rate cuts, the new regulation should provide buyers more comfort. It is very difficult to time it, but the conditions are falling in place for a real estate cycle capex recovery in India and an economic upcycle subsequently.

You were amongst the first voices speaking about how the equity market inflows six months ago were a contingent of what has been happening in the bond markets. In the first six months of 2017, how do you expect flows to be for India both on the equity side and the debt side but particularly on the equity side?

We expect domestic equity flows to continue to remain strong simply because there are not too many other asset classes where savings go and park themselves. If you were an individual investor, a post tax return on FD today is barely 4% and you still save money. Salaried peoples’ incomes are still there and flows should remain strong.The only thing I suspect you might get is if taxation on equities were to change dramatically in the budget.

There has been speculation that it might happen and hurt flows somewhat but apart from that, flows or domestic savings can keep coming into equity.

What is keeping the FIIs away? Do you think in 2017 once the budget uncertainty and state elections are over, we could see FIIs return to equities?

It is not about India, the FII flow is about the EM asset class. You cannot say people will discover India growth suddenly and decouple the country from what is happening to the rest of the emerging pack. At the moment because the expectations of the US growth are strong, bond yields or rates in the US are expected to continue to rise. There is a bit of a cloud on emerging markets which is translating into India as well. Charts are unambiguous, you will see that India has not decoupled for more than four-five quarters now. And that is unlikely to happen soon.

If you start seeing an EM rally. which we as a house find reasonably probable then the flows from an FII perspective could also reverse.

 



Besides the long term capital gains tax which you just referred to, which of course is going to mean that the market is going to take a sudden U-turn from wherever we are at that point. But besides that, how big a trigger directionally could the upcoming budget as well as the state elections, and especially Uttar Pradesh are going to be? How critical are they from a market standpoint?

I would argue that there is enough logic to suggest that the budget or at least fiscal policy should become pro growth. Now the government has done a credible job in controlling fiscal deficits over the last two years. The demonetisation has created uncertainties on the economic path and it makes a lot of sense for policy to be supportive and stimulative.

The budget should provide support and more so at the bottom the pyramid where the impact on incomes has been larger. There are many ways to do it and I am sure, the government is working hard to figure it out but that can be very important in generating confidence that the Indian economy has a flow to it and that any adverse impact of demonetisation and potentially the GST will not lead to a very major correction.

I suspect that at least the market is holding its breath to see how large and how impactful the fiscal policy stimulant can be.

What will drive numbers from here? Where is the leadership in this market to ensure that the aggregate earnings grow at 12-13%?


If you take a top down view and break up GDP into final consumption and capex, you will notice that consumption in India has actually been very acyclical. Throughout the economic cycles’ downturns and upturns, private final consumption will continue to grow at 6-7% odd year after year at a very steady rate. This is why in downturns, the consumer stocks stand out, because everything has been doing badly but consumption continues to chug along in India. It is only now that you have got this demonetisation impact that there is this cloud on whether there will be consumption growth or not and therefore you have to wait it out.

We have argued in our research that staples are perhaps said to recover faster than discretionary, but in the December quarter, whatever numbers we have seen discretionary or the autos have done better than staples.
From a recovery point of view, the more essential consumption should theoretically comeb ack faster. So that is what we have recommended to our clients. But in terms of growth we cannot write off the whole thing. If you take a four, five, six quarter view, consumption in India should continue to grow as acyclically as it was before.

There is a bit of a scare right now in IT. People were citing Vishal Sikka’s letter to Infosys employees. The whole point about how Ford is not setting its plant in Mexico but in the US and whether that will prompt other companies to do. Now there is this talk of two key lawmakers in the Congress reintroducing the reform bill for the H1B Visas as well. What are you making of all of this and what is the BofA ML stance on IT at the current point of time?

We are underweight on IT. We have downgraded several IT stocks and our arguments are that the event risk of restrictions on visas or increasing visa fees is too large. The stocks appear to be inexpensive and among them, the good quality companies are well run generally but the large event risks will keep us away for now.

We are happier to buy them 10% higher if the clarity on US policy were available than to try and get in right now on the multiple. So we have been careful and we have remained that like that until we get some clarity.

What are the top few overweight positions and why?

We are overweight on banks, staples and cement. I have argued banks should drive profit growth and banks are generally coincidental to an economic recovery.

If you do see the effects of demonetisation getting digested and some normalisation of the market, staples being essential consumption, should recover from any impact. Cement also falls into the same basket. Personal consumption should be supported naturally but also because of the rate cuts that we have seen earlier this week, these are the three top overweights that we have.

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