In India, the yield curve has steepened. It is at seven-year high. It is called the bullish steepener, which which the bond market recognises as indicator that the growth cycle has turned, Ridham Desai, MD, Morgan Stanley India, explains to ET Now.
The key talking point in the market now is what is happening with the broader market – the midcaps and the smallcaps? The indices are in tandem with global cues but there is a completely separate and local impact on the broader markets?
That is a very good point you make. The broad markets are doing a local thing. the large indices are doing a global thing. It is exactly what they did last year when largecaps were up 28-30%. Then smallcaps were up 16% in dollar terms and 70% on an average. Now we are seeing a reversal. Sometime in the middle of January, the sentiment changed, largely because of global factors. There was the protectionist bogey and a few factors came together causing the correction. That is self-fulfilling because once that starts, you have such large gains sitting behind you that it takes a little while to get flushed out.
At the end of last year, midcaps were trading at par with largecaps. They usually traded at discount and so they need to trade at a discount — may be 20% or 30%. It is hard to say what the number should be but it should be somewhere around there that the midcap or the broad market will bottom out. It has not yet done so, in my view.
Is it difficult to say how much more to go?
The drawdown as of yesterday is about 14% or 15%. During the DeMon correction, we had 16%. In February 2016, during a global correction across markets, it was 20%. So, can this do a 20% correction from peak to trough? That is pretty par for the course. By that math another 5% or even a little bit more is possible. It is not unique to bull markets that you get a 25% correction. It feels very scary and a lot of midcaps would have by technical definition entered a bear market. They have broken through 200-DMA as they have had successive falling tops and bottoms and that is par for the course it happens.
That does not mean that the market structure has broken down but for now largecaps still continue to look like they will outperform midcaps until this whole thing has flushed out. The most important thing is that I am not expecting a V-shape recovery in midcaps. After they trough out, they will take some time to gather momentum and bottom out actually. So, that process could continue.
ET Now: Do you think they will drag the largecaps as well because that is a bit of a leading factor that is always at play?
Ridham Desai: Unlikely. India is looking like it is outperforming EM this year because Indias macro is whole lot better than it has been for the past three years, especially relative to EMs. There is a risk about oil. I am keeping that aside because if oil goes up a lot, then that gets disrupted. We do have an election ahead of us which is also another drag on the market but growth is turning in India and Indias beta has crashed!
We just did some work on this. Indias beta is approaching multi-year lows. Indias relative volatility is at all time lows. India has become a very defensive market. It is a global view that equities are going to struggle. India will be okay on a relative basis. Largecaps are fine but I am not expecting major returns. Our EM strategist Jonathan Garner thinks we got a 1% or 2% upside to EM over the next 12 months.
India is not a small market so it cannot do something very different from that. If he is right and the EM index is going up 1% or 2%, I do not think India is going up 20%.
ET Now: So the upside is capped.
Ridham Desai: We are more likely doing 5-7% which is what my index target suggests.
ET Now: read that piece on beta and that was fantastic work. 15 days ago, I read that research. In 2017, 80% of the market went higher, 20% of the market was low or flat I think the reverse could happen this year?
Ridham Desai: It is already happening. The breadth is already at that level and I do not think we have capitulated.
ET Now: Why do you said that?
Ridham Desai: We have a slew of indicators; we have breadth indicators, volume indicators, the whole thing combined into a sentiment indicator. As of last week, the sentiment indicators was just below neutral territory. It tends to go one standard deviation below neutral territory before it bottoms. So, it did not go there. It went down a little bit and then came back to neutral territory in April and now it is going back down again. May be, it goes all the way down to one standard deviation. There is no signs behind this which is I can say it has to go to this level but my gut feel is that it has not capitulated. We got some signs yesterday afternoon. There was a bit of panic in the broad market but who knows there could be couple of more rounds before this thing bottoms.
Let us measure the market on three buckets — liquidity, earnings, and valuation. Would you like to do this measurement for us for midcap and largecaps or would you like to measure it universally?
Let us do it universally. What is liquidity? Let us get that defined because most people conflict liquidity with flows. Flows is not liquidity because for every buyer, there is a seller. So if foreign investors are selling, domestics are buying and vice-versa. If both domestic and foreign are buying then somebody else is selling, HNIs are selling or promoters are selling because every trade in the market requires a buyer and a seller. So, what exactly is liquidity?
Well if the QIP is fresh, then?
Well that is a seller right? Promoter as a seller. Liquidity is a force of the bid or the force of the offer. You can feel it, it is hard to measure it. I have equated it with consciousness which you can feel but cannot measure. Liquidity slips out of our hands when we try to measure it. But when there was a lot of liquidity in the market in December, you could see it on the screens that has vanished now.
All the buyers have vanished and there is a lot of selling. By the way, domestic institutional flows are still positive. Domestic mutual fund flows are largely intact. They have gone up and down a little bit but they are largely intact. Foreigners have been selling for a while. In terms of net institutional flows, nothing much has changed but the liquidity has gone because the psychology of the market has changed.
So, liquidity is mostly about psychology and that does not look positive right now.
It is hard to tell when it will return but as we try to measure liquidity, we have a few indicators which are mostly neutral right now. They are not looking bad. It is not like that they have plummeted and so they are okay. But on the screen, it does not feel that way.
Valuations are a mixed bag, the largecap valuations are okay and a lot of people look at the PE ratio and grumble that India is rich but the PE ratio has got E in its denominator and Indias E is particularly depressed. We are at the fag end of a very long earnings recession that lasted seven years. Profit sharing GDP is at all time lows. It is back to 2002 level.
Contrast that with the US. Their profit share in GDP is at all-time highs. The PE ratio in America comes at all-time high earnings, the PE ratio in India comes on all-time low earnings. Theoretically if I normalised earnings and took the profit share back to average, the PE ratio is only 12. That is not a rich multiple on largecaps.
Another way of looking at it is to look at price to book. That is a stable measure looking through earnings cycles. The price to book is at about 3 and there is nothing much that the price to book is telling us. The Indian range historically has been 2 to 4. So, at 2 you close your eyes and buy the market. You get those opportunities once in a while like you got in 2002. You got that back in 2009, you got it very briefly in 2013, it did not go all the way back but it came very close. So you get it once in three, four, five years and then it goes over, like in 2000, 2007 and valuations are not giving you much information on what to do with stocks. Midcaps is a problem as we already discussed.
Finally, earnings. I have said this two years ago on your channel and on other channels that we have hit the earnings trough. There was a terrible call, it did not happen, earnings went down another leg. I can now do a post-mortem and say why it happened but that does not matter. The fact is that it was a bad call, we had DeMon, we got GST, we got few things, we got global trade collapse. We did not see these things coming and therefore earnings actually did not take off.
The good news is that revenue growth seems to have bottomed, we have had five or six quarters of accelerating revenue growth. For the latest quarter, depending on which sample you take, revenue growth is somewhere between 12% and 15%. That is a nice number but profit growth is not there because margins are still falling. A large part of that has to do with corporate banks. If you axe out corporate banks, the earnings are looking like they have turned, but obviously this axing business cannot continue forever.
At some point, corporate banks will have to also turn. I suspect that is happening over the course of the next 12 months because government investments are strong, consumption is looking good and you can see that bottom up as well as top down exports are looking okay because the world is in fine shape and we suspect that private capex cycle is coming back so we just did a survey which we concluded a few days ago and we published a report yesterday that the private capex cycle in India is turning. Corporate sentiment is at six-seven year high.
How come that is not reflected in the credit growth just as yet, how much time will it take?
Credit growth is a lagging indicator, it lags by 12 months. On credit growth, do not look at year-on-year numbers. Actually, the year-on-year numbers show a pretty sharp acceleration but the base effect is there because same time last year we had the DeMon effect still fading. So, you look at two year CAGR and credit growth is just back into double digits.
I am also watching deposit growth because that is also an important indicator. Both of them have turned up. There is some stabilisation in the financial system and we have to keep watching that but credit growth and employment are both lagging indicators. They come with a lag of 12 to 18 months. Do not look at these two to judge whether the economy is doing well or not. What you have to look at is consumption because that drives utilisation rates higher and then capex comes and then credit growth comes.
If credit growth is a lagging indicator and 12 months down the line, what would rising rates do to that sort of projection?
Two things important here one is the quantum of the rise and the second is its timing. Interest rates can go up while demand is accelerating. That is not a problem and a good example is 2004-2007 when rates were up, loan growth was up, earnings were up, markets were up. The view that rates going up is bad for the stock market, is not necessarily true.
The correlation between bonds and equities are all over the place. They go positive-negative but yields keep rising and falling. They do all these things and you cannot actually foretell that. What we can do is analyse and understand what has happened to yields. The big contrast between India and the rest of the world and especially the US here is an example that yields have risen everywhere but in the US. it has come with the short end and is going up faster than the long end. The yields covers and the yield curve are flattening in America is a precursor to recession. It is not our base case but you have to watch that space.
In India, the yield curve has steepened. It is at seven-year high. The long end has risen faster than the short end which I would describe very cautiously as bullish steepener which the bond market recognises as indicator that the growth cycle has turned; also inflation is no longer falling in India. This is not bad for earnings it is not bad for stocks. If you go back in time in India, bullish steepening of the yield curve has actually caused stock markets to rise. There is a nice correlation. The bond market is telling me that stock prices should go up not fall.
Based on your propriety indicators do you think the odds of making markets going higher in the next 12 months to 18 months is significantly higher than markets going down? We are discussing crude, we are talking about politics, we are talking about what will happen to the world if US rates settle above 3%.
That is truly the case I imagine but that does not apply to share prices. So, the earnings could do their own thing and Indias earnings growth may turn. By the way, we are not bearish on US earnings growth either. It is not that India is doing its own thing. Finally, India is turning around whereas America turned a few years ago.
We are at multi quarter high earnings in America; in India we are at a multi quarter low earnings. So India is actually now responding to the strength in the earnings elsewhere in the world, including emerging markets. Share prices in India to some extent have already anticipated this turn in the cycle and so they may have taken a bit of a pause.
Share prices have to deal with other factors because they do not necessarily only respond to earnings, they are responding to politics, they are responding to oil, they are responding to global share prices, all of those things are not looking very good. What I think is that we are dealing with a wider set of outcomes.
From the high to low and low to high?
High to low. But in the last three years we have had only a 20% move on average. The Sensex has been a very well-behaved boy, very quietly sitting there not doing its normal naughty jumping around. So, I think the one call that I feel comfortable is that there is going to be a bit more naughtiness on part of the BSE Sensex in the next 12 months.