The high frequency data for last couple of months has been mixed. Industrial production contracted in January by 1.6% YoY after 1.6% YoY growth in previous month, Petrol consumption edged down by ~3% YoY in February after five months of growth and unemployment edged up to 6.9% in February from 6.5% in the previous month. Further, exports grew by relatively modest ~1% YoY in February (vs. ~6% YoY growth in the previous month) while rail freight traffic growth slowed down to 5.5% YoY in February compared to ~9% YoY growth in the previous three months. That said, some of the weakness in high frequency data for the month of February is explained by one less day in 2021. Also some of the demand indicators like Passenger vehicle sales (~18% YoY in Feb), non-oil, non-gold imports (~8% YoY in Feb) point to healthy recovery. However, consumer inflation edged up to 5% YoY in February and is likely to remain at elevated levels through 1HFY22. We believe, inflation is a key risk to the economic recovery in the near term.
How comfortable are you with index valuations at this juncture? At what stage would you classify a bubble?
At ~21.5x 12m forward PE, Nifty index valuations are near 15 year high on fairly optimistic growth estimates for FY22. The expensive valuations have been sustained by strong rebound in corporate earnings which led to ~8% upgrade in FY22 Nifty EPS since October 2020. However, the positive surprise was largely driven by better than expected margins and sales growth would have to surprise positively for upgrade momentum to sustain as margins may have peaked. Higher commodity prices and unwinding of some of the cost savings due to normalization of economic activity could weigh on margins in the near term. The downside risks to margins and elevated valuations leave little upside potential for index, in our view.
How should investors approach market now?
While elevated valuations could cap the benchmark index returns in the near term, select stocks could outperform the market driven by visibility of strong earnings growth. A bottom-up approach in stock selection should be preferred in current conditions, in our view.
Can mid and small caps continue to outshine after recent run-up?
The mid and small cap stocks are more domestically exposed compared to large caps and hence the expected recovery in domestic demand in the near to medium term should support the performance of mid and small cap stocks. We expect real GDP growth to accelerate to ~10% YoY in FY22 after contracting by ~6.5% YoY in FY21. Historically (refer attached excel), the outperformance of NSE midcap index (relative to Nifty Index) is strongly correlated to acceleration in real GDP growth.
Which sectors or themes are worth pursuing now?
The government preference for capital spending should support sectors like road/rail construction. We also prefer sectors like Chemicals (shift of manufacturing away from China) and Insurance which have a long runway of growth due to structural factors. Chemical look very strong due to strong tailwinds and promising opportunities. In fact, it is widely expected by industry leaders that the industry will double in size from $160 billion to $320 billion by 2025. We would see creation of some Indian chemical MNC soon. In insurance sector there is opportunity in retirals space. Changes in our societal structural and lower attention to retirement savings is leading to a massive retirement savings gap. It is expected that the total pension AUM for the organised sector can rapidly scale up from Rs.28 trillion in 2020 to Rs 118 trillion (4X) by 2030, with NPS in particular likely to lead the charge. Another sector is IT, where most leaders we have interacted with recently indicate the recent demand uptick is not pent-up in nature but was result of a reset in client priorities towards transformation initiatives.
Do you view SPAC emerging as a favourable model in India?
SEBI has recently setup a group to examine the feasibility of SPAC in India. However, given the inherent risks, the regulator could restrict participation only to institutional and HNI investors. Further, the government may have to amend merger/acquisition rules for feasibility of SPAC. Some of the recent products like REITs have become feasible only after several interventions of government and industry feedback. Similarly, SPAC model could need a few iterations before it is feasible in India.
What is your take on the cryptocurrency phenomenon?
It is not clear if cryptocurrencies have the ability to replace fiat currency. Although it is argued that the limited supply of cryptocurrency should preserve its value, it is important to note that despite a sharp surge in supply of fiat currency, central banks of developed economies have faced the challenge of low rather than high inflation. Further, high volatility and limited supply of cryptocurrency makes it unsuitable for wider acceptance. We believe, Cryptocurrency is likely to remain an alternative asset class rather than replace the mainstream fiat currency in the medium term. Also this asset class is interacting with ever changing technological innovations, hence it will take some time for majority of the investors to understand.
This interview with R Venkataram, MD, IIFL Securities was published in The Economic Times Wealth weekly edition from March 23-28