There has been a big selloff in the bond market. Is it time to start getting worried about the bond market? US bond yields have gone back to their pre-COVID levels.
Yes, the bond market is obviously the biggest worry for equity investors as well. It is to be seen if the central banks globally will be able to control the bond yields but we have been expecting bond yields to move up both in India as well as globally. If US bond yields go up to 2.5%-3% by the end of this year, or 7% or so in India, that would be quite disruptive. But that does not seem likely. Also bear in mind that both the US Fed as well as well as the RBI Governor earlier this week reiterated its commitment to keep bond yields in check. We think at least for the next few months, that should be possible.
Inflation concerns are driving bond yields higher. It still remains to be seen whether this is a structural uptick in inflation or whether this is more of a transient nature. There are a lot of supply chain bottlenecks. The economy still has not been fully opened up. So, while production is there, sometimes either the ships are not available or container movement is not possible and so there is a lot of disruption in the supply chains globally. We should keep an eye on the increase in bond yields, but it is not something to be overly worried about at this stage.
Why would you say that? There are reasons to get worried about. The price of steel, cement, rubber, cocoa and orange have all gone up. When the spike comes back, it really disbalances the trade equilibrium.
Yes and which is what I said. In the short term, definitely we will see the commodity prices going up. I would worry more about oil rather than some of these other commodities as far as India is concerned. But a couple of things have to be kept in mind. Firstly as far as India is concerned, we are not in a 2013 like situation when global bond yields went up and that resulted in a big emerging market selloff. At that time, the rupee fell from about Rs 58 to Rs 68-70 or so.
This time around, the RBI going into this bond yield spike is sitting on pretty healthy reserves of almost $600 billion. We are grappling with foreign inflows and a little bit of correction is quite natural when the market has gone up about 15-16% in the last three months. I think a little bit of an increase in bond yields because of inflation worries is not really a big concern.
As far as going back to inflation is concerned, this year, we will see a bit of a rebound in the global economy ,given the very sharp decline last year. But it is too early to say that we are at the start of a multi-year uptick in inflation. The western economy was still facing a generally weak environment. Look at Europe. Even if we see demand coming back this year structurally, it is still generally expected to be quite weak.
If you extrapolate beyond this year I do not think inflation is coming back to the bank as yet but again it is too early to say. The point I am trying to make is we do not know for sure whether this is a transient uptick in inflation or a structural uptrend in inflation. Meanwhile our Indian economy definitely is improving and we have the ability to deal with a little bit of an uptick in global bond yields and some foreign sell off.
Within financials and commodities, what is looking attractive to you with an eye for returns for the year ahead?
As far as the year ahead is concerned, we like financials. This is one segment which has underperformed the market in the last one year, last six months and last three months. This is one sector which is leveraged to the economy very strongly. Most banks are leveraged plays in the economy and if you are in an environment where interest rates are going to be inching up, the banks do not necessarily do too badly because lending rates just move upwards far more quickly than the deposit rates. Deposit rates take a longer time to move up. So banks with strong liability franchise will do quite well in this environment. Plus in our view, the worst of the asset quality concerns are anyway behind us.
Lots of heavy provisioning has been done by a lot of the banks. Many private banks have raised capital and in fact, the focus in our view will shift from asset quality concerns to loan growth. In that respect, financials are probably one of the best ways to play both from a valuation perspective as well as from a growth perspective going forward.
Would you also be looking at the larger NBFCs eyeing what is happening in PSU space or would you still be sticking to the private sector names?
By and large, in banks, we like the private sector. Within the PSUs, the only stock we like is SBI, given its strong liability franchise, decent capital adequacy and some very well performing subsidiaries as well.
But as far as the NBFCs are concerned, we like some of the better quality NBFCs, especially some of the auto financiers. In the NBFC space in general, especially in a rising rate environment, you have to be a little bit careful. Our preference would still be the private banks, but we would also go for some of the top quality NBFCs.
Where do you stand on the staples and consumption segment? Thanks to commodity price inflation, there is worry if volumes are going to get impacted. These companies don’t have much bandwidth to pass on the raw material cost to the consumers.
You are absolutely right. Raw material inflation is definitely a concern for some of these companies and we expect that in the March quarter and perhaps even in the June quarter, margins will not improve further. If anything, margins may come off. But the bigger concern is – one, these stocks were fairly expensively valued at the start of this year. The other point is looking beyond just the near-term correction which may happen because of the increase in bond yields, from a slightly longer-term perspective, in an environment where the economy is recovering very strongly and expecting strong growth going forward — then one must be positioned more in the cyclicals. So even though there is some comfort in the short term, from a longer term perspective, use the dip in the market to accumulate more of the cyclical stocks rather than FMCG.
How should one capitalise on the digitisation segment? Where do you find newer avenues or opportunities?
IT services is an area we still like despite the strong run the sector had over the last one year. Globally, given the increasing adoption of digital technologies whether it is cloud services or AI or IOT, etc, the runway for IT companies is still very strong. Valuations have become expensive but we think we will see positive earnings surprises over there for the next one or two years. So IT services is one segment.
Then there are the pure play internet services companies. It is a very business model specific. I do not think we can generalise. One has to be extremely careful about the sustainability of each and every one of those business models. But the other way to think about this is that even within the non-tech related sectors, I would look at companies which are leveraging technology to improve their comparative advantages. This could be an FMCG major, it could be a company like Larsen & Toubro. These are companies which are really using technology to improve their core comparative advantages. Whether it turns into operating efficiency, reducing raw material prices and inventory levels, connecting better with their channel partners, vendors, suppliers, distributors and so on, has to be looked into.
I would not look at technology plays or internet plays just as a pure play sector. We have to look at the companies which are going to use and leverage this technology to improve their comparative advantage. Such companies will do extremely well in the long term.
The common narrative which I hear is that based on historical parameters, Indian markets are trading at a premium of about 20% to 40%. When you have bought Indian markets at this kind of PE multiple, the future returns are even flat to negative. How would you defend that?
Firstly, the headline valuations seem expensive. By our estimates, Nifty is trading at about 23 times FY22 and about 19 times FY23 earnings. That seems to be on the upper end of the range. But the key point one should keep in mind is that this in my view is a bit like 2003-2008 period, when we saw pretty significant earnings growth and earnings surprises came through petty thick and fast.
What seems like 23 times and 19 times FY22 and FY23 PE are much lower. Now how much lower, it still remains to be seen but we will see surprises over there.
The second point is look at this in the context of the interest rate environment we are in right now. Historically, we have never had interest rates so low and even one assumes that in the next 6 to 12 months, interest rates will go up 25 bps, 50 bps, 75 bps or whatever. The lower interest rate environment also justifies a slightly higher valuation premium as far as India is concerned.
The third argument is also the macro environment as far as India is concerned. If we get upsides from things like faster than expected execution as far as privatisation is concerned, even that could result in even bigger re-rating. We could see foreign investor sentiment towards India become even more positive than what it already is.
The last point is what is going on with emerging markets globally and the outlook for the dollar. It is a pretty much a consensus view that despite this increase in yields, you will see the dollar weakness sustain. You are likely to continue to see EM funds get more flows. In fact, at Kotak, almost every global EM fund we are speaking to has seen and is seeing strong EM inflows. That in turn should result in some flow coming to India as well and that should be supportive. So by and large I would not be overly worried about valuation right now but it is fair to assume that we should not be expecting the same kind of returns that we saw in the last 6 months, 12 months. The return expectations have to be a lot more moderate given the valuations we are in right now.
