Markets based on the experience of the first wave are assuming that the impact of the second wave on the economy is going to be limited and they are playing on the recovery trade. Do you think markets are getting slightly complacent?
The economy will be fine. We will have our issues but the growth will surprise. In fact, we are now saying that for FY22, the consensus real GDP growth forecast of about 9-9.5% is perhaps 200 bps lower than it needs to be and increasingly it is looking likely that FY23 growth numbers need to be bumped up meaningfully. And let me explain why I feel so strongly about this. There are two ways of forecasting; one way of forecasting is you take year-on-year growth and you say that this was my base, on this I grow 9% on that I grow 6.5-7% which is what I think most people do.
In times like these, there is significant volatility at the bottom of the pandemic, the Second Wave. The GDP in our estimate was at one point running 21% below FY20 levels and now it is rebounding very fast. It is perhaps better as a forecasting method to look at the pre pandemic path.
There was a 6-6.5% CAGR pre pandemic path which we were on even before the pandemic hit and we are below that. People generally use the year-on-year growth numbers and then measure where we are versus the pre pandemic path. I think a better methodology given all the volatility in year-on-year numbers is to start with that assumption and then see what growth you are getting.
So on that measure, before the pandemic if you apply a 6.5% kind of growth CAGR for three years, FY23 should have been a 121 or 120.56 if FY20 was 100. Current forecasts by consensus of FY23 GDP are at about 107-108 right now. I see no reason why that should not be at 114-115. We are still below the pre pandemic path and that is something that we need to worry about. But the recovery in terms of estimates and growth is likely to be far better than what is currently being expected.
In times like these, suppose you are a sector analyst or a stock analyst and you need to forecast FY23, what are you going to rely on? You are going to rely on the fact that the house economist or consensus economic growth is x and therefore let me anchor to that. This is not the case in normal years. In normal years, the differences in growth are in tens of basis points okay, if they are at 6.5% I am at 6.3% or something like that.
In these cases where FY23 GDP could be 5-6% higher than what is currently being forecast, the likelihood of earnings estimates needing to get revised is very high. FY23 Nifty EPS has already gone up from about 750-760 in September last year to 860. This is very, very rare. Generally, we are used to starting here and ending 33% lower. This time, we have seen a 10-12% increase. Therefore, if I was the policymaker, I would worry about the fact that we are below the pre pandemic path because there is spare capacity in the economy and there is a problem with jobs. But at the same time, I need to be cognisant of the fact that the numbers need to be upgraded and therefore the markets are going to be fine.
You have alluded to the fact that we are in an earnings upgrade cycle but if you have to connect that with the market cycle, what kind of market and earning cycle combination are we in?
The first thing that we need to keep in mind when you are thinking about markets is that markets are extraordinarily expensive. That is something that we have been flagging for the last eight to nine months. On PE multiple basis, the markets are at extraordinary levels, many standard deviations above normal. At a global relative basis, they are not that badly off but on an absolute basis so the markets are expecting or anticipating or pricing in a very strong earnings recovery and that is why in the 2021 outlook that we published in December we had said that for the markets to do well, we need FY2023 EPS to start moving up right.
We have no idea over the next six months, how does it make sense but that is what the market is going to be trading alright. We have seen that FY23 Nifty EPS has gone up by about 11-12%. Now the important thing is how much further can it go because FY22 EPS is up 35% over FY21 and FY23 is 20% above FY22. Does that mean that we see 1.35 x 1.2 or there is 60% growth in the market? I do not think so because the PE multiples are anticipating some of that but if FY23 EPS was to rise another 10% or even say 5-7% from here, can the market move up another 10% in the next 12 months? I think so. If you are looking at Nifty, that kind of a return is possible but to expect that because the earnings growth is that high and because the market is pricing the same, I do not think so. While individually some people may be surprised, the collective wisdom is that earnings recovery is likely to happen and some of that is priced in.
You are already starting to include some of the beneficiaries to the portfolio counting on normalisation in terms of cement or pockets with pricing power including certain industrials. How prudent would it be to include some of these pockets?
If this is our pre-pandemic path, the potential growth that we should all have expected and if we are not 10% below that, instead of 121 we are not at 107-108 but at 115-116, then the risk of industrial capex or private sector capex or for anyone to add to capacity is three years away. So, if you are 10-11% below you are almost one year behind where you needed to be and therefore the need to invest in new capacities is then pushed out. On the other hand, if you are only three-five years away, the likelihood of getting surprised — some sectors starting to do capex much faster than expected — is there.
Secondly, we assume that the government will continue to work uninterrupted even in the middle of the pandemic. Unlike some of us, it is very hard to work in the government from home. Governments are generally geared for disaster management. There are strong protocols to manage that. A 15-month period where half of the people cannot come to office is a very very hard thing to manage in the government and therefore government spending has slowed. At the central government level, many of the projects are moving along very well. The road projects are better geared up.
At the state level, the ability to issue the cheques and get the projects going has taken a back seat. As vaccinations pick up and as we become more comfortable with the opening up process, state government spending on infrastructure and some heavy industrial stuff is actually going to pick up. That is where I see the biggest upward surprise now and if even that happens obviously, loan growth is going to pick up.
So, personal loan growth has been pushing up lending for the banks for a while. It may not be prudent to start growing at 25% but there are other drivers. There are things like an account aggregator model which would start riding that. An earlier than expected revival in private sector capex and the corollary of that being that loan growth will be better. These are the reasons why our strongest overweights are in banks and in industrials.
Do you see any major near term risks to factoring in such a confident recovery?
The market has been talking about a recovery. All I am saying is that the recovery is going to be better than it is currently reflected in estimates. Everyone thinks that we will grow. We were at 93 in FY21 and in FY23, that can go up to 108. People are expecting a recovery but it can be better than expected but risks are very important. We need to be very cognisant of that. There are several risks at any point of time.
There are risks in the market. The first is global financial volatility. As of now, bond markets have been relatively calm despite the inflation prints that we have seen. Our view is because we may have assumed or understood from our downgrade of metals and my expectation that the cost will improve, we think this is going to be temporary but if the policies in the US can keep pushing up wages.
Right now, there is a big mismatch, especially in some states where the openings are far more than the unemployed people. In that scenario, if wage pressure starts coming up and bond yields suddenly start shooting up again, there can be significant market volatility and the April underperformance that India had has been more than made up in May.
Going forward, a lot of what happens to our forward price to earnings will depend on what happens to the global markets. Similarly, a lot of people believe, including our house that China is in a late cycle of growth. Now we are starting to see goods demand not just in China but in say even in the US like TV sales were down sharp you must have seen retail sales yesterday disappointed. So as the focus shifts as the spending shifts from goods back to services, hotel rates in the US are like skyrocketing levels, there is a strong recovery in airline traffic. As that starts to happen and as the world adjusts to that and the markets adjust to that I think there will be quite a bit of volatility because these are not signals which are easier to understand.
There has been a significant increase in wealth and income inequality and it will be politically tempting for many democratically elected governments to try to respond to that and if they do not, some of them will get voted out. Those policy decisions can sometimes be erroneous and so the risk of this winding down being very destabilising is very much there.
If we can hope that 12 months later the markets could be x percent higher, I do not think it will be a straight line and there are several risks and let us not forget that it is almost inevitable that there will be a Third Covid Wave. Our hope is by the time the Third Wave hits, there will be enough people with antibodies and it will be a much milder one but if it hits us much sooner than that, then we are flying blind. There is risk capital in the informal sector which people have literally consumed and we will have to see how much of a drag that will be on the economy.
We do not know how big that is going to be till we get some data so I think those are the risks and uncertainties that I see for the markets as well.
There are two signs of a bubble or a market peak; activity in the IPO market and retail participation. The retail participation globally is at record high and the IPO activity is about to start with mega issues like Paytm and others. Both the signals are now flashing red.
Yes and some of the moves that we have seen in the much less liquid small and midcaps suggest that things are starting to become quite a bit frothy. I would be careful about what we end up buying. As I said, at the headline level, we are mostly caught up with what happened before the decline in April. At the headline index level, we cannot talk about a 20-30% upside anymore. It will be a more steady state and within the market, there will be changes.
We are starting to see quite a bit of froth in penny stocks, even in the US market. In some cases, the froth is coming off and investors and speculators need to be very careful. Having said that, I do not see a catalyst for that yet because whenever the catalyst comes, some of these stocks can be down 20-30%. I would myself not dabble in them. I do not see a catalyst on the horizon in the next three to six months.
The reverses of some of the trends that have driven this kind of speculative behaviour in the market. Generally, economic momentum is strong or is peaking up and is surprising on the upside. It is almost like a side effect of a medicine. One has to be very careful about what we are buying. But as a neutral observer whenever there is an upward momentum, upgrades are possible. The frothiness in specific stocks and outright speculation is a side effect.
The number of stocks hitting a 52-week high is increasing and the number of disbelievers are also increasing.
Yes, that is in the small and midcaps. Since our focus is on the large caps, I do not really understand them that well and they can be driven by very idiosyncratic things like exceptional ordering! Right now, used car sales in the US have gone up a lot because not enough new cars are being produced and whenever the supply chains are normalised, it is possible that some small auto component company could be seeing very strong order flows and there is a great opportunity for some of them. So it tends to become very idiosyncratic when you are in the small and midcap space. It is very hard for me to comment on who will be right but yes I would be careful when we are investing in some of those names.
