The Hindu Business Line : Be aware of what the stock prices are discounting: Fidelity

If the global recovery is not as strong as is anticipated it could lead to a big sell-off across markets in the short term, feels Mr Sandeep Kothari, Equity Fund Manager, Fidelity Mutual. In an interview with Business Line Mr Kothari shares his views on the macro factors that play a key role in the markets and his views on the Indian market valuations. Excerpts:

Are you concerned that inflationary pressures would lead to a scenario of higher input costs but less pricing power for corporate?

By March, statistically, just because of a low base effect on a year-on-year basis, you are going to see a higher 5-6 per cent inflation. Is that a big cause of concern at this point and are we going to see a massive inflationary spiral, that is out of control, in the short term? Now there is a lot of debate going on as to whether the deflation is over globally because this inflation will not be just specific to India, although obviously food prices have gone up because of the deficient monsoon and this has specific implication for India; but just putting the larger picture in perspective, given the money supply, which has been created globally, the debate is whether we are going to see massive inflation or are you going to see excess capacities?

And remember even now the capacity utilisation across industries is very low when you look at the oil prices and oil demand trends right now. Steel prices have moved up but steel capacity utilisation globally is 60-65 per cent. So can inflation start to rise when the capacity utilisations are low? One may have to see demand increase and improve utilisation for that to happen.

In my opinion I am not building a massive increase in inflation in to my expectation, at least in the medium term, that is 12-15 months. It will move up by 5-7 per cent just largely as a result of statistical movements and as a result of some prices moving up. As of now, we have not seen any major increase in manufactured products because the capacity utilisations are still low. What we have seen is food inflation and inflation in a couple of other commodities.

But there are forecasts of RBI upping interest rates probably before FY10 as a result of the inflation threat? Are corporates likely to suffer?

Globally this is a big question because all the central banks have created a lot of liquidity and at some point they have to take this liquidity out slowly. So when do they start taking the liquidity out and where are we in the growth cycle is the question? If they start tightening too early, the growth may be negatively impacted and if they don’t tighten then there could be an inflationary situation.

I think the central bank will be more vigilant here but I don’t see a massive interest rate hike coming through. I think we may see some upward bias in the first half of 2010. While we have to keep these factors in mind, we also have to be aware of what the stock prices are discounting. Just to give you an example, if the banks are trading towards the higher end of the valuation band and you start to see the interest rate cycle going against you, it is an easy decision. Whereas they may already be pricing in a small increase in interest rate. So what economic cycle will play out and what is discounted in the stock price are both important.

Certain commodities have seen mini bubbles although commodity outlook has been mixed. What is your view on the potential in this space?

There are three things one has to keep in mind in commodities. First, the investment in commodities – exploration and so on – have been cut-off over the last two years (as a result of credit crisis). So there will be a supply constraint if the demand recovers significantly. Having said that, will there be a significant demand spike in the West – the US is still a large consumer at 30 per cent, although China has overtaken it. So if the global growth recovers strongly commodity prices will see a huge rally. However if global recovery is dampened, the commodities may probably not go up that much but that will be beneficial to a domestic-driven demand economy, like India, which imports commodities.

What we try to do is see what is the commodity price that the stock is discounting and what is the consensus view and then try to build our investment case around that, rather than take a call on the commodity cycle.

When we talk of a commodity demand recovery are we relying much on China’s imports?

There is no doubt that China will be a very important factor in the commodity price cycle. Chinese demand has to be strong if the commodity prices have to do well. The investment-led growth and the kind of credit creation which happened in China resulted in a very strong lead-stock cycle.

If you think of another nine-12 months, yes, China has enough surplus money to let the fixed asset investment continue. But once the Chinese bank lending slows, it will have an implication for commodities.

What are the implication of a consumer-led Chinese economy for the rest of the world?

We read a lot about China trying to move from an investment-led economy to a consumption led-economy because of the demographics and the fact that it would make the economy much more resilient.

China has been an export-driven fixed asset investment-led economy. Now it has to move to the next stage. But the switch may be a long process. It is a generational effect.

What has been, for instance, driving huge savings in China has been that there has been no major social security; healthcare has to be funded personally, so people save for these things and as a result the saving rate was very high.

Over a longer period of time the endeavour of the Chinese government is to increase consumption.

As income levels of the Chinese go up and the next generation comes and there is more job creation, consumption will pick up.

Its implications are that everybody is looking at China moving from being a surplus economy to an economy that would import more.

And instead of the US alone driving consumption, which is the case at this point in time, there will be another engine that will drive consumption. But these are all long cycles. In the next one to two years, obviously, the indications will be there but the big switch cannot happen in the short term.

Do you believe that current valuations in the Indian markets are unsustainable?

Clearly the valuations are high and a lot more hard work has to be done to find stocks. Having said that, the business cycle in India clearly looks to be gaining strength and that is a positive. But you have to keep an eye globally too. If there are any signs of nervousness in the cycle (US job data created nervousness), you are going to see lot of volatility.

What could go wrong is that if the recovery globally is not as strong as is anticipated it could lead to a big sell-off in the short term. There will be no decoupling; every market can get sold off.

This volatility will remain over the next 15-18 months. The only point that I would like to make here is if you look at March to now all the stocks went up; especially those with bad balance sheets, the lower quality companies went up much more aggressively. So now one would start thinking more on quality as the downside risk plays out.

Would you put a number to your Indian market view?

We don’t think in those terms although we also have a EPS forecast and we look at the consensus forecast. We also know that the market trades between 10 times at the absolute trough and 20-21 times at the peak and is currently trading at 15-16 times, one year forward, consensus forecast.

So the earnings cycle upgrades should continue to happen or you get that euphoric retail participation which takes the market to 20 times. We really focus on stocks and businesses rather than trying to forecast the market.

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