Investors' Money Moving To Underperforming Sectors Like IT, FMCG
If the Federal Reserve enters into a sharp rate cut cycle, it will not be good for equities in the near term, said Dhiraj Agarwal of Ambit Capital.
The Indian market is seeing a cyclical rotation as investors are moving money into sectors which had underperformed over the last two to three years, like information technology and FMCG, said Ambit Investment Managers Pvt. Managing Director Dhiraj Agarwal.
"It started with IT in June and then FMCG and now money is slowly moving into private banks," he told NDTV Profit.
The "winds of change" is triggered by favourable catalysts like government's budgetary support to consumption, earnings growth in IT companies that have beat estimates, and attractive valuation in private banks, he said. Recent domestic economic data and commentary from companies suggest an uptick in consumption.
Dhiraj Agarwal, MD at Ambit Capital (Source: Company)
However, high valuations in Indian and US equities, that have enjoyed a significant run-up in the last one year, will lead to correction, he said.
Further, if the US Federal Reserve enters into a sharp interest rate cut cycle, it will not be good for equities in the near term but make bonds more attractive. "Markets might get a sharp rate cut cycle, but might not be paired with strong economic data. It is very difficult to predict if FII flows will turn because of the rate cuts," Agarwal said.
Growth in real estate will last longer than the earlier cycle as price rises have been more gradual, which kept demand steady and inventory levels low.
"Plateauing effect might be visible for a while as focus on valuations has come back," he said.
Watch The Full Conversation Here
Here Are The Excerpts
We are closer to the big Fed event than we were. It's an interesting conundrum in that the markets may have been disappointed if growth was very strong, because then the markets would have thought that, oh, the Fed will not move on rates. Now the growth has started to shake a little bit, and therefore the markets believe the Fed will cut rates. But because growth is wobbly, or should one be worried? So, the market is finding its own reasons. I'm trying to understand, what do you think about risk assets if we are looking at a period of the next three-four-five- six months of some significant rate easing by global central bankers?
Dhiraj Agarwal: So, two things, you know, in this whole discussion, we often made valuations as a third key important variable, the third key pillar of this whole situation. We are just looking at the macro, the news fallout of the possible impact. Now, the valuations of the strong rally on which the market stands at this point of time. So, with the current valuations on which the US and India, particularly the two markets stand, and a very strong rally in the last one year, markets will find its own reason to worry a little bit and force a little bit of correction. So that is one point.
Second is it is indeed a tightrope walk. All of us like fairy tales, all of us want Goldilocks, not too hot, not too cold, but reality is often not that Goldilocks, right? So markets have been wanting a rate cut and a sharp rate cut, but they don't want an economic slowdown accompanying it. You have to be careful what you wish for, looks like markets may get their wish this time, which is a very sharp rate cut cycle, but it might come with some negative economic data which might not be very good for the markets overall.
So, what wins? I mean, because valuations have been a concern now for the last 12-18, maybe months, or everybody who has been sitting on cash are licking their wounds as well. What do you think triumphs? Do you think valuation concerns and slower growth triumphs, or do you think fund flows and a rate cut triumphs, in terms of sentiment and therefore, market staying steady or even moving higher?
Dhiraj Agarwal: So interestingly you know, sharp rate cuts are usually not good for equities in the near term. Gradual rate cuts have a mixed track record, whether they're good for equities or bad for equities. Actually, if we analyse the rate of 40-50 years, it's almost 50-50, the probability is no better than a coin toss. A sharper rate cuts, which create expectations of many more sharp rate cuts in the near future.
Logically. I mean, if you think about it, we step back. Logically, it would make bonds a lot more attractive than equities because, let's say, theoretically speaking, the market starts to believe that the US might cut rates by 200 or 250 basis points within a span of one year. Your 30-year Treasury is almost like a sitting duck in terms of where you should park your money, right?
I mean, why bother with equities risk. So, this is one of the reasons why money tends to flow out of equities and chases bonds in the near term. Second is, obviously, as you mentioned, that sharp rate cuts also sort of communicate to the market. That is, the economy is weaker than what we are reading in the data trends. Does the Fed know which we don't know, is the Fed panicking a little bit. Those concerns also surface, but the first one itself is powerful enough. I mean, that’s fairly logical.
Just one small question on that before we move to India, and which is that the belief almost is that, and you're right. I mean, I was reading, I believe, a Citi note which said that their data analysis, also like yours, seems to suggest the first one or three months, it's negative, and then it turns positive. But usually also a rate cut cycle, or a rate easing cycle, gets accompanied by changes in fund flows towards emerging markets as well. You reckon that could happen because India's weight in MSCI EM is now significantly higher. We might even eclipse Chana at some point of time. So, what happens to that part of the equation?
Dhiraj Agarwal: I honestly don't know, is the right answer on this one. We've been waiting for incremental FPI flows in the country as our weight in MSCI has been going up, and the Indian economy has been doing better, relative to certainly, the entire EM world and there's all the logic that FIIs should be increasing their weight to the country.
But contrary to that, FIIs' weight has actually come down in the last seven, eight years, from 21-22% to 18-18.5%. So that's a little bit of a mystery, I think, to some extent. So, it is very difficult to predict that FII flows will actually turn because of the rate cut cycle, let’s see.
Okay, the template for the last couple of days seems, or last maybe a week seems to have been that don't bet on defence, but bet on defensives. Starting to see the emergence of staples, maybe some of the underperforming private sector banks sporadically showing a bit of an uptick as well, and the defence, railways theme has taken a bit of a back seat. You reckon the template continues for the latter half of the year?
Dhiraj Agarwal: I think you hit the nail on the head when you said underperforming banks. So, in general, in the last two or three months, we have seen reemergence of the underperforming sectors. So, starting with IT, which was the first sector to show a very, very strong bounce. It started, perhaps in May, June itself and then we saw follow through in the FMCG, completely ignored sector for a while, and now we are beginning to see in private banks a little bit. I mean, that's still sort of struggling. It's still just a two-way, three-day phenomena. Let's see if it stretches.
But yes, that's what has been happening. Money has been moving out a little bit from the strong performing sectors into weaker performing sectors. I call it winds of change. So there is certainly cycle rotation underway in favour of sectors which have underperformed in the last two to three years, and with some amount of logical reason and catalysts. So there is a slightly higher government support to consumption in this budget. Many state governments are providing various kinds of subsidies or incentives to boost consumption.
At the bottom of the pyramid economy, we have seen a little bit of an uptick in consumer data and consumption data, even the last GDP print, also in the commentaries of most FMCG companies. So that's doing well on that end. On the IT services, a very interesting observation I made recently was that the sector X max seven earnings growth in the last quarter actually beat the analyst estimates by almost 70-80% and that's usually good news for IT services. I mean that results in order flows beginning to pick up for Indian I.T. services with one or two quarters lag. So there are some green shoots in I.T. services as well.
Private banks are purely a relative valuation game at this point of time. There's nothing wrong. Earnings have been coming in. There are no issues with NPAs. Valuations have gotten derated. Many participants in the market now find attractive value out there. So to answer any question, yes, the winds of change, I think, should last for some more time, a few quarters for sure, a few years. I don't know at this point, but maybe.
So let's start with real estate, because it's a wide economic impact sector too. What do you do with the pure play real estate players now that there has been a rally for the last 24 to 36 months?
Dhiraj Agarwal: So, the answer is purely in the time horizon. So, as you rightly pointed out, the real estate sector is doing well, one of the biggest variables, which gives me confidence that this cycle for real estate will last longer than, let's say, '92 to '94 cycle, or 2003 to 2007 cycle, because the price rises have been more moderate and gradual as compared to, let's say, 2003-2007 cycle. So, in three to seven, home prices in cities like Mumbai went up 10x in a span of four years, which obviously killed demand at the end of four or five years.
I mean it went into speculative demand, and finally killed demand. This cycle, the pricing increases are more like 10-12-14% per annum, which is more digestible, so it can last. However, in the near term, from a stock price performance point of view, the plateauing effect might be visible for some more time, because market has just started focusing back on valuations a lot more than what the market was focusing on, let's say, even four months or five months ago, and trying to see pockets of safety.
So, it has not been reflected in the index because one sector sort of struggles or corrects, but another sector comes back in the momentum like I.T. and FMCG is holding up the Index at this point of time. But there is a slight amount of risk of effect in the market, Investors are focusing more on numbers than on narratives. The focus on valuations have come back. The focus on relative safety has come back. The animal spirits have gone out a little bit. So, it could consolidate for a while more.
But one big development that happened is the passage of the Biosecure Act. Now there's a lot of talk about the impact that something like this could have for pharmaceutical companies, non-China pharmaceutical companies across the world, because the Biosecure Act seems to target some specific Chinese companies. Now, I would love to know if you've given this some thought... Any thoughts on what some moves like these could do, are these really big moves, and is Indian Pharma well poised to benefit from this or other trends?
Dhiraj Agarwal: I think it is. Pharma has been in a very strong uptrend now for a few years, and this is one sector where, despite the strong uptrend, barring a couple of pockets here and there, their valuations are not completely out of whack, right? So, valuations are still supportive. So, the whole pharma upward trend started with generics becoming a little bit more in tight supply in the US, and the price erosion for generics, which was 20-25% per annum, came down to mid-single digits.
Globally, many of the generic players, because of almost a decade of very deep price erosion, actually shut down. So there was meaningful consolidation in the sector. Indian generic players became much better positioned from a competitive advantage point of view and now the Biosecure Act, which is, the whole genesis of the Act, is that the U.S. is feeling a pinch of high drug prices and a little bit of shortage in some of the drugs as well.
So, this gives further fillip or boost to CDMO contract manufacturing, Indian Pharma players and by itself does this change the industry fundamentals around? I don't think so. But industry, which was already doing well, there was already a very, very strong reason to say that the U.S. Generic market is stabilised, price erosion is not there, and Indian companies will benefit. This is an added, I would say, lever for the new companies to do well. So, this is the one sector, which I think is a secular trend for many more years to come as well.
Dhiraj, any thoughts here, I mean, again, too early. Just happened overnight, and if not just on the current moves, but broadly on the fact that there is some recognition around what could be happening at the rural ends, or some snacks, savouries, etc, also seeing some GST cuts there. Do you think the alignment of decision making is happening with trying to boost sentiment and fortunes at the rural end currently?
Dhiraj Agarwal: But I think in general, there is a slight shift in the government policies towards focus on Consumption as well. So overall, in general, there is a slightly more awareness of the fact that the bottom of the pyramid has not been doing as well as the middle and upper end of the pyramid.
We saw that little bit of shift in the budget also, where more allocation was done to all the rural schemes and government consumption expenditure itself, as compared to the interim budget was hiked by almost 250 basis points. So overall, there is a shift, but I think no micro addition anyway.
What I was trying to understand is we have gotten the GST impact. But I'm just trying to think whether the GST changes, plus all the other things make you believe that rural consumption-led players could now be at the forefront, because they also, I mean, they are never cheap, but relative to what they've done in the past and the last 18 months, not going anywhere. Do they present that relative value currently? Let's say Staples, for example?
Dhiraj Agarwal: I think so, yes. As you rightly said they were never cheap. But if there is ample liquidity in the market, the liquidity will always try to seek areas where the marginal rate of change is moving up and move out a little bit where marginal rate of change is going down. So, in many of the capital expenditure areas, the marginal rate of change is either stagnating or moving down slightly, the absolute rate of change is still healthy and in the consumption area, the marginal rate of change is moving up. So yes, we will see that shift continue for some time more.
What about non-lending financial? I want to bring in the non-lending financials into the picture, simply because, after a really long time, life Insurance is making its presence felt on the daily screen, and we already seen that despite regulatory moves, the buying interest in let's say, for example, the wealth or the asset managers is not dwindling. Those stocks are making new highs every second and third week as well. So what about non-lending financials? Do you like that bucket and if so, what do you like and why?
Dhiraj Agarwal: I like that bucket. So, I mean, most of them are long-term structural plays on India right on financialisation of savings or increased allocation to equities, increased requirement and desire for protection, which is Insurance. So, whether that is capital marketplace insurance, those are clearly, clearly the business cycle itself is in 10-20 years of trend.
So even now, on an annual basis, this is just 4.5% of household savings go into the mutual funds. This number can easily rise to 12-14-15% before it starts to struggle. So, it's a long journey.
We all know Indians are underinsured on the protection side. Historically Indians, we consider insurance as yet another savings instrument. It's only in the last few years that we have begun to realise that it is better to consider fixed deposits or mutual funds as savings instruments and insurance protection. So these are long-term trends, and pretty much here to stay.
Now you're constructive on I.T. services, which I heard you say that or maybe, if not constructive, you at least see green shoots there. I would love to know, what do you think about the tech-enabled consumer companies or maybe they are tech companies with a consumption angle to them, but they have done really well, and the newer features are getting added, which are making the presence felt, Blinkit, in Zomato case or some other in some other cases.
Do you like this whole bucket? Even Paytm is starting to move up. So, I'm not asking you to speak about specific stocks, just trying to understand, how do you think about the tech enabled businesses?
Dhiraj Agarwal: So, tech-enabled businesses by definition, if you get the business model right and the time is large enough, your incremental revenues come at extremely high margins, right because the infrastructure is built, incremental revenues keep on boosting your margins. So, if you're in that space where the time is large, and you can keep on capturing large market shares. I mean, you mentioned Zomato and Blinkit, for example. So, without commenting on the stock value evaluation at this point of time, I mean, this is a market which will continue to grow over the next 20 years. So globally, at this point of time, and as more people order as AOVs keep going up, the margins will keep expanding.
Whereas there would be many other, let's say, consumer companies or whatever, which use digital primarily for distribution, there the whole matrix on time may not be very clear. So this whole digitally enabled services or digitally enabled businesses, and each company is so different, and each company’s target market is so different that it is very difficult to brush them all in the same brush, and also the competitive intensity, right?
I mean food delivery and groceries now are at best a three-player market. So the competitive intensity, which was very high, let's say six, seven years ago, five, seven years ago, has come down. So that also will determine how profitable you can become. If the competitive intensity or barriers to entry is very high, then it's tougher.
Where are you most worried? Aside from the fact that you are worried about valuations, because you brought up the primary point when I asked you the first question, where is it that you are most worried about?
Dhiraj Agarwal: Apart from valuations, I think the one little shock that we saw in August and then, and that almost immediately vanished at that point of time, but we should not write it off completely, is the dual impact on the entire global financial system, of the US cutting rates and Japan increasing rates. So, for the last five-six-seven years, it was very easy for the Japanese money to flow off as the yen was in a structural depreciation mode.
So, as per one data I read on Bloomberg, Japanese offshore investments for '19 to '24 expanded by almost 3 trillion yens or thereabouts, which is about 1.4-1.5 trillion US dollars. That's a huge sum of money. So as the US rates come down and Japanese rates go up, could there be a large-scale unwinding? I don't know, for the risk is high. How does it impact the global financial market stability, whether it is fixed income or equities, again, very difficult to predict at this point of time.
It's one of those things which you can't analyse and put a number to it. But I think it's a large risk which, I mean, we saw the trailer of that in Aug. 5, which was the day of the worst crash since the Black Monday of 1987 for global markets. Nikkei was down 12% in one single day, but immediately it stabilised. Doesn't mean it can't revisit at some point of time. So, I worry a little bit about that.
