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    We are in a structural bull market led by new earnings cycle: Ridham Desai

    Synopsis

    Ridham Desai explains why midcap stocks are outperforming largecaps and cyclicals are outperforming defensives.

    Ridham Desai-NEW-1200ETMarkets.com
    I expect India to get massive FDI in the next four-five years and to reflect the shift away from China as a production centre and the shift into India as both viable production centre as well as a viable consumption market, says Ridham Desai, MD, Morgan Stanley.

    Now that it is firmly established that earnings recovery is round the corner and better days are coming, how would you approach this market?
    The overarching thing is that we are in a structural bull market. So I will keep emphasising that from time to time because that message should not get lost while we are trying to identify what the market may do in the short run or for the next few weeks. So it is a structural bull market, led by a new earnings cycle and the reason for the new earnings cycle is primarily because we have seen a seminal shift in government policy. This shift happened in September 2019 with the corporate tax cuts, The government is clearly pursuing a path of trying to boost profit share in GDP by which they get more capacity, more investments, more jobs, more wages and greater prosperity for the population.

    The previous path that was being pursued by successive administrations was to boost the share of wages in GDP. It did not really work because India has surplus labour and what it caused was inflation pressure and then growth slowed down. We are out of that 13-year experiment and now we are back into where we used to be in the period between 1999 and 2003. So this is the overarching theme. Now within that, we have had a very big market move. The market move is actually not that big if you look at it with a slightly longer timeframe. If you look at three year compounded annual returns or five years CAGR on the Nifty, it is actually underperforming gold compared to what it has done in the past bull markets.

    So there is a lot more leg to this market before it is done and dusted. In the meanwhile, what is happening underneath is two things; one is a clear move away from large caps into small caps. That means the Nifty struggles but the small and midcap indices do well. Then there is a clear shift within the Nifty-- away from defensives or the businesses that are less sensitive to accelerating growth-- to cyclicals, businesses that are more sensitive to accelerating growth. If you look at the weight of the Nifty, it is actually tilted towards the defensives because those are the stocks that have done well over the past decade. Now when they are giving up relative performance in favour of the stocks that have a lower weight in the index, naturally the headline index performance will not match the pace of the past few months.

    "We are a long way from the bull market top. I would not characterise these as bubble level valuations simply because the earnings are very depressed."

    — Ridham Desai


    That pace will slow down as the rotation happens and as new leadership emerges. After a break and it maybe a consolidation or maybe in the near term a correction in the Nifty, there would be another move up but we are a long way from the bull market top. Within that, investors who want to trade this market can look at it slightly differently.

    How does one figure out that while earnings will surprise us, the market is pricing in the template which you just mentioned?
    The challenge here is that everybody cites the PE ratio. Now I would argue that earnings are very depressed versus potential, not only because of Covid but because of 10 years of below par or sub trend growth that India has had. If earnings are depressed, then price to earnings may appear to be elevated more than actually it is. If you normalise earnings, then the market is not so rich on price to earnings. Normalised earnings for this economy may be almost double of what it is currently. So the PE ratio may almost be half of what it is currently and that is the first point to note.

    The second is default to metrics that are less sensitive to earnings like price to book. But even book values are probably depressed because earnings were depressed. There has been less accumulation of earnings over the past few years. Nevertheless, it at least offsets the challenge of using PE as a valuation ratio. The other metric that could be used is market cap to GDP. The problem is that GDP went through a big shock in the trailing 12 months and it is also depressed. GDP growth of the last 10 years may have been subpar and so GDP is also depressed.

    The problem here for lay observers is that the market is a forward looking animal, it is looking at what will happen in one, two or three years from now and if things are going to be a whole lot better, then the valuations are not going to be as challenging as they look today on a headline basis and one will realise this in hindsight. It reminds of the 2004-2007 cycle. In 2003, the Sensex started at somewhere around 2800 and by the following January, it was already at 4,500-4,600. It had almost doubled in 12 months and it continued to look more and more expensive but we got such a ferocious earnings cycle. Nifty earnings compounded at over 25% per year for four years on the trot. The market valuations looked rich and took to bubble levels and at the start of 2008, were at a level to break the market’s back. I do not think we are there right now in terms of valuations. So, I would not characterise these as bubble level valuations simply because the earnings are very depressed.

    The general belief in the market was or is that interest rates will remain low and an uptick in bond yields could ensure that a) liquidity will not come and b) repricing of equities. But in your February 23 report, you have shown how it is the other way around. Let us discuss that.
    What matters with rates is how growth is fairing relative to rates and here we are referring to long-term interest rates and not the short-term rates. When long-term interest rates are rising, we have to make a judgement whether growth will rise faster or not. I dare say right now, we are in a cycle where growth is likely to rise faster than long-term interest rates. So far as that is the case, equities actually do well.

    Again I will cite the 2004-2007 example. Very briefly between 2009 and 2010 or in the mid 1990s, there was uptick in long-term interest rates. It largely reflected the bond markets optimism on future growth. Growth was rising faster than rates and therefore the markets were doing fine. At any point in time when growth slows down relative to interest rates, that is bad for equities for all the reasons that you cited. That is the template for understanding interest rates.

    Now also bear in mind that there is a global scenario here and we have to keep that in mind. India is amongst the a) 7 or 8 largest stock markets in the world. It is not a midcap stock in the world global stock market scene. It will be sensitive to what happens in other large markets and what happens in the US is very important. We must not forget that in response to Covid, global central banks from the US all the way to Japan have responded in an unprecedented fashion. The amount of liquidity that has been put out there is almost four times more than that was put in response to the Global Financial Crisis.

    Now I would characterise the Global Financial Crisis as a crisis which triggered a recession which came from economic excesses and therefore required a very big policy response. The recession that we got last year was triggered by an external agent which we did not understand. We probably still do not understand it well enough and therefore in response, we got a stimulus on a scale that has ever happened in the history of the world. Even during World War II, we did not see such synchronous response from central banks and governments. So keep that as a backdrop. Whenever that view changes, it will produce a volatile movement in the market and that will be quite vicious for stocks.

    At any point in time, if the US stock markets start believing that the Fed has fallen behind the curve and that inflation is now ahead of the Fed, it will produce a very big sharp correction in stocks that we could see a 25% fall in stocks very quickly. We saw shades of that in February but we have not got to that point where the market has started believing that the Fed is behind the curve.

    The final point on long term interest rates is that this dovetails into the underlying structure change in the market. Stocks of companies that can grow their earnings faster than the rise in interest rates, are the ones that are going to do well. We typically group them into a bunch called cyclicals. That is why cyclicals do well because cyclicals can grow earnings faster than the rise in interest rates when the economic cycle turns. This is all very fundamental. There is no magic in this. The underlying structure change is happening within the Nifty. Likewise smaller firms tend to have greater leverage to the economy and therefore can grow their earnings faster than larger firms when the cycle is turning up. Therefore stocks of those smaller firms will do well and that will explain why mid is outperforming large cap and why cyclicals are outperforming defensives.

    Corporates are using the terms highest-ever margins, highest-ever sales, highest-ever demand. Strategists are making a bullish picture for India for next 2-3 years. HNI investors like Rakesh Jhunjhunwala and Radhakishan Damani are fully invested. Do next 3-5 years belong to India at a global level? Is this our moment?
    There is a global trend which is now apparent to most people that is swinging in India’s favour and it is what we call as the multipolar world. For almost three decades, the world was in a bipolar situation where almost all production was concentrated in China and almost all consumption was in the US and everybody else was a side player. From a bipolar world, we are moving into a multipolar world. So the consumption centres are dispersing and the production centre is also dispersing. Now India is sitting at that very sweet spot where it offers an incoming business, the opportunity to access a large market and the potential to set up production.

    The government has very smartly detected this and has therefore launched the production linked incentive schemes and has forcefully cut corporate tax rates. This is the reason why corporations around the world will be looking at India very closely and I hope I do not go wrong on this but I think India will get massive FDI in the next four-five years to reflect this shift away from China as a production centre and the shift into India as both viable production centre as well as a viable consumption market.

    India is still very small. It is only a $2,000 per capita income. It is one-sixth the size of China in per capita income. It is one-fifteen the size of the US but I guess in the next 10 years it will become a whole lot larger and that is the opportunity that businesses want. I feel India will be a very pertinent point of discussion in board rooms and there will be serious thought about shifting production. This has not happened so clearly in the past because India has not been an easy place to do business in and some of that pain of doing business is being offset by these hard monetary incentives that the government has thrown at businesses.

    So we may be at a very big inflection point in terms of wealth creation. We are not likely to become larger than China or the US any time soon. That is going to take several years if not decades, but we will become more important and that is already happening.



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    (What's moving Sensex and Nifty Track latest market news, stock tips, Budget 2024 and expert advice, on ETMarkets. Also, ETMarkets.com is now on Telegram. For fastest news alerts on financial markets, investment strategies and stocks alerts, subscribe to our Telegram feeds .)

    Subscribe to The Economic Times Prime and read the Economic Times ePaper Online.and Sensex Today.

    Top Trending Stocks: SBI Share Price, Axis Bank Share Price, HDFC Bank Share Price, Infosys Share Price, Wipro Share Price, NTPC Share Price

    ...more
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