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Financials to be big beneficiary of economic revival: Ashwini Agarwal

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Financials to be big beneficiary of economic revival: Ashwini Agarwal 2

“Domestic cyclicals, construction, realty to do well”, says Ashwini Agarwal, Co-founder, Ashmore Investment

A compulsive bull like you would always try to call it a minor adjustment but looking at what is happening to crude and how metal prices have gone higher and how bond yields have sold off in the US, are we in a spot of bother now?
I do not think so. We may see a correction in the broad market simply because we have had such a strong run without any meaningful correction all the way from May 2020 till now. It is possible that the correction continues purely because it needs a breather. I am not worried that the rising oil price or rising metal prices can play a significant spoilsport to the earnings forecast that we see going ahead. First of all, just to put it in perspective, oil is pretty much at the same level it was pre Covid, It did go down during Covid times and it has come back to nearly the same level.

In material prices also, while there is some amount of dislocation in the short run which is getting priced in by metal prices as economies come back to normal in a post Covid world and production restarts, we expect some softening in material prices going ahead. I do not see this necessarily as a spot of bother.

In the US, bond yields have risen quite significantly over the last six months. They bottomed out in July 2020 and are now trading at 1.35-1.38, just under a shade of 1.40. The crucial thing to remember is that prior to Covid, the long bond yields in the US were around 2%. We are very far from there. There is no chatter at the end of the Fed to taper its programmes. So, I do not think that the increases in bond yields are going to be runaway increases but yes, they can go up to pre Covid levels as inflationary expectations take root in the US. Does it mean that it will be as disruptive for the markets as it was in 2013? I do not think so because you are really going back to where you were pre Covid.

While we have seen a remarkable comeback in consumption whether it is autos or white goods or economy-related sectors, at what point in time, would markets say high risk of inflation, high metal prices could hurt us? Are you worried?
It is my experience that the future expectations of growth, future expectations of what is going on in the economy determine the patterns of consumption and determine aggregate demand much more than interest rates in the Indian context or even inflation. On the contrary, if inflation is moderate, it is positive for both corporate earnings as well as consumer demand because at the end of the day, some amount of inflation gives you the pricing power and the ability to offset the cost of borrowing.

At this point, I am not worried. What would worry me is if the government execution falls short on the big promises that the government has made via the Budget. That to me is the real thing that we need to watch because the government has laid a very ambitious programme and if it is able to deliver on it, then for the next 3-5 years, we could see a growth trajectory which is very different from what we have seen in the last 10 years.

In that environment even if we have a little bit of inflation, even if we have some compression of margins in the short run till companies adjust their product prices, the market will take it in its stride. So the key driver for the market going ahead is going to be very different. I am not so worried about input costs as things stand right now.

Let us assume that the government is able to deliver 75% to 80% of what they have indicated. What happens to the market and to the economy next then?
Six months ago none of us could have expected that earnings for fiscal 21 and fiscal 22 will look the way they are looking. Even now there is a significant amount of cautiousness when it comes to the health of the financial sector. If the government is actually able to deliver on 75-80% of its programme like you say, there is going to be a renewed confidence in the health of the Indian economy., the health of the financial system and that to me is going to be a huge positive.

Investments are going to restart in a big way if the government delivers on its programmes. We will see new assets go into the ground and foreign investors putting fresh money into India in long-term projects. PLI is a game changer. Lots of things are happening and in the short run it is very difficult to determine how much the market will overreact to these signs of positivity or under-react to that. But suffice to say that if the government delivers 75-80% of its programme like you said, then the earnings for FY23 or FY24 will turn out to be a lot stronger than what is currently implied in the stock prices.

Has there already been a substantial shift towards cyclicals or is it still in the works? Where are we at in terms of creating an ideal portfolio mix given that we are in the midst of this recovery right now?
In the middle of last year when we were looking at a fairly uncertain environment, we had moved our portfolio significantly towards exports, towards market leadership and stocks with a lot of other defensive characteristics. That played out quite well through to the end of CY2020. Sometime in the last quarter of the last calendar year, we started moving significantly into financials and these continue to remain fairly attractively valued especially if you consider that if the economy actually grows faster than what is anticipated and the government is able to deliver on a large part of its design, then we will probably see much lower NPLs in the financial system than what the Street is fearing.

My view is that financials have to be a significant beneficiary of what is going on and I do not think the recovery in stocks prices this recovery in. Coming to cyclicals like materials, we tend to be a little more circumspect about it because there are lots of global drivers for materials including what is going on in China, what is happening to production elsewhere in the world and so on. I have learnt that I am in no position to predict where material prices go so I am not a huge supporter of that theme simply because I do not understand it. I am not saying it is good or bad.

Coming to other domestic cyclicals — both industrials and construction activity will see a pick up. Real estate should also do well. The shifts to the domestic economy is not over yet, at least in investors’ portfolios. I still find a lot of stocks quite attractively valued, considering the optimistic outlook in the last two or three months.

You have been favourably disposed in the past to the IT majors. Do you see a little bit of a shift now as they are slightly more expensive?
One very interesting observation is that soon after the Global Financial Crisis of 2008-2009, all the IT stocks rallied hard and after that there were some winners and some losers. Today, something similar has happened. All the IT stocks had come back because these are fairly defensive with good earnings. But going forward, there is going to be a differentiation because valuations are no longer very cheap.

Now, we have to bet on companies that will deliver earnings which are much better than what is already implied into stock prices. If you look at PE ratios on a historical basis, you will find that most IT services companies are trading well above one standard deviation away from a long term median which indicates that even if you assume a very strong recovery in earnings over the next two years, the stocks are reasonably valued.

So from here, one will need excellent execution or a much better than expected delivery from an IT services stock for it to be able to outperform. That is a challenge. We continue to own some IT services names and we really like them and the debate in our head is do we go with new ideas more aligned with the domestic economy or do we continue to run with them because the earnings trajectory is looking quite robust as things stand? So we had shifted some. We have not shifted entirely but valuations are looking toppy. So, earnings surprise is going to be the key for individual stocks that deliver in the IT services space.

Do you think this year could be what we saw back in 2003-2007 when equities continued to rise irrespective of rising interest rates? Could this be a year of that aberration?
What you are really worried about is inflation driving up rates and inflation getting into corporate earnings. So, let us take the two separately. Coming to inflation driving up interest rates, I do not think that is going to happen in the current year. RBI is being very vocal about it and we are getting similar noises from central bankers all over the world. Everybody wants to put Covid-19 in the rear view mirror before anybody takes any step towards raising rates.

On the other hand, the real rates are now in the region of about a percent, and if you plot real rates over the last 15-20 years, this is probably the lowest that we have seen for quite a while barring may be a small period towards the early part of you the previous full cycle. To me, the real interest rate is the real thing to monitor because low real interest rates encourage investment activity, encourage people to borrow and to put new assets into the ground. High real interest rates discourage that activity so that is a very big positive in my view.

Second, there is apprehension about inflation eating into corporate margins. I would reiterate that this is just the back to normal trade. Crude at the end of the day is back to pre-Covid levels it is not at a $100 or a $120 where it got to post GFC which was seriously debilitating. Inflation at $60-62 is manageable and moderate inflation actually is positive for corporate earnings and not negative. It is something that the consumers can absorb.

It is only when inflation gets to 9-10% that it starts to become a serious problem where inflationary expectations start to get entrenched and wages tend to go out of sync and companies are not able to pass on the cost increases. A 5-6% inflation on the consumer side and 2-3% on the wholesale side is quite positive for corporate earnings in the medium term. Quarter to quarter, you might see some aberrations because there is always a lag effect of cost increases versus price increases. There might be a little bit of a wobble in some corporate earnings for the March quarter but in the medium term, a moderate inflation is positive for corporate earnings.

If the big worry is whether or not high commodity prices would eat up margins, should an investor tactically reduce exposure or maybe avoid staples for now?
For a long period of time, as value investors, staples never really appealed to us. I have been out of them for a long time and we paid a heavy price for that stance. I cannot say anything beyond that.

Later this year, a lot of exciting internet or the new age companies will go public. It could be Zomato, policybazaar, Delhivery. How excited are you?
India has very few new age listings and the scarcity premium and what is going on on Nasdaq prompted investors to pile into the few names that were available and those stocks have done exceedingly well. Some of these companies could get much bigger in size over the next five years or seven years. So I am very excited that we will have new listings to look at and despite a value bias I would be lying if I said that we will not invest in any of them for the simple reason that value can be sought even in highly priced or high PE numbers if there is a long runway to growth.

The only risk is that if the US markets were to take a tumble for reasons I cannot predict, then some of that rub-off effect that we have seen might be missing. But these are great businesses and they have a great future ahead of them. So selectively, I am quite excited and hoping to invest in some of them as things go along.

Organised retail is one sector where valuations and disruptions are highest. , Tatas, D-Mart all are trying to compete and valuations are rich, what are markets telling you?
I think the secret to that lies in the very large unorganised space that is going to yield ground to the formal space. That is an inevitable trend. We all talk about this K-shaped recovery. It is a fact that large listed organised players are gaining ground over the small unorganised ones and nowhere is the opportunity bigger than in retail and that is what the Street is trying to tell us. So intuitively valuations look expensive but there is so much ground for growth and there is so much room to take market share away from small unorganised players that I may be wrong in calling them too expensive. The runway of growth is so long and so big that there can be multiple players that can survive side by side.

Some of this unorganised to organised shift might happen online, some might happen offline. Most of the retail chains that you mentioned are creating a very formidable online presence as well. So, it is not very clear whether they will lose the entire online business to a third party or an aggregator. Some of it will come to them. We are in a very interesting space there.

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