Nilesh Shah: 2 themes to balance risk and return in this market:

The first theme relates to rupee depreciation and the opportunity for export-related and import-substitution 66441007 66431356 66426272 companies and sectors. The second theme is a game-changer of sorts, arising out of US-China trade war as China starts losing it premier manufacturing hub spot, Nilesh Shah, MD, Kotak AMC, tells ET Now.Edited excerpts: How should the market read into the so-called standoff between RBI and the government? Should markets get nervous or is this is something that has happened in the past also and we should move on?In the past also there has been differences of opinion between RBI and the government. But clearly, they have been managed behind closed doors rather than being out in the open. Clearly, we need magnanimity from both sides. There will always be difference of opinion between central bank and the government. If we look at the US economy, President Trump has been going berserk about Jerome Powell, about how he is raising interest rates earlier than necessary. There is traction between the central bank and the government all over the world but these matters are better resolved through consultations behind closed doors.What are you trying to imply – get nervous or not?I am not really sure because clearly the market has discounted whatever is there in the public domain and lot will depend on how events shape up. It is quite possible that like in the past, RBI and the government will sit across the table and resolve their differences. In that case, the market has no reason to be nervous. On the other hand, reverse could also happen and then there is all the reasons for market to be nervous. This is a binary event. We just hope and pray that it will settle like it has always get settled in the past.The market seems to have put on the back-burner the fact that crude has declined to a two-month low. Brent is at $75-76 levels. Why is the market ignoring the fact that there has been such a significant cool off?It is not that the market has not taken into account the crude price drop but the fact remains that the September 18 quarterly result numbers have come a little bit subdued than market’s expectation. Of course, a few companies have delivered beyond-expectation results, but they are far and few between. Majority of companies have delivered around or slightly below expectation results. Probably, it is the subdued results of September 18 quarter that is impacting the market, making it ignore the crude price drop.Are global markets going to correct because the sneezing and the coughing have just about started there?Over last one year, India was caught in a perfect storm. Oil prices went up from $55 to $75 and that movement prompted rupee to depreciate because it had been appreciating between 2013 and 2017. The depreciating rupee prompted RBI to sell dollar and that took away rupee liquidity in banking system, raising short-term interest rates. It probably resulted in an IL&FS kind of credit event and finally a sum of all that was reflected into the stock market where the smallcap index is down almost 40% plus from the top. The good news is that majority of the bad news has been in the prices. Rupee’s over-valuations have been corrected to a great extent. After rising relentlessly, interest rates have started coming down with RBI’s open market operations (OMO). RBI is pushing liquidity through open market operations and LCR relaxations. The oil prices have also softened a little bit. Putting all these things together, a lot of bad news is already reflected in the prices. The valuation of the stock market which was at a premium to its 10-year historical price to book, is now at a discount or at around fair value. The small cap index was at about 33% premium to its 10-year historical price to book average in January 2018. Today it is at 10% discount. The largecap was at 10% premium, today it is at 4% discount. Valuations have come down from premium to around fair value and a little below fair value for largecaps as well as smallcaps. Going forward, markets will be impacted by two things – one, trajectory of oil and second election. If oil goes to $100 a barrel, certainly there will be a downside to the market. If election produces a coalition government, then there could be downside from the market. On the other hand, if we get a little lucky with oil and get a stable government, then there is upside from the market. So oil and election to a great extent will be driver for the market in the next six to eight months. What would be the portfolio setup at the current juncture? Would one be aligned towards being more defensive? How would you balance between risk and return?Rupee depreciation has been advantageous for companies which are exporting goods and services from India as well as those companies which were facing unfair import dumping from China. So, this is one theme; great opportunity for export-related or import-substitution companies and sectors. The second thing which is happening is an opportunity of our life time. It is related to supply chain disruption being caused by US imposing huge amount of tariff on variety of goods from China. The inorganic chemical industry is showing volume growth of about 40% year-on-year quarter for last three quarters. This is happening because a), rupee depreciation has given some breathing space to inorganic chemical manufactures and b), China has been moving away from that market and that is allowing Indian companies to capture export orders. This kind of supply chain disruption is occurring in various other parts as well. Last week, The Economist published an article on how supply chain disruption is moving manufacturing from China to other countries. Footwear is going to Cambodia. Food processing is going to Vietnam. Electronics is going to Malaysia and Thailand. Computers are going to Taiwan. Clothing is going to Bangladesh. Now clearly this is our opportunity. We have the ability to make footwear, clothing, computers, electronics and other items. If we can take away that manufacturing base from China, there will be a huge opportunity. We have seen a big crowded trade in FAANG stocks reversing. Facebook, Amazon, Alphabet, Netflix is where bulk of the global stock market and ETF concentration is. Some of these stocks have corrected 10-15%. What will be the implications of this reversal in trade and could that impact emerging markets a bit more?When I was in the US, one question which came up between the lines was why should they invest in emerging markets? Over a 5, 10, 15, 20, 30 years, American markets have delivered better returns than emerging markets. Frankly speaking, I was running out of answers because for American investors it made sense to invest in American market rather than emerging market. US markets have outperformed virtually all emerging markets. A large part of outperformance has come because of FAANGs and when these stocks start coming down, then that will be a reason for investors to diversify away from US markets into emerging markets. It is extremely important for emerging markets’ sake that American stock market and emerging markets stock market return differential reverses where emerging markets starts outperforming American market for attracting American capital. The second thing which will happen with FAANG stocks’ correction is that it will allow other companies, other sectors to go up in terms of valuation. A lot of money was chasing FAANG stocks because many people were underweight these on stocks and that resulted into capital pulling out of many other sectors many other companies. We do expect a reasonable distribution of capital across non technology, non FAANG stocks now. But again, the correction in FAANG stocks would be short lived. The world has changed and that change has been brought by these FAANG stocks. Also, we are not going into 2000 kind of scenario where many dotcom websites and dotcom companies disappeared. There will be price correction but these companies will continue to exist and prosper.One thing that could challenge the market optimism is because of a crunch in liquidity, credit offtake may start slowing down, consumer spending will start slowing down and that could challenge FY19 and FY20 estimates?Undoubtedly, that is the big risk being faced by Indian market and Indian economy. Last year, we had seen one-third of the credit coming from public sector banks, majority from non PCA banks, one-third of the credit came from private sector banks and one-third from NBFCs. Today, the PCA banks are not able to lend credit. The private sector banks and non PCA PSU banks will continue to lend credit but they will have a limitation. The entire NBFC sector, which was funding credit to real estate sector and to small and medium enterprises, is slowing down and coming to a grinding halt in some cases. If we do not provide adequate credit to the economy, undoubtedly there will be impact on the GDP growth and corporate earnings. We were talking to a few electronics distributors in Mumbai and they are saying there is a reasonable amount of slowdown in footfalls as well as sales primarily because many NBFCs are not in a position to provide consumer durable financing. Now when NBFCs step out of consumer financing, the banks can step into automobile financing and they have the requisite expertise to provide financing for two-wheelers, four-wheelers and commercial vehicles but they really do not have expertise to provide financing for washing machines and television and refrigerators. That space was the exclusive domain of many of the NBFCs and there is a slowdown coming and that slowdown will be reflected into consumer durables. So, it is extremely important that we check the boxes. One, there should be systematic liquidity. Liquidity cannot be negative so that there is capital available to everyone. Second, that capital should be available at appropriate cost. Today we have slightly higher real interest rates. It needs to be normalised. And fortunately, we have seen some reversal in the 10-year yield from 8.25 to 7.90. Third, there should be transmission of that liquidity at appropriate rates to the needy sector. Now PCA banks are out of the system from a lending point of view and so NBFCs have to take the load and there should be transmission of liquidity at appropriate rates to the NBFC sector, so that the economy continues to get the credit which is so necessary for the growth.Three months from now, what could we be staring at?We just need to be lucky and sensible. If we are lucky in oil and we are sensible in voting, Nifty will be higher than current level. If we are unlucky about oil and we are not voting sensibly, then Nifty will be lower than current levels.What is sensible voting?It is all about a stable government. Before I close, I just want to take the liberty of pointing out one thing; this is related to MSCI emerging market indices. India’s weight in MSCI emerging market indices is about 8%, China’s weight is about 28%. Most of the investors I met expressed concern as to how their portfolios are going to get impacted as China’s weight in MSCI emerging market indices will increase from almost 28% to more than 50%. Their doubling of weight will result into lowering of India’s weight. Today majority of investors are overweight India and from being overweight they will become extremely overweight as our weight reduces. Majority of investors are underweight China and they will become extremely underweight China as China’s weight doubles. This will have serious implications about FII allocations to India as well as to their existing holding in India. We must engage with investors to engage with MSCI that they should not make MSCI emerging market indices MSCI China indices and other emerging markets. It should retain its diversified nature. It should give fair representation to Indian equities. Today many of our large companies like HDFC Bank, many PSUs, IndusInd Bank, Kotak Bank are not part of the MSCI emerging market indices and we must engage with investors to ensure that when China’s weight increases, our weight does not reduce correspondingly. That is going to ensure that FIIs’ allocations to India remain stable. Otherwise, we could see a dramatic reversal in FII allocation as well as selling from their existing holding.

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