Unless commodity prices zoom from here, inflation may not be a risk to equities, says R Venkataraman of IIFL

Market Outlook

IIFL Securities Chairman R Venkataraman believes the rapid normalisation of developed economies like the US and the UK should support India’s export sectors like IT and pharma.

While several experts are talking about inflation risk to equity from the recent rally in commodities, Venkataraman is not too worried—not unless the prices gallop from current levels.

In an interview to Moneycontrol’s Sunil Shankar Matkar, Venkataraman says the commodity sector should benefit from favourable demand-supply scenario as China may implement production cuts to meet emission targets. Edited excerpts:

Experts are worried about inflation risk given the rise in commodity prices and a probable interest rate hike in the coming quarters. Do you think the risk is real or a supportive factor for equity markets?

Our base case is that inflation in India will remain in a range around 5 percent YoY through FY22 and hence, the MPC should maintain status quo on policy rates and policy stance over next couple of meetings. Although some economists have raised concerns about a sharp rise in inflation in USA, TIPS (Treasury Inflation-Protected Securities) implies that inflation could peak at 3 percent over the next one year and then edge down to 2.5 percent YoY. Hence the worries of a sharp pickup in inflation could be exaggerated. The US Fed has, so far, not hinted at any tapering. The recent change in the US Fed mandate that allows it to tolerate inflation over 2 percent to compensate for the low inflation of the last several years also provides room to maintain the status quo. Unless the commodity prices accelerate sharply from current levels also, inflation may not be a risk to equity markets.

Will India fail to report the expected double-digit growth in FY22, given the pressure in the first quarter of FY22 and an expected third wave?

Real GDP growth was expected to grow by around 10-11 percent YoY in FY22, partly due to the low base of FY21. However, the growth estimates could edge down below 10 percent if the lockdown restrictions are not eased over the next couple of months. That said since India has experienced a very intense second wave (providing antibodies to a large share of the population) and progress on vaccination could improve with more vaccine alternatives, India may not experience a third COVID wave (or a much milder third wave).

How do you read the March quarter earnings and have you lowered your estimates for FY22?

The Q4FY21 results, so far, have painted a mixed picture. While higher commodity prices have aided the surge in profits of commodity companies, several sectors are facing input price pressure and have not been able to fully pass on the rise in raw material cost. Overall, since the beginning of Q4FY21 reporting season, we have upgraded FY21/22 Nifty EPS by 3.5 percent/around 5 percent.

Mid and smallcaps have been giving much higher returns than largecaps. Do you think they will continue to do well in the coming years as well?

The mid and smallcap stocks have continued to outperform largecaps in CY21 so far (CY21YTD NSE smallcap index is up around 29 percent, the midcap index is up around 23 percent and the Nifty is up around 9 percent). However, outperformance of this magnitude may be difficult to sustain. NSE smallcap trailing P/B (2.9x) is trading at 0.9x Nifty trailing P/B (3.2x) compared with longer term average of 0.5x and NSE Midcap trailing P/B (2.6x) is trading at 0.8x Nifty trailing P/B (3.2x) compared with longer term average of 0.7x. Further, mid and smallcap stocks are relatively more exposed to domestic demand compared to largecap stocks and hence the lockdown restrictions may have a larger impact on sales of mid and small companies compared to largecaps. But if the economy recovers, as we expect it to by FY23, the outperformance may resume, though less spectacularly.

Do you think FIIs will return to India in the coming months as coronavirus cases decline?

While the decline in COVID cases is a positive, FII flows would also depend on the government’s reform agenda. Sustaining the reform momentum and improving the execution of reforms would be important to attract FII flows. Currently, there is a risk on sentiment, supporting strong commodity prices and growth in developed markets (DMs) making prospects for exporting emerging markets (EMs) look good. FII flows should continue and India will get its share. China has been tightening on big tech, and that constitutes a third of China’s market capitalisation and that is another reason for hitherto China-focused funds to increase India allocation.

Which are the COVID-proof sectors for the coming quarters?

We believe the relatively rapid normalisation of developed economies like the US and the UK should support export sectors like IT and pharma. Commodity sectors should benefit from favourable demand-supply scenario (demand for commodities is likely to remain strong even as China may implement production cuts to meet emission targets.).

The chemicals sector also has a long runway of growth and is relatively immune to the outbreak of COVID waves in India. However, if the market catches on to there being no third wave, as we expect it to, by Q2, and also recover from shaky Q1 results (we expect them to be bad), from then on, domestic cyclicals and reopening trades should outperform. Banking, auto, industrials, etc will do well from then.

Do you think globally COVID-19 will remain a big risk for economies? What are the other risks?

COVID remains a big risk for many economies. However, the rising penetration of vaccination should help contain this risk. Also, the virulence could reduce with mutations over time. A big risk is if mutations become more virulent, in which case the existing vaccines will need to be reinvented and readministered. This will be a difficult task for large countries like India. Fatigue could also set in with vaccinations and lockdowns. Globally, inflation is also a risk with monetary policy being so loose and labour markets in US beginning to tighten (many companies from Chipotle to Mcdonald’s have raised minimum wages).

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