The Indian banking system has witnessed quite some events in the last 5-6 months including the exposure of frauds as well as developments in the resolution process of NPAs under NCLT.
The new NPA recognition norms would make the banks reluctant to issue loans. The fact that Rs 50 crore and above NPAs can be investigated for fraud will be a deterrent, said Neelkanth Mishra, MD of the Credit Suisse.
"Therefore, if two-third of the banking system is reluctant to lend, it would naturally impact growth of the economy", said Mishra.
He further said that it was unlikely that there will be sharp corrections in the market but with all the uncertainties, it was unlikely to outperform.
Talking about their model portfolio, he said they had a constructive outlook on select NBFCs but valuation was a key concern.
He also expected a 10-15 percent growth for IT stocks.
Talking about the concerns for the economy and market, he said, "One, the aggregate government spending is likely to slow down to 10 percent in FY19 from 14 percent in FY18. Two, there is perceived change in possible outcomes of next general elections and as that political uncertainty pickups later in the year, it could be an overhang on market."
He also mentioned that the agricultural income growth was weak leading to slowdown in consumption.
Mishra stated that it would be wrong to expect a strong GDP growth in FY19 than we are seeing right now.
Neelkanth Mishra Managing Director and India Equity Strategist Credit Suisse
Below is the verbatim transcript of the interview. Latha: I noticed that the view you have of India, is also something which is fraught with a little bit of problems. You think that the state of the banking system is going to make growth hard to come by?
A: What has happened over the past five-six weeks, has been quite worrying. So what has happened is, the non-performing asset (NPA) recognition issue has been changed, so, all the alphabet soup of scheme for sustainable structuring of stressed assets (S4A), strategic debt restructuring (SDR), etc. has been replaced with just insolvency and bankruptcy code (IBC). What this does is, it brings forward a lot of the lost recognition, and so, this erodes capital for the banking system. The bond yield increases that we have seen have also eroded capital for the banking system.
In addition, the change that Rs 50 crore and above NPAs can be investigated for fraud, means that there can be significant reluctance among the bankers, especially the PSU banks, to issue new loans. Now if two-thirds of your banking system is reluctant to issue new loans, then there is no way that the economy can accelerate. Plus, the concern is that the bond yields have stayed higher for too long and that the longer they stay at these elevated levels, the more the drag on the economy.
There are a couple of other concerns, the first is that the aggregate government spending growth, is likely to slow down from about 14 percent in FY18 to about 10 percent in FY19. The second concern is that there is at least perceived change in the possible outcomes of the next general election and as that political uncertainty picks up, as the state elections play out in the rest of the year, I think that can also create some overhang on the market.
This is in addition to all the distortions that we have been observing that the agricultural income growth is weak, so nearly half the economy cannot consume, that the private sector investment cycle is not picking up, it is picking up in pockets, but not a very broad-based recovery. Lastly, in the last two months we have become very concerned about the rupee being among the weakest currencies in the world and possibly this weakness would last.
Latha: Much in what you say, but just a little earlier, we interviewed Uday Kotak and his point is that the non PSU banking and NBFC space has got enough money and the clout to lend. As well separately we have been picking up from say Bharat Forge, Larsen and Toubro (L&T) all those road guys that actually the order cycle is picking up. So, you don't think that there are enough growth drivers to counter the negatives you are speaking?
A: Let us put the current growth numbers in perspective. So December quarter growth was 7.2 percent. The 25 year CAGR growth in India, GDP growth, is 7 percent, and five years CAGR is also something similar. So 7-7.2 percent is actually not very exciting growth. Now what we are saying is not that we see a growth collapse, but what we are saying is that a consensus view that growth continues on its upward momentum, that it accelerates from here to 7-7.5 percent, is unlikely to happen. So, very likely the peak in GDP growth or the growth acceleration is now already behind us. It is wrong to expect that we can see stronger GDP growth in FY19 than we are seeing right now.
I fully agree, I think private sector banks and the non-banking finance companies will benefit. So that is why in our recent model portfolio changes we had gone neutral rate on private banks in October last year when we thought that PSU banks would have growth capital and therefore margins would come down. However, now we have partly reversed that trade, we have now again gone overweight on private banks because they are going to benefit from this lull.
However, remember that there is a decision-making freeze, this is not just about activities or rather it is not just about availability of capital, it also about the willingness to take decisions. If all the problem loans beyond six months going to get thrown into the insolvency procedures, I think that is a bit too harsh because there can be wrong business cycle decisions, and that kind of reluctance, it is very hard to offset by just saying okay now capital is available.
Nimesh: You know India has relatively underperformed since the beginning of 2018. What are you picking up when you talk to your clients at the conference?
A: Sentiment by and large here seems to be quite cautious on India, that there is something wrong and that is the issue. The currency is looking a bit wobbly, the bond yields have spiked, the term premium -- if you were an observer and I have stated this now for the last several months, if you were an observer of the Indian economy and if the bond yields and the term premium was the only thing you were looking at, you would say that there is a crisis brewing in the economy, that there is something seriously wrong.
I don't think there is anything seriously wrong, there are growth impediments, there are headwinds that have emerged, but the point is if you were looking at the bond yield, you would say my god, there must be something wrong. There has to be some response, there has to be some way that this unintended monetary tightening is reversed. So the mood here is cautious, there are concerns emerging and all the news flow around the political developments, the concerns around the fact that there is uncertainty on how banking system profitability may emerge over the next 12 months all of these are issues.
Latha: Just to continue with what Nimesh is asking, therefore for the next 12 to 18 months you are not just expecting a fall in multiples, but also a fall in earnings or rather a slower earnings growth?
A: The P/E multiple premium that MSCI India enjoys over MSCI World, is about 17 percent right now. Slightly at the higher end of the band it has been in the last eight years, but it's not really out of band or egregiously expensive. So you can spin an argument about a 5 percent drop in the P/E multiple to make it the average of the last eight years, but it is neither here or there.
On the earnings, what has been remarkable in the September and December quarters, is that we have not seen any meaningful cuts in FY18 and FY19 earnings and as a result, as we move forward, as we roll forward six months, the one year forward EPS for Nifty and the BSE 100 is already up 10 percent in the last six months. I suspect if the banking system NPA issue does not really lead to a sharp cut in earnings in the March quarter, in the June quarter, it is quite possible that this roll forward benefit continues to happen.
So I would hate to be very bearish on the market; unless the global markets really tank or some really serious volatility comes because of this trade war, one of the key issues that is being discussed here and I am sure in media all over the world is a trade battle, a battle of tariffs between China and the US and how that plays out and the uncertainty it throws up. So unless something really serious happens globally, I don't see a very sharp correction in the Indian market. However, the thing is, with all of these uncertainties, it is very hard to see it outperforming.
Nimesh: Given that you don't expect a sharp fall for Indian equities, I want to focus a bit on your model portfolio and some micro questions as well. You have been massively underweight on NBFCs and you have very largely shifted from PSU banks to private banks in the model portfolio barring for State Bank of India (SBI). Take us through the rationale behind being underweight on NBFCs and not looking at anything beyond SBI in the PSU bank space.
A: On NBFCs, the key concern is valuations. I fully acknowledge that with the PSU banks becoming short of capital again and actually being reluctant to lend, the prospects for growth for the NBFCs are quite strong and therefore we are also quite constructive in our earnings forecasts on some of these companies. What I worry about is valuations and for some of them I think keeping growth at 30-40 percent a year is actually going to be very hard to do without meaningfully raising risks. As some of these firms become larger given that they are primarily wholesale funded, there is a risk of liquidity, the propensity to keep growing their book is something that leads to a lot of risk build-up. So that is our concern.
Within NBFCs also there are a few names that we have published that we are overweight on. In fact in the last six months, the sector that has given us most outperformance over benchmark in our model portfolio has been NBFCs because we were long a name which did very well and short a name which did not do very well. So we are not slamming down the whole of the sector, but I think there are only a few names that we like.
On PSU banks, I think the concern is of course the valuation gap with private banks has again widened to near record levels and therefore there is a temptation that you bottom fish, but I don't see anything structural changing. The reason why we even added to weights on PSU banks in October was that there was at least growth capital coming in and there was a prospect of sort of digging themselves out of a vicious cycle of falling capital and therefore falling incomes and stable cost and therefore again bigger and bigger losses. However, I don't see that cycle ending as of now. So we would stay away from there.
Latha: Sakthi Siva told us that you are positive on IT and metals. Anything else that is attractive now, especially I mean construction since we hear of so many road orders?
A: Industrials is something that we are positive on, construction in particular. Construction is something that we have liked since I would say late 2016 when we shifted weights from consumer staples to some of the construction names because order momentum, construction activity did pick up. At least selectively in some of the sectors, capex is reviving. So steel finally, it was unthinkable two years back, but you know there is already 10 million tonne of new capacity announced. It is possible that in the next one to one and a half years you see another 10-15 million tonne of capacity announced and it would be necessary for India.
There is stuff as you said happening on roads, there is stuff that will be needed for airports. So, I think in pockets activity levels are starting to pick up. This is early cycle, it is nowhere close to a phase where at one point we had 35 million tonne of steel capacity under construction on a much smaller base, so cycle will turn, but I think at this stage we would be overweight that sector.
A: No, there is only so much of big sector changes that you can do. We remain overweight an IT. It has already outperformed, the valuation gap has narrowed, but we think there is another 10-15 percent increase that can happen from here.
Nimesh: Last year you give a very big call on IT and that really has done well in the last three-four months. Any big call within the sectors that you like and which probably will outperform in 2018?