Post June quarter results, there has been a sense of uneasiness over stock valuations

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on the Street. Prateek Agrawal, head of equity at Bharti AXA Investment Managers, told Bijoy Sankar Saikia that the indices would lag growth in underlying earnings in terms of returns over the next few quarters. Excerpts:

How would you assess the Q1 earnings numbers? A number of companies failed to meet Street expectations? Is there a case for earnings upgrade or downgrade?

The earnings numbers came broadly in line with expectations and, hence, we do not expect any significant upgrades or downgrades in the overall outlook for the market.

Are these earnings levels sustainable going forward? We have a rising interest rate scenario, inflation remains very high and the global recovery has been at best timid. Meanwhile, the much-awaited capex cycle has not yet taken off.

We believe over the next few months, inflation would taper off. Yes, global recovery has been weak. The second half is when we do expect the capex cycle to take off. The signs of that would be found in the credit offtake from banks. We agree, if the capex cycle does not take off as expected, then the GDP growth outlook would have to be moderated.

Clearly, with our expectation of moderating inflation, we do not expect lending rates to see any significant increase. However, interest rate increase will impact earnings outlook further and reduce PAT margins going forward.

After the recent surge, the Sensex has become the most expensive benchmark in Asia and Bric markets. This has come on the back of a rather patchy earnings season. Is there something amiss? How does one justify this significant premium? How comfortable are you with current valuations?

We believe the indices are fully valued. However, stuff outside the index is trading at a significant discount to the index and that is the part of the market where we will see outperformance over the next 12 months. However, given the challenging macro environment, the risk of high volatility in equities in this part of the world remains.

We believe the performance of the index in terms of returns would lag the growth in underlying earnings. We ought to see Indian valuations in the context of historical valuations in the country. Comparison with peers should also be with historical trading patterns in mind. The Indian market has always traded at a premium to its peers and this may be on account of high ROE and cash-generating businesses like FMCG and software that form a significant part of our indices.

The Federal Reserve’s confirmation of a slowdown in US recovery appears to have put all estimates back by at least a year. How do you look at the scenario now, from India's point of view? If the Fed now loosens liquidity, what implications will it have in terms of rupee outlook and investment inflows into emerging economies?

Directionally, the consensus view at this point in time is that developed world currencies will weaken over time versus currencies in the developing world, where growth has been better and the leverage — both domestic and international — is more manageable. However, currency markets have been very volatile and have had moves, which were not predicted. Short-term domestic competitive advantage has forced central banks to act in a manner that opposes trade-linked moves of a currency.

As far as the rupee is concerned, we are not positive on its strength. India is a large trade account deficit country and if the rupee strengthens, it may impair competitiveness. The reserves of the central bank are significantly lower than the peak reserves and we expect the central bank to absorb the inflows on the capital account to rebuild reserves. This will also release liquidity into the system in a scenario when inflation will have come down and industry will need capital for funding capex.

We do not believe that currency movements have a big role to play in capital flows (except for speculative purposes). Stable capital will flow in depending on the growth outlook of the country. At this juncture, it is our belief that the India story stands out in the world as a sustainable long-term growth story.

DII investment in equities has been on a decline as mutual funds are bleeding amid redemption pressures and lower inflows and insurers face a similar prospect as inflows into Ulips drop. It’s the FIIs, which are supporting the rally. Now with the Chinese market taking off and other emerging markets promising a better deal, is there a risk of FII inflows slowing down?

We believe at this juncture emerging economies have a good story to tell and among emerging economies the Indian story stands out for its demographics, increasing economic competitiveness and the depth of the market.

One doesn’t see too much of retail participation in the market though? What does it portend? Is there a sense of uneasiness in the recent market rally?

The volatility in markets, both Indian and global, has been of a high order and that has not encouraged retail participation. Moreover, in terms of market movements, the focus has been only on the index where the valuation comfort has been low for some time. Moreover, while the market has been volatile in terms of absolute returns, returns from the large-cap index have been lower than that of returns offered by debt markets.

The regulatory environment is also proposing to bring in significant changes in the manner capital gains are to be taxed. The IPO route through which retail participation comes into the market has not been delivering significant returns on listing, as was the case in earlier buoyant periods.

Moreover, retail investor is expected to take out money from he stock market as their holdings become profitable after a long period. Remember, the market is still trading below the levels seen more than two years back. If the economic growth stays strong, then we expect retail investors to come back to the market.

Is there a risk of heavy FII inflows resulting in a kind of bubble formation?

We do not believe at this juncture there is a bubble in Indian valuations, which are at the upper end of the historical valuation bands. If growth in valuations lag behind growth in underlying earnings over the next few quarters, as discussed earlier, valuations will again be fair.

How do you assess the uncertainty in global markets, especially in the euro zone? Is the worst behind us? Economist Paul Krugman has predicted a third Depression. How real is the risk?

We believe the developed world will deliver below historical trend line growth rates for a significant period in future as the degree of leverage in the system as been reduced. However, multilateral agencies like the IMF have recently upped growth estimates for the world. So, while clearly the risk is there, there is probably a higher probability that the world delivers a decent (though below potential) growth over the next year.

What should be the approach of an equity investor at this stage? A lot of investors seem to have been left out in this rally. Is it worth waiting for a dip to enter the market?

Given our outlook on valuations and the fact that we expect the period forward to be challenging in terms of volatility, we believe investors should use the dips to come into the market rather than chasing rallies.

Which sectors have been your favourites in recent times and why? Which are the ones you have been bearish on?

We are positive on banking and financials, where the results have surprised on the positive side and valuations are benign. We are also positive on the Indian auto space as a way of playing the consumption theme. We are also positive on real estate companies as there is evidence of strong countrywide absorption at prices that have improved significantly from the bottom.

We are negative on sectors like telecom where earnings outlook is not bright on account of high competition. We are also not very positive on FMCG and pharma sectors on valuations at this juncture.