Not expecting a major shift in rupee depreciation if oil stays range bound, says Citigroup

This is the quarter when for the first time the quantitative tightening is happening, not just on the rate side but also on the liquidity side and you are seeing not just Fed but also ECB coming into the picture and reducing their purchases.

All of this put together is kind of putting the world economy, the markets in front of the burning question that once the stimulus is out who is swimming naked, where does the world economy stand. That is the discussion which is also happening in the context of the trade war where it seems to be simmering, no progress made, so the backdrop of interest rates being tighter, liquidity tighter and trade conditions tighter is clearly headwinds that the global economy will have to go through. We are still looking for a 3 percent plus global GDP growth. But as I said with the minor cut that has come in last month.

Chakraborty: Our China economist don’t believe that seven is such an important psychological level from the Chinese authority’s perspective. So if the need be it can even be breached.

Chakraborty: How the Indian markets would react if you see the move from 6.90-6.97 on Yuan barely had any impact on INR. So, INR seems to be more driven by the oil story, the current account story, less the Yuan story which was probably the case in September where the move was more a Yuan driven move. So, that disconnect seems to be happening right now. The bigger problem is that China is seeing capital outflows.

If Chinese growth is not maintained through policy stimulus then how the rest of the emerging markets (EM) gets impacted, what it does to capital flows into EM is the question that we will have to face over the next few months. Because that will have serious implications for funding the current account deficit in India.

Goyal: What our global equity strategists are saying kind of ties in with this that there is some moderation in growth and the market was hot, so it is cooling off. But within that what they track on a very regular basis almost quarterly we put out this note where we have a bear market checklist and they look at 18 parameters.

In the past, when you have been heading into a bear market, a lot more indicators 10-11-12 kind of indicators have been flashing red. Right now we are still in a situation where our last update 15-20 days back was talking of a 3.50 indicators out of 18 flashing red and which is why they believe that this is volatility.

So, to that extent, yes the growth slowdown is impacting. This is volatility but they still don’t believe that we are in a bear market. Now kind of taking that a little forward, if you look at what is in the emerging market context and again Samiran Chakraborty mentioned about growth there, but our EM strategists putout an interest note that if you look at all the corrections in the EM space since 1990, so 28 years there has been a 10 percent plus correction almost 30 times.

Somewhere in that range and each of those corrections again if you take the average pullback is 22 percent. Right now where we are sitting is actually a pullback which is already more than 22 percent. The second point he mentions in that note is all those pullbacks the starting point again on an average is 1.9 times a book valuation.

In January, we were at 1.9 times book. If you look at where the correction kind of stops average is 1.5 times which is where we are today. So, these are interesting observations, one has to carefully keep watching. A lot of negative news particularly on the EM side is priced in and that is what our global view and EM view is.

Goyal: Bottoms and tops are impossible to call, so the point I will make here is if you look at our target for example even when the Sensex was at 39,000 or 38,900 or wherever the high was, we stuck to 37,300 and we have not made any change post that also. So, the point I am trying to make here is yes, there was euphoria.

Everybody was very positive on flows, globally there was a lot of liquidity and all that was kind of feeding in. Despite FII outflows it really didn’t seem to matter. Now suddenly you are starting to see all of that change. I think it will still be a function of how domestic flows shape up, how earnings shape up and again the global parameters.

But compared to two months back where as I said we had a 5-6 percent downside to our long-term or medium-term target I am more worried? No. Now having valuations have been corrected? Definitely not. So, we are not like outright positive and again I can’t talk stocks here, but if you look at our top picks they are still defensive names. So, to that extent, we are not really saying that it has kind of bottomed-out but what we are saying is a significant part of the pain is in the price. So, incrementally does one want to turn more cautious here? No. so that is the clear message.

Goyal: The challenge is even when the market was working it is not like we were having earning upgrades. Through the last four years we have lived only with downgrades.

Goyal: I said that for every year for the last three years that there will be downgrades. Even this year our top-down view is that there will be downgrade. So, if I look at our bottom-up estimates we are calling for some 24-25 percent growth. When I look at what is happening all over top-down it is very difficult to see that kind of growth coming to. Having said, is 16-17 percent terrible? Not in my view and which is where we are saying that those numbers will not come through but a 16-17-18 percent growth is bad at all.

Goyal: The challenge with earnings over the last 3-4 years is that there has always been one sector which impacts the earnings so disproportionately that the headline always look weak. To that extent even this year, I think a lot depends on how financials and commodities shape up because those are the two which are always the big swing factors.

Chakraborty: It is possible because somebody like me we had a relatively weaker than the market expectation in the beginning of the year for GDP. Then we got a fantastic number in the first quarter of 8.2 percent. Now statistically that pushes up the average GDP growth for the full year regardless of what is your directional view on growth is. So, we did not change our directional view of growth where we said that the best of growth is behind us and it is going to moderate.

It is moderating from such high level that still for the average year we had a 7.5 GDP growth number.  Now this pre the Shadow banking system crisis, now post the shadow banking system crisis in my view it is too early to put your knife out and start cutting because we still have no idea that how much will be the impairment of credit and we have to start seeing the impact a little bit on the high frequency growth numbers.

As of now, we are still looking at September data. Which is coming out in October. So, it is only the October and the November data which will probably give us the first signs of how much this slowdown is. I don’t want to be in a situation wherein post demonetisation we thought that the large shock is definitely going to completely derail the growth process but nothing of that sort really happened.

So, sometimes the way the GDP numbers are calculated it does not pick-up enough of the financial sector stress so to say. I am a bit cautious in changing the numbers, but yes the trade headwind, as well as the shadow banking system headwinds, are additional headwinds to what anyway was a cyclically slower growth expectation that we have.

Goyal: Definitely there are headwinds. If you have a crunch on liquidity and financing, there are a lot of sectors where a lot of growth was coming because of financing and the stocks started correcting; the NBFCs corrected and then the banks corrected and then auto started correcting, everything related to consumer discretionary started correcting.

Goyal: Not necessarily because it depends on where valuations are. So some of them, for example, the consumer generally both discretionary and staples; staples for different reasons, we are underweight. Autos we are marginally overweight. So the sector stance may differ and we added stocks after the correction also.

So that stance may differ but to that extent growth, the number and which I already said that I do think there is a risk to the bottom up estimate primarily because some of these factors are not easy to put in numbers and to that extent analysts always wait for managements to provide commentary and which is why this quarter as the earnings are coming in, management commentary is very important because that will help analysts to get to a number of what realistic earnings are and where there are definitely is a risk of downgrades.

The other important point from earnings perspective. So far this year IT and pharma have seen upgrades. Now if the rupee is kind of more stable then those upgrades are also gone and particularly in IT where you are suddenly starting to see some of the US corporate more cautious, starting to see some noise around the visa issues and Brexit is a concern for the UK business. If you bake it all together, IT upgrades unless the rupee depreciates again, you may not see them.

Chakraborty: Yes, some amount of correction definitely has happened even if you take a rather simplistic measure of the real exchange rate (RER) – that has corrected substantially over the last few months but beyond everything rupee will be a function of current account deficit projections. We had a good trade deficit number for the month of September.

In the past we have seen that often the September number flips over in October; if the number is good then October is bad. So if that happens then it’s a different story but if the October trends both slow the exchange rate effect as well as the growth slowdown effect because that should also theoretically show up in lower current account then rupee has already digested some part of the bad news and oil has corrected $10 in a month.

So that should also be cooling nerves a bit and the last things remains where we started our discussion which is if there is a growth scare globally then can rates go up as much as what the market fear today and that will also have an impact on rupee willy-nilly and last but not the least, the fact that the government is trying to -- I am not saying defend the currency but at least showing displeasure over rapid depreciation. So to that extent that will drive the market sentiment and not expecting a major shift in rupee depreciation over the next few days if oil stays range bound.

Goyal: The report that you are talking of – what we are arguing there and just to give you a context, we have written a report very early in the year where we had said midcaps are significantly risky because valuations are at a meaningful premium to largecaps and which may not sustain.

Now we have seen a 20 percent plus underperformance year-to-date and to that extent after a long time valuations are below where largecap valuations are. The other important point and it’s there in the note as well, if you see last 15 years, there have been four years where midcaps have been negative in absolute terms and if you see and this is the fourth year.

The prior three periods, the subsequent year has very strong midcap returns. The average of the three years is actually 50 percent plus returns and which is where we think that some of the pessimism is baked in but like my market view, I am not calling for a bottom or going aggressively positive.

There are still defensive names. So in terms of what kind of stocks we have, they are generally defensive names with good earnings growth profile, in fact, one of the things that we have provided in the note is based on four parameters; first is the marketcap, it has to be a midcap. Second, RoE is greater than 12 percent. Third, FY18 to 20 earnings CAGR of 18 percent plus and then a liquidity criteria. So we are in some ways going for the quality or the defensive part of midcaps.

Goyal: As I said even two months back when the market was 38,900 we were at the same target and now we just want to see this quarter’s earnings and where earnings settle in because I said there is a risk but analysts want to get more comfortable based on management commentary and that is when we will figure out. However, the only point I am making is am I more bearish than what I was two months back – no.

Goyal: It’s not in this report but when we were sounding very cautious three months back, this is one of the points we were making that you are going into an election heavy calendar period and that is never a great time because you are always uncertain and uncertainty is always an overhang for the market. So those things still remains. It is just that valuations have become more comfortable than what they were two months back, so some of the risks are better in the price now than two months back.