If the macro headwinds such as inflation and current account deficit persist, they may lead to earnings downgrade, feels Mr Amit Nigam , Senior Portfolio Manager, Equities, BNP Paribas Mutual. In an interview with Business Line, Mr Nigam discussed the reasons for recent market corrections and his fund house's strategy now.

Excerpts from the interview:

What led to the 14 per cent fall in Indian markets in less than two months beginning 2011?

The three macro headwinds that developed towards the end of 2010 — in November and December — getting reinforced in the month of January are the primary reasons.

The first headwind, in the form of inflation, is turning out to be far more sticky and stubborn than was anticipated earlier. In the last policy announced by central bank, the March exit inflation rate has been increased to 7 per cent from 5.5 per cent.

The second headwind is the increasing current account deficit. The data for the September quarter was a very high number which, in percentage terms, works out to almost 3.5 per cent annualised and is the highest in the last 7-8 years. The more worrying part is how the current account was funded last year. It was more of FII flows. On the contrary, this year FDI has not been anywhere close to the previous peak.

The third headwind has been the logjam at the political level and the corruption charges that are being reported in the media. This has also tempered the sentiment of investors.

And the FII outflows accentuated the fall?

In terms of outflows, in January we saw FIIs pull out only $1.5 billion, which is interestingly less than 10 per cent of what they brought in between September and December. So, only 10 per cent of what was brought in has gone out and the markets are back to the same levels from where the liquidity-driven rally had started. So I would not think it is money outflow that has accentuated this fall. I think in the months of September and October, when money came in over a very short time-span, it resulted in markets moving to a very expensive zone and macro headwinds, without valuation support, have resulted in this correction.

Now we have come back to the level we were at in August and we have seen two quarter earnings after that. So we are essentially better in terms of valuation today than we were in September.

You mentioned that valuations are more attractive than they were in September or October. Should investors be looking at buying in the market now?

Yes, they should be ready to look at the markets now. But the only thing that has changed is that the macro headwinds I mentioned have become far more prominent. Also, these headwinds may even lead to some kind of earnings downgrade which we may see in the months ahead.

When you talk of earnings downgrade, do you expect it to be more pronounced in certain sectors than others?

It would basically be in sectors where the pricing power is lower because we are seeing a lot of raw material inflation as well as labour inflation. So sectors with poor pricing power will face margin pressures.

The consumer and pharma themes have lasted for quite a while now. Is this sustainable?

We have to look at the sectors on a relative basis. If the markets were to grapple with the macro headwinds suggested earlier, then these two sectors can well outperform, though they may lose value in absolute terms. Why I am saying this is, most of the consumer and pharma players have had disappointing numbers in the December quarter. This is the first quarter where there was some serious raw material inflation.

A lot of price hikes happened towards the end of the quarter; so the latest quarterly numbers reflected margin pressure. If raw material prices were to stabilise at these levels, then in the coming quarters, raw material pressure could ease off for these sectors. Even if the raw material pressure continues, these sectors may be better placed to outperform relatively.

Two themes that have been underperformers post the recovery are infrastructure and engineering sectors. What is ailing these sectors, despite their being called secular themes?

I think the secular story is very much in place. The next Five-Year Plan has $1 trillion envisaged for infrastructure development. What has changed over the last three years is that this sector has seen a lot of competition come up. This has led to higher pressure on margins and the return ratios have come down.

If I were to compare the previous bull run of 2005-07, capital was available at a very cheap rate and therefore not too much of importance was attached to the kind of returns generated by companies. Even single-digit return of equity (ROE)-earning companies were able to fund their growth by raising incremental capital. This has not been the case in the last two years. Clearly, the sectors that outperformed in the last two years were ones that were generating free cash and higher ROCEs or ROEs. The two sectors mentioned by you, being low on those parameters, were underperformers.

The underperformance though, is now emerging as a favourable factor for these sectors. Valuations have definitely corrected from the highs of 2006-07. If policy issues are sorted out and order flows pick up, private sector capex will start coming back. The only sub-sector in this space that has seen decent orders and some execution is the power sector.

What is the direction you see for the markets and what sectors would you place your bets on?

We will continue to see volatility in the markets in 2011. When we wrote our yearly outlook we expected markets to correct. But in January alone markets corrected by 12 per cent. The pace of correction was something that was not anticipated. The main reason why we believed this would be a tough year was that we were looking at a big base in terms of FII flows the previous year. Two, our markets were expensive. Valuation is the key ultimately – if I were to go back to the March 2009 lows, despite all the pessimism, the markets bottomed out because the valuations were very compelling.

In times such as the present, we tend to maintain slightly defensive portfolios, although we do not go beyond 5-6 per cent on cash. We would prefer sectors with fixed ROEs such as utilities or those with pricing power such as the consumer sector wherever valuations are in favour.

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Published on February 26, 2011