Balancing opportunities and risks

We approach 2020 with a cautious mindset, in the back of continued macro uncertainty. A muted consumption recovery is likely, but the investment cycle remains challenged and some risks to financial sector stability still persist. We remain focused on quality growth stocks for our portfolios, with a heightened awareness of risks. The extreme narrowness of the market could partially reverse in CY20, but we will remain quality-conscious in our stock-picking.

Muted consumption recovery

We see the scope for a muted consumption recovery in 2020. Some key enablers are in place and they should play out over the next 1-2 quarters:

• There is still scope for interest rate transmission, even if policy rates stabilize for the next few quarters due to rising inflation. Banks are in a position to cut deposit and lending rates, with systemic liquidity significantly positive and credit growth muted at < 8%, as per the latest RBI data.
• The strong monsoon has positively impacted the sowing for the rabi season, and this should flow through to rural sentiment and consumption. The slowdown was particularly severe in rural areas, which have taken multiple hits over the last few years. A turnaround in this segment could swing the overall numbers significantly.
• We enter a period of a positive base effect. The slowdown had started to intensify in 2HFY19 and we enter that period now, especially in sectors like autos where the optical growth numbers should start to look better.

There are however, significant risks to the recovery. First, the fiscal deficit is a worry with revenue growth sluggish – this was compounded by the corporate tax rate cut. The government has reportedly cut back spending in 4Q to be able to meet the fiscal deficit target: this could have a negative impact on growth. Secondly, many sectors are still vulnerable and large defaults, especially from real estate/NBFCs, could hurt financial sector stability and negatively impact growth.

Global factors represent the third risk – mainly, the recent spike in oil prices. If this does sustain, it narrows the government’s policy options as it puts pressure on the external account, inflation and, possibly, the fiscal deficit. In that scenario, the growth recovery is likely to get delayed by a few quarters.

Investment cycle still challenged

We see the investment cycle still remaining muted. The enablers for private sector infra spending could take some time to fix: funding, contract stability and lowering of execution risk. On the other hand, the government’s continued fiscal challenges make it very difficult for a major uptick in private spending. Without a significant pickup in infra spending, a broad-based recovery in the investment cycle is unlikely.

Earnings growth

Earnings growth should remain healthy for 2HFY20, on the back of two factors. First, the full impact of the corporate tax would be visible over the next two quarters; there was some dilution because of the DTA losses in 2Q. Secondly, the recovery of the Essar NPA will go straight to the bank bottom lines, optically helping PAT growth. Adjusted for these one-offs, however, underlying PBT growth is likely to remain in single-digits. In such an environment, the companies that do deliver strong EPS growth will likely to get disproportionately rewarded on valuations.

Investing in 2020

Our approach to investing in 2020 remains underpinned on three factors:

We continue to hunt for growth. Even in a challenged macro, there will be winners in each sector and those are where the opportunities lie. Companies that consolidate market share in a downturn tend to be big winners in the medium term.

Valuations of the high-quality growth companies are a worry, but elevated multiples are not a worry until growth starts to falter. The key is to find companies that are able to sustain growth while keeping cash flow and balance sheet metrics intact.

The sharp 2-year correction in mid-caps has taken the froth out of valuations. We now remain market-cap-agnostic and are looking at stocks across both large- and mid-caps.