‘FIIs won't return before general elections in 2019 unless market corrects 8-10%’

Ravi Kataria, Founder and Managing Director, Investment Imperative Group, doesn’t expect FIIs to return before the 2019 general elections or unless there is another 8-10 percent correction from current levels.

Edited excerpts

Q: How do you see the current macro situation unfolding and its impact on Indian equities?

A: In 2000 and 2008, we witnessed a built-up of unjustified valuations, backed by leverage in one or more asset classes. Higher the spread of leverage globally and stretched valuations, more painful is the adjustment process.

After 2008, globally investors returned to the traditional investment asset class: equities. We have witnessed a tremendous run in global equities helped by real growth in technology, infrastructure, manufacturing and energy.

Commodities are far lower from their yesteryear’s high. Alternatives, including real estate, haven't seen the kind of spurt they had witnessed before 2008. The built-up in equities to an extent has been backed by leverage and those regions will see steeper corrections. In China, even retail investors were offered 3-4 times leverage for investments on margin money. Overall, the core economy is far better and less leveraged compared to 2008.

Indian equities have risen on long term investments, manufacturing projects, infrastructure development, upliftment of poorer sections and building up of innovation edge.

Trade wars can cause some adjustments, which can be a painful process for select economies. India’s contribution is far lower in global trade. Hence, we see more opportunities arising than fall backs from such adjustments.

There can be further correction possible from here on due to global factors but don’t see a repeat of 2008.

Q: Which money is driving the market and how long before we see a comeback of foreign investors?

A: Global fund allocation has gradually shifted towards a developed world after a substantial reversal of US monetary policy in 2016. Institutional investors are expecting a rise in interest rates in Europe, Japan and emerging markets. This will lead to a rise in expected rate of return on capital at a faster-than-expected growth in corporate earnings.

There has been a systematic withdrawal from emerging markets. Foreign institutional investors (FIIs) have been net sellers in 16 out of 21 months since October 2016 to June 2018. This has substituted largely by domestic flows through mutual funds, helped by large scale of inflows from retail investors.

Consumer confidence, rise in employment rate, and adoption of technology has helped in higher penetration of mutual funds. We expect domestic flows to continue to substitute outflows from foreign investors at least in the remainder of 2018.

We don’t expect FIIs to return before the next general elections in 2019, unless there is another 8-10 percent correction from current levels.

Q: What drivers should one look at for gauging the bottoming up of the index and gearing up for the next investment cycle?

A: Interest rate cycle: Trade wars can derail the speed of global central bankers in terms of rate hikes. This would be beneficial for heavy industries, infrastructure and manufacturing sector in India. The Federal Reserve has indicated at 2 additional rate hikes in 2018, taking the fed funds rate to 2.5 percent by the end of 2018. It has indicated 3 rate hikes in 2019 and 1 in 2020.

The European Central Bank has hinted at the end of its quantitative easing programme by December. However, if central bankers continue at the same pace, then one should reduce exposure of leveraged companies from their portfolios.

Oil prices: Sanctions and economic uncertainty in select oil producing countries is causing momentum for oil prices than supply shortages or spurt in economic demand. In the long run, we are bearish about the commodity. In 2018, supply-demand mismatches can cause oil to rise a bit further to levels of $90 per barrel for Brent crude. This would cause some more trouble for the Indian economy, resulting in higher input costs and current account deficit.

Both the above scenarios will call for investments in IT, manufacturing including pharma (generic and large scale), supply-chain solutions and retail with lower leverage. At present, the Nifty is trading at 18 times FY19 estimated earnings. Investors can look to re-enter at historical averages of 15-16 times when it comes to largecaps. However, midcaps and smallcaps can be reviewed on a stock-specific basis.

Insolvency & Bankruptcy Code: One of the greatest reforms of the current regime has been introduction of Insolvency and Bankruptcy Code (IBC) which deals with a quick resolution for non-performing assets. The Indian economy couldn’t benefit much from low-rate environment as credit growth was dismal compared to developed countries due to weaker liquidity with public sector banks. IBC framework, setting up of alternate investment funds (AIFs) by banks and investors to buy distressed assets and improved governance on fresh lending, can help in improving balance sheets and adequacy of public sector banks. We are hopeful of consolidation and cleaning up of PSBs which can be beneficial for overall credit growth and economy.

Q: Midcaps and smallcaps continue to see weakness. How long before we see some buying in this space?

Midcaps and smallcaps always witness overshooting on either side of the markets. Investors should always account for the risk-reward ratio. However, what continues to be a concern is that there are still major gaps in corporate governance and accurate reporting of performance. We have observed a lot of companies in the space have posted strong numbers in the Q2 and Q3 of FY17.

Those gains were reversed through weaker profitability or results in 4Q. Implementation of the Goods & Service Tax has addressed these issues to an extent. However, there still remains scope for further improvement in governance and vigilance. We are opting for select companies with strong management and business model combinations than just adopting a top down investment strategy when it comes to midcaps and smallcaps.