Expect FY22 to be a strong year for earnings growth: Citi

If you are purely going by valuation metrics, there are very few pockets in the market which are low or cheap by historical standards. Surendra Goyal, Head of Research (India) and Samiran Chakraborty, Chief Economist (India), Citi in conversation with Nikunj Dalmia of ET NOW.

What is in store for 2021? Should we get worried about inflation? Could 2021 be a smooth year for macro?
Samiran Chakraborty: In 2020, we saw it all. We have seen a massive correction in growth and then almost an elastic type of bounce back in economic activity which has taken us close to pre-Covid levels in terms of GDP and that gives us some optimism as we move into 2021. There is some tailwind towards growth coming from not just the pent-up demand but also the forced savings part that the actual fall in income has been much lower compared to the fall in consumption which has led to some amount of forced savings which in our view will get spent over the next couple of quarters.

But what we are really hopeful about is that once this demand kicks in, then we are seeing other kinds of pre-conditions for a private capex recovery in the second half of the year. We have already seen interest rates coming down, profitability of companies improving, some government policies helping and maybe we get a bit of tailwind from the global economy as well.

If all these things are put together, if a private capex recovery starts happening in the second half of the year, then that will make us more comfortable about sustaining the growth momentum. For now, we have a growth outlook of 11% on the GDP side for FY22 on the back of FY20 at minus 7.8%. What we need to worry about is the income inequality part of it. This growth seems to be concentrated in the hands of a few and so unless that income inequality is tackled through a better redistribution mechanism of the government, that might mean that going forward the growth momentum would slow down a bit. That will be the bigger worry.

What is the big picture for 2021 and what makes you constructive on capex/industrials?
Surendra Goyal: Samiran talked about our expectations from 2021. If you take it forward from there, FY22 is the year where earnings growth expectations are already high and where investors are a lot more comfortable. Over the last couple of months, we have seen consensus earnings getting upgraded. Part of it came through cost savings and so on but net-net, we have not seen EPS getting upgraded for Nifty in a long time. That is one of the reasons which has given investors more comfort on the EPS outlook.

The expectations about a strong earnings growth year has partly to do with low base and recovery. Coming to the second part of your question, today we have already seen the recovery playing out in some of the consumer facing sectors. Over the last few months, we saw some pent-up demand and some festive demand.

On the industrial side, we have been challenged for a while. Things have been slow for a while and it does look like that the set up is right. We see private capex coming in the second half and that is something to watch out for. But overall, the setup looks conducive -- be it interest rates, or the tax rate cut which happened some time back. There are a lot of variables which seem to be supportive and the good thing is that there are quite a few largecap stocks in this segment where valuations are still quite attractive in the context of their history. That explains the increased overweight on industrials.

We were overweight even prior to this report but we have increased our overweight on industrials and the other part of the market where we have continued to be overweight is financials where we should see growth improve. The fear of incremental stress is definitely coming down and valuations are a lot more reasonable. Financials and industrials are the two big overweights in our India model portfolio.

How does one differentiate between pent-up demand and sustainable demand? Between real demand and revenge consumption?
Samiran Chakraborty: It is a tough question. I do not think there is an easy metric through which we can differentiate between the two. But for some of the items where purchasing can be postponed, it is better to look at YTD cumulative numbers and take a YTD over last year to get a better sense of how things have been.

If I missed consuming in those two-three months of stringent lockdown, then I had a choice to postpone my consumption and consume it later on. But for the items, where you cannot postpone your consumption, even that metric is not very valid.

The other thing that I was talking about earlier is this concept of forced savings where if you look at the first half of the year, the wage cost growth for about 4,000 listed companies is approximately 3%. But in that period, private consumption growth is down 13%. That is leading to a significant amount of forced savings in the hands of people who are in the formal sector and who have not lost jobs or not lost income.

Forced savings can give you that purchasing power to consume even going forward for the next couple of years. This pent-up demand or additional purchasing power might last longer than what we are thinking right now. That is why I am not necessarily becoming bearish and we are reaching a peak on the growth path. But I will be hesitant to say that the growth momentum that we have seen in the last couple of quarters is almost impossible to maintain. So the momentum will slow down.

You have a target of 14,000 for Nifty. If you are bullish on banks and industrials, that means you are baking in an earnings recovery. Why do you have a conservative target for the Nifty?
Surendra Goyal: The key point to keep in mind here is that the earnings recovery story of FY22 has been known for a while and we have seen the market rally very hard over the last three months. You could argue that we are seeing the market rally from 8,000-9,000 to 14000 plus mark on the expectation of very good recovery. In my view, a lot of it is priced in and in terms of valuations, all the traditional valuation metrics, price earnings, price to book, the market is clearly high in the historical context.

On price to earnings, it would possibly be more than two standard deviations above the five year, 10-year means that the market has traded at. In other words, a lot has gotten priced in. In November, December, we had $15-17 billion of FII inflows. I do not remember when it last happened that way. Also, it supported the market in a big way.

The market outlook is a function of what has already been priced in and how much has been factored in and that is the reason why we are a little cautious in terms of the market target, the point you spoke about. Usually, a market rally of this kind is led by the high beta sectors but this time, the best performing sectors have been IT and healthcare.

In some ways, there are sectors which have really rallied and a lot has gotten priced in and on the other side, there are sectors like financials where people were very nervous and they are now starting to catch up. For example, in October, when we raised the overweight on financials, a couple of times we were getting a lot of pushback because things were still very uncertain. But as things have improved in terms of fear and outlook, we have seen financials really do well over the last couple of months. When you look at the valuation today and the outlook of the businesses you end up seeing a better, valuation-adjusted outlook in financials and industrials. That is the reason why we are overweight on those two sectors.

Most of the big banks like HDFC Bank, Kotak, ICICI Bank are nearing record highs. What makes you bullish on banks?
Surendra Goyal: Honestly in this market, I cannot really see too many stocks which are cheap across segments and one has to take a relative call. Some of the corporate banks, where we have big overweights, are still at mean kind of valuations or slightly above mean. They are nowhere close to the high levels of valuation that the broader market trades at. For example, in the IT space, valuations are the highest today. They are almost three standard deviations above the five and 10-year mean.

It is a question of what is already getting priced in and that is the key issue and which is why as growth returns, as fear comes down and the fact that there are still pockets of valuations, financials are close to median in a market which itself is two standard deviation median. So, financials look relatively okay. If you are purely going by valuation metrics, there are very few pockets in the market which are low or cheap by historical standards.

We have had record flows into the market. Sare jahan se acha Hindustan humara is a line which we have used to describe what has happened to flows into emerging markets when India got lion;s share. If flows continue into Indian markets and if there is disregard for valuation, what should an investor do?
Surendra Goyal: Firstly, predicting flows is super difficult. I do not think anybody gets it right. One should remember that flows are coming largely because global central banks are pumping in liquidity and the weaker dollar. At least near term, it look set to continue. Why India got a lot of flows is partly to do with the pace of the recovery as well as the EPS upgrades which came through which clearly made India a relatively attractive market.

Having said that, one should keep in mind that $16-17 billion of flows in two months is very very unusual and it is not easy to maintain that momentum. Flows can continue to be super strong okay and you will see the growth outlook improving and valuations being relatively reasonable. That is what the broad framework for the market will be.