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Awaiting CSO estimates, Budget, inflation data: Violet Arc

Sanju Verma, CEO, Violet Arc Global is disappointed with the credit policy. According to her, there should have been a 50 basis points rate cut in January itself. However, going by RBI’s commentary, a 75-100 bps rate cut is in the offing. Hence, structurally a lot if going India’s way, she says.

She believes no governor can tackle both inflation and exchange rate at the same time and Raghuram Rajan is trying to do just that. “If governor doesn’t want the rupee to appreciate any further then he will have to allow inflation to rise or vice-versa.”

Verma is keenly awaiting the CSO estimates later this month and the Budget.

She says a dovish US Federal Reserve and lower rate cycle makes it difficult to put a Nifty target.

Below is the verbatim transcript of Sanju Verma’s interview with CNBC-TV18’s Anuj Singhal and Sonia Shenoy.

Anuj: What is your call right now? We have seen a big rally but last few days there has been a bit of volatility that has come back to the market. Do you think most of the pre-Budget rally is done or would you expect one more rally going into the Budget?

A: While most people did not anticipate a rate cut today which would have given legs to the rally that we have seen in the last month or so I had not entirely given up on the hope of being surprised yet again post that out of the box surprise on January 15.

My sense is that it is difficult to say whether we will have a pre or a post-Budget rally but the fact of the matter is that whether the Nifty will go to 10,000, 11,000 or 12,000 your guess is as good as mine. The way I would approach this is that going forward there is going to be a successive rate cycle reduction. My personal sense is if you just go by what the Reserve Bank of India (RBI) governor has said that the real interest rate needs to be in the region of one and half to two percent given that the current repo rate is seven and three quarters and the last printed Consumer Price Index (CPI) inflation number came in at five percent it shows that rates need to go down at least by 75 basis points if we have to achieve a real interest rate target of two percent. Rates need to go down by 125 basis points if we have to achieve a real interest rate target of one and half percent.

So my sense is if you are not entirely optimistic but you just take Raghuram Rajan’s words as a given even then a 75-125 basis point rate cut is in the offing. Whether it will happen successively, consecutively that is the big million dollar question. My personal sense is that any rate cycle reduction to be effective and for monetary transmission to be effective has to be front loaded. So, I was a tad disappointed but given that rates will come down the equity risk premium moves up, the earnings yield moves up and every sustainable structural bull rally in India, even the one that we saw between 2003 and 2008, if there was one thing that pushed equities and sustain them for three to four long years in the 20-25 times odd PE multiple zone. It was the fact that the earnings yield was positive. Today the earnings yield on one year forward, a PE is something like 6.5 to seven percent. So, if rates come down after a long time perhaps after three to four years we will have a scenario where the earnings yield is positive purely driven by the fact that bond yields have come down.

So structurally there is lot going for us and I would vey keenly await not just the Budget but more importantly the Central Statistics Office (CSO) estimates which come in on the ninth of this month and of course the inflation data that comes in the later half of next week. My personal sense is that CPI inflation will continue to be sticky in the region of 5-5.2 percent. So, that is very reassuring and don’t forget that even the core WPI that stands at just about 1.45 percent which is a huge positive.

So, my personal sense is that there is a lot going for us. Most importantly the big thing that no one is talking about is the fact that now after the data that emerged from US in the last 24 hours it is said that US Fed will hike rates now only in calendar year 2016. It will not happen this year because for the first time the ISM factory gauge in the US which is a gauge of their manufacturing activity that actually plummeted to just about 53.5 for the month of June from somewhere like 55 in December. So that is a steep fall and even the consumer spending data, consumer spending was down 0.3 percent in December from a 0.5 percent increase in November which tells you that the extra savings in the hands of US consumers thanks to lower gasoline prices is not finding its way into the retail markets. People are willing to save more rather than spend more and that is the reason that even the US savings rate has gone up to 4.9 percent, the highest it has even been as a percent of Gross Domestic Product (GDP) in the last ten or fifteen years.

So, given the fact that the Fed is not likely to raise rates in calendar year 2015 even if it does it will not happen before September 2015. That is the biggest positive. I am not even so much excited by this USD 1.3 trillion European Central Bank (ECB) buyback but most importantly the fact that the data emanating from the Fed is very conflicting. Don’t forget that the US fourth quarter GDP came in at just about 2.6 percent well below the five percent that they clocked in quarter three. It just tells you that the green shoots in the US have not entirely emerged and there are still lot of conflicting signals which suggest that even in the US there is a lot of slack, there are disinflationary signals and given that most of us have been saying we are coupled to the US in many ways, if indeed that is true and indeed that is what you believe in then a dovish US Fed, of course the fact that we are in for a rate cycle reduction trajectory, all this put together in perspective suggests that putting a target to the Nifty will be difficult but you are assuming a target multiple of 15 times three years hence and you are assuming that the earnings growth will compound at 13-15 percent.

Sonia: Do you track  TVS Motor and any thoughts on how to approach this stock now?

A: I would not like to comment on TVS Motor specifically at this point in time because I have yet to look at the numbers in greater detail. However, I reinforce that my top pick even when  Maruti Suzuki was trading at Rs 2,000 I said that we should not be surprised if we see this going up to Rs 5,000 odd over the next one or two years. I still maintain this sounds very cliché because everybody has a buy on the stock.

My personal sense is that Maruti were to go to Rs 5,000 and you are talking of an earnings per share (EPS) of something like Rs 235-240 for FY17 then the stock would be still available to you at just about Rs 21 times which is higher than its average price to earnings (PE) multiple of 16 times for the last 10 years. However do not forget that in the December quarter Maruti has reported the highest EBITDA ever at Rs 1,600 crore. This is one company where there is still a margin expansion story. Margins are slated to go up by 300 basis points from the current 12.7 to 15.7 going forward.

So it is a classic combination of earnings profitability seeing a huge uptake. Margin expansion the yen, the rupee and the yen-dollar pair working to Maruti’s advantage. Most importantly the fact that the old earlier mean PE of 15-16 times is not something that analysts are now reckoning with. It has had a PE expansion and now people are willing to pay 21-22 times forward for the kind of earnings trajectory and the quality of the earnings growth that Maruti is willing to show.

So one is spoilt for choice within the auto space, I continue to believe that Maruti and Exide again,  Exide Industries declared excellent set of numbers better than market expectations. So these are the two stocks that I would sort of put my neck on the axe for at this point in time.

Anuj: Your view about the policy today and in general your call on the banking space because that clearly has been the leader but we have started to see bad numbers from PSU banks? We have seen Bank of Baroda (BOB) disappoint, now you have seen Punjab Nation Bank (PNB) come out – bit of a shocker of a number? Even private banks are selling off today. How would you approach banking now?

A: I was clearly disappointed by the policy as I said there should have been a 50 basis point rate cut on January 15 alone once the rate cut cycle was decided upon. I personally feel there were a lot of contradictions in what the RBI governor said. If he claims that monetary transmission takes time and have impact only two quarters or three quarters down the line then any textbook economist also knows that loans on the asset side tends to get re-priced much faster than deposits on the liability side.

No wonder banks have been cutting deposit rates at a faster pace than they have being cutting the base rates, point number one. Point number two going back to the policy last time in January he clearly said that oil, food, vegetable prices, fiscal consolidation and its quality and also international events is something he will clearly watch for. While not much may have taken place domestically with respect to data points between January 15 and February 3, clearly on the international front we have been deluged with data.

In fact there is a problem of plenty even a country like Russia which is grappling with the rouble crisis. Russia chose to reduce rates by 200 basis points from 17 percent to 15 percent on January 30. From Sweden, Norway, Denmark, Singapore everyone has been on an easing cycle. The one big lesson internationally is that austerity is a dirty word. Even countries like Spain and Italy are increasingly moving to the left.

If you take all this data and juxtapose it against what we have done clearly I feel that there is a lot left to be desired. The problem has been that the RBI Governor has been consistently trying to control both inflation and exchange rate. No central governor no matter how good or bad he is can ever control both. You can either control exchange rates or you can control inflation. So if the RBI Governor does not want the rupee to appreciate any further given that we have appreciated two percent in this calendar year alone then he will have to allow inflation to increase.

If he wants inflation to be sticky at the 5-6 percent band then he will have to allow the exchange rate to appreciate. Something has to given in, you cannot control both. My personal sense is that given Rajan’s obsession with controlling, wanting to control inflation, eventually the exchange rate will rise. I am not from that school of thought which believes that as per real effective exchange rate (REER) the rupee is overvalued.

On REER – even countries which say their capital account convertible actually have to do with manage float. So given that my personal sense is you will have a scenario where inflation will be sticky, the CPI between 5 to 5.50 percent, the rupee will appreciate vis-à-vis a dollar. Do not forget that RBI has brought close to USD 24 billion in the last 8-9 months through direct market intervention. We have a balance of payment surplus of the last two preceding quarters to the tune of USD 19-20 billion. Most importantly through subsidise dollar swap fund flows from NRI’s have been mobilised to the tune of USD 30-35 billion. So in all we are well cushioned to the tune of an additional USD 72-75 billion and if things stand as they are our import cover will go up to 17 months two years hence.

My personal sense is that because of a stable currency, dollar returns to FIIs will become very attractive and that is one of the other reasons why the markets will do exceedingly well. Coming back to banks, the governor said that the days of regulatory forbearances are over that said little has been done. The problem that you see today in the banking space has to do with the fact that from June 5, 2013, the restructuring provisions went up from 2.75 percent on new loans to 5 percent. The impact of all that is being felt now. How do you otherwise suddenly explain that Bank of Baroda and PNB has suddenly seen 18 percent sequential jump in net non performing assets (NPAs).

How do you explain the fact that the NII growth has been virtually zilch and negative for an IDFC , only a measly seven and half percent for Bank of Baroda? More importantly I am not looking at the gross NPA or the net NPA numbers. If you just look at the slippages they tell you the story of what lies ahead. The slippages for an ICICI Bank stood a something like Rs 2,300 crore. The slippages of Bank of Baroda stood at Rs 3,000 crore and from the restructured pipeline Rs 5,000 crore actually turned into an NPA; this is for Bank of Baroda. For ICICI Bank from the restructured portfolio Rs 776 crore actually turned bad and became sour.

So, either banks are not able to estimate the credibility of the restructured pipeline or things are going from bad to worse and because of the steep restructuring provisions which came into effect in June 2013 the impact of that is being felt now. So, the government including the RBI will have to give more teethes to the Sarfaesi Act, the debt recovery tribunal legislation that needs to be reworked and the governor has done nothing on that front. So, to say that the government has to improve the quality of fiscal consolidation but banks will continue to do what they are doing without any changes in terms of the policy environment becoming more facilitative, it doesn’t work that way.

So, we need to see more of a facilitative environment from the regulator’s end before we see the banking sector actually improving its overall health and people who say, why should banks not reduce their base rates because their cost of funds of an  ICICI Bank is 6.16 percent, the cost of fund for a  PNB or a  Bank of Baroda is barely 5.8 or 6 percent don’t forget this is just a nominal cost of fund but if you add to that the cost of carrying large impaired stressed book on their portfolio if you add that to it you will add about 75-100 basis points to the six percent which means that effective cost of fund for an Indian bank today is not 6 to 6.5 but anywhere between 7.5 to 8 percent.

The rule of thumb is every 50 basis points increase in NPA reduces your margins by 75-100 basis points going forward, and we have seen that happening. So, to cut a long story short I have always maintained I like SBI and I still maintain that because cash is king, they are sitting on more than Rs 60,000 to 70,000 crore worth of cash and their international loan book is doing very well. Last quarter that grew by 20 percent. That accounts for 20 percent of their overall loan portfolio. So, while the domestic side of business is sluggish like it has been for any other bank SBI, given the fact that it is the leader in the space and the delta it enjoys as and when the economy turns around this will be the first one to show signs of sustained recovery. I would still stick my neck out for  SBI and perhaps Kotak ING, followed by  Axis Bank in that order. That would be the pecking order.


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