IT Stocks Ripe For Profit-Booking After Decent Rally, Says HSBC's Van Der Linde
The consumer sector is the one where valuations are very high but growth is highly visible, van der Linde says.
India's technology stocks will see further downside after seeing a decent rally and it is better to temporarily take money away from this sector, according to Herald van der Linde, head of Asia equity strategy at HSBC.
A weak business as a result of the expected recession in the US has not materialised. The IT businesses have also seen a revival due to the recent weakening of the rupee, van der Linde told NDTV Profit's Sajeet Manghat in an interview.
On a 12 month-out basis, the business mostly will slow down and that remains a risk, he said. "It's a sector that I structurally like, and I think it has seen a nice rally and may prefer to bench a little bit better at this particular portion in time."
The consumer sector is the one where valuations are very high, but growth is highly visible. The pricey valuations are not going to change and a lot of long-term growth drivers for India are coming in the consumer sector, according to van der Linde.
The Nifty IT has surged over 7.5% since the beginning of the month, with Tech Mahindra Ltd. and Persistent Systems Ltd. leading the rally by 13% and 11.5% respectively.
One Rate-Cut Expected This Year By Fed
Van der Linde expects the Federal Reserve to start cutting rates in September, given the current direction of the inflation trajectory in the US.
The inflation numbers suggest that there is a continuous decline, and Linde said that in the second half of the year, the Fed would have to make one cut.
"When they start cutting, they will continue to cut and normally, I expect this to repeat itself. They will wait until they are very sure there is a need to cut and then will see successive cuts coming through," he said.
Watch The Interview Here
Edited excerpts from the interview:
Will the Fed go ahead with the first rate cut in 2024?
Herald: If you look at inflation just over the last, say, two or three years or so, you basically see a very nice increase and a very nice decline. The numbers that we see now suggest there is a continuous decline. So yes, I think they will be cutting interest rates.
The timing of that is going to be important. That's what you're asking for and I suspect in the second half of the year they will have to do one cut. What already happens is that when they start cutting, they will continue to cut. So normally, I expect this to repeat itself again. They will wait until they're very sure that they need to cut and then you see successive cuts coming through.
But if you look at the overall trends in inflation numbers in the US, I think there's no doubt in mind that they're going to lower these interest rates and the second half of the year is a good guess. Well that's easy to say. It's June at the moment, but let's say from September onwards or so.
Inflation was very sticky in May. It hardly moved. Do you see inflation heading lower in the next couple of months for the Fed to take the first decision on rate cut?
Herald: Of course, they will be looking for further confirmation that these numbers are going to go down. But overall, I think the direction of travel is in my view fairly, fairly clear.
But you're right. Inflation in the US has proven to be quite sticky. I think there's a lot of things going on. There's a shift, for example, in the structure of the economy. Services are doing, for example, manufacturing. It seems like strength in the US economy has simply caught us a little bit by surprise. It's been stronger. Therefore, employment has been stronger and demand has been stronger. These sort of things have made the inflation number a little bit more sticky as well. So that is absolutely right.
But, if you look at the trend of last, let's say 12 months or something like that, it looks like every time it's moving lower or stabilising but it doesn't look like it's moving in the opposite direction. So, the direction of travel is clear but the speed at which the inflation number was going to come down is slower than anticipated from at least what we anticipated in the beginning of the year. You're absolutely right.
When do expect the Fed to comment on lowering rate? Normally the Fed starts commenting before it actually takes action in either direction.
Herald: That's right. At the moment, they put themselves in a holding pattern and I think they just want to get a clear indication that inflation numbers are getting to levels where they start to think it's moving towards uncomfortably low levels.
For example, we see that could either be excessive declines, or we see by the next month a big decline or something like that. Then, I wouldn't be surprised. We really need to start cutting rates. They need to see that being confirmed in other areas as well.
The problem in the US at the moment is that demand simply outstrips supply. That there is an overriding economy, the demand side of things is just doing pretty good. That shows signs of slowing, but that's a really slow process. I think they're looking for real evidence.
The worry is, of course, if they go too early and the inflation numbers pop up again, or again they will be very slow in responding to this and therefore don't go down so quickly. Then they might be seen by the market as being pulling the gun too early and that spoils their reputation. So they're right in what they do in that sense. I think they're waiting for clear evidence.
The market, at the beginning of the year, said you need to be very aggressive. You need to cut interest rates five, six times this year. Clearly, the market had to recalibrate its own expectations and storyline as well. So it's good that the Fed didn't just listen to the market but kept on hold in the first half of this year.
The BJP back is in power and holding on to almost all key ministries. How do you see the flow of reforms from here on? Do you see some kind of change or the government changing focus, going ahead?
Herald: No. I think, first of all, the win, I think, for India was a good win. It created a sense of political stability but also not at the expense of the reform momentum.
What we're expecting to see at the moment is, broadly a continuation of the sort of policies that have been put in place for the very simple reason that the same party leadership is still in place. However, there will be a shift, probably towards more focus on welfare spending. We've seen the kind of disjunction between rural recovery and urban recovery in India. Urban recovery being very strong, real recovery being much slower. So something to deal with that particular imbalance is probably important. Some sort of welfare spending or whatever that might be. We'll have to see details but I suspect that's going to be the cards.
Is spending well within the macroeconomic framework or the glide path provided during the interim Budget expected to remain there? Is it going to change or alter in some way?
Herald: I think we'll be very surprised if this would go at the expense of fiscal discipline, but they do this in a very disciplined way. Why so? Because, in the past, they have gone out of the way almost to show that they are very disciplined about spending programmes, not overspending. Not wrapping up the Budget too far, these sort of things.
India might have learned its lessons from the past. If you run a significant Budget deficit, that can be in itself much more costly than the benefits that such an aggressive Budget generates. So they have gone out of their way to make sure that they put the discipline in place.
So I would find it kind of unexpected if they would move in the opposite direction at this moment. So I don't think that's a particular working assumption for us. So more welfare spending is probably limited in that sense, and or maybe they have to resize some of the priorities and think okay, we're not going to do this, but we're going to do that. These sort of things.
Indian companies' earnings grew at over 30% in the last quarter. How do you see the earnings growth momentum in next financial year? How do you see the Indian rate cycle also playing out?
Herald: Well, let's start with the rate cycle. First, I think in the crystal ball region, all central banks are watching the Fed. There are other countries like the Philippines, where it looks like inflation is going to come down. They probably have quite some room to cut interest rates but are they willing to do so. At the moment not, because the currency is weak. They are too early and the Fed is not doing anything that might exacerbate the situation. So a lot of the countries are like the Philippines. India is no exception to that.
They probably would like to cut but they don't want to do that before the Fed does it, because the risk is if you do that, the Fed is later. Your currency is going to be weaker and then it imports inflation and that is going to upset things. They're all waiting for the Fed to move.
In regards to earnings growth, is the 30% earnings growth that came through the first quarter sustainable? I don't think so. That will come down. Is high growth sustainable, meaning anywhere between 15-20% over the course of the next three years or something like that in India? Yes, I think. That is quite achievable, because the drivers of the underlying growth are structural in nature, but also not always dependent on policy.
We have an inflow of investments. We have a development of urban consumption taking place. We have the benefits from better infrastructure investments across say 5-6-7 years coming through and most importantly, they've seen a cleanup in the banking system. The NPAs are down. So the ability to extend loans by banks is also much better... These are kind of one of those things that really boost growth, but at some point in time taper off but I suspect it will be a few years before that really materialises.
So is a healthy 15-20% earnings growth possible over the next three years that we call sustainable? Yes, I think. Is the Q1 number of about say 30% or so sustainable? That's probably a bit too high to ask for.
What is your take on various sectors within the economy? Are you moving away from some and entering new ones? FMCG and some other sectors were laggards last year. Foreigners have been exiting some of the financials. IT has seen some kind of revival.
Herald: On IT, you are right. It has seen a bit of a revival, because the US economy is doing better than what we initially anticipated. Everybody was talking about a recession in the US about 12-18 months ago. That has just not materialised. So that's good.
If interest rates go lower, that's probably not so fantastic for the banks either but I do think that the banks look reasonably okay. The thing with India is, it is not so much about growth. We see decent growth in quite a few sectors, but the problem is really valuations. Certain sectors are really expensive. So I'd like to go down the valuation yield curve, if you want to call it like that, for sectors where growth is okay but valuations are reasonable and banks fit into that.
One sector where valuations are really high and again the growth is highly visible is the consumer sector. It is probably one of the most interesting sectors in the region for Indian consumers in general. But it is pretty pricey. I don't think that is going to change but that plays into all the different themes that we spoke about.
Better infrastructure build out allows for businesses to grow. Employment develops consumption. You see formal retail getting market share over informal retail. The inflow of FDI is good for employment as well and again, that is good for consumption.
So, a lot of these long-term drivers for Indian growth, at the moment, all come together in the consumer sector. So, no surprise that's rather expensive, So I would be fairly selective on that particular front.
Do you see that because now that you are seeing the strong growth in services side and some bit of recovery manufacturing in the US, you're going to see some kind of order flows and growth coming back to some of the Indian IT companies?
Herald: So far, I said, particularly those IT companies that sell into the US probably expected the US to be in recession now and that business will be very weak. That has not materialised. That has not happened. So, therefore, that underlying business is okay. The currency is weakened as well. That means actually that the US dollar business has been repriced to certain extent in rupee terms. So I think that is driving that particular sector at the moment but if I look 12 months out, most likely that business will slow a little bit.
So, that remains a risk to that sector. So, you like the sector's structure but I think it's a nice rally. I think, I may prefer the banks a little bit better than this at this particular point in time.
Many of the companies in the consumer sector are high margin companies compared to their regional peers and competitors. What is it that makes them still very expensive? When do you see the flows coming back to these companies?
Herald: I think the reason why a lot of people think that they are expensive is because of their good growth and I don't think that is the case. I think the secret to success, particularly in the consumer sector in India, is distribution, capabilities to distribute.
If you come in as a new player in India, it is not that easy to set up a business, and in particular getting your products across the country. It's very, very difficult. The Indian consumer market is geographically much more diverse than for example, Indonesia or China, where most consumers are located in a few large cities.
The difficulty in building out a consumer business in India has got to do with distribution, being able to get your product to all sorts of smaller towns and literally having people on a bicycle bringing from one town and one village to another one.
Now, if you can do that, you can become incredibly profitable. I think this is the success of the high profitability of the most profitable companies. They are the most profitable companies on planet Earth, simply.
I mean, you have companies that basically are more profitable than 60-70-80%. That's higher than most of the AI companies in the US or Asia that people are looking at these days as well.
So, those incredible levels of profitability and the ability to generate cash flow should be rewarded and that is rewarded in the market. So that's where high valuations come from. So it's not necessarily the growth but really the profitability and cash generative kind of nature of these businesses.
But the valuations are high and this is what you therefore see when it comes to foreign investors. They always say, we like the Indian story. We don't have to talk about this, but isn't it really expensive. So what happens is they think it's expensive, rightly so. The P/Es are very high. Price levels are high. But the moment it comes down, you see them coming in. So, although we've seen outflows from the Indian equity market, actually the mutual funds are buying on the dips in India.
Do you think mutual funds are much smarter than foreign investors? Retail investors put in nearly $2-3 billion every month through SIPs and the mutual fund route. Is that preventing these companies from correcting?
Herald: Domestic funds are buying up the equities through these SIP plans that you just referred to. That's right. You see this across the entire region. Domestic investors, Asian investors are really buying into Asian equity stories.
So not just India, but we see this in Thailand. We see these early signs in Indonesia. China has already happened, as have Korea and Taiwan.
But in India, it is quite an impactful force. Partially, also because a lot of retail investors are unable to bring all of their money outside of India. Most of it has to be reinvested in India. So, domestic buying is very strong and that crowds out the foreign investors, who say, well, it's too expensive for me. So I am out.
So domestics are buying it up and are less price-sensitive and debt is another reason why the Indian markets are expensive. But as I said, that also comes with good probability of these companies.
So, is that creating a fear of missing out as well?
Herald: I think maybe sometimes the fear of missing out. That happens very often. If markets are already running very quickly, people are going to be wrongly positioned. Most firms are well-positioned in India. So it's not the fear of missing out, but if the Indian domestic investment continues to crowd them out, you can have a situation whereby the foreigners say, well, it's very expensive, but if this market continues to perform, I need to get exposure to this. I have been sold out. I need to get back into this. That could well happen.
The infra space is witnessing cash flows. Do you expect foreign investors to be more interested in those companies, because now they've reached a maturity or where cash flow is much more predictable and growth is much more sustainable?
Herald: So when it comes to infrastructure buildout, I think what I see in India is something that I saw 15 years ago in Indonesia.
I was in Tamil Nadu a couple of months ago. I took a trip. I like temples. So I went to see a bunch of temples in Thanjavur and places as such. What happens is that you're on a highway, but you drive for maybe 10-15 km or highway and you have to get off and you get through the paddy fields and stuff like that, small roads until you get to another segment of the highway that has been constructed.
So a lot of the infrastructure has not really been built out. So that means, in the near term, it's good business for the construction companies and infrastructure companies that have to put these roads in place.
But what we've seen in other markets is that the way to play this is actually through the consumer sector, or the services sector because at the moment these railways are done, more business is going to go round, more trucks, you need more restaurants, you need more hotels. All sorts of new businesses enter there. That means, also factories can go to a new location. That creates employment in that new sort of town that is now better connected to a highway system and these sort of things.
That is one of the key stories that's unfolding in Indonesia, for example, at the moment. And I suspect that's what we're going to see in India over time as well...
How do you look at fund flows because we've seen HNIs trumping the most, nearly 38% year-to-date. How do you see flows between India and China? You have a growth story here, but there is the issue with valuation in some of the pockets there. At the same time, you have China where the growth story is not that much. It's more of an oversupply story and there the earnings growth is not as much as India growth?
Herald: The core problem in China is oversupply. Oversupply means you produce more than you consume. There's a lack of consumption. There's just not enough. They tried to export and this comes with all sorts of other problems as well. If you can't export, you can lower your prices. So that's why you got a deflationary sort of environment in China and that means that they can lower interest rates. That's the story in China.
What we've seen in China that rebounds that has taken place is really driven to a large extent, to a repositioning of funds. They have been very negative on China since the beginning of the year. Then there was a realisation that the US Pension funds, which publicly had stated that they're going to reduce exposure to the US, that they are selling their stocks that took selling out of the market that so many people thought this market could suddenly rally a bit. There you go. They have repositioned themselves in that market to perform.
But in my conversations and in say, for example, in China but also in Taiwan and Korea, is that a lot of people are looking at that but they also bring up India as well. There's a tremendous interest for example in Korea, Taiwan, Japan, of Indian equities. So I think the fundamental story in China is very difficult, but people were wrongly positioned and needed to rebalance, they have mostly done so.
So, the fundamental story is India is much healthier, but that is well-priced in. So, we've seen a near-term sort of reshift of focus. But if it comes to the next two or three years, a lot of people would be more comfortable with their investments in India than in China. We like both markets, but this is I think the general sentiment.
So, have we seen some flows from going into China? I think, maybe not as much as you think. I think there's the money coming out of Japan and so many other markets also from outside the region that are going to China. Yes, we have the suspicion that hedge funds have sold down India to buy China. However, we look at the long-only mutual funds, a lot of them actually have increased their weightage in India. So, these people have stuck with India.
So, between these Asian countries where the flows are moving, how do you rate India and how do you rate China?
Herald: At the moment, we like both markets for very different reasons. China is cheap and well-positioned but has massive challenges. So, we'll be taking a tactical view on it. India we like for more structural reasons, as I mentioned earlier. I don't really have a preference for one over the other. If you would say to me, I put my money in the market now and I want to invest literally for the next five years or something like that. Then I would say 'Hey, maybe India's story looks a little bit better and there is more certainty to the direction that China is taking it'. So then I would have a small preference for it but rating-wise we like both markets at this moment...
What's the one risk that you see in investing in India or in China?
Herald: There's always sorts of geopolitical risk, these sorts of things. I think the risks lie maybe with the equity investing in India, I think it might well be we've had a nice rally and companies have performed very well. We got to be careful that some of these valuations don't run away from us.
So, in India, we had a big rally in small and mid caps last year. The stock exchange came out and said, 'Listen, that's fine. You can buy these but just be very careful.' They made some warnings, and I think that's very good that they do so because sometimes you get this kind of fear of missing out, as you mentioned, to want to participate in something and put money where maybe in the long run, it's not so wise to do so.
Sometimes in India, you see this sort of exuberance taking place in certain sectors, we have to be careful of that. China, the risks are very different. So, the risk is simply that they need to put policies in place to deal with the overcapacity, and at the moment, it's difficult to see how they are going to address that in the very near term. So, we have to get more signals on that front. But that is the ultimate problem in China. A leg of demand I would risk is maybe that they're not doing too much on the demand side in China.
