India ‘best-loved’ Asian market in absence of China stimulus: Avendus Capital’s Andrew Holland

Avendus Capital CEO Andrew Holland spoke to Moneycontrol about the opportunities and challenges for the Indian growth story and the impact of global headwinds. Edited excerpts:

The top worry over the past few days was the Chinese economic recovery. What are you picking up in terms of sentiment and impact on the commodity space and global economic growth?

China has come back onto the radar in terms of what that could mean for global growth. I think we’ve all been anticipating some kind of stimulus from the Chinese authorities. We have seen it in little patches but there’s not been that kind of “bazooka” type of reform or injection into the economy, which the market’s been expecting. It is not really firing up expectations that the economy can recover very quickly. We’ll have to wait and see. What that means now is that India is obviously becoming the “best-loved market” in Asia. I was speaking to a number of people over the past week and when they visit investors in Asia and elsewhere, earlier they would say that China was cheap in terms of its valuations. That conversation has disappeared and it’s now about what they can buy in India even though valuations are high. So, this is good news for India until the Chinese announces a stimulus package.

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But what is the market sentiment? Will it remain negative?

Until a package is announced, there will be a negative sentiment. China is a huge economy and many countries which export into China such as Japan, Korea, their economies would also be impacted. The slowdown would have two impacts – one would be to take the developed world closer to recession a lot quicker than what the market is expecting. The second is a little bit more positive as deflation will be good for inflation coming down. It falls into our view that at some point, towards the end of the year, the Fed will have to reduce rates because the global economy, including the US, is moving towards recession. That is not being helped by the slowdown in China.

What do you think of the rate trajectory in the US? There seems to be some kind of disagreement over tightening a little bit more or staying the course.

The minutes had a little bit for everyone – the bulls and the bears. I think we’re going to watch very closely what happens this week when the Federal Reserve chairman and the European Central Bank chairwoman will be speaking. We may get some more clues into how hawkish or dovish they might be. My suspicion is that they will remain on path. Our view is that we are just starting to see deflation happen in the US. It is really only shelter which is keeping the inflation a little bit higher than we would hope. We’re starting to see that even though jobs are holding up, wage growth has started to slow and we think that will accelerate in the back end of the year, forcing the Fed to move quicker than the markets are now anticipating. The bad news is whether it will be a shallow or a deep-rooted recession. And that’s where you’ll see the markets probably retrace some of the gains we’ve seen over the summer.

Looking at the past three quarters, can you portray the best- and worst-case scenario?

If I was to say the negative first, it would obviously be the expectation that recession is going to happen. You could see global markets falling 5-10 percent from where we are today just on that basis. India would probably fall around half of that in terms of our kind of markets. Going into 2024, everyone’s going to look for growth and India is going to be one of those countries which will continue to shine. But that is very short term. Obviously, our inflation has started to pick up, monsoons are below expectations and there is still El Nino too to face over the next month or so. There are  quite a lot of things to take the shine off India. But it’s not necessarily a kind of a big fall in our markets in terms of what we’ll see globally.

How big a worry is inflation in India? What is your take on the domestic growth story?

The domestic growth story will continue to pick up in the second half of the year. This is because of the capex spending by the government and private companies. It will have a multiplier effect on the economy. We think earnings will start to be upgraded towards the back end of CY2024. In terms of inflation, a lot of it is to do with food and the government is taking its own actions on that. I think that the fear would be if China announces a big stimulus and that pushes commodity prices further. That will result in extra caution for investors if there’s a risk off trade happening because inflation is just going to be stickier and therefore the RBI will have less room to reduce rates as quickly as we were expecting.

Will corporate India or the top 100 companies or the listed space look better in terms of financials and growth in the second half of the year?

The first quarter was actually okay. There were obviously sectors which did badly and we know the IT sector is one which will continue to probably be a drag on earnings in the next quarter as well, but thereafter I think you’re going to get the multiplier effect across different industries because of the capex cycle, both by the government and by private companies and that will boost your margins and capacity utilisation, which has an impact all the way through to the bottom line. In the second quarter, I think there will be a few downgrades before we start to see the upgrades.

Where do you expect those downgrades in the second quarter?

I think it’s going to continue to be in the metal sector. The banking sector might see some kind of downgrades because of the surge towards getting deposits. The IT sector will still see some more downgrades. But you’ve also got other sectors which are going to benefit from lower commodity prices in metals at the moment, which would help their margins, in particular. I think the other problem we have is to think about the rupee, where we’re obviously importing inflation as well. We need to keep an eye on that in the short term, given what’s happening in China and the devaluation of their currency or depreciation of their currencies over the last month.

Is there any indicator that you would watch out for to call the bottom in IT?

If you think valuations are a bit stretched at the moment and you expect another 5-10 percent reduction in earnings and that the share price would follow that, you could look at maybe 5-10 percent lower than we are today in September to October. But if your expectations are that interest rates are going to fall in the US, this would be good for obviously technology stocks on a longer term basis and would probably be a tailwind and help drag these stocks higher on a very short term.

Next year, we have the general elections. Do you see any acceleration and investment spending? Do you see the impact of government capex spending play out in the stock markets?

If it’s more to do with capex – let’s just say giving out more contracts for roads, bridges, etc. – then that doesn’t have an impact on the economy at all for two to three years. First of all, you’ve got to award that contract and then secondly, it would have to be built and that doesn’t happen overnight. I don’t think that’s the factor I’d be looking at in terms of stimulating the economy between now and when the elections are next year. I see the government continuing with its capex programme. I don’t see it being anything different than we have today.

What are the top plays when you play the investment cycle or capex recovery?

If I look through the cycle over the last 20 years or so, share prices do move on the contracts being awarded. So we know that the government and private companies are going to be awarding more contracts and if foreign direct investment comes into the areas you’re going to see the order intake continue to grow. What I’ve always found a problem with has been the execution side of these contracts. I’d rather follow the cycle on the contract being awarded rather than the execution and therefore the earnings. I still think we have some more time to run in this sector because there’s obviously a very big capex cycle by the government but I also expect companies to look into India as they move away from China but also on the possibilities of growth within India and then exporting from India as well. So, that’s going to keep the capex cycle going for the next two to three years, at least.

You mentioned a few downgrades in the banking sector. How do you play the BFSI space?

Asset management is an area that is very easy because we know that savings is going to continue. There is going to be more disruption in the industry, either through regulation or through new entrants. That’s going to play in the minds of investors in a very short term. I think with the banks and the non-bank financial companies, there are two schools of thought. One is obviously a lower interest rate environment that probably favours non-bank financial companies in the shorter term. That seems to have kind of drifted out now because of the Fed rates and higher for longer possibly. With the banks, obviously there’s the squeeze on margins. So there’s no real catalyst at this moment in the short term looking for quick returns from the banking and financial sector. I think there’s enough pressure there at the moment just to keep it where it is and if I’m correct in expecting that interest rates will fall in the US, that’s probably the catalyst for these banking and financials names to start moving again. But there are too many moving parts.

Are there any pockets of value that you see?

Defence and renewables are two areas that are not going to go away for many years. The capex cycle is also going to continue in terms of order wins. Other sector is services such as hotels, airlines. I think we are going to continue to see domestic spending and going forward we’ll see a lot more foreign travellers coming back into India. Another new segment would be the “premiumisation” in the alcohol and non-alcohol beverage area. There is a lot more kind of growth for these companies. The final one is the electronics industry. It is difficult to find the right names because they’re all small companies at the moment. But it’s going to be a huge industry – domestically and for exports.

If you just look at market cap, small and mid-caps have had a great run, especially small caps. Do you see them outperforming large caps?

If you take the small cap sector as a whole, it is always fraught with danger because you’re going to have those companies which are going to have very good governance and those which are not. You have to be very selective in what you’re buying. If you take the electronics industry, there are quite a number of companies which are small to mid-caps. Now the question is if they can become large cap in the future. It will be about if they have the right management, products, etc. It’s too broad a brush to say that small caps will continue because I think once we see any kind of downturn to the markets I would suspect that it’s going to be the smaller mid-caps which would suffer a lot more.