“Investors should moderate return expectations given equity valuations”
A strong recovery in corporate profits even as economic growth remains uncertain due to the COVID-19 pandemic gives investors hope. However, equity investors should moderate their return expectations given the high valuations, according to Gaurav Mehta, fund manager at SBI Mutual Fund, the country’s largest fund house.
In an interview with THE WEEK, Mehta said that central banks in developed markets are likely to remain accommodating to support economic growth and that any normalization of monetary policy will be gradual.
Q. Despite valuation concerns, benchmarks continue to hit record highs. What’s your perspective from now on?
The discourse on equities globally has shifted from examining conventional valuation metrics such as price / earnings or price / book to examining equity risk premium (ERP). The ERP basically looks at the valuations of stocks relative to the level of bond yields. As bond yields remain low globally, this helps support what might otherwise look like high stock valuations.
The other thing that has excited investors is the strong impression of corporate earnings in recent quarters, at a time when economic growth has yet to find a foundation. This gave hope that the downward trend in the ratio of corporate profits to GDP for more than a decade has stopped. At a time when economic growth has likely bottomed out, an increase in the earnings-to-GDP ratio could lead to a non-linear increase in earnings over the next several years. While we are optimistic about the upward earnings cycle, investors would do well to moderate their return expectations given the valuation situation.
In the near term, the biggest risk in our view is the strained reading of our internal measure of equity market sentiment, which suggests an overheating market. This makes the market more vulnerable to any perceived negative news flow.
Even though the large cap indices are at an all time high; we’ve seen many small and mid caps correct over the past few weeks. Why?
For more than two years, even before the COVID crisis hit, between early 2018 and early 2020, mid and small caps underperformed large caps, due to a double whammy of tighter liquidity and a sluggish economy. At the COVID lows of March 2020, market capitalization was extremely polarized in favor of large caps, making the rest of the market very attractive on a relative basis.
Since then, as the market recovery took shape, liquidity and the economic outlook have improved, disproportionately benefiting mid and small caps. However, after their strong relative performance, the valuation differential against large caps has returned to historical norms, suggesting that the risk / reward ratio is now more balanced on this front.
The SBI Balanced Advantage Fund recorded record inflows. What is driving these flows to mutual funds? Are Advantage / Dynamic Balanced Funds Now Investors’ Favorite Theme and Why?
The formalization of the economy and the financialization of savings have become important structural themes in India in recent years. However, the asset allocation decision is becoming increasingly difficult today. Nominal yields on fixed income instruments remain low and do not even offset inflation. This forces many conventional fixed income investors to look for other return possibilities. At the same time, many investors may not be very comfortable with stock withdrawals, and current stock valuations make them more nervous. A combination of these factors should mean that investment avenues that promise returns above inflation while mitigating downside risks should continue to attract investor interest and inflows.
What are the areas in which you feel comfortable putting money aside at this point from a 12- to 36-month horizon?
We continue to take a bottom-up approach to our investment approach. Overall, however, the last decade has been devoted to deflationary assets, with growth remaining anemic. Within equities, equities offering security and visibility on earnings performed well. Today, while the global political environment remains strongly supportive of growth, the winners in the next few years could be very different as economic growth picks up.
More generally, investors should focus on the quantum of growth rather than security. Strong growth opportunities could come from two pockets: a) pro-economic sectors such as consumer discretionary, industries and auto accessories on the one hand and b) structural themes such as specialty chemicals, exports engineering, pharma, insurance and savings games, and consumer Durable goods should also continue to offer strong growth opportunities.
Indications from major central banks, including the RBI, are that there will be an easy monetary policy unwinding from next year. What is your opinion? Will interest rates rise in 2022?
Over the past few weeks, one of the main concerns of investors around the world has been the likely normalization of easy monetary policies by central banks and the resulting impact on economies and markets. The comments of the Federal Reserve Chairman at the recent annual Fed Symposium were, however, welcomed by the markets, as he made a clear distinction between the “beginning of the decline” and a possible “take-off” regarding key rates, the latter probably a long way off.
The noise surrounding the delta variant of COVID could possibly push back even the modest standardization, which has been set. In our view, monetary policy in major developed markets could remain broadly accommodative, leaving more room for fiscal policy, given the now well-appreciated need for continued fiscal expansion to revive these economies. Therefore, lower rates for longer could continue to be the guiding mantra of Western central banks. While central banks in emerging markets (EM) will have to take into account their own local dynamics, an accommodating position of their counterparts in developed markets (MD) should also give them more leeway in the conduct of their monetary policy.
We have seen FIIs pull out of emerging market equities, including India, in the past couple of months. Do you think this exit will only accelerate as US growth improves?
A plethora of reasons including fears over central bank policy normalization, the economic slowdown in China, China’s regulatory crackdown on the private sector, and lingering fears about waves of COVID have led to some nervousness among investors lately. Global reflationary trade suffered as a result. However, India’s performance was hardly in line with that of emerging markets. Since the start of the year, India has performed significantly better than the EM index, which has largely stagnated, and has also been better than most DMs. This has led to a significant increase in India’s valuation premium in emerging markets.
When it comes to growth in the United States, we’ve seen robust impressions so far aided by one-time benefit transfers during the pandemic, pent-up demand, and reopening. Yet for a significant and sustained recovery in growth, government infrastructure spending, as currently proposed, will need to increase, in our view. For the markets, too, legislation on this front should be an important trigger for the return of reflation trade. This should encourage flows to emerging markets, even if India risks returning part of its strong outperformance.
What impact will the possible normalization of monetary policy have on Indian capital markets? Will it be a situation like the “taper tantrum” of 2013 again (there was a sharp drop in equities after the US Fed announced it was cutting its bond buying program)?
India is in much better shape today than in 2013, with significantly better foreign exchange reserves, more comfortable inflation and much better prospects for economic growth. We also believe that after failing to overcome deflationary forces over the past decade, the central aim of DM central banks will be to bring back growth. Against this background, we expect normalization to be very gradual and well signaled, and unlikely to derail economic momentum. A look at the US bond yield curve also suggests a very different reaction to the last episode.
Unlike a sharp rise in long-term yields following the taper’s announcement in 2013, yields fell this time around. While the risks of policy mistakes are not insignificant, the greatest near-term concern remains the course of the virus and its impact on growth and inflation due to continued and localized disruptions in several parts of the world.