In an exclusive interview with ET Now’s Nikunj Dalmia, Bharat Iyer, MD-Global Research, JP Morgan India, says at 0.8% on MSCI world index, our weights in the indices are nowhere in relation to what our potential is. Edited excerpts



Nikunj Dalmia: US markets are at a record high, bond yields are at a record low, gold prices are at a fresh six-month high that is the kind of disjointed world we are in?



Bharat Iyer: Yes, these are very, very interesting times.



Nikunj Dalmia: When you say interesting, is it interesting because as Rakesh Jhunjhunwala says that mother of all the bull market has dawned on us, or according to George Soros who believes that it is time to only buy gold? What does Bharat Iyer have to say?



Bharat Iyer: As you know, we have been positive on Indian equities since the beginning of this year and that stance very much continues. Our base case target of 8600 for the Nifty has been hit and our bull case target of 9000 seems to be around the corner. But if I were to look 12-15 months down the line, I do not see why you still cannot appreciate another 12-15% from Indian equities as an asset class from here.



Nikunj Dalmia: Do you think in the next 12-18 months we could be decisively trading higher from the current levels, when I say decisively I mean 10-15%?



Bharat Iyer: I would think so. You know I would not rule out the Nifty trading at say 9500-10000 by the same time next year.



Nikunj Dalmia: That is a very conservative estimate?



Bharat Iyer: That is 12-15%. It can always get better but that is the base case at this point in time.



Nikunj Dalmia: A fundamental watcher would say that the valuation comfort is missing but the liquidity conditions are so benign that bulls can’t put a foot wrong. Every time markets go higher, we say it is liquidity. Every time markets go lower we say it is rich valuations, it is not that easy?



Bharat Iyer: It is not that simple because first and foremost, I would like to point out that liquidity does have an impact on valuations so the risk free rate today is meaningfully lower than it has even been in the last 10 years, both if you consider the global risk free rate and if you look at the local risk free rate and let us face it Indian equities as an asset class is completely exposed to the global risk free rate.



So I guess valuations have to be in sync with that. That is I think the first proposition that as a bull I would make. More importantly, even if you were to look at valuations from a very narrow construct, you know, yes the bears would say that look we are trading at about 18 times forward earnings, which is one standard deviation higher than mean and the historic average has been about 15, but as I said, a) you have to look at a much lower risk free rate; b) it is the classical cyclical argument, isn’t it? You want to buy a market at the highest multiple at the lowest point in the earnings cycle and you want to be selling the market at lower valuations but at the highest point in the earnings cycle. We are believers that the earnings cycle is troughing it out and is headed higher.



So I think even from a classical valuation point of view, the PE does not look that scary. And last but not least if I may, if you look at valuations in relation to asset values, the Nifty on a price to book is trading at about three times currently. The historic average has been about 3.3 times. So we are actually trading marginally lower than historic averages and the utilisation levels in the economy are right now at about 70%. So there is a lot of operating leverage to be harvested on the way up as far as earnings are concerned. I do not think valuations per se are a headwind.



Nikunj Dalmia: That is the domestic aspect that demand will come back, utilisation rates will move up and operating leverage would kick in but 40 per cent of the Nifty earnings are still global in nature, IT, pharma, metals and even energy, that is a problem. So your domestic earnings may expand but global dominated sectors will contract?



Bharat Iyer: I do not know if they will contract because obviously the resources spaces is a very complicated area and things could go both ways, who knows and that still looks challenged, I mean, we may have bottomed out but we do not know if we are completely out of the woods. But on IT and pharma, I still think there is a case for earnings to be growing at about 13-15%.



I do not think that base case has changed very meaningfully, yes the markets can get excited about a half a basis point miss or a half a basis point correction in guidance by some of the IT majors or pharma companies having a couple of challenging quarters but I do not think that takes away from the basic merit of the story.



Nikunj Dalmia: Buffett once said that go where fishes are, not where fishermen have reached and I get a sense that lot of fishermen have already reached India because India is more like a crowded trade, the fact that we are growing is old news, the fact that we are growing at a run rate which is enviable that is yesterday’s story, the fact that we will have a growth rate which would be higher than China next year, everyone knows about it?



Bharat Iyer: If you look at the MSCI world index, India has a weight of about 0.8 or 0.9% and investors are just about neutral weight or marginally overweight on that index and this is an economy which if you look at the next five years, the next 10 years and so on and so forth, is going to become a top five economies, potentially going to become a top three economy.



I think our weights in indices are going to go up very, very meaningfully for a variety of reasons because we are going to grow faster than the rest of the world because we are going to have increased free float from a lot of our promoters, there is going to be a lot of capital raising coming in from very, very exciting companies. So I think one needs to take a slightly longer term view, our weights in the indices are nowhere in relation to what our potential is and if you were to look at the potential is, then I think there is still a long way to go in terms of our markets being over invested.



Nikunj Dalmia: The fact that US dollar has stabilised somewhere is good news for emerging markets. China is no longer this entire black box and I am getting a sense that money is rotating back into emerging markets because US equities are expensive. So, do you think for the moment more than India it is an emerging market rally and we are simply backing on that rally?



Bharat Iyer: I think it is a combination of both but your point about emerging markets coming back into flavour is very correct. I think if you look at it emerging market equities have been an asset class which have underperformed meaningfully for a protracted period of time, three to five years now and this is an asset class which is very-very underinvested in and you have a scenario now where the growth differential between emerging markets and developed markets is if anything, widening.



Emerging market growth seems to be kind of stabilising whereas developed growth is trending lower and there are no signs of an immediate pickup and this typically is-- these are phases when you see a lot of money coming back into emerging markets. So I guess you have the growth differential equation which is our favour, emerging markets are underinvested as an asset class so money is obviously coming in.



That is one part of the equation, but also what we have to appreciate is that within emerging markets, India is perhaps one of the strongest stories on a structural basis because you look at a lot of other markets, you know, they tend to be, I would not call them one trick ponies, but there tend to be limited areas of investments and they do not have the same kind of broad based appeal that a market like India does have. So I guess, yes you are right, emerging markets are seeing flows but even within that India stands out as a very good structural opportunity.

Nikunj Dalmia: I am going to keep the Nifty aside because we have spent a lot of time looking in the Nifty and that historically influences the way we look at the market momentum, let us look at midcap, and a range of mid-cap stocks are sitting at a 52-week. Socks like Bajaj Finance or even a Muthoot Finance, I am looking at a very random list here, are you not worried about some frothing is coming in the midcap space?



Bharat Iyer: I think across the market if you ask me, there is a bit of froth that has developed particularly over the last week or so and near term I would not be surprised to see a shake out. I mean whether it happens in September or October, one does not know but I would brace myself for a shakeout over the near term because most technical and momentum indicators are looking a bit stretched at this point in time and as you point out, a lot of froth in midcaps typically also is one of those indicators that we look at.



Nikunj Dalmia: The froth in midcap, the action in IPO market, all I am saying is that these are classic red indicators?



Bharat Iyer: Yes there is a fair bit of complacency. I mean if you look at leveraged positions, if you look at market breadth, if you look at... a lot of these indicators, I would agree that technically the market is a little stretched at this point in time. So do not be surprised if you see a correction. But I think what we could brace ourselves for is a correction. I mean we have had a rally of almost 25% to 30% from the February lows. So can we get a 6% to 8% correction at any point in time, why not, I mean that would not surprise me. But are we seeing a trend reversal and are we going into a bear market? I would be very surprised to see that. I think that happens only if there is a global liquidity scare, ex that I do not see the conditions for a bear market at this point.



Nikunj Dalmia: Markets are obsessed with liquidity and more than fundamentals they are tracking and judging the liquidity events, Fed meeting, comments from ECB, BoJ and what they could do, now whereas ECB and BoJ are committed to print more money we do not know what US Fed will do, the best case scenario is that they do not move this year, the worst case scenario is that they move by 25 bps, so let us discuss both these scenarios, what they mean for India?



Bharat Iyer: See, the way we look at it, our base case is that there is one more rate hike this year by the US Fed but perhaps sometime in December but if that one rate hike comes through I do not think that really is going to disorient markets in a very meaningful manner, I do not think that is going to roil the markets. But that said, yes, this is a meaningful risk, at some point in time, with the kind of monetary stimuli that has been provided there is always the risk that inflationary factors start playing up at some point in time and central banks around the world figure out that they are behind the curve.



I do not think that is something that is necessarily going to roil the markets over the next six to nine months, but you obviously have to keep an eye on that because that has been one of the driving forces behind this market rally. So I guess what we have to do is watch inflation particularly global inflation very carefully and if it reaches a point where it is becoming a little discomforting, then one has to start factoring that into valuations. But is that something that I am worried about for the next six to nine months? Not so.



Nikunj Dalmia: There are a lot of concerns surrounding the IT sector. The fact that IT is a mature industry is passé now. We know that base is so large that they will continue to contract. But I am getting a lot of commentary, a lot of eyebrows are raised around the fact that Indian IT model will not last. They have not been able to reboot themselves. Whereas IT companies are still maintaining that they will grow, markets are punishing these stocks as if there is no tomorrow?



Bharat Iyer: I would tend to agree with you. I think there is a case for investing in the sector. I think if you look at most of the front line stocks, they are perhaps trading at discount of 10% to 15% if not more to the Nifty. I think we last saw this during the global financial crisis. I still do not think growth is that challenged. I mean these are companies which are growing dollar revenues at 8% to 10% which will likely to grow earnings at 13% to 15% and I think this is going to continue for the next three-four years and it is not that companies are not taking steps to meet the new growth opportunities, particularly in areas like digital or artificial intelligence and so on and so forth. So I think there is actually valuations that are looking appealing, I think there is a case to invest in the sector.



Nikunj Dalmia: So are you overweight IT?



Bharat Iyer: I would be an overweight IT sector.



Nikunj Dalmia: You have been overweight on private banks for the longest time. The reasons are wide open. I cannot get into stocks so I will have to perhaps rephrase my question slightly differently. So let us talk about retail banks versus corporate banks. There are private banks which are retail in nature. There are private banks which are wholesale in nature. ICICI Bank is corporate bank, HDFC Bank is a retail bank. So within the classification of retail versus wholesale, what is your preference?



Bharat Iyer: Well I think the way we are running our model portfolio at this point in time, we still have about 60% to 65% of our money allocated to the financial space in the retail banks and they have done very well for us. We have no complains.



But over the last four-five months, we have also allocated roughly 35% of the money which we have in financial to banks which the street perceives to be at one end of the credit cycle issues and that is basically because what we have seen is a gradual cleansing of the system.



We believe about 60% odd is already done and we think in the next quarter or so a little more will be done, so we think we are nearing the end of that exercise. So we are not going the whole hog at this point in time, we are not that courageous but do we have about 30-35% of our money in banks which were perceived to more risky? Yes we do.



Nikunj Dalmia: Are you endorsing new sectors like MFIs, NBFCs?



Bharat Iyer: As far as MFI and NBFCs are concerned, we still think they fall in the midcap category and we think that it is more a stock specific approach rather than taking a broad based approach. We appreciate the rally that has happened recently and I think there are reasons for it because the state owned banks in particular have been constrained for capital and also because of the credit cycle issues have really not been lending very aggressively and that has opened up a very meaningful market opportunity for these guys. I think they have done well. I mean are we worried about the rate of growth of some of them? Yes. But are we worried about a systemic blow out? No, not at this stage.



Nikunj Dalmia: What could be a mega trend and by mega trend, I mean a multi-year story? For example, if you bought into IT in late ’90s, that was a mega trend. If you bought into infra names or capital goods companies in the previous cycle which is 2003 and 2008 cycle, that was a megatrend. What is the megatrend for this bull market?



Bharat Iyer: I think a couple of trends are looking very interesting. India is still a story where a bulk of the appeal really lies in our demographics. So discretionary consumption particularly which is geared towards the young as they hit the labour market, I think is a very-very interesting theme which I think will play out for a long-long time to come.



Urbanisation is a theme which is very linked to this so again that is another theme which has legs and which could go on for a long time. And purely from a cyclical point of view, if you are looking at the next two, three years I think the government has clarified its investment priorities and articulated it, I mean, these are going to be areas like highways, railways, power transmission, defence, potentially rural infrastructure. So again sectors and segments that cater to all these areas should do very well for the next two, three years.



Nikunj Dalmia: Historically, one has always avoided buying into leverage companies, companies which have a high level of debt but when the cost of borrowing is coming down and the cost of capital globally is going to be almost zero, do you think it is time to revisit that thesis?



Bharat Iyer: We are still in the class of investors who believe that it is better to play operating leverage rather than play financial leverage because your point is well taken that the cost of capital has come down. But I guess, the risk appetite on part of the lending institutions is still not there. I guess they are still going to be a little circumspect and I would not fault them for it.



But the good part is if you look at the Indian economy, the capacity utilisation on average is about 70%. So you still have a huge number of companies with low financial leverage but which are operating at utilisation levels of about 70%. So there is a lot of operating leverage on the way up. The way we look at it, those are lower risk areas to play the potential growth and the pickup in the economy rather than go in for financial leverage.

Nikunj Dalmia: When you say discretionary, the first port of call has to be autos but if a stock like Maruti, is trading at 5000 and if the PE multiple is close 30-35 times, one wonders that there are great companies in the auto sector but can they be great investments?



Bharat Iyer: I think it again depends on where you are both in terms of the risk spectrum and size spectrum.



Nikunj Dalmia: Let us say this the starting point, is it a good starting point for autos?



Bharat Iyer: The largecaps, depending on the segments you like, could still deliver returns in the region of 10-12% or even going up to 15%. It really depends but the large caps can still deliver returns. I mean, I cannot see a scenario where they fail to grow earnings at say about 15% or thereabouts, whereas if you are willing to go down the size spectrum, I guess, there are a lot of areas, look at media, you look at speciality restaurants, you look at so many of these spaces where I guess the market cap of companies are very small and you could potentially make more in those areas, if you go down the size spectrum.



Nikunj Dalmia: Typically money is made when there is a little bit of earnings rerating and a little bit of PE rerating. Where is this kind of an opportunity where prices are reasonable and earning rerating is round the corner?



Bharat Iyer: If you ask me, purely looking at it from a very immediate term point of view, valuations are currently at a fairly reasonable to high level. So, I think the potential for rerating is a limited at this point in time. I think we have gone up the rerating-- that leg of the rally has played out.



Nikunj Dalmia: Is PE expansion over?



Bharat Iyer: PE expansion at least at the market level is broad based and is largely done. It still do a little more, but it is fair to say it is largely done. So the next leg of rally in the market is largely going to be driven by earnings.



Nikunj Dalmia: Is it time to buy risk in the portfolio?



Bharat Iyer: As I said, the way I look at it is if your portfolio was 100% invested in “defensives” or risk free stocks say 12 months back, I think you should be taking risk to the extent of 30-35%.



Nikunj Dalmia: Going forward, do you see a time wise correction or a time and price wise correction, both?



Bharat Iyer: If you put a gun to my head, I think in the next couple of months you would see both a price and a time correction. I think you should see some price correction as well but that is purely a near term point of view. As I said if I look 12 months ahead, I still see the indices meaningfully higher.



Nikunj Dalmia: A year from now, if we are interacting on the same forum, what kind of economy do you think we could be staring at?



Bharat Iyer: Well I think we could be looking at an economy which is growing at about 7.8-8% and I would stick my neck out and would say perhaps you would be seeing the Nifty somewhere in the region of 9500-10000.



Nikunj Dalmia: Which is the one data point which has really surprised you?



Bharat Iyer: I think most data points have actually been trending in the right direction. If you ask me broad based, we have been quite happy with the way most of the indicators have gone but I think the one area that really stands out for me is the government’s commitment to fiscal discipline because for the last two, two and a half years we have consistently heard that this is a number that would be breached and this is something that we will not follow the fiscal consolidation roadmap. I think we have to give them a lot of credit, I think this is one number that has consistently surprised for the last two, three years.



Nikunj Dalmia: And where are you slightly disappointed or have you overestimated the change in activity?



Bharat Iyer: I guess all of us perhaps thought that the pickup in growth would perhaps be a little higher and perhaps be a little more broad based but I guess what we did not contend with was the serious headwinds from the global environment.



Nikunj Dalmia: How do you see consumer staples moving now?



Bharat Iyer: As far as consumer staples are concerned, the base case for growth remains. I think the sector was impacted and the demographic argument is still very strong. We were impacted by a couple of years of bad monsoons. That seems to be changing now. So I guess, the growth environment in my view will continue to trend in the right way. I guess where we always struggle with is valuations.



Nikunj Dalmia: Do you think it is more like a Jekyll and Hyde kind of a situation for us? Jekyll is that we are growing at a run rate which is higher than the industry average, almost an enviable situation. The Hyde situation here is that we are not exactly cheap and there is a lot of froth in the IPO market and the mid-cap market?



Bharat Iyer: I would agree with that. I think what this market needs is one good shakeout and to give the next leg of the rally a strong foundation.



Nikunj Dalmia: Every market has a leadership, every market has a predefined leader, where do you think there are leadership features in this market?



Bharat Iyer: If you look at the last five months, if you look at the lows from February and what has subsequently happened, I think it has largely been financials. I think that is where have seen the leadership really and apart from that there have been pockets of mid-caps as you rightly pointed out.



Nikunj Dalmia: Do you think private banks can give you a CAGR growth of about 15-18% on a large base and I am referring to top three without getting into names, let us talk about them as a basket, can the top three private banks in India grow at about 15-18%?



Bharat Iyer: In terms of stock price performance?



Nikunj Dalmia: In terms of stock price performance.



Bharat Iyer: I think they can give you 15% and I will tell you where I am coming from. I think if the economy revives as we all expect it to revive then there is no reason why they are not going to grow their loan books at 15-20% and the fee income will also start picking up. So no reason to believe that you do not need very significant rerating as such, they can give you a price performance of 15%.



Nikunj Dalmia: Who will be the eventual winner in the banking space because one side you have got PSU banks, poor capital management, high NPAs, they are losing market share, private banks they have got lion’s share, the base effect has kicked in, you have got microfinance companies which are trying to put their foot in the door so to speak and then you have got small banks which are claiming that they are the efficient in digital banks in the world?



Bharat Iyer: Well if you ask me take a slightly longer term view of the system, once these credit cycle issues are behind us, I think there is space for everybody to grow because let us face it this is an economy which is still significantly underpenetrated in terms of financial services and in terms of banking itself.



We hear a lot of concerns about retail credit growth in excess of 20% but let us face it, you look at retail credit growth as a percentage of GDP and where we are in relation to even the rest of the Asian economies, leave aloe what is happening in the rest of the world, I mean, we are barely scratching the surface.



So I think there is scope for everyone to grow, there is place for everyone to grow. I guess the challenges are clearly going to be, as you rightly pointed out, there are two or three challenges that are clearly there; I mean, one is you know you need to build a very solid liability franchise because that is increasingly going to become more and more competitive, that particular area.



Two, as you have pointed again, you know, the product proposition has to be very-very contemporary and it has to be something that appeals to the customer. So it could be reaching out to the customer on a digital platform in the urban areas or how do you reach out to customers in rural areas and get your financial inclusion package right. I guess so what you cannot write off is competition but in terms of size and scope of the market there is a long way to go.



Nikunj Dalmia: We have discussed Fed and how market could interpret or could ready into the Fed commentary, there are two more unknown-unknown factors; one is this China unknown factor, today we may have pushed the China issue on the back burner, we do not know when it can haunt us and second this entire issue of Brexit, on paper, I can argue that look it is three years away but there would be negotiation, a lot of back and forth, both the parties would be firing shots at each other so the space is going to be messy?



Bharat Iyer: You may be right, I would not write these things off. See I think what has happened for a lot of the global variables we have discussed is that the can has been kicked down the road, I mean, be it the credit issues in China, be it what happens with Brexit, be it what happens in terms of monetary policy in large parts of the developed world, which is the reason, fortunately or unfortunately, our markets are very-very well integrated with the global markets at this point in time, which is the reason you just have to watch these variables, you do not have a choice.



Turning bearish too early has never helped anyone because you could have turned bearish on each of these issues, three years back, five years back or even a year back or even three months back when Brexit was at the peak of the discussion agenda. I guess you just have to keep watching these issues and if anyone of them turn disconcerting or uncomfortable, one will have to change one’s views on the market but right now the impression you get from policy makers across the world is that they have kicked the can down the road, so enjoy the party.



Nikunj Dalmia: I am going to take a punch line from your answer which is do not turn bearish early.



Bharat Iyer: Exactly. Do not turn bearish early but there are risks out there, most of them are global rather than local, keep an eagle eye on them but stay invested until any one of them turns into a meaningful near term risk.