Cyclicals to outperform and action to move to midcaps next year

By Nikunj Dalmia & Abha Bakaya

If confidence comes back now, then capex will revive and it does not require crony capitalism for capex to revive, says Ridham Desai, MD, Morgan Stanley India.

Do you really see the potential for cyclicals to outperform going forward, in the next year or so?
Yes. We will break this up into three cohorts. One is the cohort consisting of domestic cyclicals versus say exporters. Exporters have done very well, notably software services over the last five years. The bull run is over and we are going to move to domestic cyclicals -- be it consumer cyclical or industrial cyclical and that is one cohort.


The second is largecaps versus midcaps. The performance is likely to move from largecaps to midcaps. If you look at the share of Sensex companies in total profits and total market cap -- both these numbers are at peak levels and it is a mean reverting variable. It tends to go down. The case is in favour of mid and smallcaps.

The third cohort that I have constructed is all the underperformance over the last 10 years could outperform the outperformance of the last 10 years. We have had a set of companies and sectors that have done very well over the last 10 years in an environment where growth was sluggish in while we were running very high real rates. The global economy was not exactly in good shape and all this is now inflected in favour of those underperforming sectors. Quite a few changes may happen over the next several months.

What is the biggest risk for you at this point?
There is nothing which makes any view completely risk free and in fact uncertainty is why markets strain the way they do. Imagine what they were doing in March and April versus now. There are risks and we should not discard them. The immediate risk of course remains Covid-19. Even though India’s cases have declined sharply, we have an ongoing festival season which brings people together. Temperature is dropping, especially in North India and we have got rising pollution because economic activity is normalising and this combination can be very lethal. So Delhi is experiencing a resurge. The US and Europe are experiencing record high infections and very high rate of hospitalisations over the past few weeks.

I would keep my fingers crossed going into December, January. There is still some chance of Covid returning and as a nation we will have to observe a lot of discipline at the individual level. Covid is fought at individual level, it is not fought at the society or community levels. Everyone of us needs to take that precaution to make sure that we do not become a spreader or acquire the disease. The risk is still there because that could create regional lockdowns. It could create retraction of economic activity and cause people to stop travelling by planes and move around. That risk has not gone.

The second is a slightly medium--term risk. Somebody in India makes a policy error. The fact is that the world economy is coming back with a pretty strong momentum and therefore it will also bring some inflation back. The Fed has already announced that it is going to be greatly tolerant of inflation. If the inflation runs away and the Fed is too late in increasing interest rates in the US and it falls behind the curve, that would be a recipe for the end of the US bull market. Likewise, for bull markets, we are including India. We have to keep a very sharp eye on how the policy is evolving.

In India for example, while I expressed a very bullish view on domestic manufacturing and capex, there is still a fair bit of policy work that has to be done and we cannot assume that everything is done. There are several policy areas which need looking at. We have to execute on infrastructure. A lot of things need to be done and if those do not happen, then again it may cause surprises to retract. So there are quite a few risks on the horizon.

Since you mentioned that this era reminds you of 2003-2004, we all know large part of 2003-2004 bull market was also a function of inflation, rupee depreciation and crony capitalism. If that is missing, what will drive things forward?
I may slightly differ with you here. It was not a rupee depreciating environment, it was a DXY depreciating environment. The dollar was depreciating, the rupee on a headline basis may appear to have depreciated but on a trade weighted basis, was appreciating actually. Against the dollar, it was certainly in very good shape and so we got a depreciating DXY. A depreciating DXY does increases the scope for policy errors for emerging markets including India. It causes accumulation of forex reserves because the central banks around emerging markets are busy trying to depreciate their currency. They do not want the currency to appreciate since it hurts competitiveness and that causes accumulation of forex reserves and very strong domestic liquidity.

The third thing it does is it basically pushes fund managers in the US which is the largest asset management business in the world, to look for international assets to diversify away because the dollar is depreciating. That is one commonality between what we saw then and now. The second common factor is that the best performing sector between 2004-2007 was energy and over the past few months, energy has been the second best performing, if not the best performing market in India. So there is something common about it. I do not think energy will replicate that performance with regards to crony capitalism of course that is not something we want again.

What we need is capex and what you are arguing is that it was crony capitalism that led to capex. I dare say that it was actually to improve growth prospects and the possibility that growth will remain high for longer which pushes companies to invest. If that confidence comes back now, then you will see this capex revive and it does not require crony capitalism for capex to revive. What it requires is confidence that growth is reviving and that has been missing over the past few years. I feel that somewhere down the line, that confidence will come back.

So, you get a capex cycle and that is how you get a replication. Of course, it will not be the same. Those are the similarities and differences between now and then.