RBI is seen to cut rates by another 75 bps

'Growth acceleration will be gradual and it is still early days for a sharp recovery.'

The sharp fall in inflation has been cause of much cheer for markets, as it implies that sharp cuts in interest rates will follow. In all its euphoria, the markets have ignored that the fall in inflation will be accompanied by low growth. Gautam Chhaochharia (2nd left), executive director and head of India research, UBS, tells Malini Bhupta that even though the RBI is expected to cut rates by another 75 bps, FY16 will not be very different from FY15 and that he expects earnings to just about hit double digits.

Where does India stand both in absolute and relative terms?

India is in a good shape -- both relative and absolute terms -- from a fundamentals perspective. From the markets perspective, what has happened (the decline) is that the reality has finally dawned that recovery will be gradual. Our view has not changed since last year that India's macro will improve gradually and inflation will surprise everyone.

When you say inflation will come down sharply, what you are also saying that growth recovery will be slow. We also said that rates will come down as inflation declines, which surprised the markets positively. Growth has surprised negatively in the last two quarters, but it was ignored. Now, it is finally catching up.

What is your earnings estimate for FY15 and FY16?

We will exit FY15 with an earnings growth in single digits, 7-8 per cent. The Street is still looking at 16-17 per cent growth for FY16 after cutting estimates. More earnings cuts are likely. We estimate earnings growth to just about make it to double digits.

In that case, are valuations justified?

Valuations are rich, but justifiably so.

By when do you expect corporate India to deliver double digit earnings growth?

If you look at India's nominal GDP, it has been growing at 12-13 per cent, which should make double-digit earnings growth possible as the private sector is supposed to be more efficient. But that was not the case last 3-4 years. As growth starts slowing, earnings tend to fall below nominal GDP rates and when growth accelerates, trajectory of earnings moves towards nominal GDP rates and then surpasses it.

The second driver of corporate earnings is the mix between real and nominal. When nominal growth is driven more by real growth than inflation, then earnings improve.

Do you expect GDP growth to accelerate in FY16?

We expect GDP growth to be higher by 20 basis points year-on--year in FY16. Under the new series, we expect GDP growth to be 7.5 per cent. Growth acceleration will be gradual and it is still early days for a sharp recovery.

Which sectors will drive earnings?

Banks will play a big role because, we believe, as non-performing loans and net interest margins are bigger drivers of earnings than credit growth. If credit growth is slow, it won't impact profitability too much. But if interest rates come down, the impact on non-performing assets, bond-book and margins will be higher.

What is your forecast on interest rates?

We continue to expect 10-year bond yields to touch 6.5 per cent by end FY16.

The government has been criticised for not doing enough to improve business environment. How are investors viewing the Modi government?

The government is taking steps to improve ease of doing business. If you look at policy direction, steps have been taken across sectors. If you see telecom, the mess is behind us and regulatory uncertainty is behind us. Similarly, if the Supreme Court had cancelled coal blocks two or three years ago, who would have expected the re-auction to happen in three months but the government has done it.

The Coal Bill, Mines Bill and Insurance Bill have been passed by Parliament. The delta in the Coal Bill is that it allows merchant mining, which is a big reform. The only area the government is lagging (in) is land bill.

Do you expect coal output to improve to one billion by 2020, and will the power sector benefit?

Theoretically, it is possible but it will be a staggering challenge. At the margin, coal availability will improve in India because of the more concrete plans Coal India has and infrastructure will improve for specific mines. The auction of cancelled block will also help. Additionally, prices of imported coal have come down, which will also benefit the sector.

When do you expect the power sector to come out of its current situation?

Lower coal prices will help the sector. Now, SEB (State Electricity Boards)-specific reforms required are to ring-fence the state regulators, which was meant to become independent in 2003. The crux of the (SEB) reform is that the state level regulator is independent.

Where do you see interest rates in the coming fiscal?

We expect the 10-year government bond yield at 6.5 per cent by March 2016. We expect RBI to cut another 75 more bps by March 2016.

Will RBI's decision to cut be influenced by what the US Federal Reserve does?

The RBI will track inflation data. Rate differential reflects inflation differential and risk premia that bond investors would want for local economy's credit metrics. India's fiscal deficit and current account deficit is improving, the risk premia is anyway improving. India's premium or risk to US Fed is improving. India's rate cuts will be driven by inflation and interest differential with the US is not coming down on a real basis. We expect the US Fed to cut rates in September.

Where do you expect the Indian currency to be?

On an absolute basis we expect it to be on depreciating side as we expect US dollar to remain strong.

Is the currency a risk to corporate earnings?

It is too early to say. Export growth has come down and it is because of global conditions. Currency is only one driver of exports, a move of 5-10 per cent in currency does not impact exports in a major way, experience shows.

But cross currency moves do impact earnings?

That is an accounting move and not a fundamental one from long-term perspective.

What is your view on Indian IT?

We are cautious on Indian IT, as we do not see too much room for positive surprises.

Do you think the sector's valuation versus its growth trajectory is justified?

When you say growth, is it one year or five years? In the near term, it is a matter of expectations versus delivery. But a five year call is trickier as there are newer growth opportunities beyond traditional application & maintenance. On the other hand, SMAC social, mobile, analytics and cloud)can even be potentially deflationary.