equity valuation: I-Sec’s Vinod Karki’s big picture view on macro, global macro and equity valuation

“In an environment where demand is robust and input cost prices go down, I do not see any reason why margins should not sustain at the current levels, if not rise. That is the broader outlook and certainly sectors will benefit or lose but the trend is that margin pressure should start to ease going forward,” says Vinod Karki, Equity Strategist,


The way global macros have eased with crude prices coming down, US 10-year rates coming down and the dollar index coming down – all support India macros a lot and hence are positive for the markets. What are your thoughts there?
Yes, that is very important because if you observe CY2021, by the end of that year, we were preparing for going into a quantitative tightening cycle and we were hit by a double whammy of the Ukraine-Russia conflict which set the whole thing on fire.

On inflation, people had started saying that it would be like the 60s-80s when Paul Volcker had to raise interest rates to double digits in the US. That story is slowly fading and now people are saying that inflation has peaked out and things will be much better on that front and that is reflected in bond yields. The expectation of an end of the quantitative tightening cycle is important from an equity perspective because equity valuation contraction in over the last several months was primarily being driven by this fact that we are into an unprecedented quantitative tightening cycle which typically results in equity valuations getting severely contracted.

I think that is receding and will set up a floor for equity valuation in my view. So quality valuations will not contract significantly from here if we are peaking out in terms of the quantitative tightening cycle.

What it has also done is that since last year when the US Fed was at around 0.25% Fed rate and if they have maintained those rates and we were going into a recession, they did not have any ammunition left to fire going into a recession. Going by the current terminal rate, we end up around 4.5-5% in the next several months and that gives the Fed some ammunition or rather quite a bit of ammunition to support a recessionary kind of environment.

Whenever we reach that kind of an environment, although there is nothing to suggest right now that the US is going by high frequency data on jobs or retail spending, it is not suggesting that immediately there is any recession but even if we go into recession we have something from the Fed to intervene and take rates lower basically.
So from an equity perspective, that is reflecting into that quantitative tightening cycle which was being extrapolated and that is showing up in flows into emerging markets like India and other places which are risk assets globally. That is a big picture in my view from a macro, global macro and equity valuation perspective.

I was just analysing the flows which have come. FIIs have become buyers with almost Rs 30,000 crore pouring in November till date and 40% of those flows have gone into financials. Surprisingly, the second biggest area after financials where incremental FII flows are going are FMCG and IT. Margin pressures and growth slowdowns were issues for both these sectors. Do you think the peak of pessimism is already in margins in FMCG?
Yes, in the latest research, just prior to the one we released yesterday, we had pointed out that the economy is largely a zero-sum game in terms of margin transfers or profit pool transfers. A few months ago, when commodity prices were spiking, the argument was that commodity producers are getting the benefit of the profit pool shifting from the commodity users. Basically they are getting windfall profits.

Now for many of these commodity producers, their profit pool has significantly shrunk because commodity prices have come down significantly. It is but natural that on an aggregate basis, the commodity users will see the benefit that we are seeing the initial signs in terms of commentary because these contracts do not change overnight. It takes some time but we can see that commodity prices have come off and if commodity producers’ profit pools are reducing significantly, it is a matter of time before commodity users will gain at the cost of the commodity producers.

A lot of these companies have taken some amount of price hike and they would not be in a hurry to cut if the demand is robust and we are seeing that the demand in general is reasonable, if not spectacular. So in an environment where demand is robust and input cost prices go down, I do not see any reason why margins should not sustain at the current levels, if not rise. That is the broader outlook and certainly sectors will benefit or lose but the trend is that margin pressure should start to ease going forward.

You are bullish on the capex cycle. One of the capex cycle parts is CVs. The commentary seems to be suggesting that they are gaining market share today. How do you see the CV part of the capex cycle in India?
CV is another capital goods. The direct beneficiary of capex cycle revival is capital goods and it takes some amount of lag in terms of which capital goods see the first effects. Certain sectors like CVs might show it early but other larger turnkey capital goods producers will also see the benefits as and when the large Greenfield, large Brownfield project start taking off. But the main point is that capital goods including CVs will be a direct beneficiary of a capex cycle and typically the capex cycle takes time to start.

You have just seen the start of the whole capex cycle in terms of announcements and some movements that we are seeing, but these cycles do not fizzle out in a year or so. They build on the momentum and it lasts for several years. It is a very good environment for capital goods and capital intensive sectors in terms of demand outlook, there is no question about that.

There is a dilemma in the market on engineering and capital goods. Good quality companies are not trading cheap. They are quite expensive and people are scared of going into lower quality plays as far as engineering and capital goods are concerned. How are you navigating this issue?
Yes, thankfully what is happening is that the largest engineering company, L&T, is at any valuation which can be thought of as euphoric or anything like that. Although it is not extremely cheap, some of the other engineering companies are quality companies and not anyway cheap. You have to remember that it is where is the demand coming from in the economy and the valuations call is very difficult because we have observed that wherever there is a boom in terms of economic activity in whichever sectors, valuation takes a backseat.

When the order book keeps flowing, and earnings keep expanding, it is very difficult to take a valuation call. We will find languishing valuation only in sectors where the outlook is not good but a capex cycle does not fizzle out in year one or two. It takes several years. So, there will be several legs to their performance and some of these companies may have outrun in the first leg. The point is if year by year, demand keeps coming in, how will these stocks correct?

In every quarter, we will see better and better order books surprises on earnings. Things will only get expensive and that has been the problem with capital markets. Look at internet companies last year. They did not have even earnings basically but the outlook was looking great. People kept bidding up the prices and we have to look at where the demand is coming from. So things will keep getting expensive but basically one has to be there in the early part of the cycle.

In order to ride out the entire cycle, it is very difficult to take valuation calls in areas where the growth is looking to go bust. Basically, that is the dilemma.