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In an interview with ET Now, Sanjeev Prasad, Kotak Institutional Equities, says banking sector could prove to be the dark horse. The present situation is a curious combination of very bad macro and decent micro. We are not seeing that much of earnings downgrades and rather some earnings upgrades are coming.

Edited excerpts:

With rising yields and rising oil prices, do you feel things could get a bit edgy?

They are definitely on edge as far as macro is concerned. If you look at crude prices at $75 per barrel, it is not a good sign for the economy. If oil prices persist at current levels and you are looking at a current account deficit closer to 3%, it is clearly not good news for BOPS. Also, every dollar per barrel increase in crude price effectively puts a tax on domestic consumers to the extent of about $1.5 billion. So, it could crimp consumption at some point of time.

If crude prices keep on going up, that will impact us through higher import inflation and also general inflation will start rising. On the macro side, things are really not looking very good but so far the equity market has been somewhat detached from all the troubles that we are seeing on the macro. Valuations, of course, are on the higher side at about 18 times on the March 19 basis for the Nifty 50 index.

So, things are on the edge in the sense that things could go further wrong as far as the macro is concerned. I am not very sure whether this market holds up given the external environment is not looking that great and top of that the macro situation is looking somewhat weak.

You just talked about the external environment and that really brings me to the US 10-year yield which has now breached the 3% level. How critical could that be in terms of inflows into equities across the globe and thereby have its repercussions on us as well?

We have not seen that much flow anyway for the past two-three weeks. April has been a wash out as far as FII flows are concerned and if you look at the broader emerging markets, we are seeing the same thing over there effectively outflows from all the major emerging markets so clearly higher bond yields are not good news for emerging markets. The question is what is driving the higher bond yields? Is it just because of higher inflation or does it have more to do with the fact that the US economy could be peaking?

It looks like it is both the things and unfortunately inflation in the US has now gone to above 2% which means the US Fed will continue to raise rates over a period of time and that probably will not be in a good news for global markets and emerging markets for sure.

Are you bracing for a significant bout of selling gripping the markets come May because either way, May runs with the adage of take a break, go away, sell in May! Do you think that is the kind of scenario that we need to contest with?

You do have a lot many variables out there. Do remember that on May 12,th the Iran-US 35 plus one nuclear deal will come up for renewal as far as the US is concerned. If that does not get renewed, then you could see a fresh bout of uncertainty as far as geopolitical issues are concerned. God forbid! There could be a spike in crude oil prices also because Iran is a very big supplier as far as crude oil is concerned and that will definitely not be good news for India.

Also, the Karnataka elections results will be out on May 15th and depending on what comes out, the market will react. Accordingly, there is just a lot of uncertainty as of now. Macro variables do not look very good. Thankfully, it looks like the March GST numbers will come out better than the run rate we have seen over the last few months. So, that should help but in general. the macro backdrop to this market is looking extremely weak.

ET Now: If the macro backdrop is looking extremely weak then is the choice for investment naturally veering towards defensives? Perhaps IT and pharma—the underperformers — given the potential of outperformance there. Could we find the alpha opportunity there?

Sanjeev Prasad: The market is clearly positioned more in the private retail banks where valuations have become fairly rich. Consumer staple discretionary stocks valuations have become even more expensive compared to where they were let us say three months back.

IT stocks have actually been amazing performers over the last six months to the extent of 20-30% and they have actually been very big outperformers over one-year basis. The period of underperformance is over in my view.

The challenge now is knowing where you want to hide. The valuations are super expensive and these are great companies but you will have to continue with very high valuations and in the rest of the market, there is a lot of value, but obviously there is no interest over there given all the challenge some of the companies are facing.

In an uncertain environment, there is a tendency to migrate towards areas where you have some visibility in earnings and comfort with the management, governance etc. They have in a way become richer but valuations are just languishing with no interest over there.

ET Now: So where within the earnings cluster do you think there is scope for some dark horse or positive surprises coming in? Would it be restricted to capital goods as well as construction as a theme?

Sanjeev Prasad: That is an interesting part about this whole market. One of the reasons why the market is getting supported is the fact that earnings numbers seem to be generally holding out reasonably well. Given the weaker rupee, earnings upgrades are seen in certain sectors primarily IT.

Since commodity prices also seem to be doing quite fine you probably see some upgrades here too. The broader economy seems to be experiencing a decent recovery.

So, it is a funny situation of very bad macro and decent micro at this point in time. In general, you are not seeing that much of earnings downgrades and rather starting to see some earnings upgrades.

The real dark horse in my view is the banking sector, the earnings numbers can swing either way. A lot of people are extremely concerned about earnings numbers for both the private corporate banks and also the PSU banks, given the fact that you have no handle on what kind of provisions these banks will have to make over the next two-three quarters in light of the February 12 directive of the RBI.

If things turn out well in some of the NCLT cases, then you could actually see some earnings upgrades for the corporate banks over the next year or so. That will determine the earning numbers for the market as a whole.

If you look at our own numbers for the Nifty 50 index, we are looking at about 21% growth for the market for March 19. Here about half of that incremental earnings will come from the banking sector. We are assuming a turnaround in the second half of fiscal 19 for the banking sector once the provisions are made in line with whatever RBIs direction for the some of the stressed assets which are not NPLs as of now. After that, we are hoping that you start seeing earnings recovery and if that is the case, then may be it could provide some support for the market despite the macro looking extremely challenged for now.

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