Inflation will probably surprise us on the upside… could lead to higher interest rates: Prashant Jain – The Indian Express

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Prashant Jain, ED and CIO of HDFC AMC — the longest-serving fund manager in the country — speaks on the impact of global events on Indian economy and markets, surge in the number of new retail investors, new-age companies and the way ahead for investors. The session was moderated by Sandeep Singh, Resident Editor, Mumbai. Excerpts:
Sandeep Singh: Over the last few months, markets have been impacted by several events — Fed tapering followed by rate hike, inflation, FPI outflows, Russia-Ukraine war, and now the RBI moving to tackle inflation. How should one see the markets and what should investors expect? 
Probably no one has a good answer to this. The nature of markets is that in the short to medium term, they’re extremely hard to forecast. You may spend as much time in markets, but the short term is very uncertain. Markets in India are reasonably valued, but I think they will deliver reasonable returns in line with nominal GDP growth over three to five years. The economic outlook has improved post-COVID compared to what it was pre-COVID. The profit growth cycle has clearly reversed and there has been a fairly broad-based recovery in profitability across all manufacturing sectors.
What are the worries? I think retail is a very big participant in these markets. Whenever retail participation is very high, it is not a good sign. In stock markets, the majority is seldom right over long periods. If you look at the retail flow of savings into equities, roughly $40 billion a year is coming to mutual funds. Maybe, $15 billion net flows into the insurance industry and another $10-15 billion is coming through the EPFO and the NPS. If you assume direct participation in stocks to be another $10-15 billion, it adds up to $80-100 billion per year. India’s pool of household financial savings is about $300-350 billion; 10 per cent of the GDP. This suggests that almost 30 per cent of household financial savings is now getting into equities. Easy money conditions in the world and spike in household savings rates during COVID has also contributed to this. I think all that is set to reverse, more outside India than in India.
Sandeep Singh: A lot of new investors come with the hope of making quick money. Is that a challenge for the mutual fund industry?
For mutual funds, I don’t think it should be too much of a challenge. These are markets that are reasonably valued. While there are pockets of excesses, there are also pockets where value is reasonable. The profit growth outlook is quite robust. Unlike  2018-19 and 2020, which was a very narrow market, where just five-odd stocks delivered more than 100 per cent of NIFTY returns, these are very broad-based markets. As a mutual fund manager, I feel okay to generate reasonable returns for unitholders over long periods. What worries me is the shift in trading volumes in India — all of these are coming from options. This suggests that the entire retail participation is speculative. Futures and options is a zero-sum game. In derivatives, you make money only if someone loses money. When I travel to very small towns, I’m surprised to see that earlier it used to be men, now it is youngsters and women. Everyone feels very comfortable trading in futures and options. And that is a bit worrisome. I don’t think it will end nicely.
George Mathew: Despite the huge volatility in the markets, SIP investment is at an all-time high. What is driving retail investors into stock markets?
In 1992, we were in a similar situation. Everyone was investing in equities. Even in 2000 and 2007, it was  similar. What is happening is not new. Of course, technology has made this possible along with few other factors. One, post-COVID, the markets fell sharply. Combine that with good savings in households, because COVID did not impact the upper-income mid-income households in India. Their savings simply went up. Also, digital adoption was accelerated and interest rates collapsed. They also probably had a lot of time at home. Combine all of this with the fact that whatever little investments anyone made then, turned out to be extremely profitable because markets were so low. The good experience has been reinforced, and it has spread by word of mouth. Demat accounts that were about four crore pre-Covid, have risen to about nine crore. But many people are likely to be disappointed because they are looking at making money on equity as a monthly income.
Anil Sasi: Typically, rising interest rates mean a good time for equity investors while the bond investors will perhaps worry. Does that hold in the slightly abnormal situation that we are in now? With a number of global events — the US rate hike, the geopolitical situation, and the inversion of the yield curve that probably is a pointer to inflation, or at least it’s been a pointer to a recession in the past – how do you see everything put together?
The impact of global developments on India’s economy is quite limited despite the fact that India has opened up quite a bit. Given the demographics, the consumption-led economy, other than oil, we are reasonably self-sufficient, and our pool of savings roughly matches our investments. Our exports to GDP and imports to GDP are quite small. So the variability of India’s economy to developments outside India is quite limited. The best example of that is that even in the Lehman year (2008), India’s economy grew by more than five per cent. The underlying drivers of the economy, whether it is demographics, increasing working age, population, low penetration or consumer durables, all of that hold us in very good stead. When it comes to capital markets, however, there is an impact that global capital markets have on Indian markets. Not over the long term, but over the short term. I think inflation will probably surprise us on the upside. We should be prepared for meaningfully higher rates in the US. I don’t think that should have a material impact on India’s economy or even capital markets. Equities are a hedge against inflation. Inflation means companies increase selling price of goods and services and it shows up in higher earnings. To that extent, equity investors need to be less worried about inflation.
Harish Damodaran: In terms of stock markets, India has been a consumption-driven economy, more than an investment-driven economy. Is that story over?
India was and continues to be a consumption-driven economy. Of course, the patterns of consumption are changing. For certain categories, as income levels have improved, the penetration has increased and growth rates have come down. But, consumption baskets are changing. The mobile handset market is as large as the car market and mobiles take priority over cars. If Ola and Uber have come in as an alternative to owning a car, the fact that white-collar wage inflation in India has seen negative real growth, could also be impacting the car industry.
I think consumption in India should continue to grow. But we should not link this to stock markets. Today, commodity prices are going up sharply, which will put pressure on the margins of these companies. There are no tailwinds or further tax rate cuts. So whether it is paper, sugar, textiles, chemicals, metals, capital goods, banks, everything is growing now. The premium of the scarcity of profit growth is missing. Finally, the cost of capital is also going up. So it is quite natural for these companies to derate. And I don’t find that surprising.
Post Lehman, investments in the world have gone down, especially driven by ESG concerns. CapEx and capital formation have been low in traditional industries for a variety of reasons and that is beginning to show up. We have under invested and the renewable space has not been able to take up the entire space at the speed that was desired. There have also been some supply bottlenecks due to the situation in China and Ukraine. I think the balance will shift slightly, because if basic commodities experience inflation, clearly, it will mean more profits to those groups of companies and better market caps. It will mean higher interest rates and could also impact consumption a bit. This could end up adversely impacting other businesses.
P Vaidyanathan Iyer: The pricing power has shifted more towards the larger corporations who are generating higher profits. While it positively impacts stock markets, what about the MSMEs — the backbone of the industry, many of whom are facing stress, and some getting wiped out? How do you look at its impact on the economy in the midterm?
SMEs are absolutely critical because they provide employment to very large numbers. A number of factors have come together to create this. One, of course, was the lockdown. One is the formalisation of the economy; GST, which clearly has hurt them. The flow of credit to the new entrepreneurs in traditional businesses and even to the existing SMEs has clearly been challenged. Even the DFIs funding is missing in India. Lack of proper credit has created a challenging situation. E-commerce also has an adverse impact on some of these businesses as India is a land of shopkeepers. However, there are a few things that could improve. Make in India is a very big theme. We have genuinely gained competitiveness over China. Chinese manufacturing wages are now two to three times of Indian wages and their per capita income is five times ours, which was not the case 20 years back. Their subsidies are being reduced and they are themselves discouraging export of energy-intensive products. So, it’s a conducive environment for India to improve its share of manufacturing. PLI is a great initiative, so is defence indigenisation. A Rs 2 lakh crore subsidy, at the rate of five per cent means Rs 40 lakh crore over five years or Rs 8 lakh crore per year. These are fairly meaningful numbers.
When Maruti was set up, it led to the development of ecosystem of ancillaries. So, over time as we come up with these large initiatives across verticals, it will lead to flourishing of ancillaries. They are badly needed because they enhance the competitiveness of our country and provide employment. I think there will be some churn but eventually a large number of SMEs will come up in the manufacturing area.
 P Vaidyanathan Iyer: Kiran Mazumdar Shaw in Bangalore said that the hijab incident will hurt investments in Karnataka. Or the Ram Navmi processions, views on azaan or the Shobha Yatra on Hanuman Jayanti — all this may be brushed aside as politics, but do you think it augurs well for the Indian economy? 
These could be isolated incidents, these could be irritants, but there are far bigger forces that are at work here… I personally don’t think that incidents like these would have any material impact on the economic progress of the country.
Shyamal Majumdar: You followed the value investment style that went through a rough patch in the last five-six years. Did you go through sleepless nights during those phases and what has been the learning from that?
I’m used to this. I moved out of infra stocks and bought into consumer pharma. This time the pain period was a little longer. But unless you are able to withstand these periods, you will not come back. I feel blessed that I was able to handle that. Coming to this whole debate around value and growth, I think it is misunderstood. All sensible investing is value investing. There are companies that are growing faster because they are less penetrated or there is a new business model and they will deliver higher returns. People get attracted to it, and they drive up the prices much more than the growth. People also extrapolate the last three-five years growth into very long periods of high growth sustainability, which is seldom the case. But markets being markets, they make these companies extremely expensive.
I love investing in fast-growing companies, but we have to distinguish between the growth of a business and the stock price. When the stock price of a fast-growing company becomes so expensive that even the higher growth rate is not able to justify that price, that is the time we move out and look for better investment avenues, which are typically in slower-growing companies. My investment approach is simple: focus on sustainability of business, competitive advantage, figure out what is the long-term growth outlook, and don’t overpay for that. If you do, it will cause you long-term pain.
Shyamal Majumdar: Some of the new-age companies, which are now getting listed, have hugely disappointed investors. How do investors make an assessment of companies where no conventional metric applies?
These companies have not disappointed all investors. They have exceeded the expectations by a huge margin of the early investors — the private equity funds. We need to distinguish between a good business and a good investment. We need to put them into buckets, one where at least the business model is reasonably well established and the route to profits, route to profitability, is well charted. There are businesses where even the visibility of profits is not well established and it is made on optimistic assumptions. I’d like to ignore the second set of businesses because I am not a venture fund. I’ll suggest something similar to equity investors, unless, of course, they understand these things extremely well.
Shubhajit Roy: Geopolitically speaking, many analysts have equated the Russia-Ukraine crisis to past events. On the economic front, where will you place the current crisis?
I don’t think anyone would support the invasion of a sovereign, democratically elected government. But these are small economies. Russia is less than $2 trillion, Ukraine is a fairly small economy. So, that way, I don’t think there is an impact. But these two countries are large exporters of energy, grains, vegetables oils, and many metals. So that would add to inflation. Energy inflation is very critical, because energy inflation impacts us in many ways — wages, service sector, higher transportation costs,  cost of production for agriculture and manufacturing. It means higher costs for all plastics. Higher energy also means you will divert some agricultural products to ethanol. So it will lead to higher inflation in other agricultural products. Inflation will probably surprise us on the upside and it could lead to higher interest rates.
Rahul Sabharwal: The IT industry has seen about a 10 per cent downfall in the last month. Do you think that industry per se is overvalued? What sectors do you think offer growth at a reasonable valuation right now?
A lot of the prosperity, economic success that we are seeing in India today, in reasonable measure, we owe it to the IT industry. It employs probably five million people, gives us foreign exchange of more than US $100 billion, which gives us the purchasing power to even import oil. This is one industry where India is uniquely placed, it is very competitive and sustainable. While that 100 per cent growth became 50 per cent, then 30 per cent and now is growing at 10 per cent, it will continue to grow because COVID has accelerated the shift to the adoption of digital. But we cannot ignore that it is a large industry, and therefore, its growth rate should naturally be moderate. I do feel that the consumer sector and IT sector are two businesses which are overvalued.
This market is 90-95 per cent market cap to GDP. So most of the sectors are offering us reasonable value. Businesses where multiples are still below longer-term averages, are basically power companies now and nothing else. This time when credit growth takes place, it should lead to good margins because banks are sitting on low credit deposit ratios. The shift towards digital banking will lead to faster consolidation and large banks that have good platforms will gain market share faster.

Sandeep Singh: What would be your advise for investors in the market?
The long-term returns of any portfolio of an individual is driven to the extent of 90 per cent or more by asset allocation. How much money you make over 10 years is a function of whether you invested 5 per cent, 10 per cent or 50 per cent of your wealth in equities, 10, 15, 20 years back and not of the funds you bought, or at which exact index you bought. The right asset allocation for any investor towards equities is that portion of wealth, which they don’t need for five to 10 years, and on which they can tolerate volatility, both emotionally and financially. Second is the issue of small, mid-large caps, an issue that is misunderstood. If you look at long-term returns, the small cap index, the mid cap index, the large cap index, they’ve all delivered similar returns. Therefore, the key issue is how much to equities. In any industry, large or small, it is leaders who tend to outperform. So my approach to investing has been that don’t focus on the size of the business, focus on the strong players in the respective industries, large or small.
Pranav Mukul: You mentioned that you’ve been managing this fund for 28 years. That’s just about the average age of a crypto investor in India. What has been your experience with such alternative investment mechanisms? 
Something like crypto has happened for the first time in my career. I am not a believer because it is too volatile to be a currency. It is not widely accepted and is probably not legal either. One cardinal principle is that don’t invest where you don’t understand. I made many mistakes of omission but very few mistakes of commission. I don’t understand or believe in crypto, so I have simply stayed away.
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