6th July 2012

Naganath's view on the market - which is widely tracked and followed by many advisors - should come as a shot in the arm for those who are despairing about listless markets. He is fairly optimistic about central banks globally doing whatever they can to keep markets in good cheer and thus give themselves more time for growth to come back into their economies. He is equally confident that we will now see some momentum in reforms and therefore in capital spending in the Indian economy, which can support domestic markets and lift them higher towards the end of this calendar year. Read on to get his incisive insights on global and local markets and on how his equity team is managing equity portfolios in this market.

WF: Now that Fed has announced a continuation of Operation Twist and ECB seems to have found a mechanism to fund European banks directly, do you see asset prices moving up as much as we saw in QE1 or do you see a more muted response to these measures?

Naganath: For now markets are reacting positively because withdrawal of liquidity would have been a blow to sentiment given that the markets are mainly concerned about the euro zone crisis intensifying as we see more news about Spain and Italy which are much bigger economies with bigger debts outstanding. So continuation of bond buying by the Fed is a welcome move that will help to keep liquidity conditions reasonably good. However, the quantum of the liquidity infusion through this is obviously much less than what the markets are looking at if a QE3 were to be announced. As far as continuation of liquidity is concerned even a slight improvement in liquidity is a welcome move.

The core concerns of the markets revolve around what happens in Europe. Greece is one element but the markets are more concerned about ramifications of a bigger bailout that may involve larger economies. The early signs of that brewing can be seen with a request from Spain to accommodate its banks. In the recent summit there were talks about various kinds of bonds to be issued that would flow to banks directly bypassing governments like euro area bonds, etc which are a joint liability and the Germans are not very keen on that proposal. I think somewhere a via media will be reached after much debate and discussion and the markets will take that as a sign of some improvement.

On the other hand this will not solve the core problems of a lot of debt, of revenues drying up as economies slow down, and of unemployment continuing to rise. These are all problems that need structural reforms which do take a much longer time. Unfortunately time is in short supply, in the sense that markets are expecting solutions in weeks or months, particularly with unemployment growing, people do expect some solutions to come through in a month but structural reforms take much longer than that to deliver .

So I think this is a dichotomy that all alternatives need to be able to bridge in the coming weeks. As for what solutions will contribute to bridging that gap, I may not be qualified to talk about it, but leaving aside reforms that will take 5 to 10 years, I do hope that they come up with something that can at least allay the concerns of the markets on one side and also appeal to voters and public at large.

WF: Do you get a sense that we are continuing this whole game of kicking the can down the road, for another couple of years and hoping for growth to revive on its own?

Naganath: Well that appears to be the only plausible way forward at this point in time because like I said a wholesale change in structure at this point is not possible overnight. All you can do is apply solutions that are okay for the time being even as you mull over long term structural reforms. The problem with the euro zone, as opined by various commentators, is that a political union or a fiscal union is the best possible solution where there is a common oversight over budgets etc., but that may not be politically feasible. These things do take time but meanwhile the best you can do to keep bond yields in check and to keep markets reasonably happy is to apply some temporary solutions in the near term even as you grapple with the long term structural solutions.

WF: I think that one issue that a lot of people worry about when we look at this kicking the can down the road phenomenon, is whether we are likely to have another event risk like the one in 2008. This is what is keeping a lot of investors on the edge. I know it's a very tough call but do you have any sense of what the probability is of another event risk which may not be in the same magnitude as the one we saw in 2008 but something that can easily shave of 20, 25% of asset values globally?

Naganath: The thing about event risk is that you can know only after the event. It is very difficult to predict this sort of thing beforehand but one can never rule out such a probability especially if it turns out that problems in certain economies are far more entrenched than commonly believed; or if certain large institutions are more vulnerable than was commonly believed; then these things can create a sharp down draft in asset prices whether it is bonds or stocks.

On the other hand the good news is that equally policy makers will be far more alert this time round, having learnt from the 2008 crisis, to quickly come and apply all the possible solutions that they have on hand, whether it is unlimited monetary easing - a QE3 that is far bigger than what we have seen in QE1 and QE2 for example, to ensure that any lack or break in market confidence is quickly addressed. So even if there were to be such an event and prices were to drop in response to the event, I think you would see an equally sharp rebound as policy makers and central banks would quickly come together, in a synchronized coordinated effort, and bring to bear all the tools that they have at their disposal to ensure that market confidence is not damaged irreparably.

WF: Moving to the domestic scenario, are we at a cyclical bottom in terms of our own domestic economy or do you see a more prolonged down turn like what we saw in the second half of the nineties?

Naganath: No I am confident that things are likely to improve as we progress through the year and I think market expectations now also seem to factor in some optimism on moving the reforms process ahead in the coming weeks and months. And I think the market action we have seen in the last week or so does lead one to believe that this is more a cyclical bottom. It is a pity that our investment spending cycle has been very sluggish for the last two or three years and there are various reasons for it and the crisis of 2008 was of course the biggest reason. Also perhaps the higher cost of funding for projects, lack of confidence in demand outlook over the next 3, 5 years might have led to some slow down in capacity expansion and in investment spending. But I do think that it will start picking up steam as we progress into the latter part of this year and into 2013-14, I think if that engine of growth can be revived, even if consumption remains reasonably steady and even if consumption were to be a little softer, overall GDP growth in the context of rising investment spending and stable to moderate consumption growth will lead to your GDP growth remaining well above 6%, potentially in the 7 to 7.5% range - I think that would be a good enough outcome.

WF: The RBI has laid out its cards clearly on the table recently, by signaling that between inflation and growth, inflation is its primary concern and pointing to the government to do whatever needs to be done on the growth aspect. Given that kind of a monetary stance, given the high inflation and the current sluggishness in growth, is it right to say that we are already in a stagflationary scenario ?

Naganath: No, I think that inflation will remain somewhere in the 6 to 8% range. Given that certain elements of costs will continue to rise, for example soft commodity prices; food prices etc., I think it will remain reasonably sticky. Second with the depreciation that we have seen in the rupee, imported inflation will contribute to inflation remaining in that band. Even as oil prices have corrected the fact is some of them would have been negated by the depreciation of the rupee.

If reforms in the next few months seem to be reigniting growth momentum especially on the investment spending side then if growth picks up obviously that deficit will narrow to the extent that tax revenues will begin to pick up and so all of that will lead the RBI to take a more benign view on rate cuts. But first they will want to see what actions the government takes with regard to the reforms. I am confident that we will see more momentum in the economy consequent to reforms, investment spending picking up and that in turn will lead the RBI to conclude that the deficit is in check in some sense and that will lead perhaps to some rate cut later this year.

WF: Leading on from there in terms of your view on the market, we have been in a very broad Sensex range of 15000 to 19000 for a few years now. Do you see us remaining broadly in the same range over the next twelve months or do you think that some of the momentum that you see coming back to the economy will finally help us break out of that range somewhere in the next twelve months.

Naganath: Well, I will say that between now and the end of the year perhaps that range will hold good, which is 15000 to 19000. In other words if you see the markets heading down from 17200-300, which is where we are today, and if for reasons external, principally like you mentioned if there is an event risk which causes a sudden down draft in prices around the world for equities including our own, then one should be looking to buy. I think that as momentum gathers here, both on the reforms front and in terms of economic growth momentum, it may well see the higher end of that band potentially visible by the time we get to the end of this calendar year. I think we could see QE3 coming in sometime in Aug-Sep 12 - and that should further support asset prices going into the end of this calendar year. I am hopeful that 2013 should be a much better year for Indian equities than what we have seen so far this year, although I expect things to improve for equities, sentiment to improve, prices to improve as we progress through to the end of the year.

WF: Finally one issue that a lot of equity fund managers have been grappling with is that when we look at the Indian market scenario we have the consumption theme that has fundamentals going for it, it seems fairly resilient but does not have too much of valuation comfort because just about everybody has been chasing the same sectors. On the other hand you have infrastructure, some would argue that is now a deep value play because valuations have corrected, but the fundamentals continue to worry a lot of people because they don't see business momentum as yet. Now in this kind of a situation how are you asking your equity fund managers to position their portfolios?

Naganath: Well I think currently most fund managers or at least most portfolios tend to be somewhat defensively positioned is my opinion. There certainly are very interesting pockets of investing in the area of infrastructure and allied sectors. But that does not mean that one makes a fundamental shift where you put the bulk of the portfolios in those sectors, because you know the expectations are only now beginning to build up and they will play out also to next 6 to 12 months or more. So what could be done is to increase the beta of the portfolio gradually, by considering investing in those sectors - capital goods and infrastructure - which have not been the flavor of many portfolios for many many months now. But I would still tend to think that the bulk of a diversified equity portfolio would ideally still be anchored to banking and financial services on the one hand and other consumption themes, because while they may be somewhat more expensive relative to the beaten down sectors, the fact they are still chugging along quite well. I don't think anyone is going to invert the portfolio composition because that would mean assuming too much risk, even as the first signs of a pick up in investment spending are there but I am sure as we move closer to the end of the year you will find a lot more portfolios having greater exposure than they have today to sectors like infrastructure. And that progression will happen gradually.