What Comes Next

We recommend investors increase exposure to select automobiles, banks, mortgage-finance NBFCs and regulated utilities post the recent (1) outcome of elections in the US and (2) demonetization of high-denomination currency notes in India. We would recommend reducing exposure to high P/E consumer staples and durables and building and construction materials, especially in companies that have got re-rated meaningfully without any meaningful change in fundamentals.

US elections: Higher global yields and global risk premium possible outcomes
We see higher global yields and higher equity risk premium in the future. Global yields have anyway started to harden. We expect higher fiscal spending (and deficits) as (1) the US increases spending on infrastructure (possibly along with tax cuts) and (2) Europe and NE Asia possibly increase spending on defense. It may be early days but markets will probably attach higher geopolitical risk premium for potential negative geopolitical developments in certain geographies, especially if the US retreats from its global ‘sheriff’ role.

Demonetization: Some winners, some losers
We see limited impact on general consumption as most of the low-income, middle-income and high-income households will be largely unaffected by the demonetization measure. The use of cash is quite high in India for low-value transactions but we note that India has not banned the use of cash for such transactions. Also, very few households will have large amounts of illicit cash. Nonetheless, consumption of high-value items (jewelry, real estate) will get impacted as these have found favor as a ‘store’ of unaccounted income or wealth. We believe small businessmen and self-employed professionals would make attempts to become a part of the formal economy over time by reporting higher income and paying full income and indirect taxes.

What we like? Our central thesis of higher financial savings, lower interest rates got boosted
We have been positive on two investment themes of (1) higher financial savings and (2) lower interest rates for the past two years and recent developments will further reinforce these themes. We believe banks and select NBFCs are best-positioned for the former and they will also benefit from the demonetization measure (see our November 8 report titled Smash the cash, the economy will dash for more details). Regulated utilities should benefit from a possible decline in interest rates as (1) we expect inflation to come down further and (2) demand remains subdued in parts of the economy (real estate in particular). Also, the demonetization measure could be ‘deflationary’ leading to lower interest rates.

What we don’t? High PE stocks with somewhat ‘weak’ fundamentals
We recommend reducing exposure to high P/E stocks in consumer staple and durable sectors and building and construction materials sectors. These stocks have got rerated significantly over the past few years (some without any improvement in fundamentals) on the back of low global yields and higher gross/EBITDA margins. As argued in our November 9 report titled Learning to price risks properly, we believe both these drivers have played out. On the other hand, the demonetization scheme will affect demand in sectors (building and construction materials) with deep linkages to real estate demand. Anyway, we see the rerating in some of the sectors as unjustified given their somewhat inferior models compared to consumer staple companies; see our November 1 report titled No ‘easy’ business. Finally, NBFCs with deep linkages to the cash economy will face business challenges as their borrowers would have to reinvent their business models and pay higher taxes, which would affect their profitability and financials.

This is an excerpt from Kotak Institutional Equities Strategy note dated November 10, 2016. Copyright 2016 Kotak Institutional Equities (Kotak Securities Limited). All rights reserved