6th February 2012

WF: We have seen a very strong rally across the world in Jan and to top it off, we have the US Fed statement pledging to keep the interest rates low for until 2014. Is this basically only a liquidity driven rally or do you see any signs that the Eurozone and US concerns have abated?

Chandresh: I think what happened throughout last year was the risk off trade and with the kind of news flow coming in, people will continuously looking to cut risk. While there was slightly better data coming in from the US, the major worry was that the Eurozone issue would really hit the markets quiet severely. Now that ECB has made available more than 500 Bn euros at 1% and has committed it for 3 years, Eurozone banks have got refinanced. Their near term funding requirements have been taken care of. While the problems in the euro land may still persist, a complete meltdown of the financial system which people were worried about last year, is right now on the back burner. This development, coupled with the fact that last year people have shunned risky assets means they were hugely underweight. That's caused risk appetite to come back and that's what has led to this sharp rally. And obviously, with the FED's announcement of rates being low till 2014, the feeling is that markets will not turn out as bad as expected.

WF: So what you are saying is the event risk is now off the table?

Chandresh: Yes, I feel the big event risk is off the table. You will still see volatility depending on the developments in the Greece and now even Portugal is in the dock. But there is confidence in the market that there is unlikely to be a complete meltdown.

WF: In the Indian context, is this rally again purely driven by the phenomenon that you explained or is it there something at the margin in Indian fundamentals that you think may have turned better, so that FII's have turned a little more bullish on India specifically?

Chandresh: I believe CRR factor was certainly a welcome factor but then CRR is something which happened just last week and this rally had started a little earlier. At the margin, I would still attribute this rally to the global liquidity and the move towards riskier assets. The fact is that most of the buying which has happened is largely due to the money coming in from the global markets. Locals have actually been sellers in terms of perception of fundamentals. As far as medium term fundamentals are concerned, not much has changed, except the fact that the results season has not been as bad as people had expected. So to an extent, companies which have pricing power and brand power have been able to hold up. While top lines have been affected, margins have held out. Lots of banks have their P/E down because of the NPA worries. Frankly, some of these NPAs may only hit them later - but the market environment is such that companies which have come out with decent numbers, their stocks have done well. Even companies which have come up with poorer numbers than expected, people have accepted that the worst is probably getting over. This is partly because of the prevailing general mood and sentiment.

WF: One issue which you have flagged when we last spoke in September 2011 was that you mentioned that going forward you expected rate sensitives to be the big story because at that time the call was that there would be an impending turn of the interest rate cycle. Now that perhaps we are at that turn, what is your call in terms of the interest rate sensitives and which sectors and segments within that broad theme appear attractive to you?

Chandresh: The expectations are that this year we will see something like 100-150 basis points cut in the interest rates by the RBI. And I think to some extent, it has already played out in the markets largely in the auto sector and also partly in the banking sector itself. A sharp rally in banks has already played out - but I think there is room for some more upside here.

One of the concerns is that the 100-150 bps cut was expected in September itself and we were looking at the cycle turning. So, now we are trying to assess the longevity of that cycle and gauge whether the RBI is going to continue cutting in calendar 2013 as well. Looking at data closely, one gets a feeling that by late 2012, inflationary pressures are probably going to rebound. It's too early to predict but we know that inflation is largely on the supply side since not much capacity augmentation plans have really pulled through especially in the last 18 months. So, we feel that inflation may turn sticky again within 6-9 months from now. So, while we still believe there will be rate cuts from April this year, whether that cycle will continue into 2013 is what needs to be closely tracked.

Auto sector will clearly benefit from this turn in the cycle. However, the period is just too short for say Capital goods and Infra to take a meaningful turn around. It is too early to predict and say that infra companies can now borrow 200 basis points cheaper and hence new capital projects have suddenly become extremely attractive and IRR has become appealing. Some of the other issues in the infra space need to get tackled apart from borrowing cost. We don't see any signs of big ticket order flows coming into this sector any time soon.

WF: One of the things that lot of market participants have been worrying about is the fiscal slippages and the widening deficit. For bond fund managers, the implications are very clear. But as a person managing equity assets, what sort of actions would you take with this kind of a worry ?

Chandresh: It is a real dilemma. Yesterday, the RBI governor talked about the dilemma and if you incorporate the fact that we might see a jump in inflation in late 2012 and early 2013, then the situation becomes a lot more challenging. There could be a narrow window to play the rate reversal cycle - but the timing has to be kind of cute - which most fund managers don't get right.

In terms of fiscal slippages, right now, RBI can undertake OMO's because they think that the implication of short term inflation trend is lower. Next year, suppose the credit growth is slightly higher on account of 150 basis points cut, then you start seeing fiscal slippages - in such a case, meeting demands for money is going to be high which means that rates are going to be high and if the inflation is high, RBI will probably not risk OMO's in which case, we will come back to a reasonably high interest rate scenario. That's why I say that this rate turn cycle window is likely to be short - and therefore not worth betting too much on.

At the end of the day, what makes sense is to focus on companies that are executing well, that have good brands and good pricing power. If you have a GDP growth of 6-7%, an annualized 15-18% profit growth will materialize for them. So from that perspective, our core portfolio strategy does not really change. We do certainly worry about fiscal slippages, but as long as there are some self correcting mechanisms, the situation would not go completely out of hand.

WF: You mentioned that you are expecting inflation to get sticky towards the second half of this year. Is this because you expect global commodities to rise on the back of another QE or are there more domestic issues?

Chandresh: Currently, what is driving inflation lower is food and primary articles. The core inflation is already quiet sticky in the sense that the manufacturing inflation is still quite high. The pricing power with companies is still quiet strong and that's why the results have been pretty good. The companies have been able to pass on the prices except for the retail sector where there has been a very sharp decline in the December quarter certainly and notably in the months of November and December. Right now, there is a huge bargain sale happening there and the numbers have actually started to improve. I think rest of the good quality companies are doing reasonably well. So the hypothesis is that as a result of currency depreciation, fuel costs have gone up, all primary metals prices have gone up and they are continuing to rise even in dollar terms. All this is going to impact the next quarter. The government will have to pass through the fuel prices ultimately. On top of it, the general and manufacturing inflation are lingering on. Once this food inflation advantage goes away in another 7-9 months, we will again start seeing elevated inflation. Now obviously RBI can come and say that I am comfortable with 7%-7.5% inflation and I won't act. But looking at what they had done last year, I doubt that they would want to remain behind the curve again.

WF: You mentioned in our last chat that we had in September that you are looking at adding on some risk into your portfolios. But at that stage you were a little wary about the global scenario. Now that you know this event risk is hopefully behind us, how are you actually positioning your portfolios? Are you adding on incremental risk now or would you still prefer to stick with little more defensives?

Chandresh: Generally speaking, we have added risk over the last three months. In November particularly, we have added and partly we have also reduced risk in some sectors. The move has been quiet sharp and that's why in some sectors, we are now reducing risk. So our overall risk profile is quiet similar to what it was in November or even mid of December. We are even looking at investing in some of the cyclical and volatile sectors based on valuation as right now the valuations are compelling.

WF: What would you pen down as one or two biggest risk factors that you will be watchful for on the Indian market?

Chandresh: I feel there are two things which affect the markets, one being the market cycles or the market volatility and what drives all that is the sentiment volatility. Today it seems like it's a complete classic change in sentiments and certainly the sentiment cycle needs to be tracked. There are still enough things out there and I think it could be just Indian politics, it could be the budget, and it could be globally something that still goes wrong. I believe there are enough risks to keep us worried but one of the big risks is the developments in Europe. In Europe, I think the leaders realize that there is no way out, so ultimately there will have to be a haircut somewhere, some bail out somewhere. They are using this opportunity to pass on some important regulations and rules. That's a positive.

Another worry is that, if we are really not able to tame inflation, then we have a long term worry in the Indian markets. Earlier in 2007 and again in 2010, everybody was proclaiming India as a great growth story. And from that perspective, we said that the economy is growing 8.5-9% and there will be these 500-800 companies which will do phenomenally well in the next five years. All this will build great wealth in India. But whatever has happened in the last one year has shown that maybe the scenario is actually not like that. Instead of these 500 companies, it's probably only about 100 companies which are going to do well in an elevated interest rates scenario in which currency maybe under pressure. One will have to be a lot more selective on the quality of businesses you buy. One significant implication is that probably beta is not going to work in the longer term as much as some of the proponents of the wider India story think. Its going to be a story of alpha generation through superior stock selection.