You have been consistent with your views and have been consistently bullish and look at the levels we are staring at.
Yes, the market is looking good. We are in a new profit cycle and I reckon that corporate profit margins will hit a new peak over the next few quarters. If you take a 3-4 year view, we may end up with a compounding of over 20% on earnings. Some of it is priced in, but the market cannot price all of it because there is always some uncertainty as this profit cycle unfolds. I think we will see higher share prices over the next three or four years, so that is the basis for why there is such a strong bid on share prices. And the profit cycle is coming from very earnest government action. There was a policy inflection that we saw in September 2019 when corporate tax rates were cut, and then we got impeded by Covid otherwise, profits may have already been significantly higher by now.
But through the pandemic, the government continued to assert its desire to lift corporate profits to get the investment cycle back and take India’s growth to the trend line. So successive policy changes have happened over the course of the last 18 to 24 months. All of those point to a higher share of profits in GDP, which had dropped to all-time lows by 2019. So we are coming out of those troughs, and there should be significantly more earnings growth that we could witness over the next few quarters.
Everybody is talking about is the Fed tightening. When markets know something will happen, they tend to price that in. So if this is the most anticipated event of 2022, why is there a discussion every morning about what will Fed do. Everybody knows it will happen, but we debate it every morning.
The market does not care about things that it already knows. We can continue to debate them. And if the market thinks that it already knows what the Fed is going to do, then what the Fed does will not matter. However, at the moment, we do not know. We will see how that unfolds, and the minimum it will bring more volatility. The Fed exiting from its QE programme and raising rates per se is not bearish for equities. What is bearish is if the Fed does not anticipate inflation and falls behind the curve. So far, Fed’s nose is ahead of inflation, the markets will be quite okay. A template for this is 2003, 2007 cycle. The Fed raised rates successively quarter after quarter after quarter, but it did not cause equity share prices to stall more than a few corrections that came along the way. We continue to get a rise in share prices. So it is not just what the Fed does. It is whether the Fed has anticipated inflation and has moved at the correct moment, and this is something that we will only be able to tell in hindsight.
So I think the Fed actions will bring volatility. We should be prepared for greater volatility in 2022 compared to 2021. So it is very to call that volatility will be higher. And that it is not just the Fed. Even in India, there are lots of other things happening.
There is a slew of state elections that are around the corner. Headline valuations are not low. There is an RBI exit that will happen probably starting next month. So, there are a bunch of things that may induce more volatility in share prices. We got a window into that in December, because if you recall, we have seen a fair bit of yo-yoing of share prices over the past four to six weeks, and such behaviour may persist through 2022.
Bank NPAs are better, the cost of capital will be low but then there is a technology disruption that is happening and this will change the fee-based income for a lot of banks. The fintech is attacking the distribution chain, insurance chain; every fintec has now become specialised in changing the way of how banks get their fee-based income and that is a large component for banks in terms of their profitability. How do you see that changing and that dynamism impacting large banks?
We have to separate what may happen in 2022 versus the medium to long-term trend. Financials have been market leaders for several years now and depending on which index you take, they have a weight between 25% and 40%, which will reduce in time. In part, this has to do with the newer sectors coming into the index and also because the relative earnings profile shifting away from financials. So, the medium to long-term call is that financials will lose share.
One reason is exactly what you talked about — there is disruption happening and some banks will win some may not. There will be pressure on earnings. It is very hard to actually make those judgement calls today but overall we can sense that it is likely to be a lot harder than it has been in the past, with respect to fee income.
Now, this disruption is not unique to financials. It has been happening in many sectors. At the aggregate level, it does not take down earnings because somebody loses somebody gains. The aggregate earnings probably go higher and not lower but within that, you get winners and losers.
In this context, another point that I would like to make is this remains a stock pickers market. It is not a market where the headline index will give the type of return that you got in 2020 and 2021. Most of the returns will come from alpha and not beta. So, it is a stock pickers’ market because of the disruption and how operating leverage is building up on the company balance sheets and how various companies are responding to their environment. There are a lot of idiosyncrasies that are there and the stock pickers will do generally much better than they did say last year or the year before.
Your view for 2022 is that we are in for a year of moderate returns. You are not making a case of no returns or negative returns, right?
Yes, moderate returns. It has to be seen in the context of what we got last year. I do not think that is likely to be repeated, especially for small and midcap stocks. They will be a lot more volatile. The large-cap index may probably end up doing better than the small-cap index but underneath the index, there will be a lot of opportunities. So, the headline returns are likely to be more modest than we have seen in the trailing 12 months or trailing 18 months.
EV has become a popular theme. You are making a mention of EV in your strategy report as well but do you think somewhere this entire EV has become a hype and an overextended story?
Let me just move away specifically from electric vehicles and talk about the broader theme of ESG. It is here to stay whether we agree or disagree. There are a lot of investors who think it is a fad but the fact is that the developed world consumers are making conscious choices based on ESG. In the developing world like India, we are still not doing it bottoms up, it is still coming top-down to us. But in the western hemisphere, there are bottom-up choices that consumers are making. They are looking at the products they are buying and judging whether they are complying with the environmental, social and governance standards that they expect their companies to do. That is the change that is happening there.
In India, it is more top-down; more and more capital is flowing into the ESG bucket. There is a huge debate out there on what exactly is ESG friendly and that is an evolving debate. A lot of things that we think are environmentally and socially friendly may evolve over the next three-four years but the fact is this capital pool is going to grow in size and therefore ESG as a theme is not going to go away.
Within that ESG theme, the electric vehicle is a sub-theme. There will be areas where things get a little overextended and in some places there will be other things that catch up but the ESG debate is not going to go away. Unfortunately in India, there are not many options in this theme. I like the electric supply chain. It is less disruptive and it is more reliable. All the auto parts that are in the power chain, in the whole automobile construction, there are several things that do not change irrespective of whether it is an electric vehicle or an ICE engine. So, those are the companies that will probably end up being clear winners while there is disruption happening at the electric versus ICE level.