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Ridham Desai, MD and Co-Head of Morgan Stanley, believes the credit market conditions in the US are still very bad. He expressed his surprise at the recent resilience of US markets. He expects US growth to rebound by Q3CY08.

He is of the view that the farm loan waiver ascribed in the Union Budget may not really be bad for the banks, and infact, may be a short-term positive.

The funding waiver from divestment will be good, he said. There might not be a big cut in lending rates. And 2008 will be a down year for markets, he said.

He expects inflation to come off by 30-40 bps after the Budget, but said the drop in inflation will not be enough to warrant a rate cut.

Excerpts from CNBC-TV18's exclusive interview with Ridham Desai:

Q: Before the Budget, a quick word on what’s going on in the US, we just thought it was stabilizing and suddenly, two really bad days coming and hit us; how bad is the situation in the global markets?

A: The credit markets in America are bad. The equity markets have consistently ignored the signals from the credit markets, so we have had further price falls in the AAA market in America and the equity markets are now waking up to that all of a sudden. So I have been surprised with how resilient the US equity markets have been, and what we have seen over the last couple of days is just a response to a worsening credit market situation in the US.

Q: Where do you think it’s going to head in time from most equity markets? Do you think a lot of the poison is out in the system which is sourcing from the US or we are still on a long road ahead?

A: That’s a complex question to answer, because I think the key ingredient to the time response will be how successful the Fed is to offset the sentiment and the financial losses in the US, which is how quickly is this monetary response going to work. I think the risk that we run here, albeit small, at this moment of time, is that the monetary response does not actually work. The US is actually going to get massive fiscal stimulus as well in the second half. It’s quite likely that the US growth rebounds in the third quarter sale and that’s our forecast right now. So this US recession fear will be all done and dusted by the end of second quarter.

The problem is what happens again in '09, because then you run into a higher base and you can't actually provide more fiscal stimulus. The Fed may have cut rates all the way down to two or even sub two, and it may not have enough ammunition left if things in the credit markets don’t stabilize. That’s the risk. It’s a small risk right now, but that’s what I think we will have to worry about in the second half. For now, I think this is looking more like a second quarter thing, and then better stability in the third quarter.

Q: There has been a considerable debate on the debt waiver in the Budget, how have you read it, both for the central fisc and for the bank stocks and the financial sector?

A: I would take three points from this - firstly, this isn’t a bad thing for the banks in the short run. I should caveat by saying I really don’t know how the impact is going to be passed on the banks, so we don’t have much clarity on that. Whether this will be a short tenure bond issuance, whether just cash or income on the bank’s balance-sheet, or a deferment in terms of liabilities. We don’t know how the banks are going to get this money, but assuming that they were NPLs relating to agriculture loans, in the short run, this is positive news. The long term risk and the point on 'moral hazard' that we are running here is what happens to the credit culture. When we used to have these loan write-offs in the 80s, it was clearly not a very good thing for credit culture.

So does this leave an impact on credit culture? That’s a long term issue and a question that will be answered over the next several months, we don’t have any answer to that.

The third point is on the fiscal side. From whatever we have heard the Finance Minister say and what’s coming in the newspapers, it appears that the part of the funding is going to come from divestment and that couldn't necessarily be bad news. So in the short run, this is okay. The concerns surrounding this write-off will actually emerge longer-term.

Q: Your last report indicated the fact that you expect this year to see a reversal in terms of trends PEs, the stocks that had low PEs would now begin to get more attention. The higher PEs would get less attention. In that sense, do you think the Budget has addressed some of those sectors in terms of an impetus to growth?

A: There is obviously a stellar effort, on part of our Finance Minister to revive consumption growth, which as we are all aware had slipped to almost 0% YoY, recently. The credit markets in India or we should say the banks have turned a little more risk-averse. They are not willing to dole out credit for consumption purposes and obviously we needed fiscal stimulus to get this thing going. So the effort is there, it will take some while, to get this into the growth numbers, because I am still wary of banks actually loosening up on credit norms, so we may not see big cuts in lending rates which may be necessary to boost. There maybe a selective recovery in consumption, say in small cars or staples, and those are areas where growth may recover a bit.

The point on low PE is actually one for the long term, which is that if you are a 3-5 year investor, it makes a lot of sense to focus on. If you are a 6 month investor, then sometimes PE doesn’t work, as we have seen in the last 6 months, high PE stocks did extremely well, but over a 3-5 year period, low PE stocks do much better than high PE stocks, even in raging bull markets.

Q: How meaningful would the moves be for sectors like FMCG and autos? Would you like to sit down now and start upping your EPS estimates if not for this fiscal, but for the next fiscal because of the demand stimulus that might have been put in?

A: I don’t think it is that straightforward. Obviously auto stocks are responding nicely in the market today. I think it is partly to do with the fact that ownership levels have been low in that sector, the sector has not done well, and the valuations may have turned more attractive. But I don’t think it is so straightforward for us to just go out there and raise estimates, because on one end you have some stimulus coming from the fiscal side, but the monetary stimulus may still not be forthcoming. That is also a critical part of the whole consumer discretionary space. You need both of them going to get that sector to revive meaningfully. So, yes there could be a few upgrades here or there but nothing really meaningful for now at least. That is what I feel.

Q: This has been a tough year to put your finger on in terms of what the equity markets will do as a performance; what kind of base case scenario are you working with, for India in 2008?

A: We have to break this up into two parts, the next quarter is going to be rather volatile, and we will pick up cues from global financial markets. I don’t think we are going to be differentiated from what happens to the rest of the world. India continues to be a high-beta market, and will respond as such, because of the linkages we have through our balance sheet. Our macro-balance sheet is still funded by flows from the US. So that linkage remains.

We will be over dependent on what happens in the US. The next quarter is likely to be volatile and possibly down.

The second half could be slightly better, compared to the first half, in terms of volatility and maybe in terms of returns. It will primarily depend on the monetary response, what the RBI does and what happens to inflation. As I mentioned earlier, how deep the fiscal and the monetary stimulus in America gets. So we unfortunately will have to take this month by month, I still feel this is going to be a down year compared to last year, but all the fall maybe concentrated on the first half rather than the second half.

Q: You have got two scenarios, one base-case of 14,800 and a scary bear case of 11,000 for the Sensex. What are these two scenarios predicated on?

A: Firstly the scenarios are predicated on what happens in the US and what happens to inflation in India. So, we have a Budget that has tried to be disinflationary and I think with the excise duty cuts, our estimate is that inflation could come off by 30-40 basis points. It may still not be in the comfort zone of the RBI.

So, we may not get rate cuts. Inflation is one important parameter here. I think that is going to depend on global commodity prices, global food prices, and we are seeing a lot of supply shortages there, and a weird situation where growth is slowing down, but prices are still high because supply is disrupted. So, that is one ingredient. If inflation surprises on the upside, I think we’ll get closer to the bear case.

The second ingredient is of course what happens to the US and how bad the credit and financial markets fare. Depending on the outcomes of these two parameters we swing between base-case and bear case.

My own view is that the market response in India is going to be fairly asymmetric. I think on the way down, it may also be concentrated on a few sectors. Financials account for more than a quarter of this market at least in terms of index weight. That I think could be the biggest sector at risk followed by industrials, whereas consumer staples, pharmaceuticals and even to a certain extent technology could be okay. I think there is asymmetric risk to the market and you see more downside in certain sectors versus other sectors. That is how I think we get to our base-case.

DISCLOSURE : It is safe to assume that my clients & I may have an investment/ interest in the stocks/sectors discussed.

Source: Moneycontrol.com