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Andrew Holland, DSP Merrill Lynch & Nilesh Shah, MD & CEO of Envision Capital think in the short-term the pressure from commodity prices, food prices, oil prices will have an impact on markets, and this is going to hurt earnings.

While Shah thinks valuations are no longer cheap. The markets could probably move up to 18 times earnings. But any incremental newsflow could definitely spoil the sentiment. "So a combination of both these factors would make us cautious in the short-term," he said.

Excerpts from CNBC-TV18's exclusive interview with Andrew Holland and Nilesh Shah:

Q: Much has been said and talked about what May might deliver but how are you feeling about what kind of ground the market has covered and where it might head?

Holland: I am feeling very nervous globally at the moment. I think markets have had a great run, they are looking somewhat overboard now globally. I just think there is some bad news coming and it is just not making sense to me at the moment the way commodity prices are moving and the fact that we are becoming complacent about it. If I am in the US and my house is fallen by 10%-12% over the past year, I have less spending power. So I am not going to buy a car and I do not know how the car manufacturers can take higher steel prices. It is just not working; the common sense is not prevailing at the moment. So I think short-term I am just very negative.

Q: What do you think is feeding the enthusiasm right now because as you have mentioned, most of the strength has come in from the core market, the Dow and the Nasdaq and people are now talking about higher levels for those markets?

Holland: Yes, I think after the Fed drew the line for Bear Stearns that obviously that helped all the markets. Q1 results have been okay from both the US and Europe, so that has given the markets some kind of positive signs. But really when you are in any kind of downturn, it is not really going to impact and I think this quarter we are going to see the biggest impact globally and particularly for companies in the US and Europe. So I think there is bad news to come and that is why I am very nervous at the moment.

Q: What is your sense because when we stepped into this week there was almost consensus about the fact that the market might go back to retest lows, so earlier this year and by the end of it we have actually covered significant ground on the upside?

Shah: I think by and large we are clearly seeing some kind of a tug-of-war going in the market place because I think the market has very clearly divided. On one hand you have participants who are looking at a lot of the external variables and seeing what is really happening in the external environment both from a global perspective as well as from a local perspective and clearly there are lots of clouds on the horizon. So I think that is making a lot of participants negative, but at the same time I think you also have a set of participants who are reasonably optimistic saying probably the worst is over statistically the US has probably not yet slipped into a recession. Back home in India corporate earnings have not yet deteriorated materially, we are still seeing a situation where corporate earnings are growing at about 20%. So I guess it is basically a tug-of-war, which is going on.

My sense is that broadly valuations are no longer cheap compared to where they were. The markets had touched a low a couple of months back when we were trading below 15 times, we are now back to about 17.5 times and they could probably move up to 18 times earnings. But I guess that is clearly where the market could get capped in the short-term. In addition to that any incremental newsflow could definitely spoil the sentiment. So I think it is a combination of both these factors, which would probably make us cautious in the short-term.

Q: If you had to pick out one big worry for the market right now between the currency and commodities and something else perhaps what do you think it is?

Shah: I think currency and commodities are the obvious worries because they could have implications in terms of raw material cost. So if you are an importer of a commodity you are hit actually on both fronts, you have a rising dollar and you have rising commodity prices, which significantly increases your input price. But I think the biggest worry right now is that as a producer do you really have the ability to pass on these increased cost whether they come in through higher interest cost or high commodity prices or higher cost because of currency. I think that is probably the third biggest worry, which corporate India could have that if you are a cement producer or a steel producer or an oil producer, will you really be able to pass on these increased costs to the consumer? I think that can materially impact earnings.

Q: How do you read the surging crude prices and what kind of damage it might do to a market like ours?

Holland: Basically the deficit goes out into a tailspin, I suppose subsidizing everybody in India so the bill just gets higher by doing so and inflation just continues to rise. Usually I would be more bullish about India as well despite global downturns and we have always said that I believe in the Indian story and I still do, but in the short-term I see the pressure from commodity prices, food prices, oil prices having an impact and it is something that you cannot put a number on at the moment, but we will start to see that come through in the next few quarters. To my mind this is going to hurt earnings and the markets have already reflected some of that, but in between you have the government policy which is a bit confusing to everyone and therefore you cannot take any long-term views on the sectors which are being affected or positively affected as well.

I think something is going to crack soon, I am not quite sure when but when it does, it is not going to be nice.

Q: What is your sense of the more likely outcome of our markets, to see a sharp downside or get away with a rangebound month?

Holland: I think if I am correct global markets will head down, I think risk will be taken off the table again and if you are looking at India relative to other emerging markets and higher global commodity prices means everyone’s stretch is going to remain in Russia and Brazil to the detriment of China and India. So that looks as it is going to be the case for sometime. So I do not think India escapes in fortune and I think the markets will head down.

Q: To go back to the point on currency, do you think there is more rally in technology now?

Shah: Our assessment is that broadly in the short-term, the dollar to the rupee could be headed towards 43-43.15 mark, which clearly means that there is not probably much room of appreciation for the dollar and not much room of depreciation to the dollar in the short-term.

In addition to that, by and large most participants have been trying to build in the case that this level for the rupee would sustain which means they will benefit right through the rest of the year, however that situation may not be valid enough.

In addition to that, we are seeing that most of the bellwethers are trading at about 20 times and these are clearly levels where they enjoy these P/E multiples a couple of years back, but if one looks at the last 6-12 months most of the bellwether IT companies have been trading towards that 15-16 PE multiple mark and so they are trading at the higher end of the range and our sense is that probably there could be another 3-5% upside in some of the frontline tech stocks, but they are clearly no longer a strong buy at these kind of levels although one could hold on to them for the next 3-5%, but at those kind of levels one definitely cannot be overweight and there might be a case to shed some of the positions.

Q: The big worry for our market and for many other emerging markets is the way inflation has been moving and this time around it has only ticked a bit higher, how concerned are investors in India about that figure you think?

Holland: I think globally there is concern about inflation figures because it is having an impact on what Government and Finance Ministers are doing; I mean if you are European Union, even though you can see that the economy is turning down, they keep interest rates very high and so it impacts how foreign investors look at all countries, but particularly with India, it is more governments' response to inflation, which concerns most investors and in certain sectors, we have actually got to pass on the costs are not being allowed to do so and one cannot look at the earnings going forward because of that. So that concerns investors. Obviously in the year were we expect elections to take place then this is going to be me more the norm that its one off.

Q: There has been a big pall of gloom over the oil and gas space for the huge PSU fraternity, how would you approach that whole pocket and in specific one pure exploration and production (E&P) play that we have?

Shah: It is difficult to take a fundamental call on the sector and the stocks, because the reality is that input costs are going up for them whereas they are really not able to pass on the higher input costs to their end consumers and that puts an uncertainty in terms of their earnings outlook, so I still think that the sector as a whole is best avoided.

There are a few oil exploration companies which are benefiting because of the oil price rise, so it’s best to play the sector through those standalone exploration plays.

Q: The other takeaway this week was that in small bits some of power started seeing buying; do you think that is beginning to see buying interest again?

Shah: Some power stocks have got significantly battered down and a lot of them are trading at significant discount or are trading at significantly lower levels compared to where they were trading at about six months ago.

I think lot of investors are perhaps trying to average their positions or some of them believe that these are good value opportunities. Our stand is that if one wants to play the sector then one has to necessarily have to take a long-term call and do the valuation keeping in mind the capex they would have to incur to arrive at those installed capacitates, after that there is value left then probably one could go ahead and buy.

But in the current environment, I think it’s probably best to avoid the sector right now and better to play it through providers of capital equipment to some of the power projects.

Q: Our other global linkage this week has been through base metal prices, how are you reading that entire market in talk of how supply demand might take a different turn because of what happened in China?

Holland: I think we had a rally because of what happened in China, but the demand-supply doesn’t support the higher steel prices and if you are a car manufacturer and you are trying to sell in an economy in Europe or the US, no one is buying and so even if you reduce your capacity utilization which would hurt your own profits or you take a margin hit because of higher input prices to sell your cars or consumer vehicles etc, so why would one do that? why would you help steel companies make money, it doesn’t make sense, so something will give in at some stage and when it does, the bubble that some people are talking about in commodities will burst and when that happens it won’t be nice. So I think we have to very careful at the moment and tread carefully because there are lots of things out there which are not making sense.

Q: What do you think this market might throw up this month, do you think it is at best going to be a ranged market with perphas a wider range to it where we will continue to struggle when we get closer to that 5,200-5,300 mark or is there a case now for some kind of a deep cut?

Shah: My sense is that we may or may not witness a deep cut, because broadly globally the equity markets at least in the near-term look reasonably sanguine form a trend perspective, although one may not agree from a fundamental perspective, but from a trend perspective they seem to be reasonably good enough and in response to that our markets may not witness a very deep cut. We might try to scale pass that 17,500 mark or try and go towards that 18,000 mark, I think that is probably where this market could be in the short-term.

Q: What has been happening on the flow side, what are you picking up by way of money interest into India?

Holland: I think it is very low, I do not think anyone is doing anything. If you are a foreign investor, now you have to think of whether you are going to lose money on just depreciation of the currency which three-four months ago most people were saying that the rupee would head towards 37-36 even and now they are talking about 43. So you lose money by just coming in India at the moment and when you are already seeing negative returns of 10%-15% another 5% on currency is really not going to make you rush to the Indian markets. So I think flows have been very lackluster.

Q: How wary are investors of any additional fiscal or monetary policy action for India?

Holland: I think there are always concerns, I think more so at the moment for some of the emerging markets including India because, obviously when you have high inflation, governments can compel the measures, which you were not expecting whether it would be windfall tax in oil or barring a futures on commodities. You just do not know what is going to happen. So you kind of more likely to see what policy response is and see how severe it might be before making any kind of call. So I think there is a combination of still risky markets and investors trading very carefully.

Q: Purely by way of trading momentum if global markets were to remain this strong, do you think there could be a case for this market to give you a meaningful bounce?

Shah: No, I do not think that this market could potentially give you a meaningful bounce, if it does then I think it would be very short lived because yes on one hand, this market could get tailwinds because of a strong global environment for equities, but I think at the same time our upside could get capped because of a lot of several reasons whether it is the currency or the commodity market outlook or maybe just because of certain control measures which could be taken by the government to contain inflation. So I think combination of all these factors will ensure that our market gets capped on the upside. In addition to that of course there will always be an issue of valuations closer to that level of 18,000 we would no longer be kind of trading cheap. So I think you have a combination of all these reasons because of which even if there is a strong rebound I am not sure whether it will be strong enough to sustain itself.

Q: What did you make of those inflation figures because the market seems to be shrugging it off week-on-week and this time around it actually came in as a bit of a negative surprise?

Shah: Yes and no, because I think by and large we somewhere seem to kind of believe that inflation is likely to sustain above the 7% mark and maybe even above 7.5% mark for the next few weeks or next few months. In addition to that, I think by and large if we really look at prior to the announcement, some of the pink newspapers had the number of 7.8%. So I think it did not really come as a surprise. What we have also seen is whenever you have seen heady inflation numbers getting announced probably on that particular day, the market is strong but inevitably or virtually the next week the markets tend to weaken. So I think we probably need not get carried away with strength for one particular day.

Q: What is your own sense of what we might have to deal with by way of a dollar-rupee rate and might that impact institutional interest as well into India?

Holland: I am not a currency expert, I just think that globally at the moment, investors are pretty complacent and I think volatility is going to hit as hard against it on the global front. So the currency might have some impact in terms of how foreign investors are looking which I said before in terms of returns, but I think most investors are trying to look at India from a long-term viewpoint. But at the moment there is still a lot out there, which is causing a lot of uncertainty. Whilst India still has a very good long-term story, there are some other stories that you can get in the developed markets like exporters out of the US when a weaker currency, which investors are focusing on. So India is not going to stand out in terms of its growth story in the short-term, because these are the factors of which we talked about, which is keeping investors away and will continue to do so.

Q: You would say after the kind of rally we have had and it’s been a meaningful bounce back ever since March this would be a good time to just take some profits and risk off the table right now?

Holland: It is always tempting to do that, it depends on your time horizon but what I would say is that global cues is where I am more concerned at the moment, I do feel that investors are too complacent about developed markets and I think that is going to hit us all quite hard soon.

Q: One quick word on the politician scenario, there were some kind of murmurs we had through the week as well do you expect there to be any worry or hiccups on that front?

Shah: I think by and large, most political parties now are fully aware that in the next 6-10 months you are clearly going to have elections in several States and for the nation as a whole. So one is going to see a lot of murmuring but the most important thing to look forward to is basically the outcome of the Karnataka elections and that might give us some kind of indications as to how the political scene will unfold over the next 6-10 months, so I would probably watch out more for the Karnataka polls.

Source: Moneycontrol.com