Pictet Asset Management is cautious on the Indian market, even though it likes the long-term story, says Nidhi Mahurkar, its Head Asia Ex-Japan Long Short Fund. In an interview to CNBC-TV18, Mahurkar sees persistent inflation, twin deficits (fiscal and current account) and weak growth as the big worries.
And while the RBI has been cutting the benchmark repo rate, it is not reflecting in the rates that banks are charging their borrowers.
Mahurkar says the government needs to take more steps to revive growth, while adding that the fast tracking of certain projects by the Cabinet Committee on Infrastructure was encouraging. She sees political uncertainty as an intensifying risk for the country.
Below is an edited transcript of the interview on CNBC-TV18.
Q: From what I see from your recent portfolios you probably have an underweight compared to other markets, underweight in India. Can you tell us why?
A: Let me enumerate the context in terms of our current stance in India. It is a compromise between liking the long-term story of India versus concerns that we have had on cyclical basis. India has had weight on its shoulders in the last six months although the one year performance of the market is pretty decent. The market is up about 20 percent, but over the last six months we have had concerns on how the macro has evolved in particular on twin deficits, sticky inflation and growth being well below potential. So, in that backdrop while we continue to like the long-term outlook for this market, we have kept a somewhat defensive cautious stance on India. Having said that incrementally we feel more positive about India going forward and to that extent our stance in India is gradually changing as we speak.
Q: Over the last few weeks some of your peers have taken comfort from the fact that some commodity prices have started coming off and maybe the current account deficit number will also improve going forward. Have you started therefore recalibrating weightages by upping some of your exposure in India over the last few weeks?
A: We are cognizant of these changes, the delta in both the macro and the micro indicators. Let me outline few things that incrementally make me more constructive in India. In the first instance, inflation which has been sticky in India for the last year and a half and has been the reason behind the Reserve Bank of India’s cautious policy both in terms of rhetoric and in terms of the actual easing of the interest rate cycle. We have now seen some amelioration on that front, so we expect a gradual easing cycle, which we think, has an impact on asset markets in India.
There has been some relief on commodity prices of both gold and oil although the extent of relief is debatable because there has been some recouping in the price of gold and oil. Also some very green shoots of recovery in terms of the industrial production momentum although the high frequency indicators are more mixed, but if growth begins to turnaround both from a low base effect and some acceleration, we think that the market will reward that. So, it is a qualified in terms of improvement in the fundamental picture. India is emerging from two year downward adjustment in earnings growth forecast, which we see as having plateaued.
There are certain parts of the market which are colossally cheap and others which have maintained their valuation premium where you had a more consistent delivery of earnings growth, a record of consistency. Now we see that earnings downdraft over the last 18 months have plateaued. So, putting it all together about 13 times more earnings, which is close to historical average for India we feel more constructive on India.
Q: While most would agree with you what you have outlined on the inflation front, the concern is on growth because we haven't seen any major pickup in earnings growth yet in the quarters that have gone by and even the fall in core inflation would lead some to believe that the lack of pricing power is coming through from a demand slowdown and therefore one cannot say with certainty that growth has bottomed out. Do you worry more about growth now than about the inflation and the current account deficit (CAD) which was the big problem that was reining in the Indian market performance?
A: The big catalyst for the Indian market will be definitive visibility that growth forecasts are being upgraded and to that extent while the easing cycle will have some impact, we have had 100 bps of repo rate cuts which haven't really been transmitted into the asset side. If you look at the gap between the mid corporate sector and India's borrowing, the difference between the repo rate and the street rate for mid corporates is about 900 bps as high as it has been. This in turn is raising pockets of concern in terms of cash flow impairment in the middle corporate part of the economy.
So growth is below potential and easing hasn’t really transmitted, which is an awkward spot for the country to be in. However, looking ahead we think both the base effect as well as month on month improvement will result in some pickup in growth. I will qualify it by saying that we certainly need more from the government in terms of administrative reforms. We need to see progress on reform agenda be it on subsidies, infrastructure, insurance and pension, food security, which unfortunately have stalled in the most recent session of parliament. The investment cycle and corporate cycle should recover.
Q: While it is good to hear that you are upping your weightage now in the light of slightly incrementally positive macro in India, you are doing it at a time where in the next few months you will have some important state elections and then it is anybody’s guess when the next big general election happens. Do you see that as a pivotal event for Indian market performance or as a headwind in investment decisions as such?
A: The state and national elections are scheduled over the next 10-12 months in India. This is an intensifying risk to the extent that reform measures are beholden to either opposition pressure or like a recent ally walking out of the government. This will be a headwind. We are hopeful that they move forward on the reform trajectory to get growth back on track again. 5.5 percent or below gross domestic product (GDP) growth is recessionary growth for India.
So, yes, this does remain a wild card and our stance is defensive going into the elections. However, we are hopeful that things will get resolved. Some small areas of encouragement are that the cabinet committee on investment (CCI) has begun to fast-track investments in those areas. In the areas of coal, energy, power, they need to take more steps and we are seeing some fast tracking of mega projects in that arena.
Also in the power sector tariff hikes have been taken. We think that the power issues will get resolved over the next six-nine months. We are quite encouraged by the transparency that the Reserve Bank of India is providing moving on to the banking sector by gradually shrinking the restructured book of the public sector banks. The step that they are taking to institute minimum provisioning on restructured loans of these banks is a welcome step in the right direction.
However, there is a lot more that they need to do in particular on land acquisition, subsidies and infrastructure. We need some concrete progress there and to the extent that recently we had to two ministers resigning. If the government is beholden to coalition pressure and you begin to see some pushback on legislative progress then that is the window of opportunity lost and will be a cause for concern.
Q: Let me ask you about the kind of mood that you see among global investors in the area that you manage money in, which is Asia Ex-Japan because we saw earlier in the year a lot of money moving to Japan after many years. Emerging markets in Asia not being the favorite place to be because of three or four years of underperformance relative to global markets, what is the mood right now? Are people putting in money into Asia Ex-Japan or it is not the most favorite part for global investment managers?
A: Most investors are perplexed and baffled by the underperformance of emerging markets and Asia Ex-Japan over the last 12-18 months. The bull market really has been about US equities and about Japanese equities. In the US, there are two key factors which are underpinning the market. One is the fact that even though the crisis started in America we had a very professional unified response where there was massive quantitative easing (QE) and a quick re-capitalization of banks.
They were quite smart about fiscal austerity, which has been delayed. We are in a situation where 2-3 percent gross domestic product (GDP) growth is in the bag in the US. One may be skeptical about the potential for an upswing in second half growth rates, but the patient is not dead, so the US growth outlook actually looks amongst the most sort of robust in a global context.
The second key factor in terms of fund flow into the equity market is that the US equity corporate sector is ridiculously under-leveraged. So, we are seeing buybacks on a scale that we haven’t seen before. There is a rotation from fixed income into equities by the corporate sector, by the issuers. S&P today offers you a dividend yield of about two percent plus buyback of about two percent. So, four percent is a very decent yield pick up relative to global bonds. So, the US market I would say is underpinned by these two factors - a rotation from the corporate sector, the buyback activity going on there as well as relatively fast recovery.
Europe on the other hand is messier. The banking sector here is under-capitalized. The weakest economies in Europe have tight fiscal policy. The currency is too strong. You don’t have leadership in Southern Europe and we don’t expect much too change till the German elections take place. Japan is in the situation where they are creating liquidity globally. The Japanese economy needs stronger growth and the government as well as the central bank have committed to massive monetary and fiscal reflation.
Although the question remains on fundamental reform and that remains unresolved, for the moment they are doing a lot, part of this is motivated by the fact that the Chinese have become so big. China is now a USD 7.5 trillion economy at their doorsteps. Japan is undertaking QE about two times what the Fed did. We think the Nikkei can go much further in this environment and would remain constructive on the US and Japan. In this backdrop, as equity markets continue to do well, it will sort of be a tide that lifts all boats, but we would expect continued underperformance of emerging markets and Asia versus the US and Japan.
Q: You are not seeing any major inflows into the Asia Ex-Japan universe per se or as such despite global markets doing quite well?
A: The inflows have come from cash and money markets at the moment. So, we have seen inflows and I am sure the fund flow data captures that India fund flows themselves have been quite robust year to date (YTD). But what we have not seen yet and which we expect to see going forward in terms of liquidity is a move out of fixed income.
We expect a sort of chain reaction out of government bonds into corporate bonds, high yields into convertibles, dividend yield which we have seen and then into equities. So, we expect the search for yield to continue, but we expect basically a rotation in particular as global bonds back up and this may be six to ten months down the road. We also expect rotation from bonds because there simply isn’t enough value with them at lower and lower yields globally. At the moment, sort of fund flow seen is really out of cash and money markets into emerging markets and Asia.
Q: You did make the point that valuations are quite polarized in India. We have the defensives and the high quality banks which are quite expensively valued or fairly valued while a large part of the market which is investment oriented remains quite cheap, which part are you deploying the money in as you up your India weightages?
A: Our stance in India remains very much on high quality Indian financials, stocks levered to explosive middle class demand in the consumption basket, stocks in the media sector where we think there is significant operational leverage. Media spend has stagnated in India and there is progress on digitization.
So, it is more levered to consumption and high quality financials. The cheaper part of the market is capital goods, infrastructure, materials and perhaps the public sector banks. While these stocks may be due a relief rally because they have been laggards and they have underperformed, we are still not confident that this will be a rewarding part of the market to be invested in.
One of the red flags is that many companies in these sectors are not really optimized for minority shareholders. The stake holders may be the government, may be the promoters, may be the employees but not the minority shareholders and that remains a concern in the ultra cheap part of the market. The second factor to point is that the earnings delivery in this particular cyclical cheaper part of the market has been poor. So, state owned banks if I were to take that as an example - recent results showed some stabilization, but we think that these banks are under buffered from a profit and loss (P&L) perspective.
If you look at provisioning levels for state owned banks and what is yet to come in terms of non-performing loan (NPL) recognition or the migration from restructured to non-performing assets (NPAs), we think that there is just simply not enough buffer on the P&L. So, the cheaper parts of the market is where earnings risk resides and we therefore retain a more defensive, more quality focused stance on India.
Q: What about the global plays like IT or pharmaceuticals?
A: IT we have liked it in Indian context and for pharmaceuticals recent results have shown you that it is the Indian business which has driven results. In IT Infosys was a big part of the earnings downgrade cycle for India on a weighted average basis. So, there were mixed results there with Infosys and Wipro underperforming and Tata Consultancy Services (TCS) reporting good results. We are not supper optimistic on the space overall, but rather selective at a company specific level.
Q: What about the auto basket both domestic plays like two-wheelers and four-wheelers and also some of the globally levered plays like Tata Motors, where does your exposure stand on those names?
A: This is an alpha-rich opportunity for a long/ short fund like ours. We find lot of opportunities to put on gross exposure, but not necessarily net. In the recent past we have seen some relief for the Indian auto plays, I am talking of the most domestically oriented ones both from the Japanese Yen weakness as well as benign commodity prices and so that has given us opportunity to put longs and shorts respectively in a more market neutral environment.
We have been concerned about autos both from the financials - who finance autos and the overall slowdown that you have seen in industrial production and economic growth rates. In particular, in commercial vehicles, we have been worried about companies, which are exposed to fleet operators or project finances as oppose to people who are using them for self transport. That has reflected our underweight stance in more domestic-orientated autos, but this is more an opportunity rich place for us to put on a gross exposure as opposed to net.
A: We don’t really have any positions in Indian energy now. The state-owned companies, which benefited from the initial reform, a progress on diesel liberalisation and liquefied petroleum gas (LPG) caps – that valuation recovery and rerating has played out, so at this point in time we are not present in Indian energy.
Q: You spoke about being in some of the consumer names, but some of your peers find valuations quite limiting despite strong earnings delivery in those names, does it worry you that some of the recent numbers might be betraying a some waning of consumer demand given the kind of valuation levels that they are trading at today?
A: We are seeing a variance in how companies are executing and delivering on a case-by-case basis. So, in the discretionary space, we are seeing a clear slowdown, whether it is footwear retailing or organised jewellery. We are seeing a slowdown in the discretionary space. But in the more staple part of the market in tobacco stocks, staples and food, we see this as a secular growth opportunity. Sometimes this is the environment when India is coming out of a growth slowdown that we would really like to built positions because the long-term outlook for these companies remains very robust.
Q: For someone who runs a long/short product or long/short products what would be your favourite shorts in the Indian context, would it be from baskets like infrastructure, real estate, even metals?
A: I wouldn’t be able to go into the individual names that we would position. But these are basically companies have levered balance sheets, which are missing earnings expectations, which are not able to sort of self finance their growth at big picture level. Some of these opportunities are in the infrastructure sector, some are even in the retail sector.
In fast food for instance, we had successful short that played out recently and in the earnings results, in the IT sector. So, it is really spread out, it is very company-specific, but broadly companies with balance sheets, which are under stress, earnings, which are continuing to experience downgrade or downward momentum or haven’t stabilised the downward momentum that we have seen in earnings across India and valuations which remain demanding.
Q: The way the rupee has moved versus the dollar, are you finding a little bit more confidence that the currency might be stable now with what is happening with the current account deficit (CAD) or does that still remain a big worry for overseas investors?
A: It is fair to say that the Indian rupee has found a level. It would be a bit presumptuous today to say that the worry is behind us. At the end of the day, the CAD needs to come in below 3-3.5 percent of gross domestic product (GDP). Over the last 12 months, India had one of the largest CADs which could still get destabilized quite quickly. Oil and gold, while they had an impact in terms of turning things around, but the latest number showed that oil and gold have recouped 50 percent of those losses.
We do remain vulnerable in terms of the CAD. The RBI has been very prudent in terms of not pursuing an overly slack or an overly loose monetary policy, which could easily destabilize the current account. You also need to take into account looking elsewhere in the possibility of the resurgence of the Japanese carry trade. I said earlier that the Japanese are creating liquidity globally. The Japanese carry trade getting reignited is a real possibility and the foot print for that is basically some appreciation in emerging market currencies.
Now first in line will be currencies like the Malaysian Ringgit, Philippine Peso, but we could see some fund flow on the back of real revival in Japanese carry trade. From an India specific standpoint, we are not out of the woods. The current account remains a hurdle for India at this point in time.