Morgan Stanley underweight on India; sees lower FY11 nos

Excerpts from Bazaar on CNBC-TV18 Watch the full show » ALSO READ See what other FIIs are saying about the markets See what other experts are saying about markets See what Udayan Mukherjee is saying about the markets

Contrary to consensus, Jonathan Garner, chief Asian and emerging market equity strategist at Morgan Stanley, in an exclusive interview on CNBC-TV18 says he is more cautious on Asia and emerging markets. He expects lower earnings in the next fiscal year.

India, he says, is more vulnerable to higher deficit and, therefore, he has turned underweight from equalweight on India.

Garner says corporate governance is the key reason for the recent contraction in prices. Hence, most FIIs are concerned about the price contraction in India.

He also adds that higher crude prices are a headwind for emerging markets and he sees a divergence in demand growth within energy and materials.

Below is a verbatim transcript of his interview with CNBC-TV18's Latha Venkatesh and Sonia Shenoy. Also watch the accompanying videos for the complete interview.

Q: There is a bit of a trepidation that inflation control will get the better of macro economic policy making. Do you think could slow down growth and what are your views on the Indian markets for 2011?

A: Certainly for India, indeed for Asia, generally, we are more cautious than some of our competitors. We are highlighting that policy rates still have to rise in Asia and that includes India. The mid to late phase of the economic cycle and inflationary pressures, particularly, input side inflationary pressures from rising metals prices, rising agricultural and commodity prices, are starting to impact corporate margins.

So we are somewhat concerned about the impact that may have on earnings growth and we are expecting lower earnings growth in the consensus. Over the year as a whole we should work our way to something like a 10-15% dollar return. But that is considerably more cautious than some people in the market expect.

Q: There has been an increasing view that perhaps there will be a shift of capital from emerging markets like ours to China because of both the demand situation and because of what is happening with valuations. What are your thoughts on the preferences in the emerging market space?

A: We downgraded India from overweight to equal rate in the summer. In fact, it has underperformed the emerging markets in the Asian universe in the second half of the year, after having outperformed in the first half. One of the problems was that the valuations had reached very expensive levels compared to other markets, approximately 50% higher in forward price earnings multiple by the summer.

That has corrected to some significant degree. We are now back to close to the long-run average premium that the Indian market enjoys. We are not as negative as we were, now that that relative underperformance has happened.

The bigger story is not so much funds flow between different countries in Asia and emerging markets as maybe funds flow that could be heading out of Asia and emerging markets, back into the developed markets, particularly the United States where we are now expecting a 4% GDP growth next year.

I think Asia, emerging markets and India as part of that has benefits to a lot from portfolio allocations away from the developed world in the recent three-five years. It's not so obvious now that United States has started to surprise on the upside. But that capital should flow persistently into Asia and emerging markets. Indeed, it may well be that wealth can actually flow the other way.

Q: In which case what would be the sectors or stocks to hide in India itself?

A: We like sectors in markets that are more oriented towards the US. So the tech sector certainly has some positive features in that regard. We are also looking heavily at the mid to late cycle sector outperformers which in rising inflation and rate environments tends to be energy and materials. Upstream energy names particularly, in oil and coal. Those are areas that we like across Asia.

Q: You spoke about this possible flow of capital from emerging markets to US markets. With respect to India itself, what kind of a downside do you think that can generate?

A: Because India is running a current account deficit, it is more vulnerable than the average Asian country. India does need to attract foreign capital inflows to fund that current account deficit.

It's one of the areas of caution that we would have, where we would differentiate ourselves somewhat from competitors who are emphasizing on flows that have existed this year and extrapolating those into very strong flows next year. But that's not appropriate given this change in the environment in the United States.

Q: The issues with regard to Europe don't seem to be dying down at all. There are concerns about the euro breaching that level of 1.31 and there are many issues that the contagion is spreading to other countries as well. What are your thoughts over there and how much more of a dampener could that be to other markets?

A: Certainly, we as a firm think the issues are unresolved in Europe. We were quite early in calling for a problem on the sovereign risk side in peripheral Europe and indeed arguing that it may well spread to the core of Europe. Europe's policy makers are gradually moving towards a more fiscally Federal approach and that may need to actually happen to stem the concerns that people have over holding debt in the peripheral countries.

 I wouldn't want to over emphasize it, though, in the global economic environment, northern Europe is doing very well. Parts of Asia have almost done too well in terms of overheating. The US is now recovering. For global growth, we are going well over 4% this year. That is one of the reasons we expect upward pressure on inflation and policy rates. I don't think what's going on in developed Europe's sovereign debt is sufficiently large to offset that.

Q: There have been issues about corporate governance in markets like ours where a whole host of sectors have been hit by it. How are FIIs reacting to that and how much of a sentiment impact could that have going forward for the markets, apart from what has already been priced in?

A: This was a big reason for and did act as a catalyst for the multiple contractions, the 50% forward PE premium eroding in India's case. We have actually had five separate specific instances in relation to corporate governance or governance more generally in the Indian stock market in the second half of the year.

Now this is not unique, obviously, there are issues that take place in other emerging markets but it's the concentration of these issues over such a short period of time and the seriousness of at least two of them has caused significant concern to foreign institutional investors that I spoke to.