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Underweight on India, China: Morgan Stanley

Published on Tue, Nov 20, 2007 at 14:47 | Source : Moneycontrol.com

Updated at Wed, Nov 21, 2007 at 15:17

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Jonathan Garner, Head of Emerging Markets Strategy, Morgan Stanley

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Jonathan Garner , Head of Emerging Markets Strategy at Morgan Stanley believes India looks relatively unattractive versus the others like Brazil, Russia, Turkey or Taiwan.

He has become more cautious on emerging market equities recently and has reduced overweight position on them to a minimal one. He said that Indian RoEs are good, but there are valuation problems in certain sections.

They are looking at lower Indian returns and some P/E contraction has also been seen. They are also looking at mid teen US dollars in emerging equity, little less for India and will see limited economic decoupling and moderation in growth.

Garner added that short-term risks outweigh the potential returns and is underweight on both India & China. He said that they would be more comfortable with Sensex P/E of 17-18x and may see less relative out performance in 2008.

Excerpts from CNBC-TV18's exclusive interview with Jonathan Garner:

Q: How have you read the events of the last few weeks, all Asian markets have come off about 15% odd from their recent highs, India is almost flat? What are your observations on this outperformance?

A: We certainly have got a lot more cautious over the last few weeks on emerging equities. So, we have reduced our overweight position to really quite a minimal one compared to where we have been most of this year. I think the issues are those increasing evidence of economic slowdown in the US and problems spreading to the Euro zone. Now, classically of course, other Asian markets are much more geared into that through their export sectors than India is. So, to that extent, obviously that is one of the reasons why one is probably seeing a bigger correction elsewhere than in India.

But certainly other emerging markets than India, in Latin America, have equally held out very well.

Q: What is your sense, can this outperformance continue or are you getting cautious about India because of its relative outperformance and valuation levels?

A: The way that we evaluate markets is disciplined, monthly quantitative process that I set in trend, after I arrived at Morgan Stanley about a year ago. Within that context, India looks relatively-speaking unattractive than compared to other large emerging markets like Brazil, Russia, Turkey or indeed Taiwan in this region. I think the issue is the Indian corporate sector is delivering spectacularly in terms of return on equity. It is tapping into the economic growth dynamically very well, but in key segments - not only in the overall market, not in certain parts of the market. But you are looking at problems on valuations, I think.

Q: What do you think might be the more likely scenario, that this market gets a bit range bound and lacks direction or you think there might be a sharp cuts somewhere down the line?

A: Obviously, India as well as some other emerging markets has benefited from the twin influences of strong domestic mutual fund inflows and very strong foreign investor inflows, particularly these people who sought to diversified out of the US and Europe. Now specifically from emerging equities next year, we are looking at a mid teens US dollar return from here. What we would expect to happen in India is probably return of somewhere less than that because we think the aggregate market needs some PE multiple contraction here; it needs the earnings essentially to catch up with the PE multiple in some cases. But there will be plenty of opportunities for stock picking in certain sectors.

Q: How important are rate cuts by the Fed in that context for the entire emerging market universe?

A: Well, the Fed is very important in stimulating some of the fund inflows we have just had through the 50 basis point rate cuts in mid August. But actually, if you look at the situation now, the Fed is signaling that they really don't want to cut interest rates anymore, even though the credit crunch in some respect appears to be intensifying.

So, there is a little bit of a standoff developing there. And, that might, in fact, make it more difficult to generate further sustained flows towards the EM equities, certainly of the scale we had over the last 3-4 months. They are fairly unusual. That is why we have, as of 8^th of November, when we did our downgrade, been significantly more cautious over the last couple of weeks. We are sensing that balanced risk between the deceleration in growth in US, Europe and then the positive feature of this liquidity starting to shift more to the more dangerous scenario.

Q: What is your best-case scenario for the next couple of months? Are you expecting a bigger sell off in emerging market equities?

A: Our best case is that we have some economic recoupling next year - some limited downside recoupling. That doesn't mean that emerging markets are going to go into recession or anything like that; but some moderation in growth rates. Remember, some of the largest emerging countries are tightening policy, India certainly is and China is because of domestic issues.

Their business cycle is to some extent quite matured in some of the emerging countries. At the same time, it is obviously the export side, is likely in certain cases to experience difficulties from what is happening in US and Euro zone.

Emerging equities are volatile asset class. We have just had very strong period of returns since mid-August, we had two big corrections already this year, one in July and a smaller one in February. They do come around; at the moment we would generally be looking for better value to get re-involved again in emerging equities. So, yes, we do think that the risk in short term outweigh the potential returns.

Q: Tactically speaking what are the chances that it gets better before it gets worse, that there is a bounce back from this recent pull back?

A; By downgrading as we did on the 8^th of November, we were looking for this kind of a pull back, its obviously underway. It is not as large by any means as what we saw in July from which we recovered quite quickly. We will obviously assess it as we go along and we will assess relative value in terms of how the different markets are shaping up as we go along.

But overall, we would still suggest that we are in a bull market for emerging equities. The asset class had many strong positive fundamentals underlying growth, superior Fex reserve positions, low leverage in the household and corporate sector. That is why we are getting these funds flow but we have to navigate what is sometimes a very volatile asset class.

Q: Lot of out performance has come from the non-index stocks from the midcap fraternity aside from the valuation concerns you pointed out are there any technical concerns you have on India as a market right now?

A: If we compare it to China, we are underweight both India and China globally and in recommendations. What is interesting about the Chinese market is its been more broader based in terms of multiple expansion and certainly the Chinese domestic market, the Asia market we have a generalized P/E multiple expansion - that way exceeds what we have seen in India and so, in India, it is right to say that whilst this narrow group of largecap stocks that led the market to that are on high multiples in the end context; there are other parts of the market particularly in sectors like energy, steel or indeed in sectors that have superior earnings growth and I would highlight the telecom and telecom is still one that is growing earnings well above the average emerging market. I think it's still worth being involved. So we are basically saying to people that they have to pick their exposure within their market here.

Q: Is there year-end Sensex Level of Sensex band that you are working with right now?

A: It depends on how we grow into the current P/E multiple. But I would rather again get involved with the market when P/E multiples are 17-18 times next years earnings rather than 22 or so where it is on consensus for the year-end 2008, and that is going to happen in two ways; either the market can come back very quickly over next weeks and months or it can grow into that and come back more slowly. But it still ultimately means that I doubt it is going to be as strong relative outperformer next year as a whole as we have actually seen this year.

And as I said at the start, that we prefer firmly in our exposure to highlight markets like Russia, Turkey, Taiwan and Brazil.

Q: So you wouldn't be surprised if there is a 20% kind of correction in India?

A: I don't like to make explicit calls in terms of the likelihood of particular percent of decline and certainly not for individual markets. What I would say is that we have had 11 corrections in EM equities of more than 10% since this bull market began in 2003, and none of that has ended the bull market. And we remain over weight EM equities a bit less that we have been this year. So we are not making a call that this is the end of the bull market in emerging equities or indeed Indian equities. What I am trying to stress is relative valuations and relative opportunity.

DISCLAIMER

As of October 31, 2007, Morgan Stanley beneficially owned 1% or more of a class of common equity securities in Bharti Airtel , Infosys , L&T , Tata Steel . As of October 31, 2007, Morgan Stanley held a net long or short position of $1 m or more of the debt securities of Bharti Airtel. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from L&T, Tata Steel. Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with L&T, Tata Steel.