India looks expensive; Fed tapering to worsen things: Pro

Nicholas Ferres of Eastspring Investments says the way the currencies has responded to Fed’s talk of tapering suggest that people still want to own dollars in preference to their local currency and that is quite bearish.

The Indian rupee led declines in emerging Asian currencies on Wednesday despite broad weakness in the dollar as regional shares fell to their lowest in a month amid uncertainty over when the Federal Reserve will start scaling back stimulus. Ferres believes the INR could see further weakness ahead. “The problem for the equity market in India is that it is still not particularly cheap in the global context,” he told CNBC-TV18 in an interview. He says the broad market is still trying to get over 14 times forward earnings and 2.5 times book value and that is a comparable valuation to the US equities. "I would certainly put India back towards the lower end, probably a standard deviation cheap versus its own history at the moment. I think it is a little bit cheap versus its historical average but it is not particularly cheap. So 12 times could be plausible," he told the channel. Below is the verbatim transcript of his interview to CNBC-TV18 Q: More and more voices are now penciling in that perhaps US tapering will begin as soon as September, if that happens has it already been priced in and what will be the reaction that we will see in emerging markets from hereon? A: I think the key thing to keep in mind is that the tapering is only the start of the normalization process. So the Fed is being buying around USD 85 billion per month and so withdrawing that is the start of the normalization process. Eventually of course they have to start thinking about raising rates. We have seen a pretty big episode in emerging market currencies already and the Fed hasn’t even started to raise the cost of capital. So, it could go a long way. Q: The numbers are well-known, do you think the market has already factored in something in terms of the way in which emerging markets fell? A: I think some emerging markets have certainly sold off a lot including the Indian rupee but from my perspective the price action in the rupee itself is quite bearish. It is quite possible that an actual scramble for dollar is underway. The way the currencies has responded post their Central Banks’ action suggest that people still want to own dollars in preference to their local currency and that is quite bearish. When an emerging market currency doesn’t rally in response to policy action by the Central Bank, it is a very bearish signal. Q: Would you have a view on how much worse it can get for the rupee? A: I wouldn’t want to put a specific price target on it but it is certainly not showing any signs of stabilization in my view. One of the problems from a global perspective is that it could have clearly given the importance of the equity portfolio flows into the Indian market, it could have a reflective impact on the equity market as well. So the currency could lead to further weakness in the equity market, which feeds back into the further weakness in the currency. The problem for the equity market in India is that it is still not particularly cheap in the global context. Clearly as you highlighted some of the financials have been beaten up but the broad market is still trying to get over 14 times forward earnings and 2.5 times book value and that is a comparable valuation to the US equities. _PAGEBREAK_ Q: FII ownership in the Indian equity markets is at an all time high close to about 22.5 percent. Given the fact that you are concerned about the rupee weakness, Indian markets still looks quite expensive compared to its peers, do you see that FIIs perhaps starting to pullout money from the Indian markets because that hasn’t happened so far? A: That has not happened so far that I guess we are in the northern summer period where most global investors are holidaying in Europe. As we get into the September-October period if that starts to happen, you could see a larger scramble out of the equity market by foreigners. Q: How much cheaper can equity markets get, you spoke of 14 times, what would be a bottom, 12 times? A: I would certainly put India back towards the lower end probably a standard deviation cheap versus its own history at the moment, I think it is a little bit cheap versus its historical average but it is not particularly cheap. So 12 times could be plausible. There are these other emerging markets as well. In particular if you look at South Africa, it is a slightly different story of course because South Africa was a commodity exporter in contrast to India. However, it is going through a similar episode in terms of its currency and the valuation of that stock market is very similarly expensive. So I don’t think the episode in EM is really intensified to the point where emerging market equities have priced in all the bad news or the potential bad news. Once the Fed starts to get underway, it will actually exacerbate the process.
 
Q: One of the reasons why the historical valuations in India were perhaps higher was because the growth rate was higher compared to several comparable EMs and even developed markets, now that is coming under threat. We are seeing repeated downgrades of India’s GDP and it is only a matter of time before the earnings downgrades also come in. Do you think we have to get used to lower historical valuations? A: That is a good point in rather than freaking about GDP or profitability now I think India’s valuation historically has probably been justified by superior profitability relative to the rest of the world. Return on equity or profitability for Indian companies in aggregate has been trending down for a number of years now. It is coming under more pressure perhaps because underlying economic growth is weakening and also reasons for cost pressures and like as well. So, I think that suggests that you could get in even further de-rating from what we were talking about just before. Q: If you had clients in India, where would you expect them to put their money in then because equities are not doing well so what is the best bet for emerging market investors? A: I think in the short-term probably cyclical will come under further pressure. Cyclical stocks whether it is in the emerging world or in the developed world for that matter are actually a bit wayward with valuation or where the discounted valuation is. In contrast, investors have largely been hardly in expensive domestic demand stocks or stocks that have perceived to have stability of earnings and cash flows and the valuation rating of those stocks is pretty expensive relative to history. My understanding is that that is also the case in India as well.