See 10-15% upside for India in dollar terms: Morgan Stanley

Investors are looking ahead to key global cues this week that could help ease the euro zones debt crisis and help global markets rally a bit as they search for the right catalyst. But which key event or events can push markets higher again?

Will it be the European Central Bank (ECB) taking fresh easing action in the form of a Long-Term Refinancing Option (LTRO) later in the day to calm market jitters? Or will it US Federal Reserve chairman Ben Bernanke's testimony before a Congressional panel on Thursday? Also Read: Only technical bounce, see mkts heading south: Julius Baer
In an exclusive interview to CNBC-TV18, Gerard Minack, global cross asset strategist at Morgan Stanley says his US counterpart believes there is an 80% chance that we will get a further quantitative easing when the FOMC (Federal Open Market Committee) meet. The focus is also on the outcome of the June 17 Greek election, he adds.
Looking at the emerging market (EM) space, Jonathan Garner, chief Asian and emerging market strategist at Morgan Stanley says for nearly eight straight weeks EMs witnessed FII outflows. There was dollar strength which impacted EM currencies during this risk aversion phase.
Garner feels that any quantitative easing (QE) would be helpful in relation to reversing some of the dollar strength. However, Morgan Stanley is also looking for some policy response from within the emerging world to help boost markets back up. “The upcoming China data package this Saturday is really vital particularly in relation to inflation. That’s a very important degree of self-help from within the emerging market space,” adds Garner.
On India, he says our inability on the supply side to keep pace with aggregate demand growth is why we see particularly stubborn inflation as well as slowing growth and a widening current account deficit. "I think the Indian market will underperform during any rally and will likely maybe we are looking at plus 10%, plus 15% as a price target for India in dollar terms whereas we will be looking at substantially more than that for the overall asset class in the EMs," he says. Below is an edited transcript of their interview to CNBC-TV18. Watch the accompanying videos for more. Q: What are the key events for global markets in the near-term? Minack: Europe is still dominating but I don’t think it is a European story alone anymore. Certainly, a month ago we were talking about global stress being very euro centric, but what changed through the course of May was this morphed into a global growth concern and that’s all broad based losses in risk assets. So there are really two strands now running. There are euro specific events and central to that is the Greek election, but now the market concerns are far broader now looking for policy response in the face of this global growth slowdown and that’s what we think you will get.
The big debate will be how effective it is, but one of the key events we are looking for is also the FOMC where my colleague Vincent Reinhart in the US believes there is an 80% chance that we will get a further quantitative easing. So looking at the two aspects, what’s happening in Europe and the risk events there and the policy response elsewhere in the face of this global growth scare. Q: That’s a pretty high probability in terms of more quantitative easing from the Fed. Do you think that will be the likely solution by the end of June – that the Fed will blink first and there will be a liquidity gush that enters the system? Minack: Yes, we think it’s the base case. There is a debate about how effective that will be. I think most of us on the team, they are relatively skeptical about QE’s effectiveness as a macro stimulant. The problems from the Fed’s point of view is that it’s the only lever it can pull, so it will pull it but I think even some people on the Fed are doubtful that it is going to make a big difference to the macro outlook.
The other big debate is the impact on risk assets. Of course the precedent of QE2 was quite promising. My own view is that QE2 was an overrated factor for markets. What was decisive about the QE2 rally was that actually the macro data picked up and if the macro data do not pick up then any QE3 rally would last hours or days but not weeks or months.
Part of the issue there is as soon as we lift our gaze beyond QE and look at the end of the year we have this fiscal cliff issue in the US, this very dramatic tightening of fiscal policy that’s due to arrive on January 1, 2013. If policymakers in the US don’t change course then it’s almost inevitable that you will have a US recession next year regardless of what the Fed does with QE later this month. Q: What kind of immediate impact would you expect to see of this kind of liquidity measure for emerging markets because going into this month, opinion was, there is going to be a flux of outflows and emerging markets may continue to underperform the developed market space. Are you changing that strategy around given your expectations on QE? Garner: We certainly had outflows; we had eight straight weeks of outflows from the emerging market space and we had dollar strength which has impacted emerging market currencies during this risk aversion phase. QE would be helpful in relation to reversing some of the dollar strength but what we are also looking for is policy response from within the emerging world.
Here the upcoming China data package this Saturday is really important particularly in relation to inflation. Our expectation is that China is also going to join the party in terms of monetary ease either in June or July with the first rate cut that it will make in this cycle. That’s a very important degree of self-help from within the emerging market space. Q: Given the amount emerging markets have underperformed already, what are the base and the bear case scenario for the second half? Are you expecting to see much sharper price falls or do you think EMs will generally muddle through; it will be a flat kind of second half performance? Garner: We haven’t actually underperformed either euro stocks or Japan. We have only underperformed the S&P but it’s true that if you go back to the peak and performance relative, it is a long way back to September 2010 versus the S&P. But we are trading around our bear case. We have to get back to 2004 to find our markets as cheap as they are now to the S&P.
I think the catalyst comes both externally in relation to global monetary ease but also internally. We are expecting earnings growth particularly in the more cyclical sectors that are China influenced to reaccelerate at some point during the second half. On our numbers, we are trading below 1.5 times price to book for the overall asset class which has been good entry point in the past. So having downgraded tactically in mid-February we are looking to redeploy that cash back into the market but we have not chosen to do so yet. Q: The second half of the puzzle is the problems in Europe specific to Greece. At this point, would you say markets have priced in the potential impact of a Greek exit and how deep might that impact be you think for global equities? Minack: I am not sure they have although it is true that the only exceptionally cheap equity markets I can find tend to be European equity markets. Greece was to leave - is the serious contagion risk. We see it in a sense analogous to the shock that we saw after Lehman’s failed and then after the Greek default, both those events triggered important contagion effects. We think a Greek exit would in a sense change the nature of money in Europe and in a sense an intensified flight to the centre which would put enormous stress on the periphery. We are not convinced yet that policymakers have the tools in place to stop that getting out of hand.
I would also have to say in the medium-term view, perhaps the biggest risk for Europe is not that Greece leaves and has a deep recession, the biggest risk is that Greek leaves and then in a year or two it’s growing. So you got for example, for the other members of the euro zone struggling under austerity but if you do leave it’s a light at the end of the tunnel where that would be a very bearish medium-term outcome for Europe.
But for this year our view is what we need to see to stabilise things is a move to a greater fiscal integration, the possible introduction of euro bonds, a Europe wide deposit insurance scheme and effectively the individual countries giving up a degree of fiscal sovereignty. That is a chance as an endgame. Our only point is we think you need to see a bigger crisis to get the policymakers to agree to that sort of solution.
It’s been a whole pattern of the European crisis over the last two or three years where policymakers have only responded when the crisis has got big enough. I don’t think we have got a big enough crisis yet to get to that fiscal integration which would settle Europe down for sometime. Q: What form and shape do you think a crisis of that size could take? Would it be a belly-up situation like we saw during the Lehman crises for a couple of the European banks? Do you think it will be a sovereign issue again? _PAGEBREAK_ Minack: That are all connected and that is the problem in Europe. We have seen that the sovereign and the banks bound very closely together. Partly, it is an unintended consequence to some of the prior policy responses like the LTRO for example which encouraged the banks to buy a lot more of their own domestic sovereign debt. So this is close intertwining which means that if it got very serious, it would be a crisis both of banking and sovereigns that may come later in the year.
Of course, the other risk factor that has made the whole European situation a lot more unpredictable is that for two-three years we have been analysing Europe in terms of looking at the central bank leadership, political leadership, the IMF. What we have seen over the last two-three months, is every time the forgotten group in Europe which is the voter is kept aside; they have been throwing a spanner in the works.
The issue of course is the obvious one that voters don’t like austerity. So let’s introduce a new unpredictable risk element to the European equation. I have to say it’s a more bearish risk element. We are now looking at the fate of the Euro in a sense in the hands of the Greek voters in a couple of weeks and that’s inherently difficult to forecast. Q: The problem also is that this growth shock has hit home. India reported its worse GDP tick in nine years. How worried are you about the growth parameters in the emerging market in the Asian space? How much more downside risk do you reckon there maybe on the core growth argument? Garner: Certainly we have modestly downgraded our growth outlook for EMs overall this year. It’s about 5.7% GDP growth which is far from disastrous for the emerging world. But in India’s case we have done a sequence of GDP downgrades. Chetan Ahya, our chief economist for the Asian region has been quite on top of the situation that has unfortunately developed in India.
I do think the problem in India is the inability of the supply side to keep pace with aggregate demand growth. That’s why we see particularly stubborn inflation as well as slowing growth and a widening current account deficit. India screens as an underweight for us in terms of our current recommendation. We think that the valuations albeit that they are low to the markets own history are still about 30% premium to the rest of asset class on the trading PE metric. That’s too expensive for the slowing growth environment in India. Q: Are you working at this point with a price target in terms of what you think might be a more comfortable level to get into the Indian market at, even tactically? Garner: I am reluctant to give explicit price targets but whereas for the overall asset class we see substantial upside through the end of the year, probably of the order of 30%, I think the Indian market will underperform during any rally and will likely maybe we are looking at plus 10%, plus 15% as a price target for India in dollar terms whereas we will be looking at substantially more than that for the overall asset class in the EMs. Q: What markets have probably not at this point priced in is the possibility of a US growth shock that you were alluding to. What is the probability that you would attach to that? What then could be the downside risk for equities? Minack: There are two issues about the US; the first is the instability as a result of what we expect will be quite tense negotiations over this fiscal cliff. Just to recall, we have got this 5% of GDP tightening coming on unchanged policies on January 1 next year. We do not expect to see it be allowed to happen but it will be a very narrow window from the election date - the first Tuesday in November to December 31 to sort the mess out. We think the uncertainty around that will be in itself a stabilising factor for markets.
Looking beyond that we do think there probably will be some fiscal tightening. My US macro colleagues have penciled in 1.5 to 2 points of GDP as a tightening next year. That means two things - firstly we are expecting slower US GDP growth next year compared to this year. That contrasts with the blue chip consensus which is looking for faster US growth next year.
My colleague Adam Parker, our US equity strategist is expecting S&P EPS next year of USD 98. The current consensus is around USD 120. So we are also looking for a very substantial earnings miss of US equities. I would like to add my personal footnote, I think economies when they are deleveraging, tend to be quite fragile and to that degree a fiscal tightening could lead to a recession particularly if the rest of the world is in a very bad way as potentially Europe, UK and maybe Japan.
This is something I do not think people are focused on. The US has been the premium valuation market globally in equities, as Garner mentioned it’s been a stellar outperformer over the last 12-18 months. Therefore, the bigger downside risk to developed world equities is now centered on the US rather than Europe. Certainly from a strategic view, given America’s very high premium valuations, I do not think investors are giving a reward if they are taking on risk in America. At least in Europe whatever you think equity valuations are so low now there is the prospect of getting above average returns for buying an asset that faces an above average risk. Q: Would you say there is a possibility that most markets worldwide have seen the highs in the first couple of months that we had in this calendar year and may even go onto test the lows that we saw in December? Some markets have not done that yet. Minack: We were on the global equity team, tactically more upbeat as we came into the end of last year and the start of this year, but my colleagues in Europe and the US had price targets well below the levels we got to in February. Our hunch is that they were the highs for the year. Of course the nature of these markets as we have seen since the rebound in ’09 is that we see these substantial rallies and then setbacks around a relatively flat trend that is completely typical behavior for after these major crashes that we saw in 2008-09. It’s a pattern that I think will continue for sometime which is alternating vanilla bull and bear markets. But, yes, at the end of the year, we think markets will be lower in the developed world than they got to in the February highs. Q: The one thing that’s provided some relief for emerging markets is the kind of cool off we have seen in commodities, albeit a lot of that has got gobbled up by the kind of currency depreciation many markets have faced. Do you think it’s durable? Could that lead to any near-term outperformance for EMs versus the DMs? Garner: It is certainly helpful for Asia as a whole compared to EMEA and Latin America amongst the markets that I cover and particularly for countries like India, Korea and Thailand that are very large oil importers. It is an endogenous factor that has actually kept growth from slowing more. Q: How are you approaching the second half of this year? Are you looking at just raising cash levels across some of these emerging markets? Do you think there is a much sharper cut coming after which there could be a trading bounce that could be milked? Garner: We did already raise cash in the middle of February. We have some cash on the sidelines that we are actually looking to deploy. We are trading closer to European valuations than we are to either the S&P or even Japan valuations for a far superior structural economic growth story. We are not facing some of those deleveraging issues that Gerard mentioned that are present in the developed world.
In terms of the ability of the corporate sector to generate ROE we are still forecasting superior ROE from EMs overall going forward probably about 200-300 bps above the developed world. We would also expect that we will benefit from structural fund inflows coming into both equities and fixed income out of Europe which is structurally overweighted within endowment insurance pension funds on a global basis.
So, it’s important in this problematic environment. It is highly problematic right now to remember some of the structural positives about the Asian EM story. I do suspect we will see a good opportunity in the second part of this year to outweigh it again. Q: What has the liquidity experience been for India because we haven’t lost a whole lot of money, but our conversations with a lot of investors seems to indicate that long only money is still quite reluctant to get into this market. It’s basically been a play of ETF kind of interest that we have seen? Garner: As I mentioned the 8 out of 10 weeks outflow India would have experienced some of that particularly on the ETF side, about 70% of that outflow is ETF-related and active managers are overweight on India and in fact there overweight is bigger than the average over the last 5 years. So, the typical long-only managers being quite reluctant to sell down India despite the disappointing macro performance and that’s because if you are a bottom-up stock picker you find some very high quality of business models here and that’s why people have retained this structural overweight bias. Q: Cycles change as we know, but the question that’s on everyone’s mind is how much longer? It’s been half a decade of a bear market performance already for markets across the world. What’s your sense of when we will actually begin to see the first signs of the recovery after, which of course the markets can get into any kind of bull zone? Minack: The problem is firstly you have seen that the big sort of set backs that we experience in 2008-2009, history says that you tend to stay in these extended range bound periods for 5-6 years. So history suggests that we have further to go on these range bound markets. The second point is that we are coming off what was on the data I have that the most monumental credit super cycle of all time. It was monumental in terms of how levied the developed economies got and it was the most broad-based credit super cycle that we have seen and the bigger the bubble, the bigger the pop, we have enormous structural issues that I struggle to see any clean solution.
What we have seen over the last two or three years is rallies on the back policymakers kicking the can down the road. I think here comes a day when they won’t be able to kick it down the road any further and that’s when I suspect, we break the range, the range bound pattern of the last few years, but we break it to the lower side in a sense that’s what Europe has already done. Some of the peripheral markets are extreme distressed valuations, levels where historically if you bought equities at those prices you have ultimately done very well, but elsewhere we not needed those distressed levels.
There is no sense of resolution and really it’s now about fixing up the public sector balance sheets, which are on a completely unsustainable path and the US is a role model for the inaction of the policymakers. They will continue to kick the can down the road. At some stage they won’t be able to do that, which either means we face recession as they finally tighten fiscally or they try and avoid the hard decisions and may end up with higher inflation.
So for me there is nasty endgame out there. What we have been doing over the last two or three years is really just postponing that end game and in fact on a long view you can even say that the response of the tech wreck in 2001-2002 was the same story. On a very long view, I think we have started the bear market in 2000 that continues and I can’t see it ending any time soon.