India fairly highly valued; policy action key factor: PIMCO

India is still a market that is fairly highly valued, says Masha Gordon of PIMCO. "The key here will be the delivery of earnings growth and the delivery on the policy agenda," she adds.

She further says, "In 2013, there is a high probability that China manages to find an equilibrium, political stalemate that comes from the Europe political transition is behind us and we see a turnaround in that dynamics. That will be positive increment for commodities. That clearly will be positive for the largest market in emerging markets (EMs) i.e. Chinese." Also read: EMs less risky for investment than Europe, US, says Jerome Booth Below is the edited transcript of her interview with CNBC-TV18's Udayan Mukherjee. Also watch the accompanying videos. Q: How are you feeling this year about emerging markets generally, cautious or bullish? A: I think we have a number of things that are going in the right direction. Inflationary pressures are subsiding across EMs. That should be very helpful for policymakers, when they contemplate the level of rates. We have seen fairly accommodating central banks. You have seen clearly a cut in your own country with RBI being fairly aggressive. So, there tends to be a tailwind to the growth momentum. Now, clearly the offside of that is a transitional challenge of growth in China and a growth challenge in other EM countries that come from decline in exports. So, I think that there are reasons to be cheerful, but there are reasons also to tamper an excessive optimism. Q: Do you think we will muddle through this year with not too much by way of absolute performance or you think we can actually get some return out of equities? Last year it was very difficult to get anything out of equities at all. A: Last year was a year of a big blowout; the European issue came to the forefront. This year clearly that issue remains in the background. But, we think that the story is far from over and that will serve as a reminder of the need to have pretty high risk on risk assets. Now on EM equities and equities in general, you are seeing a number of healthy tailwinds that should help on the earnings front. The supporting last year for EM equities if you were to forget what the markets did, despite of a pretty lukewarm earnings growth, roughly 3 percentage points, you have had a very healthy growth in dividends. EM Inc, so to speak gave 16% dividend growth that is given low leverage likely to continue in the coming years. So, we are clearly worried about the potential for earnings downgrades coming from the transition in China, but we are also hopeful that the dividend growth story continues to come through and that gives a nice support for EM equities. Q: Are you looking at equities this year as quasi fixed income plus kind of investments with not the possibility of major upside in terms of real absolute returns? A: There will be markets and there will be markets, right? There will be places where the growth trajectory takes off. We think that in Brazil, in particular, we probably would have seen the worse of the growth scare that has come on the back of pretty aggressive tightening. So, in that country we should see earnings troughing this year and starting to get the positive momentum upgrade. So that’s the place where earnings are inexpensive and where you have a skillful potential for capital appreciation. In the market like China, it is a question mark how difficult the transition in the quality of growth is because you are changing in a very profound way. So, when you look on aggregate, it is difficult to say whether the earnings in some parts of the market would not simply collapse. Q: How would you rate the BRICs right now in terms of your order of preference? A: Russian market is exceptionally cheap. There are reasons why it is cheap, but there is probably less of the downside than there is for other markets that still trade in double digit multiple. The fears of policy inaction are in place. Again some of the blue chips are very, very cheap indeed and now are support by a fairly healthy yield. Brazil is probably my number two preference. It should see a reacceleration in growth. There is a number of what we call falling angles growth stocks that have been disappointed, but the sound secular story is very much in place. So, I think that market should see a fairly strong second half. India is still a market that is fairly highly valued. So, clearly the key here will be the delivery of earnings growth and the delivery on the policy agenda. Investors are exceptionally sceptical. There are a number of very interesting pieces written whether India reverts back to very low growth because of the failure to export, the failure to rein in public finances and the failure to mobilise our private investment for infrastructure. So, we need to see developments, whether it’s a funding story, whether it’s a story of responsible public finances or more than anything, the story on delivery on reforms to get that market moving. _PAGEBREAK_ Q: So Russia, Brazil, India, China or Russia, Brazil, China, India? A: China and India are a tie. Q: Both underweight in your book? A: That is right. Q: What is your principle concern on India? What makes you most underweight? What makes you worry the most about - the list of concerns that you just outlined?
A: It is two-fold; valuation is not rock bottom. You still have pretty healthy growth premium priced in the stocks. So, these stocks will have to do deliver earnings growth and that has to be funded. There are number of growth companies have an essential problem of being able to grow at the expense of own cash regeneration. So, I think that part of the market is still very vulnerable. These are your infra plays, consumer finance plays, they need access to continued access to market to be able to deliver growth to justify their multiple.  Q: Do you think equity funding will be difficult to see for Indian companies who need growth capital? A: I think you need bull market to make that happen. I think for the companies that have a solid underpinned and a cautiously optimistic strategy that is growing let’s say 10-15% versus trying to grow at 30-40%, the markets will remain open. But for companies that have grown and have used to the notion of growing through capital gathering, I think that will be very difficult indeed. Q: Does Indian macro worry you, all the recent talk about current account deficit the S&P lowering its outlook because for a lot of macro watchers that has been a problem area? A: India has had that problem for a long period of time. As one of the observers put it out there, it is a failure effectively fairly to exploit. You have a huge pool of unskilled labour that should be perhaps engaged in manufacturing. Yet India has had a very-very low market share globally maybe because of infra concerns and concerns of regulations surrounding labour to gain that market share. So, as China starts to seethe that market share in like manufacturing perhaps its India’s to have. In order to rein in current account deficit, you need to be able to produce the goods that the world needs. IT and pharma alone is not going to salvage the story for a country as large as India. Q: Are you generally more cautious about companies in India which have some kind of government interface? A: Yes because you always have a dual agenda. Coal India is an agenda of growth. From a social stand point, it is a good thing. Clearly, India needs a lot more power and cheaper power. But if you are shareholder in Coal India, you need to be very cognizant that the delivery of that agenda may cost you your incremental returns. You have to always look through the lines of the asset prices to see what is priced in and do you have a margin of error should the government turn its back. Now, if you look at regulated areas like telecom, clearly the government has been very draconian most recently with its pricing of the spectrum that the companies probably will start needing in the very near future. So, policy seems to be quite conflicted. Certainly, the way it looks today not beneficial for returns. _PAGEBREAK_ Q: You seem to have been disappointed with experiences like Coal India or even some of the Indian telecoms, did you own them and did the policy turnout surprise you eventually? A: We own a telecom company, we own Idea Cellular where the hope was that finally the market was coming to a more rationalisation. Shareholders tend to like more concentrated markets where pricing power starts to emerge. So, we have seen pricing power starting to emerge with operators being more rational in putting through price increases, yet at the same time you have seen regulator continuing to invent a fairly unpleasant issues for these companies. So that is a question mark. Coal India, we have contemplating investing. As a shareholder, I want to be absolutely certain about the set of rules of the game. There, the rules of the game could change. So, I remain quite  sceptical about that investment, given the level where the company is priced. Q: You mentioned Bharat Electronics as well; did you have an exposure on that name? A: Yes, we own Bharat Electronics. We are long-term holders. We are long-term bulls on the defence issue. We think companies like Bharat will be long-term winners in the game. But again this just highlights the earnings risk in what seemingly should be a very low volatility business because ultimately government is your contractor. So, this is why even low volatility industries or business in India may deserve a lower rating. Q: You said that in Brazil earnings might trough out this year. You can’t say that with confidence for Indian companies, can you? A: I think it will be a strong statement particularly because you have a very diverse benchmark. So, if you were to take Reliance, company we don’t own, it is a company that continues to struggle on a number of parameters and there it’s very difficult to make that statement. If you take IT sector, again the one we don’t own you have had continuous negative revisions coming from bigger players. So, it is a difficult one to make a strong statement. The banks, the ones that we have owned have done very well and the share prices have reflected that. But, then again it was a question of stock selection rather than the wholesale statement on the sector. Q: Do you own the big Indian consumer names? A: No, we don’t. I will tell you why. We look at the world globally; we don’t need to own every single sector in every single country. So, one may compare ITC with British American Tobacco (BAT), BAT had given us a better risk return in volatility space than say ITC. So, we tend to steer towards companies that have lower volatility, have higher yield and still give us a strong exposure to end consumer. Q: What about crude? You spoke about Russia and Brazil and it’s important for both those markets. It is very important for India in a different sense. How much of your view on India and the fact that you are circumspect is tied to where crude is trading today? A: We don’t have a very strong view on crude. I can give you positive and negative risks that are implied currently in the price of oil. Clearly, there is a geopolitical risk premium implied, yet you probably have a potential optionality on the asset should China grows faster, because today you probably have more skepticism priced in that crude markets on Chinese growth. China is clearly increasing its consumption and becoming a bigger consumer in oil. So, we would say our view on oil is fairly neutral. In our view, there was no huge risk or symmetry one way or the other. So, how does India fare again on the secular horizon? We believe that oil price will remain elevated. India will have to find the way of harnessing its gas reserves to provide itself with a greater energy sufficiency. So, I think that remains an Achilles heel of India. Should the world grow faster, you have the negativity come in on the price of oil and clearly oil is very sensitive to global growth. Q: Do you worry about the fact that the government is unable to pass down oil prices at all? A: That’s a question of profitability of companies. I am worried much more about the inability to struck sound contractual arrangements with gas producers to incentivise perhaps offshore development in India. So, energy security will remain key to non-inflationary growth potential for your country. _PAGEBREAK_ Q: Do you see inflation coming back this year because we have just had a reasonable cut from the Reserve Bank of India? Do you see the central bank following up with many cuts this year or you think it is unlikely? A: I don’t have a strong view on how many more cuts will be coming through. It is general view on the market that RBI has been fairly aggressive. Again, as I quote before, in EM we are seeing a low base effect starting to help. On the inflationary front; we are seeing lower prices on food, number of food groups. So, that should help inflation on the cyclical horizon this year. Going forward again as the world hopefully starts growing a bit more and the low base effect wanes, inflationary pressures will re-emerge both in India and in the rest of EM because of shrinking labour pool in a place like China, improving diets, wealth, etc. Q: What about Asian currencies? How do you see them doing because it affects your end returns at the end of the day. Do you see the rupee being as weak as it has been? A: Our view on Asian currencies is positive, but it’s a view that is long-term in nature. Currency is one asset class that gets heavily influenced by the governments and central bankers that can and have intervened heavily in those markets. So in Asia, central bankers have in general been very supportive of weaker currencies. Although Asian currencies look very under valued, in particular the rupee. It is very under valued on let’s say purchasing power parity (PPP) basis and the time to realize the value of appreciating currency maybe longer term in nature. So, on the fixed income front we are long on Asian FX, but we take a view that it will take time for a strong thesis to get realized. India stands out in Asia as a currency with pretty high carry, so that is supportive of rupee in this level. So do we see a significant weakness in rupee? I doubt it because again over supportive of a high carry in regional context than in global context. Q: Do you see a really strong bull market in emerging market equities anytime in the next 12-18 months? Do you think we could be on a strong uptrend or is this wishy-washy kind of market which is broadly trading in a range? A: Let’s think about what we need to see a very strong bull market. We need to see the supportive valuations. We have that. So, that’s a positive. We are trading some 1.5 standard deviation away from historical mean. We need to see trough in negative earnings revisions. We have seen some indication of that in the first quarter, but more recent earnings delivery has been fairly mixed. What are earnings predicated on? Earnings are predicated on the growth momentum. So, what do we need to see? We need to see continued support from the central banks. Of that growth momentum, we need to see China finding some equilibrium in this new world of lower FII growth and stronger consumer. Clearly, the most important ingredients here is continued supportive risk loving environment. That is clearly predicated on European story muddling through without any explosive elements. That is a more difficult one to put high probably on, given that the problem remains with us. We see populations around Europe grappling with austerity and austerity is never easy. We see electoral cycles challenging the resolve that politicians have to take the bitter medicine of greater fiscal integration, greater austerity etc. Do we see an extraordinary bullish markets? For that we need to see very strong turn in the growth momentum and a definitive muddle through in Europe. Q: In 2013, you think the probability is higher of the factors that we spoke about rather than 2012? A: 2013, there is a high probability that China manages to find an equilibrium that political stalemate that comes from the year of political transition is behind us. We see a turn around in that dynamics that will be positive from that increment for commodities. It will be a positive for the largest market in EM which China is.