'Valuations working against Indian equities, not politics'

Despite the policy paralysis and political turmoil in the country, Richard Titherington of JPMorgan believes it is valuations that are working against Indian equities. In an exclusive interview to CNBC-TV18, the chief investment officer and head of emerging markets for JPMorgan says that the early gains of 2012 have made India an unattractive market.

This, however, doesn’t mean he isn’t concerned about the political scenario in the country. So as to achieve its long term goals, Titherington believes India needs an active and effective government. “But ultimately, I think that valuation is a more important driver of equity returns, so more focused on that than I am the broader political issues,” he said. He goes on to say that people will stop concentrating so much on the macro issues once a derating comes India’s way. “In bold terms, I think India is most of the way through a process of being derated to a level that is more similar to the rest of Asia,” he explained. When the derating does come through, he says there is a possibility that the market will fall to the lows of December 2011. On the monetary policy side, JPMorgan is of the view that the RBI has room to ease going forward. “I think inflation is cyclical and not structural, so in the second half India has got room to ease in one form or another,” he said. Despite this, Titherington is negative on the financial space in India. He believes the slowing economy will have an adverse impact on the non-performing loans of banks. Below is an edited transcript of his interview with Udayan Mukherjee. Also watch the accompanying videos. Q: A lot of large global investors seem to have the sense of disappointment about India, do you share that? A: I wouldn’t sound disappointed in India; it’s still a great long-term story. If anything I think the market has surprised in 2012 with how well it did at the beginning of this year. When you look at India, I am more worried about valuation after the market has done well than I am concerned about the political issues that I know a lot of investors are worried about. Q: So did you use the opportunity to take money off the table in India? A: Yes, we reduced our exposure in India a little bit just recently, particularly in the financial sector. As I said, most investors were surprised how well Indian equities did in the first quarter of the year and that gave us an opportunity to reduce our exposure a little. Q: Would you say you are underweight now? A: Modestly underweight in India. Q: And is it only true with valuation or do you share some of the concerns which have been reining in people on the market? A: I share the worries about the political structure, particularly the inability of the government at the moment to move forward with reform. For India to achieve its long-term potential, I think that India needs an active and effective government. So I do share that concern, but ultimately I think that valuation is more important driver of equity returns, so more focused on that than I am the broader political issues. Q: Do you think valuations will come off in India, do you see the prospect of a derating which gets India more in line with some of its Asian peers? A: Yes, in bold terms I think India is most of the way through a process of being derated to a level that is more similar to the rest of Asia. It has got little bit further to go and I think once that process is over then the macro issues, particularly around the politics that concern people so much today, will be less important. Q: In the process of derating, do you see India going back to the levels we were in December 2011? A: I think that is quite likely, but if we do get back to the level I think Indian equities would be attractive. We were buying Indian equities towards the end of last year when there was a lot of pessimism in the market. So if we do get back to that kind of level, I think that will be a good time to buy. Q: But relatively, you think China has more value than India at this point? A: Chinese equities have clearly been derated. Over the last several years, they have been disappointing investments, there is a great deal of pessimism I think about the short-term outlook for China. So from a valuation perspective, Chinese equities are clearly more lowly rated than their Indian equivalents. Q: What are your expectations of monetary policy in the region now, that is India and China? Do you see a lot of easing happening or do you think we should not be factoring in lot of easing from the central banks during the course of the year? A: I am quite optimistic about monetary easing. I think that, in both India and China, inflation is in the process of peaking. I think inflation in both countries is cyclical and not structural, so in the second half I think both China and India have got room to ease in one form or another. If that is right, then that is a backdrop for the rest of the Asia to ease as well. Q: This despite the price of crude and how sticky it has been on the way up? A: Yes, crude is obviously a short-term concern. I think it is more of a concern for India than it is for China and again that is largely due to government subsidies. I think that crude is being driven largely by geopolitical concerns rather than economic fundamentals and I am not expecting it to move significantly higher from here. Q: So you don’t see inflation coming back in the next three-four months which reins in the Reserve Bank of India’s ability to cut rates further? A: As I mentioned I think that inflation is cyclical, so I think it is trending down. The RBI has been quite hawkish on inflation, which in a big picture sense is a good thing because you want a central bank to be hawkish on inflation. So if my outlook is correct, then yes, I think they have room to ease going forward. Q: Then what makes you cautious about Indian financials, it is just valuations or because you would expect the financials would do well in a scenario where rates keep easing during the course of the year? A: I think there are two things to worry about. The first one, and for me the most important one, is valuations. The state oriented banks have performed very well and we were happy investors there. Secondly, it is the question of non-performing loans (NPLs) and the impact of the slowing economy on the banking sector and I think that is still a problem. Q: Do you think earnings have troughed out in India or do you expect three-four quarters of very sluggish growth still from here? A: I think we are going to have at least a couple of quarters of sluggish growth from here. I think there is a lag that will take place between the central bank easing and the economy responding, so I am expecting a couple of quarters of weak earnings from here. _PAGEBREAK_ Q: Since you manage such a lot of money in emerging markets in Asia including India, what did you witness in January and February when we saw that gush of liquidity coming into India? Was it funds like yours which were getting the money or was it ETFs which primarily got that money in? A: I think it was primarily ETFs. We have seen flows into our funds towards the end of last year and a little bit in January, but we certainly didn’t see flows that would justify the sharp increase in markets that we saw over that period. I think our investors, our clients are still fairly cautious in general. Q: What is making them cautious and why are they still risk-averse? A: The global macro economic environment is still uncertain, the issues going on in the euro zone and the fact that financial markets are highly correlated. So when we have concerns about Spain, emerging market equities fall and I think that correlation makes people cautious because they feel they need to be optimistic about the whole global environment in order to buy emerging markets rather than just focusing on the asset class itself. Q: Do you see another wave of risk-off which is possible in the next few months because of the issues that you speaking about Spain etc? A: I hope not. I think that central banks in the G7, particularly the Fed and ECB, have made a pretty clear commitment to provide liquidity and therefore we shouldn’t go back into a crisis environment. My view is that when markets sell off as they have done just recently, that is a buying opportunity because I don’t see us going back into what I call a severe risk-off environment. Q: What is your base case scenario for the rest of the year in terms of how European markets do? A: I am not an expert on European markets, but my assumption is that Europe from a political, economic and therefore financial market perspective will muddle through. I don’t think we will solve the problems, but I don’t think we will go back into crisis. So I am expecting a benign outlook for European financial markets over the rest of the year. Q: So nothing that jars sentiment towards investing in emerging markets for the rest of the year? A: I think sentiment will remain nervous and I think you will see a pretty rapid changes between positive and negative sentiment. But I don’t see significant movements, 20% plus or minus in either direction out of Europe. Q: That makes for a fairly stable kind of an emerging market equity scenario for the rest of the year you think? A: Given current valuations, one should expect emerging market equities to be significantly higher in 12-18 months time than they are now. So there is room for markets to rise in the second half of the year, particularly if Asian central banks do ease the monetary policy. Q: What about currencies in that region, do you expect currencies like the rupee to depreciate further or do you think they are oversold? A: I think that the rupee is a very good value currently and whilst I am still a little bit concerned about equity valuations in India, I think the currency is clearly cheap. It could sell off a little bit more, but in general I think the Asian currencies offer good value against the US dollar, which is itself quite cheap against the other major currencies. Q: So you are not in the camp which believes that during the course of the year, the rupee might plunge to 56-57 to the dollar which would mean bad news for investors like you? A: I am not expecting the rupee to plunge from these levels now. Q: Do you base that assumption on the fact that the central bank might go out and defend it or do you think fundamentals might pull it back again? A: I think the central bank has proved to be quite hawkish on inflation and therefore if the it eases as I expect it to, investors will see that as evidence that inflation has peaked and so I don’t see a significant deterioration of India’s economic fundamentals over the next three-six months. Therefore I don’t see a justification for the currency to fall sharply from what are already quite oversold levels. _PAGEBREAK_ Q: There has been a lot of talk in India off-late with the S&P changing its outlook to negative and with the current account deficit reaching 4%. Do you think they are minor blips, you wouldn’t worry too much for them? A: I am a long-term optimist about India. I think that the concerns that people have today are primarily driven by a sense of political paralysis and I think that that will change over time. Most of the concerns that investors have, I wouldn’t call them blips, but I think they are short-term issues. When we look out over the medium-term time horizon, India will resume its growth trend and investors will turn to be more optimistic. Q: When do we see the next bull market of the 2007-08 varieties? Do you see on the horizon anytime soon? A: I think that we need to move to an environment where global investors feel comfortable, but we are not on the edge of global crisis. So in order to have a sustained bull market environment, you do need some resolution to the euro zone question and you do need a sense that the developed world is stable and moving forward, which will allow the positive dynamics of the emerging world to once again come to the fore. So I think it will take some time to get back to that situation. Q: So investors need to feel more convinced and confident and comfortable about where they are in their own countries to be able to put money to work in Asia? A: I think that is right. I think the recovery from the financial crisis had just started to take hold when the euro zone crisis came along. Having two such serious issues in the space of a few years has damaged global investor confidence and you see that when you look at retail flows which are still pretty modest, so I think most investors have yet to recover their nerve. Q: Have there been any issues from your investors about the recent GAAR controversy in India for maybe people domicile out of the Mauritius? Has it made difficult to attract flows at all in your eyes? A: I don’t think that’s been a major issue. I think governments are looking at taxation around the world both in the emerging and the developed world. It’s not a positive but I don’t think it’s a significant issue on its own in order to determine investors attitude to India. Q: How would you rate your preferences in emerging markets right now among the big ones? A: I am most overweight China because that’s a non-consensus view, most people are quite worried about China and Chinese equities are as cheap as they have been in long time. I am neutral in terms of Brazil and Russia mainly because I think the domestic markets are quite attractively valued, the currencies are expensive because of their commodity orientation. I am modestly underweight India because I still think that after the sharp rise we had at the beginning of the year valuation are little bit high in India. Q: What would make you change your underweight stance? Are you looking for valuations to adjust or would it be something positive in terms of policy stimulus which you think can then lead to slightly higher multiples for us? A: Primarily valuation. I wouldn’t base my view on India on domestic politics. As I said, if the market comes down and moves back to the same kind of valuation levels that we were at at the end of last year, then a lot of the bad news and concern that I know a lot of domestic investors do have about the political situation would be priced in and if that happens I am very happy to own the Indian market. _PAGEBREAK_ Q: What are your big bets in India? Have you changed your portfolio orientation at all or have your bets remain the same? A: We tend to be pretty consistent long-term investors. We like to own the higher quality Indian companies names. We have bought into some Indian companies with very successful operations abroad, so to a certain extent our portfolio has been less impacted by the domestic economic slowdown. But for us, the number one priority is always to own high quality transparent, well managed businesses. Q: When you say operations abroad, are you talking about IT services or are you talking about large companies like Tata Motors? Are you primarily talking about companies exposed to Europe or generally the IT space? A: I don’t like to talk about individual stock names, but suffice it to say I am not talking about the IT space. Q: Is financials still your biggest overweight in India? A: It was at the beginning of the year, but we have reduced our financial exposure. So no, I wouldn’t say financials are our biggest exposure now. Q: What about infrastructure in India because that is a space which has underperformed for the last couple of years? A: Infrastructure is the area of the Indian market that is most dependent upon government policy. I think you need to see a resolution of the political paralysis currently in order to be more optimistic around infrastructure. So I think it is too early to go back into that area. Q: What do you think will drive performance in emerging markets this year? Will it still be the feeling that there is a lot of money being printed and some of that liquidity from the West will flow in or do you think it will be predicated on improving fundamentals? A: I think improving fundamentals are always a long-term driver. When you look out over the next six-nine months, I think that foreign money will come into emerging markets firstly if we avoid a return to crisis, and secondly if global investors see improving fundamentals. So I think improving fundamentals are the most important issue. Q: What is your biggest risk perception about emerging market investment over the next two years? A: Clearly the high correlation with developed markets. I think that whilst the emerging story is increasingly self sustaining from an economic standpoint, in terms of financial markets, the emerging market equity story does rely upon first world capital and consequently the risk appetite of first world investors. So my biggest concern is a return to crisis in the developed world be that Europe or the US. Q: But you do think that the worst is behind us in terms of that, you think things are improving and lot of that is in the price? A: I think the central banks have made a commitment to avoid a return to crisis, so in that sense, I am an optimist. But obviously I am not an expert on the policy of European and US central banks, but I think that they have made a commitment to avoid going back to a crisis environment. Q: Do you think that the recent rumblings between France and Germany and the kind of views we are hearing from Spain could inject risk back into the system again? A: They clearly could. I think the Europe has yet to find a solution to its problems, but I do think that the ECB stands behind the financial system and as you have seen in the first few months of this year as long as liquidity is made available, you avoid the financial paralysis that we witnessed during the financial crisis in 2008. So in that sense, I am optimistic but clearly European countries have got a great deal of work to do over the next few years. Q: But that risk aside, you would use most dips in emerging markets to be adding to positions? A: Yes. As markets fall in the emerging world, they are becoming cheaper and therefore more attractive. I don’t think equity market falls are telling you there is a structural problem in emerging markets and so yes, it is a buying opportunity. Q: Are you able to convince your investors about that or are they generally leery about emerging markets still? A: There is an interesting distinction between retail and institutional investors. Retail investors I think are still cautious; institutions, be they corporate pension funds or sovereign wealth funds, are much more willing to invest in emerging markets for the long-term. So yes, I think they are happy to invest.