Amit Bhartia, Portfolio Manager-EM Equities, GMO says investors who were underweight on emerging markets last year have turned neutral now.
One is witnessing an increases appetite from asset allocators to reallocate money into EMs, with the fund flow data showing record inflows into these markets, says Bhartia. However, there is still a fair amount of skepticism towards EMs.
India, for asset allocators, amongst the EMs stands in the middle of the pack from a short-term (12-18 month) perspective.
From a longer-term perspective, India unlike China does not de-risks its growth model. It is always dependent on oil, monsoons, technology, environmental issues etc, which can derail domestic growth, says Bhartia.
However, some of the government’s initiatives would de-risk India, feels Bhartia, adding that strong domestic liquidity has been a big positive for the economy.
Growth in the economy is still quite muted because the private sectors seems very reluctant to spend, moreover capacity utilisation is low. Although the consumer as a driver has been quite aspirations and much more resilient and government sector is spending.
However, with the corporate capex missing, it is sure to impact earnings in the next few years and that is a negative for India.
EMs over the past 5-6 years have underperformed the developed markets (DMs), the rally witnessed in the EMs in the last 6-7 months is real and comes on the back of few drivers, he says. The vulnerability in asset class has come down significantly as currencies have adjusted and oil prices have fallen, so the risks are low now.
Below is the verbatim transcript of the interview.
Q: It has been a terrific rally across Asian Markets, emerging markets (EM) since the start of the year. Does it feel real?
A: Yes, of course it does. If you see, emerging markets have underperformed developed markets for the past five and a half – six years. It is only in the last six or seven months that emerging markets have done quite well. We think the rally is real and that comes from a few drivers. One, the vulnerability in the asset class has come down significantly over the past few years as currencies have adjusted, oil prices have fallen so the risks in the asset class are significantly lower than they were a few years back.
On top of it you have an asset class that has so massively underperformed developed markets I think we are seeing increasingly appetite from asset allocators to reallocate some money in emerging markets.
Q: Is that really happening because I speak to some long only fund managers or country specific funds and they seem to be puzzled that India has got USD 5-6 billion in a month or a few weeks, but they have not got any money. They say may be exchange-traded fund (ETFs) are getting money, maybe people are chasing momentum but we are not getting too much money. That is inconsistent with your experience?
A: If you look at the fund flow data which is pretty clear that emerging markets continue to record good amount of inflows, so obviously some amount of money does flow through India whether from a domestic perspective or from a global perspective. But, I think what matters in India much more is domestic liquidity and that has always been an attraction towards India and maybe that is finally happening as some of the savings that are re-deployed back in equity markets rather than fixed deposits.
Q: Do you get the feeling that asset allocators are finally feeling that after 3-4 years may be EM is the place to be cyclically speaking or are they still sceptical?
A: I think there is a fair amount of scepticism still there, but on our indicators a lot of indicators have turned positives for EM. Indicator actually which is a very good contrarian indicator has actually tuned negative which is allocation towards EM. So, last year while everybody was consensus underweight in EM now it is not as negative. So, people are actually neutral on EM.
Q: But not bullish, not over-bullish?
A: Not overly bullish so you can argue both ways. Look there is a huge amount of opportunity still there but you can also argue that lot of money has already come in to the asset class.
Q: How does India stack up because sitting in India you get the feeling we are having a terrific run, but everybody is having a terrific run so how does it stack up for you – I mean India compared to the other markets that you look at?
A: I would answer this question from two perspectives one is from a shorter perspective and from a longer term perspective. From a shorter term perspective I would argue that is a 12-18 month period, India is at the middle of the pack. The positives going on for India is very strong domestic liquidity, as I just talked about, money moving from domestic savings to equity markets, that is positive. On the negative side corporate earnings are actually quite poor in India so I would say lot of it is also a hope based rally going forward. Let us not forget in two years we will again be talking about political outcome, social issues and so on; so these are pluses and minuses from a shorter term perspective.
From a longer term perspective I worry, as Bon Jovi likes to say, we are always kind of leaving on a prayer kind of mode. So, India unlike China is not really de-risks its growth model. So, we are always dependent either on oil, monsoons, technology, environmental issues which can de-rail domestic growth and create huge kind of problems, so that is on the negative side.
But on the positive side obviously as oil has come down, I mean if you look at it oil is down about 70 percent from the peak in Indian rupee terms so that is a huge positive for India. I like some of the initiatives what the governments have done which can de-risk India in some sense whether it is creating new domestic driver so I like that.
Q: You spoke about earnings, two and half years there has been practically no earnings growth are you confident that we are going to start to see the needle change or as you said it is still in the realm of hope?
A: The biggest problem which is impacting earnings is private sector, so the private sector is very reluctant to spend and obviously a part of it is capacity utilisation still is quite low compared to existing capacities, lot of balance sheet issues are there in private sector and there is no kind of growth in the economy. So, it is kind of creating this vicious circle in which the private sector is reluctant to spend. So, you have got consumer as a driver who has been fairly aspirational and much more resilient and you have the government sector which is spending but the corporate sector capex is completely missing which will impact earnings in my opinion for the next few years.
Q: It is interesting that you say that there is not too much growth. If you speak to the government they say what are you talking about we are growing at 7 percent plus, we are the fastest growing economy, so where is this lack of growth, but is it consistent with some of the other data that you look at which indicates how fast we are growing?
A: Not really we track a number of other indicators and if you look at cement data, port data, auto sales and correlate that with historical growth series, it is pretty clear to us that GDP on a like to like basis is not growing maybe 4-4.5 percent. So, growth is quite muted in India that is for certain and another problem I have is when politicians talk about growth rate is looking at a very myopic picture in my opinion because what matters is the absolute level of growth in dollar terms or in real terms.
So, let us take some numbers, right, so India’s per capita income is about USD 1,700 a year basically so even if you grow at 7 percent what the government claims it to be, per capita income is growing only at USD 115 a year compared to let us say China where per capita income are growing at USD 500 a year or even in Philippines where per capita incomes are growing at more than USD 200 a year. So, a Philippines consumer is growing twice that of India in dollar terms, a Chinese consumer is growing 5 time more than India in per capita dollar terms and that is what matters.
Q: So, you are saying from a market perspective, those are more relevant numbers to look at?
A: Absolutely, because ultimately what matters is the absolute amount which gets spent on, which becomes revenue for a number of different companies and leads to growth. So, while on paper, while maybe growing at 7-8 percent, my worry is that the absolute quantum gross domestic product (GDP) per percent is not growing fast enough in India.
Q: Is that why earnings growth is lagging for the last 2-3 years, not quite significantly growing like the GDP numbers might be suggesting?
A: No, that is not the point. It is more to do with corporate capex. It has also got to do with some of the traditional drivers in Indian economy, software, pharmaceuticals, commodities that are not growing as fast.
Q: So, you are saying maybe 4 percent kind of GDP growth is practically what is happening on the ground. With that, do you see earnings going back to those 15-20 percent kind of annual growth rates which can support the valuation multiples we are trading at today?
A: If you look at India, the traditional Hindu rate of growth was about 3.5-4 percent in the early 1980's. So, I would argue that that traditional Hindu rate of growth of 3.5-4 percent is now maybe at let us say 4.5-5 percent just because of technology, innovations which leads to a productivity boost and so on.
So whether India grows at 4.5 percent, assuming nothing is happening, still you can grow at 4.5-5 percent and then if you have a very conducive policy environment and a stable macro environment globally, India can very well grow at 9-10 percent or maybe more. Let us not forget, China per capita income grew by about 14-15 percent in dollar terms for pretty much a decade on a much higher base. So it can be done and that is the optionality for India and that is the attraction for India, I would argue.
Q: You spoke about some of these sectors like auto and maybe cement. What about bank credit growth? I mean, just at 4-5 percent, that is not a very bullish indicator is it?
A: Yes, that is the point, but you have to distinguish between state owned banks and private sector banks and obviously, the private sector banks continue to do quite well, lending to consumers. So that is a positive side and you are absolutely right. There is no growth or degrowth from the state owned banks which is impacting overall credit growth in the system.
Q: So what about valuations? Are you comfortable India versus the rest of the EM pack or does it make you slightly dizzy, the kind of levels we are trading at?
A: As I mentioned, there is a hope rally at least for shorter term basis, but markets in India are also fairly efficient and a lot of very smart investors who invest in India. So, the fact about markets is that near-term earnings are a very small percentage of overall valuation. So, what matters to valuations is also a longer term view. So, if the market participants believe and it is possible it may happen that overall India's risks are coming down. So, it can justify higher valuations in spite of corporate earnings being weak for the next one or two years. So, if you argue or believe that look oil is going to be permanently between USD 40 and USD 50 per barrel range, it would justify a much higher valuations for India even with poor corporate earnings for the next 2-3 years.
Q: You spoke about the capex cycle being a problem for earnings. What about the non-performing loan (NPL) problem because a lot of people say that is a reason why credit growth is low and growth is actually not being able to flesh out as well as it could. What is the political way around the NPL problem because the Finance Ministry has started talking about addressing this problem from a policy perspective now?
A: Yes, we have been hearing for the past two and a half years, there was a committee that came out also about how to solve some of these issues and that is the biggest impediment, I would argue to India's growth and a big risk factor also that when you have state owned banking system which is pretty much crippled and NPLs at 15-16 percent, it is definitely a problem. Remember the whole world used to worry about NPLs in the Chinese banking system. Now, a lot of people are worried about Indian banking system and the risk is that more and more international investors start to worry about NPLs in the state owned banking systems just like China.
Q: What is your prescription? What is your solution politically? What would be acceptable to you from a market point of view?
A: It is difficult for me to say but again, there are expert committees that have been out of there which have argued either to create a bad bank or other ways to get around that. The big advantage for India is also a huge amount of domestic savings. So, there are enough financial instruments available which have been tried in the west, which can be used to solve some of these NPL issues. You have a market that has done phenomenally well, so with the right set of policies, the government of India can actually take advantage of capital markets to solve some of these issues.
Q: Sticking with banking, where do you see the monetary policy cycle right now? Do you think interest rates have bottomed out for the near-term given the recent inflation readings that you have seen? Is there a threat that contrary to what one believed three months back, rates might actually head up?
A: Domestic liquidity is quite strong, so what is the driver for credit growth is not interest rates, but just a lack of demand for credit given the poor state of Indian economy. So I do not think even if rates have come down by 50-70 basis points or 100 basis points, corporate credit will pick up.
But, I like some of the initiatives the government has done, especially for interest subvention, especially in low-cost housing, even in middle-class housing. So, obviously that will make an impact because rates in that sector has already come down by about 100-200 basis points.
Q: Your mandate at GMO is to focus on sectors or themes which are very country specific and not export specific or global, so what kind of themes do you play in India? If IT, pharmaceuticals, chemicals, the big export sectors are ruled out, what is the basket that you are left with in India?
A: The mandate for my fund is to buy domestic businesses and the attraction is pretty clear. It is these domestic businesses are uncorrelated to what is happening in the west. It does not matter whether Fed raises interest rates or not, but if we can fund businesses which can march on its own beat, whether it is in India other in other countries, that is a good investment thesis in our opinion.
So, India, given the demographics, given the opportunity, there are a lot of domestic driven sectors which offer you that kind of growth whether it is a private sector bank, hospitality, healthcare, infrastructure, these are businesses that can just do well. The question is whether you grow at 12 percent or 17 percent, but obviously growth is there and that is what we like.
Q: But, willy-nilly then, is your portfolio too skewed in favour of financials?
A: We have a significant bet towards financials, but we also like a lot of other sectors in India, infrastructure, gas beneficiaries and so on.
Q: Infrastructure, despite the fact that the capex cycle has been pretty much dead for the last 3-4 years?
A: Yes, but we are finding specific companies that will benefit from likely spend in infrastructure, so we like such companies.
Q: You do not invest in IT per se, because it is global, but how do you read what is going on in the US with Trump policies as a fallout towards Indian sectors which are exposed globally?
A: I worry about the impact on Indian software. The Indian software which has been a big growth driver to Indian economy, people forget the point that it was the second largest job creator in the Indian economy. It has jobs created in the software sector. It has a huge multiplier effect on the domestic economy.
These professionals buy houses, buy cars and there is a massive spill-over in all aspects of Indian economy. So if this sector gets impacted either because of visa issues or inability of some of these companies to do business as usual, it will start impacting domestic hiring plans, it will start impacting how many people for example, can be on the bench, it will start impacting these businesses' margins and can have a negative effect on the Indian economy specially in a context where job creation is at a multi-decade low in India. So, that is what I am worried about.
Q: Unemployment or job creation gets such a lot of headlines across the world. In India, we do not seem to care too much about it. Does it worry you that we are not addressing that aspect of I which will come around to bite that per capita growth figure that you were talking about finally?
A: Absolutely. I find this lack of discourse on job creation extremely frustrating as an investor in India, as an India. Job creation is pretty much at multi-year lows. In fact, the recent data indicated that you have net job losses in a day and the reason is nobody wants to talk about it because it is a tough problem unlike some of the other issues when one can talk about it, there are no convenient easy solutions. It requires huge amount of patience, huge amount of focus to stick to one investment strategy for example, from a political perspective. And that is definitely not happening. That is why maybe you see this discourse keeps moving from one area to another area because it is a very sensitive and touchy issue.
Q: Do you see any policy answers? How do you see the policy or political landscape in India in addressing some of these issues?
A: Definitely the government has taken steps. Even though they are not big enough to move the needle. But whether it is the government focus on IT on Aadhaar which basically will create a new industry which helps banking reach a certain new level, a different set of consumers. So, it is quite positive that way. Thrust on low-cost housing, again that can create jobs. So, yes, these are steps being taken, but they are not big enough to move the needle in India, my opinion.
Q: Let me ask you about another domestic focused sector, telecom which has been out of the investors' books for the last four years but has come back on the discussion table after the recent moves, Idea, Vodafone, etc. Is it a sector one can look at in terms of good value or would you stay clear of it?
A: We do not like sectors where there is a lot of competitive intensity. So, we have avoided the sector, but if the valuations are reasonable or sentiments is incredibly poor, one will look into it. But right now, it looks like the competitive intensity will prevail and that prevents a cap on stock prices.
Q: You said India is the middle of the pack from a short-term perspective. Which countries look more attractive now in the Asian basket?
A: We like China quite a lot.
Q: More than India?
A: Absolutely. My argument is very simple. Conventional wisdom is that China has taken a lot of debt and it is going to implode one year or another. But, the devil is in the details and unlike India, China has effectively used domestic savings to create a phenomenal infrastructure, huge amount of productivity boost and it is doing the transition from a low value added country to spending on value addition. For example, this year, artificial intelligence is number one priority for China this year. In front of our eyes, in the space of 20 years, China per capita income was same as India in 1987. Today, per capita income in China is USD 8,000. And it is quite possible over the next 10-15 years, we will see the transition of China moving from an emerging market country to a developed market country. So, I am quite bullish on China because of that.
Q: So you think fears of China imploding are overstated?
A: Absolutely. What people miss the point is that a lot of debt that has been taken has been used to build infrastructure, has been used to build roads, has been used to build airports and so on. So, 85-90 percent of the debt in China is all domestic driven debt. So basically you are taking from a domestic saver to a build an asset which is a point not really well thought about by investors and politicians.
Q: Which other countries would you rate higher than India?
A: I like Philippines quite a lot in spite of some of the political issues that is going on and I would argue that Philippines has been the biggest beneficiary of India's lack of focus towards education towards the business process outsourcing (BPO) sector. So, a lot of jobs that initially came to India from BPOs and things like that have now moved to Philippines. So, Philippines is pretty much moving towards a full employment. Per capita income has reach about USD 3,000. Fixed asset investment is growing at about 25-27 percent a year compared to hardly any growth for example, for India. So we like countries like Philippines.
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