Demonetisation: Good for bond mkts, short-term negative for equities, says CLSA

Wood also said that he expects Reserve Bank of India (RBI) to cut rate thrice in the next year.Below is the transcript of Christopher Wood and Rajeev Malik’s interview to Nimesh Shah on CNBC-TV18.Q: I will ask you about India because you have just raised further overweight. But first on the Trump victory and the bond trend which we are seeing which is impacting all emerging markets including India as well in the short-term.Wood: I was expecting a bond sell-off and a Donald Trump victory because Donald Trump has got an incredibly aggressive pro-growth agenda. The details of which were lost in the noise of the election campaign which tended to focus on more colourful issues and not what his policies actually were. But to be brief, he is advocating aggressive tax cuts aggressive fiscal spending increases, he is focused on massively increasing infrastructure spending in America which is basically public sector construction spending at post World War II lows in the US as a percentage of gross domestic product (GDP). He has also got a policy of seeking to try and create some tax amnesty deal with US corporates where they bring the estimated USD 2.5 trillion of corporate cash sitting offshore back into America. The US corporates keep it offshore because they have the highest tax rate in the world. So, all this is creating a potential that the growth direction could change and is leading to a bond sell-off where so many investors are positioned for longer. And the 10-year yields now at a key critical technical level or near 2.25 percent. If we break that level, the bond ride can continue for a while longer because clearly, we are in the kind of no man’s land between the presidential election, but an inauguration remains several weeks away.Q: You are expecting a bond ride on a Trump Victory. There has been a surprise move on the dollar as well. You did not expect that and maybe that is impacting the emerging market flows as well?Wood: I have to admit, if you had asked me before the election result, my guess would have been that the dollar would sell off because of the very aggressive fiscal spending he is talking about at a time when the US economy has already got quite a lot of debt. But the market has chosen to focus on the bullish side of this eye that potentially US growth could pick up, that the US is going to have higher bond yields relative to other countries and the market is focusing on the potential positive impact of the dollar, of all this money potentially coming back to America. So, that has definitely triggered a rush for the exits in emerging market debt. This year, emerging market debt has been one of the best trades. So, it is now the middle of November, people have had made money on this trade and they are rushing for the exits before all the profits they made disappear. So, that is the dynamic we have seen in places like Brazil, Russia, Indonesia, Turkey are examples of markets where currencies have done well, bond yields have come down and now those trades are reversing.Q: Which is why you have cut two percentage basis points on Indonesia and added back to India. You are already very much overweight on India and still very bullish?Wood: I was quite heavy overweight Indonesia too and in my view Indonesia is the best example in Asia of the market that had been driven by this rally in emerging market debt and Indonesia cut its rate by 150 basis points in this year alone and the currency had gone up.India in my view is structurally less impacted negatively by this emerging market debt sell-off because India never really profited from it. Rupee has not had a big rally this year but actually what is interesting right now with this demonetisation move announced by Prime Minister Modi is that one of that is a negative for equities in short-term because growth is going to slow particularly in certain sectors but for the bond market and currency we think demonetisation is a positive.Q: I will ask you about India specific sectors which will get impacted, but one question on the Fed meet in December. It is consensus driven that there will be a 25 basis point rate hike by Fed in the December policy. You are not too sure about a rate hike by Fed in December. Why so and what is your view on the rate hike?Wood: My view since the start of the year has been no Fed rate hikes. Now obviously the consensus view was four Fed rate hikes. Obviously, that has not been forthcoming. But, based on the last US wage data where average hourly earnings growth accelerated to 2.8 percent which is the highest year-on-year (Y-o-Y) on growth rates since 2009. My view then changed that there would be a Fed rate hike in December. That was before the US Presidential Election. The Fed Chairwoman is now seeing the dollar rally, bond market sell off, that means a tightening in monetary conditions which will make her more nervous about raising rates. But frankly, I believe she has to raise rates because it would look political not to.Q: I know you have been a big Modi fan. You have been writing in your reports as well. A bold move by the government last week in demonetising the Rs 500 and Rs 1,000 notes. What is your first take on that? I know a lot of investors must be asking the question to your as well on that move. What could be the near-term impact in terms of growth and in terms of liquidity?Wood: My main view on this demonetisation move is that it is an incredibly bold move. Normally such moves only happen in the midst of macro-economic crises which is clearly not the case in India. Our view of our office here sums it up. Short-term pain for long-term gain. The key question now is how quickly they can technically implement the necessary changes such as recalibrating ATM machines.Q: Even your strategies spoke about the short-term pain. A lot of market participants are factoring in a GDP cut from 7.4-7.5 percent all the way to 6.5 percent in Q3 and not more than 7 percent in Q4. With that sort of cut in the GDP growth and earnings not supportive for the next two quarters. Is India’s valuation looking attractive enough for you?Wood: Indian equities are clearly vulnerable from a growth point right now because valuations are quite high. The hope was that earnings were finally bottoming and picking up. But there is one compensating factor that is the currency should be stable and we are now forecasting I believe three rate cuts next year. This is probably not consensus because what we are anticipating is that this demonetisation move will lead toward increase in deposits in the banking system. That should both stabilise the currency and it should give a greater potential for banks to pass on rate cuts to borrowers and basically it should lead to a further decline in inflation so that is the positive aspect of the demonetisation move. But in the short-term it is going to be more positive for bonds than equities.Q: I believe this will be a huge negative for real estate and proxy real estate sectors at least in the near term and you have been bullish on some of the Indian property stocks. Are you disappointed or do you think this will now have further pain in the Indian property sector?Wood: This is clearly, before this demonetisation I was of the view and office was of the view that the property sector was showing signs of bottoming after a protracted downturn, helped by lower rates and the excess supply gradually coming down. I am talking obviously residential property - - clearly those expectations are now going to be delayed and in a specific case of property, I think the downturn is likely to be more than 6 months.The worst in fact would be in a smaller cities tier 2 cities and lower where cash transactions are much bigger part of the overall business. I think the combination of this demonetisation and the enforcement of this new real estate law regulating the real estate sector is going to lead to a dramatic consolidation in Indian real estate, which is ultimately extremely bullish for legitimate property developers, but we are going to have a bloodbath of consolidation on a 12 month view.Q: Which are the other sectors in India which you think can be hugely negatively impacted because of this demonetisation?Wood: I think real estate hit the worst, then obviously there will be negative impacts, but likes of cement and housing finance and probably to a certain extent autos, but to me these are the precisely the sectors you want to be owning in India or you should have been owning . In the case of cements and autos they have done very well this year, housing finance was doing very well this year - - that’s why my Indian portfolio been doing better than the Asian benchmark that is going to get hit, but I am not going to sell these sectors because the news is already discounted in the market. The issue for me is when you add to them.Q: I want to ask you on this Asia model portfolio that you run, it has been a huge outperformer, within that I believe that you are overweight on financials, autos, cements to some extent and the properties as well. Anything that changes your perspective in the near term to either selloff or to add more in this correction either the autos or banks or NBFCs.Wood: But the issue is how much they correct, but I would be looking from a medium term basis to add to these areas, because these are the areas which I think you want to enter.Q: I am not too sure whether you own the Indian pharma names as well, they have corrected sharply off the highs. Do they give now opportunities to buy?Wood: No, I think Indian pharma looks attractive short term because it is more defensive. It is a sector that is not immediately impacted by this demonetisation, so I can see people rotating this sector short term - - is not the sort of area I want to be invested in my portfolio though personally, because I am not on top of it.Q: And they are likely to be under pressure at least in the next two quarters will you ride that pain?Wood: My plan right now is to ride that pain, but I am in the middle of checking this out. I would say one compensating factors of big listed names tend to be more focussed on the biggest cities in terms of real estate and I would say the real crunch is going to be in the smaller cities where cash is a much bigger part of the transaction. This is a dramatic move. The other issue raised by the demonetisation if the estimates are true that 10-20 percent of the cash will never be returned, so the question is does that create a windfall profit for the central bank and then the question becomes what is that money used for.Q: The other big sector which is really underperformed and most of the stocks are at 52 week low are the IT stocks in India. They have done really well over the last many years in the past, but now it is in a bit of a doldrums. At this valuation you think there is a lot of value in the IT space?Wood: Yes, but people are going to be nervous on that because just specific issues of whether the growth areas over, but the other issue is obviously Donald Trump. Personally, I don’t think Donald Trump is going to be as protectionist as some people are fearing, but clearly that is a risk. In my view Donald Trump is going to be focussed on renegotiating trade deals as opposed to blanket increases in tariffs, but the fact is nobody knows for sure I think for a 3 month view that uncertainty will persist.Q: Your message to the Indian viewers would be, be longer Indian markets, the way you have been for a very long time?Wood: My message is that this is a fundamentally very long term positive move and in fact it is a dramatic move, but clearly it got near term negative implications for growth, but the positive is that it should lead in our view to lower interest rates on a sustainable basis and could also lead to a fundamental structural decline in the fiscal deficit here in India.Q: The big talking point for the last few days has been this big surprise move by the government in terms of demonetisation of the currencies both Rs 1000 note and Rs 500 note. Your first reaction, what could be the near-term impact on growth?Malik: Unquestionably a bold move, I don’t think anybody whether they agree or disagree or would not acknowledge that it is a very bold move, implementation could have been better. Fully well acknowledging that the element of surprise was very important, it is just a case of functional, on the ground reality in terms of how post the demonetisation things etc would work out. So that last mile connectivity input from an operational perspective could have been a lot more constructive.I do think near-term, the fall out on the real economy would be there, maybe it lasts about couple of quarters but people generally would be willing to absorb it simply because the political angle in terms of an issue, which has been literally addressed with a sledge hammer or at least I should say partially addressed with a sledge hammer would go down quite well.I say partially only because it addresses the stock. It is a one-time fudge of the stock of part of the black money in cash. It doesn’t do anything about the generation of the black money, which one would have thought would have been a more constructive and less disruptive move to go ahead with especially when you think about the fact that goods and services tax (GST) next year would have improved compliance in any case.Q: So while some of your peers have already started penning down the Q3 and Q4 gross domestic product (GDP) forecast and probably for the next year or so as well, have you looked at paring down your expectations for Q3 and Q4?Malik: We haven’t formally revised it but the short-term impact could be anything from half to one percentage point of GDP. I don’t think it will impact FY18 forecast in any meaningful manner.Q: The other big hope or expectation is a big lollypop coming out of RBI to the government. It is a long debate, lot of people have endorsed to it that it might happen, some of them have said that this is now a possibility. What is your take given that there is so much of hope building up that with this demonetisation move, it could be a big windfall for RBI which probably government will be able to take it back in terms of dividend?Malik: Just take a step back and think about it intuitively. If all countries where fiscal was under pressure and all emerging markets (EMs) have a certain black economy or informal unaccounted economy, all of them would resort to demonetisation, have a big windfall because of lower currency liability and then tell the Central Bank to transfer that to the government and they will be laughing away to wherever.We know that doesn’t happen from real life and there is a good reason for that because Central Bank's balance sheets don’t necessarily operate the same way as a private entity. Central Bank balance sheet has a big impact as far as money supply, money creation etc is concerned. You also have to see what happens on the balance sheet compared to the banking sector balance sheet. So my own sense is while the fiscal will get better simply because the part of the informal or unaccounted economy will get captured in official statistics, I am not buying this lollypop of a transfer from RBI to the government and that will solve all the problems.Q: The other big thing which lot of people have not spoken about -- the next few quarters which now people have started anticipating that there will be a slowdown and probably that reflects into the equity markets as well but beyond these six months, given the way the GST is likely to roll out next year, the way this thing is moved out, the currency has been stable for a year now, you think there is a fair chance of a rating getting upgraded for India, if not in the next two quarters, maybe in the next one year from now?Malik: Implementation will matter and implementation has never been India's strong point. But I do think just on the GST and I am not a big fan of the final design, the rates should have been lower and fewer in number but still it is positive, it is better than nothing and it certainly will improve the situation from what we have now and all those tractors on their own will justify rating upgrade as far as India is concerned.I think lot of government's spokesperson tend to be in a hurry, rating agencies will take time when something is implemented, what the on the ground reality is because they want to be sure that that is how it is playing out and in India what is announced and what is implemented and what the outcome is, often times can be different but I am pretty convinced over a 12 months period India will certainly witness one rating upgrade.Q: The other good part so to speak has been the resilience of the rupee in the last six-eight months, almost for a year now, a slight bit of a worry now is picking up, the dollar has strengthened, some of the emerging market currencies have started reacting to it. You think India is in a better stance at this point of time given to what it was in the last 2013 crisis?Malik: Unquestionably and I will also say that it is better compared to some of the other emerging markets. It is important to realise that in an interconnected, interdependent world, there is no such thing as a country that is an island on to itself. So yes, rupee will get impacted but what is important to note is since the American election outcome, both rupee and Indian bonds have outperformed and that underscores how the situation has changed.Obviously, for the bond market, the demonetisation and the flood of cash into banks and what it means for bond yields is an important play as our expectations about RBI easing, which I don’t think are fully well priced in yet. So those are differentiating factors. So I do think over the next 12 months, RBI will have room to cut rates even if US rates go up.Q: You had a non-consensus view since the beginning of the year of a possible 75 bps rate cut by the RBI. With this demonetisation move, with the liquidity now going up in the banking system, you think there could be a positive surprise in terms of sharp rate cuts?Malik: Market rates will clearly come down and some of them have already started to come down as far as yields are concerned. I think the bet on RBI's stance has to be seen in the context of the inflation profile, which is going to be pretty benign. In any case, they have got a far wider band, the MPC does that gives them a lot of leeway plus don’t forget, the negative fallout on the real economy as a result of this demonetisation might make the MPC a bit more amenable for cutting with the idea that look, it is a strong reform, near-term negative but has lot of merits over the longer-term.So I still say, December we will see rate cut and a total of 75 basis points (bps) over the next 12 months. Can RBI be more aggressive? Possibly. But right now, even that 75 is not fully baked in as far as market expectation.For more, watch accompanying videos...