Demonetisation has paid rich electoral dividends for PM Modi: Chris Wood

Gautam Chhaochharia, Head of India Strategy at UBS Securities too said that with the Uttar Pradesh verdict, the markets will expect the government to focus on the reform agenda, including the implementation of Goods and Services Tax (GST).

The markets are hoping that the government will now push forward tough reforms, Chhaochharia said. There has been a pro-poor tilt seen in the government’s policies, he said, adding that spending on rural roads and infrastructure has picked up in last six months.

Below is the verbatim transcript of Chris Wood's interview to Latha Venkatesh and Anuj Singhal on CNBC-TV18.

Latha: What is your assessment of the Narendra Modi impact on the economy itself, now that he has gotten stronger and probably more likely to return in 2019, what does this mean for the Indian economy?

A: I haven’t seen the Indian stock market reaction today but I am assuming it is a positive one. Clearly the victory in UP was of a far greater dimension than people were expecting. So investors will now conclude that Modi looks highly likely to win in 2019 and that will increase expectations that he can continue to implement his agenda, which is basically both promoting developments and digitalisation.

It is also just from a political perspective an incredible story that Prime Minister Modi took this massive risk of implementing demonetisation policy a few months before India’s most important state election and clearly their high risk strategy has now paid off dramatically. I cannot think of another incident where mainstream politician has adopted such a high stake strategy and seen such an incredible electoral dividends from that strategy in such a short space of time.

Latha: The market incidentally have celebrated the Nifty touched 9119, which is the prevailing all-time high. So a new high was set today but the point is with this strengthening of Modi even after this demonetisation gambit, how might has policy changed, would you see him becoming a little more pro-poor and therefore a little less earnings friendly? Generally what would be the impact on the economy and on policy-making?

A: No, I don’t think PM Modi -- his focus is clearly not on the stock market. His focus is on the development agenda, it is on promoting digitalisation to accelerate, to take up banking accounts etc but in my view, that is both pro-earnings and pro-poor. Obviously, there is one very successful policy from the previous governments in India namely the UID card scheme which the PM Modi had the good sense to keep up with that policy and we are now beginning to see the early dividends from this incredible ID card.

The fact is so many -- that most adult Indians have now digital identity. This is a very unique story to India in terms of the global emerging market context. I think demonetisation will serve as a catalyst to promote the user financial assets in the Indian economy. It will also serve as a catalyst to move economic activity from the unorganised to the organised sector and I think the combination of the electronic ID cards and the arrival of the smart phone in India, which have the exploding takeout rates, makes the whole feasibility of promoting digital banking in more remote areas more feasible. So India because of the domestic demand story is by a long way in my view, the most exciting emerging market equity story in the global context because of all these factors.

So the only problem for me is I cannot raise my weightings in India as a result of this unexpected victory in UP because I am already so overweight India.

Anuj: You have been arguing for India and China as your top two markets with 53 percent weight compared to a benchmark of 33 percent but between India and China now, which market do you think offers better risk reward right now at current levels?

A: In the short-term China is very cheaper than India so there has been a trend going on in China and it can definitely outperform India in the short-term but in the long-term, I am very much structurally overweight India. I have more than 50 percent of my long only Asia ex-Japan portfolio, which is like 25 stocks in Asia linked on micro themes in India but I am very much focused on the domestic demand story in India.

Right now, we began the year with many foreign investors looking for reasons to sell India. In meetings in UK and Europe at the start of the year, I got a lot of pushback on the positive Indian view. People did want to listen to it but I would say in investor meetings in Singapore in two weeks ago foreigners have started to capitulate because Indian markets have been more stronger than they were expecting and I think this election results out of UP will further accelerate that capitulation by foreign investors.

Meanwhile the key story in terms of flow of funds in Indian equities in recent past has been the ongoing inflows into domestic equity mutual funds. So this market is being driven much more by the domestic investors not by foreigners and that is a fundamentally healthy development.

Anuj: At the same point, is the risk of – especially in these domestic stories, a bit of a bubble creation with too much money chasing too few stocks, stocks like Maruti, banks they have been some of your favourites as well but these stocks have done well and are not inexpensive?

A: No, the critic of the Indian equity market for years has been that it is too expensive and the best regarded growth stocks have always been the most expensive and clearly they can be profit taking in these sort of stocks at any time but the lesson of the Indian stock market over the last 10-15 years is that it pays off to buy quality to buy expensive stocks and it does not pay off to buy value cheap stocks because in the best cases, the value stocks end up as value traps and the worst case the value stocks end up as something much worse.

In terms of many highly rated stocks in the private sector, financial services area and on that point, my one criticism of the Modi government since it has taken over has been the lack of progress and recapitalising the state-owned banks. Clearly we have an overhang of a significant amount of stressed assets in the Indian banking sector, most of those stressed assets are in the state-owned banks that overhang is delaying the commencement of the new investment cycle in India that is a negative. It seems to me that the Modi government has decided they do not want to proactively recap these banks because it is too expensive, because the government doesn’t want to reduce the stake of the central government below 50 percent.

So if you are not going to get the proactive recap, these state-owned banks will continue to suffer ongoing attrition and the strategy seems to be now to allow the opportunity for the private sector banks to increase their market share at the expense of the public sector banks an exciting point there is that this represents a huge growth opportunity for the private sector banks and their ability to grow market share has now risen dramatically if not exponentially precisely because of the arrival of the practical ability now to implement digital banking. So to me these growth prospect justify the high valuations. I am just remaining structurally overweight this area.

Latha: You may not want to move away from these stocks but would you buy more of them at current valuations?

A: I cannot discuss individual stocks but in terms of sectors to own in India on this financial asset digitalisation theme, I would say private sector banks, insurance companies, housing finance companies and broader financial service players involved with the world of mutual funds consumer finance etc that is the area you want to be, that is the core area you want to be in.

In terms of long-term plays, there is a very interesting long-term story. I emphasize the world long-term in the real estate sector because demonetisation, the attack on black money this very dramatic reform of the real estate market where I believe you are about to see implementation of a rule where if a developer is doing an apartment development, they have to put 90 percent of the pre-sale cash flows into Escrow. These sort of policies goes out in a dramatic consolidation amongst real estate developers there will be probably a blood bath and that means there will be a tremendous long-term investment opportunity buying the best Indian property developers with the solid balance sheets and a track record of completing the developments.

That is a long-term story, it is not a short-term one.

Latha: Give us a word on Indian IT that had been the bellwether of the previous two decades. How would you see those spaces, IT and pharma which have benefited from exports, you don’t see them coming into your portfolio anytime soon?

A: They are fine but I only have 25 stocks in Asia, so they are not my preferred area to be. There are issues for these stocks look comparatively cheap, there are issues of potential policy action coming out of Washington which could potentially affect these areas and we just have to wait and see what the concrete proposals of the Trump administration are.

Clearly, there has been a lot of noise about this, there has been a lot of noise about this potential border adjustment tax but there is a lot of concrete details, so we just have to hold until we see the detail assuming that at some point the detail is announced which is not the case up till today.

Anuj: Let us talk about the Federal Open Market Committee (FOMC) decision, we were just talking to Adrian Mowat from JP Morgan, he pointed out that last time when we had big rate hike cycles from Fed, emerging market had their best rally, do you see something similar play out and also your view on what the US bong market is indicating?

A: Obviously the markets are assuming now a rate hike this week. Last Friday’s US wage data was sufficiently positive to make a rate cut inevitable given the speech was made by the Fed governors but we need to recognise that the reason why monetary tightening expectations have picked up so significantly in recent weeks is not because the US data has become dramatically better, what has changed is the language of the Fed. So the Fed’s more hawkish language seems to have coincided almost to the day with Donald Trump entering the white house. So that political reality needs to be understood.

In my view, the US bond market is a key area to watch. We had a bond riot triggered by Donald Trump’s election, we have some very aggressive stimulus that policy has been talked about. If it looks like these policies are going to be implemented then my best case is that we would get another sell-off in the bond market and a potential testing of 3 percent on the US 10-year treasury yield.

However, if these policies, if the market starts to get a sense that these policies are not going to be implemented anytime soon then in my view, the risk is that the bond market rallies because in my view the trigger for the bond market sell-off we saw after Donald Trump’s election was expectations of policies, being implemented highly reflationary policies if for whatever reasons the markets starts to think these policies won’t be implemented or will be significantly delayed then this whole cyclical reflation trade becomes very vulnerable.

Latha: What is your own base case? Do you think the markets will go past, it is already at 2.61 -- the 10-year bond yields -- do they breach that 2.64 high set a few weeks back and go on towards 3, is 3 your base case or is 2.64 your base case?

A: No, my view is simply do we get the policy or not. If we get the clarity on the policy, we get another bond sell-off. If this policy is not forthcoming and we don’t see any clarity on the policy in the next two months, let us say the Trump administration gets bogged down dealing with the Obama Care, nothing happens on the tax reform and personally I think the bond market is more likely to rally. It is much less about the US data and much more about what policies are announced or not announced. The US economy today is not that strong. It is all about whether these expectations of tax cut happen.

Latha: I was reading your latest edition of \'Greed and Fear\' and you have some question marks over the US growth pace, you point out that systematically growth forecast tend to get wound down by both the Fed and the US government. Are you unsure only about that piece, generally the global economy seems to be heading for a better year in 2017 as evidenced by the Chinese growth, as evidenced by inflation, as evidenced by the rise in the Baltic freight rate, generally import data from Association of South East Asian Nations (ASEAN) and Asian countries. Are you confident that global economy will grow better in 2017 vis-à-vis 2016?

A: The Chinese data has definitely improved and there is definitely an evidence of pick up in global trade data, exports are good examples. We believe a lot of this pick up in trade is connected by the increased purchasing power of commodity countries that have seen a pickup in commodity revenues because of big rebounding commodity prices. My point is that in terms of US real GDP growth, we haven\'t seen any pronounced pickup. In terms of inflation data a lot of this increase in inflationary driven expectations is on the back of the commodity rally but we are now seeing the peak year on year effects of that commodity rally because the oil price, I believe, bottomed in February last year. So all I am saying is a lot of people are extrapolating things forward and in my view it is not so clear that everything is so much stronger that everybody seems to think. So fundamentally my view is this whole cyclical optimism in the US, bond selloff we saw late last year is all based on the anticipation of highly stimulus policies in America; be it corporate tax cuts, be it a corporate tax amnesty to try and incentivise up to USD 2.5 trillion of corporate cash sitting outside of America to return to America. It is predicated on potential focus on the border adjustment tax, on the change in the tax law to allow 100 percent deduction of capex in America, the year you spend it. So basically for the bond market to selloff and the cyclical trade to kick in, you have got to see policies that make market believe there is going to an investment cycle in America even if it is at an expense of an investment cycle in the rest of the world.

Anuj: Getting back to India - equity market is about greed and fear and I am not saying that because we are talking to you. Last year there was a fear in the market. In February the Nifty was sub-7,000. In one year, do you think the meter has turned towards greed? What is the big risk for Indian market from here on? Do you think this market now runs away and at some point become so overvalued that it falls under its own weight?

A: I think that is more likely. Right now the shift is - what has started to move towards greed since the announcement of the election results but it is early days because as I said at the beginning of the year - foreigners were looking for reasons to sell India; I can tell you that because I have meetings with a lot of foreign investors. If you argue the positive story on Indian equities in January of this year, you have got a lot of push back from foreign investors.

I would say that psychology has changed by two weeks ago because the last time I talked to a lot of investors in Singapore and at that time the psychology was its gone up but we hope UP election results, which is unlikely to be a big victory for the BJP, will lead to a pullback and we can buy. So that has not happened. So there is now potential for foreigners to feel under pressure that we forced into the market.

Latha: In the past half an hour, you have indicated to us at least three red flags. One, US growth need not be as good as several observers are making it out to be. Two, Trump\'s tax policies and infrastructure spending is yet to be proven and three, the commodity countries which have led the risk-on trade globally, led the global trade higher could see a peaking off. If these three are true would you say that the global risk-on trade is at risk?

A: It is potentially a risk, but none of this detracts from my overweight in domestic demand India because a great thing about domestic demand Indian stocks is that they are not really geared into the commodity trade, they are not geared into expectations of Trump\'s tax reforms and therefore, they are much more trading on their own merits - that is why domestic demand India remains a core holding.

Latha: Let me just put in one more red flag with respect to the India story that you are positive on: the rupee. You have pointed out in your latest report that Malaysia is attractive because the ringgit is so cheap. The Indian rupee is an island of stability, even appreciation. Would that be a red flag?

A: That clearly could be a risk on the rupee. That is much less straight story, forward story than the equities but right now I have a neutral view on the Indian currency and the fact that the central bank did not ease when everybody was expecting it to ease, has given it a bit of stability. So, the level of the Indian rupee today, I have a neutral view on it and it is not a reason not to invest in India. What I was highlighting last week was not that the rupee is particularly strong, but the Malaysian currency is extremely undervalued at an Asian context, because in real effective exchange rate terms, the Malaysian ringgit is at the same level as it was at the worst point in the Asian crisis. So that is a real outlier for that particular currency. Otherwise, many Asian currencies are not particularly expensive or particularly cheap. I have a kind of neutral view on them.

Anuj: This is something a lot of Indian investors want to know. Do you think we could have a rally in the longer-term similar to what we had in the last bull market - 2003-2007? We have not seen that kind of a bull market. Do you think we could be at the cusp of a rally like that?

A: Logically, that should happen sooner or later, but the one big missing link in this Indian equity story remains the lack of an investment cycle. So, the big distinguishing feature from the current period or the period of the Modi administration thus far and what we saw between 2002 to 2009, in that period we saw a big investment cycle in India and that is precisely what we do not see today and that is where the failure or the lack of willingness to recap the Indian public sector banks more proactively is undoubtedly delaying the onset of a new investment cycle. So, that remains the negative in the Indian story. But that macro negative creates a big growth opportunity for the private sector banks precisely because the state owned banks have got these overhangs of stressed assets.