EMs gaining from asset switch, but expensive now: Morgan Stanley

Emerging markets are right now benefitting from an 'asset allocation switch' as investors are moving their money out of Europe into emerging markets, says Jonathan Garner, Managing Director and Head of Global Emerging Market Strategy. He says almost 70 percent of the funds pouring into emerging markets are from exchange traded funds. In an interview to CNBC-TV18, Garner says the challenge right now is that emerging markets are fully priced at around 14 times forward earnings, compared with their long-term average of around 11 times. Garner is not bullish on growth opportunities in China. As for the US, he says the economy there needs more of a fiscal stimulus than monetary stimulus to boost economic growth. Garner sees India as a fast growing market and expects the growth to accelerate further in the coming days. He says it is among the bright spots in the post-Brexit world. He is bullish on consumption, industrial and cyclical plays. He sees private sector banks faring better than state-owned banks as economic growth picks up because state-owned banks will take some time to fix their bad loan problems.Below is the transcript of Jonathan Garner’s interview to Anuj Singhal, Latha Venkatesh and Sonia Shenoy on CNBC-TV18.Anuj: My mind keeps going back to the conversation that I had with you when you were in India for your Morgan Stanley Summit. You were quite bullish on emerging markets, but are you surprised by the ferocity of rally even post Brexit?A: We have emerging markets as our number two favourite region globally behind the US but well ahead of Europe and Japan and we are definitely seeing asset allocation away from Europe towards emerging markets right now. India is a bright spot in terms of growth acceleration, so is Indonesia and to a lesser extent, we expect a move out of recession in countries like Brazil and Russia.But there are still significant issues, so we are not bullish on growth outlook in China, we do not think commodity prices have much further to rally if at all. We are still below consensus on earnings growth. So yes, it is our second favourite pick, but we are wanting to pare that off versus our cautious view on Europe and Japan.Latha: At Morgan Stanley, do you have some worries about the way in which central banks and governments now are pushing in stimulus? Do you think that this is going to create asset bubbles?A: Certainly valuations on global equities are moving higher. For the All Country World Index, we are about 20 times trailing price to earnings (P/E), which is around the 90th percentile of the 10 year range.But, in terms of the stimulus, we are of the view that in terms of affecting the economies that the monetary stimulus is increasingly less effective. So what we are arguing is that there is a need for increased fiscal stimulus particularly in the US, Europe and Japan.Sonia: I was going through Morgan Stanley’s key portfolio and within that, you have been bullish on a couple of paint companies like Asian Paints. We were just speaking to the management of Asian Paints and they indicated to us that the domestic growth looks much better, so rural markets are picking up. Do you think this should be the strategy of investors to look to more domestic stories in India, to more consumption stories? Would you continue to be positive there?A: We recommend consumption and industrial investments, cyclicality and the portfolio in India. I cannot talk about specific stock names because we are not preapproved to do that on your programme. But in general, we see India as a market where growth is accelerating and it is going to be the fastest growing of the major economies going forward, which is quite exciting and in the rest of our portfolio, we have much less cyclicality and we are much more into high dividend yield, high free cash flow yield stocks.Anuj: How high is the risk of the exchange traded funds (ETF) or hot money chasing stocks and creating a bit of a bubble in a couple of pockets in emerging markets?A: I answered that in the first appearance on your show. We certainly are seeing this rotation away from Europe where we took our growth numbers down towards emerging markets where there is more resilience including in countries like India.Again, on the valuation point if you look at emerging markets overall, we are on about 14 times our numbers for forward P/E which is not cheap and the long run average is around about 11. So, that is the challenge in terms of overall index performance that the valuations are relatively full.Latha: Now, we are on the anvil of a huge fiscal stimulus from Shinzo Abe and perhaps, tomorrow we are going to get another dose from the Bank of Japan (BoJ) as well. What are you expecting from the BoJ and would that change fund flows with more money going towards Japan, any impact on emerging markets (EMs) at all?A: Japan along with Europe is our least preferred region, it is about 10 percent downside to our Tokyo Price Index (TOPIX) target price which is 1,190. So, the growth challenges are very immaterial. We are factoring in some additional quantitative easing (QE) from the BoJ tomorrow and indeed some fiscal easing. But it is in the context of very weak global growth and domestic growth. So, our overall view is that you will see additional QE from the BoJ tomorrow, but as long as it is in line with our base case view, it does not change our outlook for the equity markets.Sonia: Drilling it down to some more sectors then, you did mention that you are positive on consumption related themes. I also noticed that you guys have recently added HDFC Bank to your Asia Pacific ex-Japan focused list. We were Geosphere Capital just earlier in the day and Arvind Sanger was telling us that now, perhaps the worst of the banking problems seem to be behind us. Would you concur with that view about the Indian banks and how would you approach this space as a whole?A: The Indian banking sector is interesting in the sense that you obviously have the private banks and state-owned banks. There is the strategy for addressing the problems in the state-owned banks. But our view is that that will take some time to come to fruition. The private owned banks are benefitting substantially from a market environment that has improved cyclicality in terms of the upstream we talked about earlier and they are also in an environment where the household sector is not particularly highly leveraged in India. So, in terms of the ability to grow earnings double digits, they are much better positioned than the average emerging market bank.Latha: You have spoken about banks but the standout performance in the finance space has come from the non-banking financial companies (NBFC). Notable names like Bajaj Finance and even yesterday, Shriram Transport Finance Corporation numbers were good. Larsen and Toubro Finance was not bad. Does that space attract you? There are the smaller boys like the Ujjivan Financial Services and the Equitas Holdings who have been just recently listed.A: They tend to be too small for our global clients to show a lot of interest in. But they fit within this overall story that I have been telling you about which is improved economic growth and with a cyclical upswing and a credit system that is not particularly highly leveraged. In fact, most of the last 10 years or so, the credit growth in India has been very muted.Sonia: When we started the conversation, you did mention to us that you are noticing a lot of fund flows increase towards emerging markets. Is it the more sticky money or the long only fund interest that is picking up or do you think that more of that tactical money is coming into India?A: In emerging markets overall, it is about 70 percent ETF flows that tends to be related to asset allocation, which is away from Europe towards emerging markets and there is relatively little money that is coming into actively managed funds. So at the moment it is more of an asset allocation switch.