Expect India to deliver 15-18% returns in 3-4 yrs: JPMorgan

Puri: On the FOMC, I think what we are looking at is still a 50-50 percent chance of a rate hike. We think in terms of the data that has come that is definitely supportive for a rate hike. The only thing which remains concerning is how global markets have reacted to the potential of a rate hike coupled with the China view.

If China stabilises -- which it appears to have but we need to give it some more time -- and we do see a Fed rate hike, we would definitely see the dots move lower. So the Fed would want to put a dovish tilt to it to ensure that it does not roil the global markets. If that happens then outside of the immediate day or two of a knee-jerk reaction, we think the market should settle down and because whether it is September or December, it is something which is an eventuality. So the earlier the better.

Latha: The key question is whether emerging markets will continue to be a hated class. Is it that the jitters are over, the worst is over and we may start to see at least outflow stopping, what is the view?

Iyer: I think as far as emerging markets are concerned, the houseview is that once the FOMC has done its bit then relative enthusiasm for EM should pick up but that said, I guess if you are going to look at it on a two-three years basis, I don’t think EM is going to perform very uniformly as a class. I think there are going to be pockets that are going to be light and pockets that are not going to be light based on the relative growth inflation dynamics and I guess in that context, India still looks very good to us.

Sonia: For a medium-term investor, will equities continue to beat other asset classes like fixed income etc?

Iyer: If are you looking at three-five years, yes. I think our base case is that Indian equity has delivered returns of about 10 percent through to March-April next year. This is going to be a year of consolidation after the 30 percent return we saw last year. Beyond that we wouldn’t be surprised to see returns in the region of 15-18 percent for the next three-four years.

Latha: Since Sonia spoke about fixed income, growth did take a beating globally as well, so what does this open up in terms of space for rate cuts?

Chinoy: I think India is one of those exceptional countries where a massive sort of commodity disinflation benefits us and a lot of other countries are forced to raise rates now. Brazil has, South Africa has, Turkey is still at tightened conditions. So what you are seeing is that for the first time there is a meaningful downside risk to the 6 percent inflation target that the Central Bank has. The global commodity index in dollar terms is the lowest since 2003, it is even lower than the depths of the financial crisis. In rupee terms, it is the lowest in five years.

So the fact that commodities have collapsed so much in the last three months has been this double dip and the fact that food prices remain content for a variety of reasons -- we have discussed -- despite of deteriorating monsoon, I think does open up a little bit of space for the Reserve Bank of India (RBI). We do pencil in a 25 basis points cut (bps) cut in September.

I will just make one more point, let us step back for a second and think about the possibility of a cycle of cuts in the next year. We have had the best possible confluence of events, commodities have collapsed, minimum support prices (MSPs) have been low, food prices are much below the historical averages and we still end up with inflation around 5 percent by January when the dust settles. So that is going to give the Central Bank some pause that growth is weak, there is no pricing power, every disinflationary force has worked in our favour and we are still at 5 percent.

So as the Central Bank is looking forward, you have to say what happens when some of these forces reverse, what happens when pricing power picks up and therefore I think while we will get one cut in September, I don’t foresee there being a cycle of cuts._PAGEBREAK_

Latha: There is a difference between one cut and a cycle of cuts, there are some numbers in between.

Chinoy: Sure.

Latha: You told me there is a chance of a substantially lower number than 6 percent and you said 5 percent. Now 5 percent with the RBI’s 1.5-2 percent real rate is still a repo of 6.5, you see 6.5 repo in six months?

Chinoy: Two things, I think we should not confuse targets and real rates because then the system is overdetermined. Ultimately what the RBI's target is 6 percent by January and then a band of 4 to 6 percent over the next two years. That is the target. The real rate is whatever the real rate needs to be to reach that band. You can’t have two simultaneous objectives that I must have a certain real rate and a certain inflation target because then in a sense the system is overdetermined.

What I am saying is even if you end up at 5 percent -- I am not saying that is the RBI’s forecast our own forecast is 5.5 percent. However, let us assume you end up at 5 you now have a band of 4 to 6 you are in the middle of that band at a time when every possible global and domestic forces had moved in your favour so I think you will get a cut.

Latha: A cut?

Puri: From the markets perspective what has been driving bond yields has been the RBI policy credibility that it has gained over the past few months. That is also evident in the way the bond market has hardly reacted to the global turmoil. So, as far as the markets are priced in, they are looking at it fairly conservatively.

If post FOMC we do see the market settle down, I would think we probably see on the 10-year yield move down of between 15 bps and 20 and then again like Sajjid Chinoy mentioned depending on the data, the market would look for more.

However, in the medium-term like you mentioned if 4 percent is the target which is going to be achieved and we are going to see a real rate of 1.5 to 2 percent then the timing is questionable but we should see more cuts over the coming couple of years.

Sonia: Coming back to the kind of growth that India will see but in a space where there is so much global turmoil, do you think India can outperform because less than about two weeks ago people were talking about the possibility of us being in a big global bear market with incremental pain coming in from China. How have you assessed the entire situation?

Iyer: India does have the potential for relative outperformance and meaningful outperformance at that because as I mentioned earlier we are little distinct from the emerging market pack because we are net importer of commodities particularly oil. Apart from that, we have two unique advantages -- one is we have very favourable demographics and the second is we have large need for infrastructure.

We are one of the few economies with absorptive capacity to take a lot of capital. Put these three in context, I mean the favourable demographics, the need for infrastructure, the ability to absorb capital and the fact that globally commodity prices are going to be very, low which is not very good for lot of other peer group markets. I think it is a reasonably potent combination.

Latha: Are you confident of the executive capabilities of governments in India, not just this government? Are you betting on infrastructure, any infrastructure, capital goods?

Iyer: I would bet on it on a two year context because let us face it -- our view has always been that given the challenging environment that this government inherited, it would take them a couple of years to clean up the mess and put the building blocks for growth in place. They are doing that, I think for three to four quarter they were into the process, it is going to take another three or four quarters but there is no need to despair in terms of a growth in infrastructure. In four to six quarters we will see a very different environment.

Latha: So all the road contractors, the Larsen & Toubro (L&T) would be in your buy list?

Iyer: What has happened is to start with the government given the limited fiscal space that is available is focusing on three areas -- road, rail and defence and it is a right thing to do. You don’t want to spread yourself very thin early in the cycle. So these are three areas that look very good to us. Companies related to these three areas but down the line I guess other areas will get added to these spaces as and when fiscal space opens up.

Sonia: Coming on government spending because the market is extremely optimistic about the seventh pay commission, the One Rank, One Pension (OROP) and the kind of spending it will unleash but realistically what do you think could be possible.

Chinoy: For me the composition of spending is almost more important than the quantum because the overall fiscal envelope in now fixed. The deficit is 3.9, it is going to be 3.6 and 3 percent and having already relaxed the targets this year unlikely the government will relax it again. For me the big positive was that with lower oil prices and lower subsidy bill, it opens up much more space for capital expenditure (capex) spending and over the last six months there has been a big burst of capex spending.

Of course this is just intertemporal shifting, the more you spend now the less you spend later. However, what you are seeing from the government is a focus to spend more on roads, more on railways some on defence so that you can crowd in private investment. We feel there are green shoots of capex not in the traditional commodity sectors but it is public investment. If you look at capital goods production in the index of industrial production (IIP) over the last six months or look at commercial vehicle (CV) sales or look at National Highways Authority of India (NHAI’s) order book or look at L&T’s order book, you are seeing some green shoots of public investment related capex which is positive.

Latha: Very small question on bonds because you are so confident of fiscal spending. The OROP is an extra amount of money that they have to spend. The tax receipts are not what the budget indicated at all? You are so confident?

Chinoy: I am confident that the target will be met. Now how the target is met every year we worry about the composition, I will say some of the benefits are with oil at 45 or 50 per barrel, you will save up money both on fertiliser subsidy bill and your fuel subsidy bill.

Latha: Budgeted for that anyways?

Chinoy: Fertilisers was quite large. There is also a food subsidy element which you can play around a little bit with. There is challenge in the disinvestment target no doubt about that. Indirect tax collections have been strong, direct tax collection have been weak.My sense is ultimately if there has to be a spending squeeze this year there will be a spending squeeze because in this global environment where there is so much concern about emerging market macro fundamentals I don’t think the government is going to breach that 3.9 percent target. But next year -- you make a very good point to the extent that the wage bill is higher whether it is OROP or other wages is that going to squeeze out capex expenditure from the budget at a time when the private sector is highly leveraged is a legitimate concern._PAGEBREAK_

Sonia: We had an very interesting discussion about will she or won’t she, we are talking about Janet Yellen and whether she will hike rates or not in the September policy. You had a very interesting view that she should perhaps go ahead with it this time because of the way the labour market is improving?

Chinoy: I think so, if you look at the US domestic fundamentals in isolation, this is an economy at full employment. The unemployment rate is at 5.1 percent, it has fallen by 0.4 percentage points in the last three months. This is now in the central tendency of what the Fed had forecasted for 2016 and 2017. So, the whole promise of a calibrated increase, a very modest increase in rates over the next two years rests on starting at the right time.

You don’t want to be in a situation where you wait till December, the unemployment rate is below 5 percent, the economy is growing above potential and then you have promised that you have to raise rates slowly is not credible any more. So, I would much rather -- you get this over with, get moving because otherwise you are in this game theoretic solution where no Central Banks wants to move first. So, it will be good given the data flow the Fed moves and we begin to live in this environment where the ventilators gradually being pulled out.

Latha: If that is the global environment that the yield is rising and therefore bonds will not be the preferred global asset class, here it is unlikely that foreign institutional investors (FII) debt investors are going to get too much of a headroom because everyone from the Prime Minister to Rajan don’t want an appreciating currency. How much money is there to be made in Gilts? 7.8 percent today, what is the best case one year down the line?

Puri: It depends on where commodity prices settle down post potential Fed hike, potential China stability. So, the base case is that we are currently in a stretched environment, we will have commodity prices move up a little bit once markets stabilise. If that happens then to achieve our 5 percent 2017, 4 percent 2018 target will probably require a slightly tighter policy for a longer period than we envisaged. Therefore, the potential cuts may be more back loaded than we think at the moment.

Latha: What is the average return on 10-year for the next 12 months? Does it get less than 7.5 percent?

Puri: I would think if you look at the coupon plus capital appreciation, the range should be somewhere in the region of 7-11 percent. So, it is a fairly tight range, not a whole lot. However, the point is, in this market of uncertainty what is the kind of risk return dynamics that as an investor you are looking for.

Sonia: What are the sectors that you think would lead the markets higher in the next one or two years?

Iyer: If I look at the next six to seven months, we still remain very constructive on both IT services and healthcare. As Sajjid Chinoy has been pointing out, the demand and the growth environment in the US and the developed world remains fairly solid. So, the demand environment remains very good for them. As Latha Venkatesh rightly mentioned, the currency is going to have a depreciating bias, so, that is a very potent combination. So, we would remain overweight on IT services and healthcare.

Coming to the domestic economy, one still has to be selective. We are still not in rah-rah growth land; we are still making our way up there. So, early cycle the preference remains for financials with a very solid capital and liability franchise and secondly manufacturing sectors, which have low financial leverage and high operating leverage and which are very well tuned to the government's early cycle priorities of road, rail and defence. So, what I would include there basically is cement, commercial vehicles and capital goods. These are the three segments which from a manufacturing sector look good and as I said on financials, stick to quality.

Latha: Just to put your views and Brijen Puri’s view in contrast, the JPM view would be that equities would return more than Gilts?

Iyer: If I were to look at it on a 12-18 months basis, I wouldn’t be surprised to see equities deliver more than Gilts.

Latha: Would you bet on midcaps? We did see a fair amount of catch up by the midcap space; would your bets be equally placed on both sectors?

Iyer: Not necessarily. At this point in time, first and foremost I will caveat it, I will say that midcaps tend to be stock specific, unique stories and themes. So, it is very difficult to talk about them as one holistic homogeneous pack. However, having said that, if you are going to put a gun to my head and ask me, I would say that immediate term I wouldn’t be surprised to see midcaps stop for a breather.

What we have seen over the last six to seven months is that midcaps have outperformed largecaps meaningfully and what we see in terms of valuations is both of them are now trading at more or less the same valuations. So, what you want to see is midcaps correct a bit and that valuation gap to open up again or you want to see largecaps move up. So, immediate term the midcaps probably take a breather and the largecaps will have to do the heavy lifting._PAGEBREAK_Latha: You say that you think there is a domestic growth story lead by roads, railway kind of investments and yet your maximum overweight is IT and healthcare?

Iyer: Not necessarily. As I said these are four themes we like. We like IT, we like healthcare, we like high quality financials and we like manufacturing sector that cater to these segments. So I guess it is quite evenly divided across these three or four themes but we are still not prepared to go down the quality chain in terms of the domestic cyclical.

Sonia: When you say quality financials. Can you just elaborate because in the last one month or so there is some concerns with regards to payments banks coming in and disrupting the entire banking system and asset quality issues are only getting worse with so many metal companies but private sector banks too are getting impacted now?

Iyer: As I said I am not making a distinction here between private and public. I am making a distinction between quality and not very high quality, so you could have banks in the private sector which are very high quality and which are not so high quality and likewise even in the state owned banks. So the distinction for us is in terms of quality and not in terms of state owned or rather it in terms of private sector.

Latha: What about the distinction between non banking financial companies (NBFCs) and banks?

Iyer: As far as NBFCs are concerned, we been underweight that space for quite some time and that stance continues because the potential for rate cut is rather limited at this point in time, a lot of them tend to be borrowing at the wholesale end of the market, so it is not going to get easier for them there and we also have to appreciate that a lot of them are very geared towards rural economy and there the distress is getting worse because initially what you had were cyclical pressures but now probably seasonal pressures are also coming to the fore.

Latha: So no-no for consumption stocks of any kind?

Iyer: Not consumption stocks of any kind but rural discretionary consumption is going to be no-no for some time.

Latha: No fast moving consumer goods (FMCG)?

Iyer: It could mean motorcycles, it could mean tractors, it could mean FMCGs which are very highly geared towards rural areas because let us face it - these guys have been -- don't get me wrong - the structural potential is enormous but they had cyclical party for nearly eight-nine years and policies turned a little on the other side, the seasonal factors are stacking up. So there are going to be better entry opportunities here.

Sonia: The biggest shock for market this year globally has been what has come out of China and now although the Chinese government themselves have scaled down their GDP estimates; nobody believes their growth numbers anymore? What is your expectation of Chinese growth, whether there is more pain in store and whether there is more policy action that one can expect?

Chinoy: I am not sure that the China growth slowdown is a big surprise. China has been slowing for the last five years and this year we expect growth to be below 7 percent. I think the worry has been that there has been impression globally that Chinese policymakers have magic weapons and at any point they can tweak the economy and growth stabilises and over the last three or four months you have seen various measures to tweak the economy, the stock market, the currency and things haven't quite panned out the way people thought - that's been the source of nervousness that are Chinese policymakers losing control. My sense is eventually they will stabilise the economy.We forecast that growth on a sequential basis reaccelerates in Q4 but let's step back and remind ourselves that China is on a structural policy induced slowing, they want to rebalance the economy away from the old drivers of growth which is investment and exports towards domestic consumption and that bodes well for a country like India because that means the same 6.5 or 7 percent growth, the China experiences has a very different impact on global commodity prices which help countries like India.

Latha: What is rupee one year down the line?

Puri: The rupee is going to continue with its gradual depreciation path 3-4 percent annualised until our inflation and growth differentials change. So around December of this year the path maybe different depending on how global markets go, we could overshoot, we probably end this year around 66-66.5/USD range.

Latha: The Nifty level in 12 or 18 months?

Iyer: By the second quarter of next calendar year we take out the previous 9,000 high on the Nifty.