India looks expensive with downgraded earnings; underweight on IT, pharma: JPMorgan

The current Indian government managed to push through significant reforms, he said, adding while thinking about next general elections in 2019, one needs to look at fiscal policy rather than structural reforms.

"There is more nervousness at developed markets issue rather than emerging markets issue," Mowat said.

Below is the verbatim transcript of the interview.

Anuj: At the end of every earnings season, we ask the same question. Earnings did not pick up, so what is this market betting on apart from liquidity? And I ask you the same question. Are you slightly worried that we are not seeing any kind of pick up in the earnings?

A: I am neutral India although with an overall bullish context on emerging markets (EM) and then we are underweight IT, we are underweight healthcare and we are also underweight consumer staples as they are expensive within a global benchmark where neutral discretionary, neutral materials and we do have an overweight at this point in financials.

I am concerned about India's relative earnings revisions. Broadly, EM has upgrades in earnings in the last six months, about plus 7 percent for the overall integer for EM whereas if you look at India, we have had downgrades. So India is an expensive market with earnings downgrades. The forward P/E is around 17 times that we will use MSCI India and the expectation, the full cost embedded in that is 20 percent growth. So, India to us, is a market that we are fundamentally anxious about.

The reason we do not have an underweight at this point in our global EM portfolio is that the flow of household savings into equities remains very strong and globally, after the last week which was the first week of outflows in 31 weeks, we are seeing inflows into global EM funds and India gets its share of that capital.

Latha: There is a bit of a risk off in global markets as well. Do you think it is minor, will pass?

A: It is funny. You ask me about a risk off in global markets. There is quite a lot of green on the screens at the moment. Many of the key sectors in EM are very close to their year high and every time we see a bit of a pullback, there seems to be a very strong demand for EM equities. The US equity market is technically looking a little bit more vulnerable. We have moved below 20-day moving averages.

There are levels of concern about lack of policy direction, concern about how to predict what is going to happen with US inflation, which then has an implication of what is going to happen with US interest rates. So, I see the nervousness being a little more a developed market (DM) issue rather than an EM issue at this point in time.

Anuj: You spoke about Indian IT. You may not want to comment on individual stocks, but I wanted your thoughts on how foreign investors would approach something like an Infosys after the kind of developments that we have seen. We have already seen quite a bit of selling, but your thoughts on that?

A: I certainly do not want to talk about specific stocks, but just on a broader statement here, the Indian IT service sector, which has been a terrific sector, I remember investing in Infosys back in 1993 when I was on the buy side, had massive secular growth, had huge competitive edge. Now there are challenges to this.

There are challenges around US trade policy, there is challenge that the rupee is relatively firm. This US trade policy is forcing more employees to be closer to the client which is pushing up costs. There are other items, which are hitting all software services companies, particularly cloud computing.

So instead of companies buying IT services, so they can set up their own systems, they are just simply buying the service they require, whether that service is video conferencing, whether it is outlook, whether it is storing data, whether it is processing data. And that is a challenge for the software services industry. So when you are facing all these challenges, clearly you need a well thought out strategy and a coherent leadership team that you can then execute on those strategies in difficult times. So I will leave it at that in terms of how international investors are looking at this.

Latha: Would you worry about the fairly consistent foreign investment selling that we have seen in India in the month of August. This is something like Rs 110 billion that we have seen month to date in August itself.

A: Remember the other side of that is the domestics bought. So you could asked me saying, are you pleased that domestic investors are buying so much of the Indian equity markets. I am always not entirely sure how to answer these questions because there is never any net buying or net selling.

We have experienced last week some outflows from EM open ended products, the first time we had seen that in more than 30 weeks. Also, international investors have had to deal with some regulatory issues here. We had short covering going on because of changes in regulations with regards to what could be underlying on P-notes.

You may have people selling the long sides of those short hedges. So I think there is a number of dynamics that possibly work here. But again it is back to your previous question of why are you long at market where you are a little bit nervous about the fundamentals. It is because domestic flows are very good and perhaps we should focus on the fact why domestics have been net buyers.

Anuj: For a lot of the domestic investors, maybe the avenues right now are limited in India with cotton savings rate and also other asset classes also getting a bit narrowed but do you think this leaves market a bit vulnerable? This domestic money has not been tested yet in tough times. Yes, there was one demonetisation led sell off, but after that we have not seen a big decline. Do you think this market could be a bit vulnerable if we have a bigger global decline?

A: If the tide goes out and the domestic savings stops being a net buyer, the market is quite vulnerable at these levels. What we require for the market to be okay is for the flows to remain in place but much more importantly, we need to make those 20 percent EPS growth numbers over the next 12 months. We need to see evidence that the economy is doing better cyclically.

There is a reasonable argument around that. Think about having a clear path ahead that does not have demonetisation, does not have goods and services tax (GST). That could be quite helpful. The fiscal position looks as if it is supportive, the central bank has been pushing down rates. So okay that is bad news for the savers, but it is good news for investors, it is good news for those that wish to purchase real estate, real estate activity in India is weak as developers have to deal with their new constraints, their new requirements on the real estate format, one would hope for a normalisation in that.

So, it is a good question, if India fails to pick up, relative earnings fail to pick up, domestic flows weaken then the market correction can be deeper as it will be when valuations are stretched.

Latha: Financials, which part of financials?

A: Again, 80 percent of the benchmark is private sector financials. So you tend to focus in on those. And, it is important when you look at the underlying story for Indian financials, very healthy net interest margins, healthy return on assets, return on equity and I was looking at the growth numbers for the broader index with diversified banks, around 30 percent, they are pretty decent numbers. And so, India's banks' premium valuations is justified by the underlying fundamentals.

Anuj: And consumption? We have seen stocks do remarkably well and at least some consumption companies have come out with good earnings and we have seen a bit of a deal as well. We have a large foreign company buying one of the listed companies here. I am not sure if you would have gone through the news flow, but do you think this space can continue to command a premium over its median valuations?

A: Yes, I think we will split consumption into two areas. Broadly, we like discretionary at a thematic top down basis. It is a little bit harder constructing the portfolios with some of the bigger stocks in that sector. So as a strategist, yes, we like discretionary, currently sitting with a neutral versus the balance of EM.

But we are underweight staples India as we are underweight staples globally. These were great stocks to own when you were in a bear market as we were in EM up until early 2016. Now they are too expensive relative to the long-term growth that they are delivering and that is why I have a style bias to be underweight them. You have to be careful in looking at year to date performance of Indian consumer staples because there was a significant decline due to demonetisation and the first quarter was really just a recovery post the final quarter of 2016 declines.

Latha: Metals, they have been the stars, but then the more important question. Incremental money coming in with Nifty at 10,000. What is a reasonable return expectation over the next 12 months?

A: At the moment, we have not reset our targets. We are still in the view that the market is consolidating at this point. So it will be inappropriate for me to imply a new target. With regards to metals, there is a very interesting thing going on in China. The government there is very focused on the profitability of over-capacity industries.

So the irony is that China used to force down the price of metals. It is now providing a pricing umbrella and we like metals throughout the region. We are long materials in Korea and Taiwan. We like selected materials in India and I think investors are going to be surprised by just how resilient steel prices are. Look at the iron ore prices at the moment. You are approaching the high 70s.

So I think this is a sector where investors were very cynical particularly as PMIs rolled over in the second quarter. And it is recovering now and I think offers good opportunity particularly for those who analyse it on a free cash flow basis.

Anuj: What about politics? Over the last three months, we have seen significant moves. We have seen the NDA getting back in governance more in Bihar, we have seen one southern state where the governing party is getting part of the NDA. Do you think the market could start to factor in government majority in the upper house as well by the end of next year and could that be a bit of a positive trigger for this market in terms of reforms?

A: It is a good question in terms of what the government could do. The only thing I would say is that this government has managed to push through a lot of significant reforms. I think there is probably a limit of how many big items they have got left to do. So, I do not think it is too significant an issue.

If you are looking at politics, then one should start to think about the next general election and how will more short-term policy like fiscal policy be in the year ahead of the next general election. So I think it will be more fiscal policy that the market will be focused on rather than structural reform at this point.