India safe EM but Fed hike to make developed mkts safer:UBS

Though the world is bearish on the emerging market (EM) space, India is still better placed, says Bhanu Baweja, Global Head of EM Cross Asset Strategy at UBS in an conversation with CNBC-TV18 from the sidelines of UBS India Conference. The combination of growth and dollar strength in the US could give the Federal Reserve the ammunition to hike rates in December and could result in more weaknes for EMs towards the year-end. However, since markets have already priced in a 70 percent chance of rate hike, it is unlikely that they will crash, says Baweja.As an impact of Fed hike, money will leave EMs but not so much from India because India is an equity trade and not fixed income trade like other emerging markets. Same goes for China too, says Baweja. “So, fresh EM sell-off likely but it is not going to be a crisis,” he adds.
Therefore from a risk asset perspective, investing into developed market equities is prefered compared to even safe EM stocks like India and Mexico because the RoE derating in emerging markets has been quite severe, says Baweja.Below is the verbatim transcript of Bhanu Baweja's interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18. Latha: Global cues are somber, we saw a commodity crash on the London Metal Exchange (LME) overnight, and those inflation numbers in the United States, is it indicating that there is a hike but growth is not in place? A: Growth is in place if you see the United States, this is something that the Fed has been speaking about for a while. They have said that they are looking for the inflation to go back up and that is why it is time to move monetary policy to closer to normal levels. The problem is that the rest of the world which has basically made its rationale of investment, the idea that US rates were to remain very low for very long is in a very bad place to adjust and India relatively speaking is in a better place but again that is a relative comment and in absolute terms given these level of valuations, I think it is still a problem. Latha: How should we prepare for fund flows you think up until the end of the year? Should we expect some major turmoil in currency markets especially emerging market currencies and equities, now that this inflation number has come in positive? A: I think the market is already pricing in about a 70 percent chance of the Fed hiking in December. This is not entirely new news, so I would say that you would not expect crash but markets have already been weakening for some time now. There was a brief spell through late summer probably towards late September till mid-October where you saw a little bit of short covering in emerging markets and I think that is well past. So you will see likely weakness moving towards year-end. I think to the extent that people will move into risk assets at all and to the extent that people will go into risk assets, I assume they are going to go into DM stocks not even safe EM stocks like India and Mexico because the RoE derating in emerging markets has been quite severe. So I do think that there will be headwinds for EM particularly for equities and for Fx but what is different this time is that emerging markets credit is also slowly but steadily deteriorating. You were speaking earlier about the problems that EM is going to face on the back of Fed but in addition to that, EM's intrinsic issues are also coming to the fore, in fact I would say for the bulk of this year, it is EM's intrinsic issues typified in China that have led the bulk of the move down.Sonia: You are one of the few who called this emerging market rout when it took place. Although the likelihood of fresh money into the emerging markets is low, do you also get a sense that we are perhaps at the early stages of a fresh sell-off in emerging markets and do you think that a lot of money could be taken out of emerging markets like India?A: I do think that some money can leave emerging markets but probably not as much from India because India is an equity trade. Yes, there has been some debt money that has come in to India but because these markets are largely closed, India and China, which is the other debt market which is largely closed are pretty much equity trades, not fixed income trades. That is very different from emerging markets as a whole.The reason we have been quite bearish on emerging markets is because we think that the reality has deteriorated whereas the fund flows have not changed because the bulk of these flows have been fixed income flows. South Africa, Poland, Malaysia, Turkey, all of these countries have not seen any of that fixed income money come out. The equity money has been going out for some time and I think that will continue.So, there are two parts to your question, you said is there a fresh emerging market sell-off likely. I do think it is likely. Is it going to be a crisis? I think it is a bit early for that. I don’t think we are going to move into crisis mode but certainly the kind of cues that we are getting from China along with as Latha says what is happening in the US that is not a great combination. It is something that should have happened earlier but it is finally happening and I think emerging markets will sell-off even further from out here but markets like India, I think again I would like to emphasize, are only relatively speaking in a better position.Latha: How are you looking at the dollar index itself? It is almost touching 100. By the year-end or in this run up, you think it crosses 100, what are the levels you are looking at?A: I think it does. The point is that earlier in the summer, the Fed was actually quite worried about global factors which is when Stanley Fischer, the Vice Chairperson also mentioned the value of the dollar has been quite important and the last statement of the Fed, the Fed did so much to mention international factors and there wasn’t the word dollar mentioned at all. So clearly they are getting more confident about the domestic recovery in their labour market about fixed asset investment improving the US.So, that means the sensitivity to the dollar while not completely absent has certainly declined and this is the first time in a long time that I can think of that you are seeing two completely different guidance’s from two major central banks the European Central Bank (ECB) and the Fed. The last time it was so different was in 2007 but the roles were completely reversed. If you may remember, the ECB was quite hawkish and the Fed at that time was beginning to get dovish. So, that time of course euro-dollar was touching close to 150 and today euro-dollar is moving slowly towards that parity mark.So, I do think that the Fed is actually prepared for a modestly stronger dollar because I think they are rightly confident that the US economy is improving now. The US has a major current account deficit whereas the eurozone as a whole is a big current account surplus area so that will limit the extent to which the euro-dollar is going o decline or certainly the pace at which the euro-dollar is going to decline. However, for the short-term, what drives currency is usually its guidance from central banks in terms of the direction of the frontend of monetary policy and the Fed and the ECB could not be more different._PAGEBREAK_Sonia: What should Indian equity investors be prepared for? If we do see a sell off in the early part of 2016 what could the downside for the market look like?A: The risk certainly is that China doesn’t come in and help at all in terms of emerging markets and that you do see commodities going much further, which in the short-term also impacts India. Over the long-term, weakness in China benefits India but in the short-term through commodity markets, which are very important for our exports, which are also very important for large parts of our earnings, as a risk case you could see the markets coming down another 5-10 percent.Our base case, our equity strategists are looking for slightly better levels and they acknowledge that earnings have been pretty poor in the near-term. The medium-term case for India they believe is still quite strong. The risk case of China goes into a severe recession on the fixed asset investment you could see emerging market stocks getting hit by about 15 percent.Latha: What is your own assessment of China? Are you expecting that severe recession or will it just ease that 7 percent gross domestic product (GDP)?A: The point is that China's GDP is almost irrelevant. The only thing that matters for the rest of the world is Chinese investment particularly real estate investment because that is what drives prices of copper, iron ore, oil markets more generally.So the point is that your GDP could be at 7 percent, that could be driven by consumer services, that could be driven by telecom while at the same time, your fixed asset investment particularly fixed asset investment in real estate could be very poor that is what matters. So we are a bet, emerging markets in general are a bet on Chinese investment not as much on Chinese consumption. Chinese consumption is a bet on Chinese consumption. That is why I think that the landing is already reasonably hard for places like Australia, Brazil it is pretty obvious but even for the rest of the EM, it has not been a very pretty year.Latha: Let me ask your thoughts on India as well since you do follow Indian equities very carefully. The growth has been elusive as much in India especially earnings growth, do you see that in this quarter, in the next quarter, the last quarter of FY16?A: It is going to take a little while to turnaround. The earnings expectations for this year were already quite poor and even those expectations were underwhelmed. So it is going to take some time. Fixed asset investment is going to take some time to recover given the kind of stresses we are seeing in sectors like in steel, power and construction.The medium-term earning story is still reasonably strong where India stands out as much superior than the rest of the EM as the fact that India -- the cost of equity of these companies should not ratchet up disproportionately given the fact that inflation is reasonably low right now given the fact that India's credit albeit quite tight is unlikely to get much wider as can happen without the markets like Brazil and Turkey but on pure earnings, we are not expecting a near-term turnaround. We think next year will likely be a better year. We are thinking about numbers in the range of sort of 12-15 percent but that is still sub-consensus. I think the consensus is still closer to 18-20 percent. It will take at least six months for us to see a clear inflection point in investment, for us to see a clear inflection point in earnings. Asset turns are quite weak given what is happening with capacity utilisation in the manufacturing sector.This is -- India is not alone. We think India as a place where many investors come, trying to bet on the domestic economy but you will be surprised, how many similarities there are between India and the rest of emerging markets. Look at disinflation, export performance, how earnings are being revised, capacity utilisation in industrial sector, non-performing loans, all of these are exactly the same. The trajectory of all of these is exactly the same in the rest of the EM and also in India.Sonia: You spoke about the stress in sectors like steel and power but what about consumption because we are seeing a slight uptick in discretionary spending especially in spaces like auto and now we have the seventh pay commission report that will be tabled tomorrow and there is a 15 percent hike expected, do you think this is a theme worth playing for the equity investor?A: That is the theme that has already been played. This is the sector that the global investor wants to be in. Indian consumer is almost the holy grail of emerging markets. So if you wanted to bet on strong demographics, on the story which is going to be a middle income economy going into a slightly upper middle income economy, Indian consumer is your big bet.I do agree that there will be a slow but steady improvement in Indian consumption. The risk out here is what happens to El Nino, what happens to rural incomes. Incomes are not growing at a pace which is strong enough to write home about, it is a slow but steady recovery in consumption and even in autos, the results were quite mixed recently.I don’t think that investors will bail out of Indian consumer in a hurry. I think that is where they want to be, they have made good money on that and that is why the valuations out there are likely to be premium valuations.Latha: What are you expecting from the Reserve Bank of India (RBI) in terms of rate cuts from now till all of 2016?A: We are probably looking for another 25 bps from out here. So nothing on the December 1 policy but it is possible that they grow in February and for that two things needs to fall into place. You do need to see the inflation number come back towards 5 percent. As you know the consumer price index (CPI) number is a one that the RBI is going to be paying much more attention to relative to GDP deflator -- they are moving towards from a multi indicator model to a sort of they are focusing more on CPI. Now CPI comes back towards 5 which is intermediate target and a possibility of cut is reasonably high. That is our base case view.It depends on the degree to which global commodity markets and global currency market sell off as a result of what is likely to be the beginning of the Fed cycle. Our sense is that it is not going to be a catastrophe, I think we have already seen significant weakness, we are not expecting a turnaround at all as we were discussing, we expect further weakness but we are not expecting volatility to go exponential. So it is possible that in this situation, we do get another 25 bps before the fiscal year is done.