Although Q4 earning season has been a dampener for Indian equities and woes of a poor monsoon season looms large, experts from Morgan Stanley are super bullish on India’s prospects.
On the sidelines of the Morgan Stanley India Summit, Jonathan Garner Chief Asia & EM Equity Strategist says while Japan is among the most preferred market right now, India too has the potential to see a significant uptick in growth.
Agreeing with Garner's view, Chetan Ahya, Co-Head of Global Economics & Chief Asia Economist, said that India gross domestic product (GDP) could stand in at 6.5 percent for FY16 and 7 percent for FY17. This estimate, he adds, is based on the earlier GDP calculation method and hence is likely to be higher.
Furthermore, Ahya says the market concerns of poor monsoon stoking higher inflation are unfounded. Ahya says unless there's a drought-like situation, there is no real reason for inflation to rise.
Citing current account deficit (CAD) and rural wages, Ahya says most of the sources of inflation have been killed and it is likely to come in at 4.75 percent for FY16.
On the micro-market front, Garner believes earnings will see a meaningful jump in the next 2-3 quarters and he expects the Sensex to close the year over 30,000. Below is the verbatim transcript of Jonathan Garner and Chetan Ahya's interview with Latha Venkatesh on CNBC-TV18.
Q: To what do you attribute this mid April onwards selling that we are seeing in emerging markets to some extent as a whole but a little accentuated in India? Is it that EM has lost its sheen as an asset class?
Garner: Emerging markets is certainly still our least preferred area in global equities. Our top pick is Japan which is being going the other direction and unfortunately yet again the earning season has turned out to be quite disappointing and that includes India.
In terms of India’s actual performance, most of the underperformance of India versus the rest of emerging markets took place earlier in the year between January and March. At the moment, India is holding its own relative to other EM. The EM index overall has been down 11 straight days.
Q: To what extent should we worry about things like German bunds rising? I remember mid-April it was 0.05-0.07 percent on one day, now almost 85 bps higher and likewise US treasury is 1.9 percent mid-April and now almost 2.4 today perhaps 6 bps lower but should we worry about these bonds, is this the reason why we are seeing this outflow?
Garner: Earnings is one of the catalyst for the performance. Certainly rising bond yields under strong US dollar has been the other catalyst. Japan for example a weak yen helps corporate earnings but for most of emerging markets, you get a negative dollar translation effect which is that dollar strengthens and your debt servicing cost also rise. However, we don’t think India is as vulnerable as other parts of our coverage universe this time around. So at this conference two years ago we were very worried about India but we are hopeful this time around that India will be more insulated from these problems than other emerging markets.
Q: Do you think this yield hardening scenario continues for sometime so we should worry that emerging market equities as an asset class is going to be under pressure for sometime?
Garner: That is right. We see the 10-year yield going higher and we think we are only mid-way through a probably 5-7 year dollar bull run and this is a negative feature for emerging markets overall. Now that said in terms of India’s near-term outlook if there is a better chance that growth picks up in India than almost anywhere else that we cover in the emerging world, that is an early sign of encouragement in that regard then that is the reason why we are overweight India within this overall bad environment in emerging markets.
Q: So you would think that if you have to give me a view for the next 12 months, it would be not terribly favourable for emerging markets but India could outperform?
Garner: That is our view. We have been ratcheting up our exposure to India now to quite a large overweight as the market has had a relatively poor year that is what we like to do, we like to buy low sell high and if our economics is correct that strategy should work quite well.
Q: We just had a credit policy which gave the third rate cut for 2015 or the third rate cut for the cycle, but the bond markets were not enthused what are your initial comments on the credit policies take away?
Ahya: The bond markets were not enthused for two reasons because of what is going on in the global market; today global bond yield are rising and second is that Reserve Bank of India (RBI) a very hawkish inflation forecast. I know that there was a lot of focus in the media on the January 2016 but for March 2016 it was close to 6.4 percent. That was definitely a big spanner in the view. So that is what I would explain the bond yield rise in India too.
Q: What is your own sense, inflation gets as bad as that? Let us assume for the moment that the monsoon is a mediocre not a drought year but not the best of monsoons.
Ahya: Except for a drought I struggle to find a reason why inflation will go up to 6.4. Crude is unpredictable and our view is that crude is not shooting up to 100. If it stays below 80, that is not going to be a big deal. Fuel directly doesn’t have much impact on consumer price index (CPI) as we know. So from drivers of inflation perspective, how we have approached is two sources of drivers - one is domestic and the second is external. As far as the domestic drivers are concerned the first and the most important issue at length is rural wages. They have collapsed. They are growing at 5 percent. Inflation is a 5 percent so on real basis rural wages are growing at 0 real rate.
Similarly the second biggest domestic sources of inflation is the government spending. That on a 12 month trailing is growing at – central government is growing at 5 percent which is also on a real basis growing at zero. So the domestic sources of inflation have been killed. Then comes the issue of the external side. On the external side it is global commodity prices. We had macro imbalances like current account deficits so currency was volatile that was adding to the pressures on domestic inflation. So, from all the sources of inflation that I can see, I struggle to find one. Property prices they are also not growing and probably close to at zero. So housing, imputed rental cost and CPI which is about close to 10 percent rating is also going to continue to decelerate.
So I want to really conjure up a number, we are at 4.75 for March 2016 and we are not seeing it going up above 5 in our forecast. Only for a short while, with some base effects it goes to 5.1-5.2. Largely it is around 5 or below. You have to really make a bearish call on weather and then if it is weather how long can I assume inflation is going to be high because of weather. What happened because of unseasonal rains? Nothing happened, we have enough inventory. Domestic wheat and rice prices are actually higher than international prices. It is going to be hard to be get even food inflation with some weather problems.
I am not saying that they are doing the wrong thing, they have to make a rational and conservative call but the market's stress out of it is I would say is probably bit too much.
Q: In any case, as Jonathan will definitely second my view, India is not bought by foreign investors or any investor because it has got balance, because the macro economic parameters are now in balance or there is quality in other macro economic parameters – the only parameter why India is bought is growth. So, how does that look to you because RBI lowered that as well?
Ahya: Growth is a little complex one and that I think is probably agreeable. The world is in a difficult shape. We have very weak neighbour which is China and we think that is one of the key drive on the global growth. In our global universe that we cover, China is about close to 20 percent on PPP weighted basis. We all look at the headline number but we have another proxy for China but that is in kind of recession.
So, if you impute the right China numbers, the global growth is weak. Therefore we are also seeing that in some form or the other, of course in form of lower commodity prices and inflation but also in form of lower export growth. Exports are contracting for five consecutive months, together goods plus services exports to GDP is 24 percent. So, we can’t ignore that line item. So, that is the first one.
As far as the earnings growth is concerned, I am getting a bit into Jonathan’s area but there is an element of commodity companies seeing the same impact of global commodity prices and we see that impact in wholesale price index (WPI) inflation. It is now contracting as well. So, that is showing up in total topline growth and earnings growth. So, on earnings growth there is a complex story from the global side which is going on. From a growth perspective, whether I should be concerned or not, I look at just one single parameter which is what is happening to the capex cycle.
On the capex cycle, you look at engineering and construction companies order book, on an aggregate some are giving bad numbers, some are giving good numbers particularly Larsen and Toubro (L&T) had a big one. It is heavyweight on that total number and most importantly a transparent number, no messing around with it is capital goods imports. That is now up for five consecutive months in a significantly positive territory.
So, capex cycle is picking up and then the other side of the capex cycle is the FDI. On a gross basis, they are up by 25 percent, on a net FDI basis because of domestic entrepreneurs now not going outside is up 90 percent on a year-to-date (YTD) basis. So, we have seen a big increase in capex. So, we think that the capex story is holding up the overall growth story and so we are not yet turning bearish on India.
Q: What are you working with as a number, if you are working with the old GDP series then what would it be?
Ahya: I would prefer to look at old GDP series. So, we were at 4.5 percent trough in FY13, we are looking at 6.5 percent in March 2016. So, that is a meaningful steady acceleration that we are building and then March 2017 we are at 7 percent.
Q: We were expecting this turn, 4.5 percent is FY13. I am sure FY14 also by the old series is closer to 5.5 percent but we have not seen the earning cycle turn. In which quarter do you think we are going to see a meaningful jump in earnings growth?
Garner: I would say in the next two-three quarters. In the most recent quarter we are running at about 1 percent year on year – that’s probably the trough and if we get this growth pick up that I am talking about, we could be looking at high teens year on year earnings growth by this time next year and that’s a better outlook for earnings than we have almost anywhere else in emerging markets. Many we are underweight countries which are trapped in quite deep or severe recession places like Brazil or South Africa or indeed Russia and actually with worse currency outlook that India has. So that should be borne in mind.
Q: You would say India could give an earnings growth this year in FY16 of over 15 percent?
Garner: I think it is entirely possible. If you look at the March 2017 yearend, my colleague Ridham Desai, who looks after India in detail, is about 15 percent above consensus – that has an effect on forward multiple on the market. If he uses consensus earnings then India is trading above one year forward about 16 times and that is back inline with long run averages. The entire Modi premium in Indian equities versus the rest of emerging markets is now gone now, we are back in valuation relative terms to where we were at the end of 2013. That’s why we have been looking to upgrade India.
Q: If indeed the RBI is able to achieve a stable, if not 4 percent at least 5 percent inflation over the two years that we have been talking about, will that up the valuation matrix because it is going to be stable inflation country?
Garner: It depends what happens to valuations globally, but that multiple I just gave for India is little bit below the multiple on the S&P and on Europe and we think it is more than fair for the return on equity that India delivers right now and we are at the peak, we are trading about 60 percent forward PE premium to emerging markets and that was late last year and that’s now almost halved particularly with the underperformance from January to March.
Q: Nevetheless, the China contradiction is a little difficult to understand for an Indian investor. When we speak to an economist like Chetan, they are continually telling us that China is going to do worse with each passing year in terms of gross domestic product (GDP) growth. And yet, we saw this extra ordinary performance in the stock markets. Do you think that stock market performance will not sustain?
Garner: If you look at the Asia markets, we have argued that the risk reward has deteriorated and going forward it is getting less attractive. For the off-shore markets, the MSCI China, we downgraded from overweight to equal weight recently. MSCI China formed emerging markets about 4,000 basis points over a year. So, in terms of booking profits on that and rotating towards India that has underperformed recently, that is what we have been trying to do.
Q: But, with the MSCI Index getting recast and possibly A-shares of China being included in that index, could there be a pull of money possibly intended towards India going towards China for a tactical gain?
Garner: We will find out about that tomorrow. We think it is a close call, we do not know for sure what is going to happen. But even if it does happen, there is probably only about one percent of the MSCI Benchmark shift that is likely to take place. So, China’s A-shares will not come in at a full market capitalising initially; they will apply a probably a five percent free-float rating. And one percent is a tracking error; it is the size of a market like Poland which investors either decide that they want to be in it or they do not. I really do not think it has a particular significance for India, this event tomorrow.
Q: What is your forecast of China?
Ahya: The headline number is something that we have to try and predict as to where the official numbers will be, so that is around seven. But the industrial China or the one which matters for the rest of the world which is what is measured in MS Checks, as we call it is in a recession condition. Or the other number to look at would be non-oil import growth in China. That is averaging about minus 15 percent in the first four months of the year. So, I would say that we would rather look at these indicators to know what is going on in China in terms of growth trajectory.
Q: Considering the kind of inflation forecast you have, how many more rate cuts are you expecting from the Reserve Bank.
Ahya: We are expecting another 50-75 basis points by March, 2016.
Q: So, what might be either the ten-year yields or base rate for that matter? You see that also falling by about one percentage point; the cost of money in India for borrowers.
Ahya: That is right, you have to look at the weighted average yields on loans and advances; that would probably be down by about 75-100 basis points. And the other measure could be looking at commercial paper rate which is already actually down quite significantly. That could also be down by another 75-100 basis points in another six to seven months time.
Q: Well, you are in good company. Aditya Puri or HDFC Bank also told us that he expects base rates to fall by around 100 basis points or at least 75 basis points in the next 12 months. You gave us an earnings forecast, how much do you think the Nifty or the Sensex might gain in the next 12 months and in the next 24 months if that is a more comfortable time period?
Garner: Getting back above 30,000 on Sensex is really quite likely and really that is the target that my colleague Ridham Desai has. So, weighted scenario probability of going back above 30,000 on Sensex a year from now seems likely to us.
Q: But, more in terms of equity returns over the next 12-24 months?
Garner: I guess you are going to see probably reasonable double digit returns from here for the dollar investor and the Indian rupee investor given we think rupee is likely to be reasonably stable.
Q: Would it be realistic to expect a 15 percent equity return in the next 12 months and another 15 thereafter as well?
Garner: I would say, 10-15 percent, 12 months out and then obviously, we would want to review the situation but, that is much better than the forecast we have for emerging markets overall, where we have maybe three to five percent upside.
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