Overweight India; FMCG, cap goods look good: Morgan Stanley

Excerpts from the conversation.

Q: What’s your view on India?

A: We have recently increased our overweight on India. It's at the top of the list of countries that we cover, number 1 out of 27 countries that we cover and partly it is because of that correction has taken place. So valuations have moved back substantially. We are below 16 times forward PE.

More importantly, for people like me that look across the emerging markets space, all the valuation premium India had versus other emerging markets at the end of last year has unwound. So it's actually as cheap as it was in November 2013.

Q: So, it's a good point to enter?

A: It is as long as we are right that the economy is going to pickup and corporate earnings is going to pickup and we are well above consensus on earnings growth over the next two years.

If you actually look at the deficit-to-GDP, it came in much narrower than people were forecasting. So, 4.1 percent and we are heading for sub 4 percent fiscal deficit to GDP. So, government’s current consumption spending at subsidies were reduced, which is a good thing to kind of rebalance the economy in India.

However, you did see a near term impact on corporate earnings. When you actually look now at things like corporate capex and auto sales which are picking up probably are lead indicators of a better earnings environment then we do take comfort in that.

Q: How do you see oil prices impacting India?A: India still has sensitivity to oil and also to global food prices. Our base case view is that we are not going to get significant increases certainly year on year in either oil or food from last year and therefore India’s current account position is going to remain approximately balanced which is one of the best current account positions I have ever seen India in. I have covered India for almost 20 years now.So, it is certainly true that you have seen somewhat of a back up in bond yields in India recently and that may also play the role in the equity market weakness but we suspect that that’s an opportunity again in the bond market. So, it has been somewhat of a counter trend move in relation to bond yields reflecting that increase in the oil price.Q: Coming back to the equity markets and we talked about the 10 percent correction, what do you attribute this, is this just profit being taken off the table? Is it people rebalancing their portfolios putting liquidity into other markets that are looking better at this point in time, what do you attribute this to and how concerned are foreign investors about this entire imbroglio related to the FII-MAT taxation?A: India has recently replaced China as our top pick market in global emerging markets and China has outperformed India very substantially year to date. One of the reasons that we were not maximum overweight India before was positioning. If you actually look at foreign institutional investors’ holdings in India, they have built-up very substantially both before and after last year’s election. So, by the end of last year the average global emerging market fund was essentially double weighted on India.That meant that for further performance in the market you needed either the domestic retail investors or truly global money that is EM or Asia or Ex-Japan benchmarked to be attracted towards India and nether of those two things have happened yet. However, I would say in relation to domestic retail investor interest in India, if those bond yields can move lower and the macro turns then it is very likely that domestic retail investor interest will grow in India. We have seen that actually in China recently.Q: It has been about a year since the Modi government took office and there were a lot of expectations on what this government would actually be able to do deliver on the reforms agenda. Perhaps fundamentals, expectations ran ahead of reality. At this point in time would it be fair to say that the mood has changed significantly on the reform front? You talk to some people and they believe that euphoria has now turned to despair; you talk to others they believe euphoria has turned to realism, which camp do you belong to? A: Let us try and be precise about the kind of reforms that foreign institutional clients really want to see from India, I think the goods & service tax (GST) is really important and there it looks that we are actually getting progress. It has passed the lower house; it should pass the upper house. The other really big one is land acquisition which is much less certain in terms of actually passing in terms of the reform agenda. In addition I think FIIs want to see that Budget deficit structurally lower and that must mean addressing issues like the size of the Indian civil service. If you look back at other really truly reformist governments where you are inheriting similar problems to those that India actually faces structurally, addressing the functioning of the civil service in India is extremely important.Q: Do you get any sense that we have moved the barometer at all on that parameter?A: Modi has done some great work from the top in terms of actually pushing the buttons and actually getting things like the road building programme working and we can see that in some of the capex numbers. But what you still have to do is deal with the actual government current consumption spending and the size of the civil service and civil service pay and that is extremely important. It is the kind of thing that Ronald Reagan or Mrs Thatcher dealt with when they inherited similar problems in the 1980s in US or UK.Q: On the infrastructure side and the government has allocated substantial amount of spending both as far as the road sector is concerned, the railway sector is concerned. Private spending on infrastructure hasn’t kicked in just yet and that is because we are suffering from broken balance sheets so to speak within the private sector. Do you really see private capex picking up anytime soon specifically as far as the infrastructure side of the story is concerned? How confident do you feel about the turnaround for the infrastructure story?A: What you need there is stability particularly around the taxation system which is really crucial. If you are going to invest in long run projects and you are going to try and make returns over many years which is how these infrastructure projects work. You got to have some certainty about the rules of the game that you are operating in particular the taxation system. Again I think that needs more clarification going forward. Q: On the taxation system and specifically the issue with regards to the levy of MAT on FIIs and FPIs, how much of a concern is this because the kind of outflows that we have seen especially between April 15 to about now which is almost about USD 2 billion of FII money being pulled out of the market a lot of people believe that this is linked directly to the confusion over the MAT levy?A: Yes, Retrospective taxation is never a good idea for any country and you need ideally have a very simple, corporate, income tax system that is fairly administered and is consistently administered through time and that remains a challenge for India.Q: This doesn’t worry you clearly?A: It is one of the number of things that we look at. We were actually slightly overweight India by the end of last year and into early this year. We have now increased it very substantially because on our view this near-term pickup in economic growth is just about the best story that we see in our general coverage universe. One of the things that concerns us about China is we have had a very good run in the market but actual economic growth is still losing momentum. In Indonesia, it is losing momentum quite significantly in the same areas actually, things like automobiles and capex where we can see early signs of a pickup in India. So, India has a number of structural challenges but the near term growth number that we are forecasting for this year is 7.7 percent and that is an acceleration from last year and it is actually a better performance that other markets we cover.Q: In terms of sectors that excite you about India given the current valuations what are you looking at?A: We like some of the cyclical’s - both industrial cyclical’s and consumer cyclical’s and we also like the private sector financials and that should be the core of the portfolio. There are other areas historically, pharmaceuticals and software names and some quality stocks in consumer staples have generated very high returns and those were actually the names that we liked when we were much more concerned about India before Modi was elected. Right now we think it is right to add more cyclicality to the portfolio.Q: Specifically as far as the pharmaceutical and the software sector is concerned and the linkage to the rupee because we have seen the rupee now at a 20 month low, what is the outlook as far as the currency is concerned and the impact on sectors like pharma, IT for instance?A: We think going forward it is going to be broadly stable in lets say 62-64 to the dollar range. We are actually at the higher end of that range right now probably linked to the move up in oil that you mentioned earlier and the slight move higher in bond yields.

So, may be coming back down towards 62/USD level and that is again a better outlook than we see particularly for other countries currencies in Southern Asia. So, we would see currencies like the Indonesian Rupiah and the Malaysian Ringgit all actually weaker than the Indian rupee going forward.

We have recently increased our overweight on India. It's at the top of the list of 27 countries that we cover and partly it is because of that correction that has taken place. So valuations have moved back substantially.

We are below 16 times forward PE. More importantly, for people like me who look across the emerging markets space, all the valuation premium India had, versus other emerging markets at the end of last year, has unwound. So it's actually as cheap as it was in November 2013. Q: So, is it a good point to enter? A: It is a good point to enter. As long as we are right that the economy is going to pickup and corporate, earnings is going to pickup and we are well above consensus on earnings growth over the next two years.If you actually look at the deficit to GDP, it came in much narrower than people were forecasting.

So, 4.1 percent as we are heading for sub 4 percent fiscal deficit to GDP. So, government’s current consumption spending at subsidies were reduced which is a good thing that kind of rebalances the economy in India.

However, you did see a near term impact on corporate earnings. When you actually look now at things like corporate capex and auto sales which are picking up probably are lead indicators of a better earnings environment then we do take comfort in that.