Real rates too high; earnings so far not too bad: JPMorgan

As far as the Bihar election goes, an NDA defeat will not be taken positively by the markets, says Mowat. As this will perhaps imply another session of Parliamentary logjam, he explains, and while nobody expected the Land Acquisition Bill to go through, the GST Bill being held up is definitely a disappointment.Below is the verbatim transcript of Adrian Mowat’s interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.Latha: What is the sense you are getting, we have moved a good 10 percentage points from the recent lows and now the globe as it were has started to a slide a bit. Do you think this is stoppish, 8,300 tough to breach that level? A: I think India will go back through its 52 week high. We have had one of those troubled summers again, third quarter was particularly bad and we learnt a lot more maybe about the Chinese economy. We had that big sell-off in the Asia markets, we have had a lot of confusion around the Fed but if then look at some of the detailed data, the European growth numbers are good. It is actually growing above potential particularly peripheral Europe, places like Spain growing at 3 percent. We just had some good economic data again out of Europe. Also, we have got that good data with the European Central Bank (ECB) remaining very helpful and Draghi continuing to make good comments, talking about more quantitative easing (QE) which is certainly necessary in Europe. Remember Europe has still got a lot of debt, deflationary pressure. Then we would expect the Bank of Japan (BoJ) to do something as well and we are still reasonably optimistic that Prime Minister Abe will pursue reform and then we go and look at the US economic data, perhaps some of the data points for last month or so have been a little bit weaker but the non-farm payrolls continue to expand. Private credits accretions growing at about 6 percent which looks pretty good. So, I actually think the world is not that bad. Some of the data we are seeing in economies like Korea where housing sales are strong, car sales are strong, so, if we look at the data and maybe get little bit less caught up in the markets, I think there are some reassuring things out there. Sonia: Just trying to play the devil’s advocate here, we are starting to see some weak spots emerge in some of the earnings performances so for example private banks and pharmaceutical, some of the cleanest companies there, the likes of Axis Bank, Lupin are starting to show slower growth signs. Would you worry about what trends you have seen this earnings season? A: I think it is relatively early. I think we are about 30-35 percent the way through. We are sort of looking at the numbers and they are sort of more beats than misses. So, on a normal status-quo ratio it is not too bad. Some of the private sector bank numbers have actually been quite strong as well and there are some specific issues and we have got some interesting guests coming on where we can particularly talk about the monetary transmission mechanism. I think the problem in India is running real interest rates that are too high. Particularly if you think about real interest rates, about where inflation is a year from now and that is why credit growth has been relatively weak. It is difficult to expect the corporate sector to invest when you are giving them such a high real interest rate. When thinking about real interest rates you probably shouldn’t just think about the consumer price index (CPI) number, you should look at the gross domestic product (GDP) deflator and if you think about the mix in terms of inflation for the economy we have got wholesale price index (WPI) which is actually in deflation. So, I think this is the issue and we need to get a new framework when it comes to where interest rates are in the world but maybe particularly in India. We look at India and Indonesia, those two countries where we think the central bank should be doing more from the perspective off the investor and the economy.Sonia: One of the biggest losers this morning is Axis Bank, it is down 6.5 percent, but, you have a couple of private sector banks that you are overweight on as well names like HDFC Bank and ICICI Bank. There has been increased stressed asset formation for the likes of Axis. Would you worry that the worst is not over in terms of stressed assets for this sector? A: Typically the way this works, we are running real high rates in India so you are going to get less credit growth and you are going to get asset quality problems. The way the equity markets are going to view this that as far as the RBI remains on hold then you are going to get further stress developing. If the RBI was to surprise us and cut rates then the equity markets would look through that. However, it does seems to me to be logical with real rates rising especially when we use the WPI as a deflator you will get to stressed assets.Latha: The passing of rate cuts has not been what it used to be. In fact the difference between the RBIs repo rate which is 6.75 percent and the average of base rates that we have is the highest today than it has been in the past several years. So, this transmission issue will keep coming back because banks are putting away money for their stressed assets. So when does this lock-jam break? A: This is a big issue for investors, why is the monetary mechanism not working as efficiently as it has and maybe it is a function of distressed assets but I would just go back to the more sort of ecommerce-101 view is real rates are too high. Latha: Speaking about Axis Bank itself, the stressed assets were more than what the market was prepared for. Would you rethink your investments in private sector banks in general?   A: I think we have just been listening to the Tata Communication story and their results were different than some of the other companies’ results. I think there is a story here where you don’t say buy private sector banks, you may be more specific about what you are willing to buy and there is definitely a story of certain companies executing better in these conditions. Sonia: You did mention when we started off that you expect to see the Indian markets back at their 52 week highs. What are your projections, by Diwali where do you think the markets could be? Are we staring at 8,500?A: I am not going to make short-term predictions. We sort of think by June next year you could easily be back above the highs that we have seen in the last 52 weeks. If we look at our projections for emerging markets, six weeks ago when we are saying 9.25 which was a 16 percent return that looked very high, it is now 5 percent return for the balance of the year. However, next year we actually think emerging market could do very well. You start to sort of drill down and look at the key companies in the big indexes such as in China, Korea, Taiwan and India. I think they will be generating reasonably good earnings growth. I think there is a chance to recapture some of the lost ratings that we have experienced particularly since the highs in the second quarter. Latha: The Thermax numbers, that is the first of the capital goods numbers that we got. That was a disappointment, even the order book actually shrunk a bit by about 20 percent. Would it be largely a consumption led story? A: It has to be for consumption led story because to get the corporate capex to kick in, the corporates are obviously looking for a lower real price of money. We keep coming back to the same issue and from the corporate sector maybe WPI is more important than CPI. I think this is an issue and what we probably need is a combination of greater guidance from the RBI that we are going to get lower interest rates combined with a government being more effective in spending its money. We have seen this in quite a number of countries, the first year of administration, they are actually quite poor at spending money and it is just the practicalities of getting the right people in place, reviewing contracts, etc. So, I would hope for a little bit more of the fiscal tailwind next year combined with maybe a more accommodative reserve bank and then you could see a corporate capex cycle gradually beginning to recover. However, let us go back to this WPI story, WPI is telling us that there is a lack of pricing power which one were to soon in aggregate means there is plenty of capacity in the system. _PAGEBREAK_Sonia: What about the consumption pie because over there as well, we have not seen any recovery. In fact, we are starting to see some signs of a slowdown whether it is in the white-goods makers, the likes of Hitachi Home, whether it is in the paint companies, the likes of Asian Paints, how do you approach that?A: I think there is concern around that. However, maybe, instead of getting too caught up in short-term numbers, if you look at India’s household debt, gross domestic product (GDP), it is about 6 percent. It is one of the lowest you will find globally. The way we would approach this is you get some short-term noise that is less good and remember that the agricultural sector, the rural sector is feeling a fair amount of pain at the moment.It is really the urban consumer that has got a slightly better environment and the inflation is coming down. The news around the bad monsoon, the movements in the rupee all of this could have hit consumer confidence. However, when we look at the long-term story for Indian consumption, it remains extremely good. You have got demographics behind you, you have got a very underleveraged consumer and we would argue you are probably going into an environment of structurally lower interest rates. All that will allow a growth in housing, a growth in more expensive discretionary items such as autos.Let us look at the medium to long-term and maybe understand why you get some short-term disappointing noise.Latha: I guess, even in consumption, it is one company doing well and another not. We had good numbers from Symphony even if we had bad numbers from Hitachi, so, even in the air conditioner business.A: The other thing about consumption is people are spending more time on their smartphones, they are consuming technology, they are consuming media, that is consumption. Maybe it is easier to count the number of refrigerators, but there is a lot of consumption going on. It is just what we consume is changing.Latha: Any reason why you will want to buy any of the non-bank companies or would you prefer banks and private banks?A: Again, I think it is an issue of execution here because we have got an interesting situation in India where there is aggregate credit growth. Then you have got quite a big part of the financial sector here where the capital is constrained. So, those that execute well can eat someone else’s lunch as well as be part of a growing pie. Again, it has got to be specific. So, interesting comments he was making about the relative size of their home loan business versus the total home loan industry. There is demand out there and there are part big players who are constrained in their ability to grow.Sonia: That makes you wonder about the onset of new technology and how it could really be detrimental for some of the legacy players, for example, the onset of payment banks and small banks and how it could impact some of these smaller private sector banks. How are you looking at that?A: At JP Morgan, we are worried about that as well. We have trillion dollar balance sheet. This is a very important question, because, you start off with most customers tend to be a little bit irritated with their banks anyway and more conscious about the charges and there are these very efficient ways of transmitting money cross-border, making more efficient small payments and this is a global issue and where in emerging markets, it becomes perhaps a bigger issue is that you have got people who are trying to move into the, individuals moving into the formal banking system and then they may decide not to move into the traditional or formal banking system and adopt the new technology. If you look at Kenya, the bulk of financial transactions are being done over a mobile phone and there has not been a move to a traditional bank account. So, I think this is quite a big threat. Now, as we look at the story with HDFC Bank, they seem to be adopting technology quite aggressively.Latha: I want to ask you about the Bihar elections. Would you see it as a referendum on the centre, would you be terribly disappointed if the NDA lost?A: Yes, we would be disappointed. I would think this would make the next session of parliament a bit of a red herring that nothing is really going to be achieved and there would be a concern about whether the BJP moves or the NDA government moves to a more populist stance. So, at the moment, they have been passing some quite tough policies which is good.Now, with regards to the specific regulations they could be passing, there is a lot of disappointment around goods and service tax (GST) not going through. Most people in the market did not expect the Land Acquisition Act to go through. However, GST, there is disappointment with that and if they do badly in the Bihar election, it feels like it is going to get kicked well into the future.Sonia: So is India still your most preferred market in the emerging market space and have you increased your allocation to India lately?A: No, for both. Actually we think near-term markets like China, Korea and Taiwan will probably do better than India. Now, that is partly because India has not had the same trouble, the same changes in perception that these markets have had. So I think they have more potential to recover from their lows than a market like India which has been outperforming during the correction. So if you are asking me my sort of three month view, India would not be my top market and if you are asking my three to five year view, I think India would still be the best structural story.Latha: In the event that the NDA does not win, would you see your 9,000 prediction not coming through?A: Yes, I think this could prevent a quick recovery to the year highs and it would be perceived as a negative for the Indian market.Sonia: You were telling us that a 52 week high is not ruled out; in fact by the month of June you expect the markets to touch those highs. So just give us an expectation of what the sectoral leaders could be from now till the months of June.A: I think you continue to focus on quality. It is the private sector banks that are doing the right things. Within the building material space, we have a government with a priority on road, rail and defence. So you think about the government priorities and look for the companies that best execute whether its priorities are in place. So I think that is the sort of, the type of leadership. When we look at maybe the IT space which has up till now been a big outperformer, I think that will be less of a focus for investors, because I think we have probably moved out of the period of maximum weakness in terms of foreign exchange (fx) declines in the emerging space.Latha: Speaking of IT itself, have you reduced your weightage for IT?A: We have in our global emerging markets portfolio so we were running an overweight in our global emerging markets portfolio, we have moved that to a market weight for Indian IT.Latha: We did see a re-emergence of flows of foreign investors. Is that a trend that is likely to continue? Almost after 13 weeks we saw that number turning positive.A: I think to put this in context we have seen about USD 52 billion of outflows from the open ended funds that you can easily measure. Now if you put that in context during the global financial crisis in 2008, there was a USD 48 billion outflow and assets under management back in 2008 were greater. So we have had the worst year I have ever seen in terms of outflows. The days of last week I think were plus USD 300 million, it is barely scratching the surface of outflows. So the confidence in the emerging markets (EM) story remains low.Latha: At least the outflows have stopped.A: Yes, so we are banging our heads against the wall less frequently. The question is can we get people to pull the trigger to put more money into emerging markets. Now the good news is clients are asking a lot of questions and their positioning is very bearish. So the question is can we draw them over the line. I think we can, we are seeing some positive earnings revisions out of China, I talked about some of the strength in the Korean domestic economy, we are beginning to see a seasonal uptick in tech.Now if you look at Korean and Taiwanese tech hardware, it is one and a half times the size of Brazil and Russia combined in the benchmark. So it is important to get tech to work. So that is all coming through, because what really matters here is earnings revisions. So just to put this in context, the earnings per share (EPS) integer for emerging markets today, for 2015, is 26 percent lower than the forecast 12 months ago. That is a fundamental massive negative. Until earnings start to turn around, you are not going to get the flows. Flows follow fundamentals and that is the key thing. We spend too much time talking about flows. Flows tell you that someone has made a decision, markets are about trying to pre-empt whether someone makes a decision.