Benchmark indices have witnessed a strong run in the past couple of months, clocking record highs ever since the results of state assembly elections were announced.
Experts say that a large part of the rally is also due to high liquidity and better flows from DIIs and FIIs as well as retail participation through mutual funds.
The next big trigger for the market will now be earnings growth, which has not seen much upside for a while now.
JPMorgan is of the view that the market will maintain its current level of rich valuations. There is an environment where domestic mutual funds have seen strong inflows, fixed deposit rates are at the lower end of the cycle and we have a nice technical position, Adrian Mowat, MD, Chief Asian & EM Equity Strategist at JPMorgan told CNBC-TV18 in an interview.
He also outlined how they set index targets in case scenarios such as bull or bear pan out. The bull case scenario target for the Nifty was 10,500, he said. “Part of what is going on India is a bull case…what is not consistent with the macroeconomic data, specifically with the corporate investment. We need to see those data points coming through to see the Nifty finishing with that target,” he told the channel.
Speaking on the rally in emerging markets (EMs), he explained that they value it based on earnings per share (EPS) and return on equities (ROEs). In 2016, EMs delivered positive earnings growth for the first time in five years, he highlighted.
Furthermore, he expects the earnings to go up with earnings growth numbers. Results for FY17 will be relatively pedestrian and growth will be in high single-digits, Mowat told the channel.
But, in FY18, one has to keep an eye on these figures. Areas such as banking need to see a pick-up in activity.
Mowat also saw a recovery in emerging markets and expects financials to lead it. An early stage of that would be lower credit cost, he added.
Meanwhile, he saw optimism around consumption space and likes building materials space.
In the banking space, he said that distress among borrowers was improving as well.
Furthermore, among non-banking financial companies (NBFCS), he likes some housing finance companies as a big opportunity was delivered due to constraints of PSU banks’ capital issues.
Meanwhile, on the affordable housing policy of the government, he sees it being a difficult environment for the private sector which is dependent on policies. “A change in government policy can have a profound impact on business model,” he told CNBC-TV18.
Mowat is the guest editor on the channel for the day and will be interacting with representatives from different industries through the day.
Below is the verbatim transcript of the interview.
Latha: Almost all indices are at all-time highs, it is not just Sensex and Nifty, the midcap indices are at all-time highs, smallcap indices are at all-time highs, does it give you a sense that there is a sugar rush here or can we continue to buy?
A: There are some things to be cautious about. So we have an environment in which we have got strong inflows into domestic mutual funds. They are quite encouraging in many ways because they are monthly inflows which is definitely the right way to buy equities as opposed to buying them at the top which often happens with retail money.
We have also got a dynamic where the positioning in emerging market funds is still very underweight relative to global funds. So you have got a very nice technical position but at the same time, you are buying markets on reasonably high valuations. So look at things based upon the MSCI indices for common comparison across markets, so India is about 18 times on a forward P/E, that is about 0.9 standard deviations above its 10-year mean. I do in fact, while talking to clients, get the general feedback that it is difficult to find things to buy. They know what the themes they want to play, the sectors but the valuations there they are anxious about. I do not think that situation is going to change for now.
If you think about the relative opportunities, we have got a very flush monetary system, fixed deposit rates have been much lower than they have been historically, bond yields are behaving themselves and the rupee is proving to be surprisingly strong relative to expectations. So, I think we will maintain these premium valuations but our view is that the market should probably go up with the earnings growth numbers. We are going to be getting the results for fiscal year 2017.
I think they will be relatively pedestrian, high single digit growth. The question is what do we achieve in fiscal 2018. I think that is where -- we have got some guests from the real estate sector, from the banking sector and these are the areas where we are going to need to see activity pickup particularly in the banking sector when it comes to corporate loans, which have been quite disappointing.
Then we also have the distortion of the final course of last year, the calendar year with demonetisation and how does that come back. It is a very interesting dynamic because if you look at India for Q1 in terms of stock markets performance and some of the data points, it looks very strong but remember we are comparing that to a weaker base in the final course of last calendar year. So it is a very interesting dynamic at the moment.
Q: Emerging markets after a long time have come out of a funk. This year at least they have started to perform, deliver some returns, why do you think that is and what would your view be between developed and emerging markets for the rest of the year?
A: I with respect describe my clients as growth tourists. So they sit in London, New York, Tokyo and they buy emerging market equities for premium earnings per share (EPS) growth. It is not about gross domestic product (GDP) growth etc, you have to live a premium earnings growth if you are an equity and from 2011 to 2015 the EPS in EM fell. Developed markets were delivering premium EPS growth, they are delivering EPS growth I should say. In 2016, that was the first year in five that emerging market equites delivered premium earnings per share growth. For this year again we are delivering the same thing.
The positioning is extremely bearish by the global asset allocators in emerging markets because they had five years of underperformance. So the core fundamental of premium earnings per share growth is now in place. The reasons for that are many but if I was to think of some key big reasons, in 2009 and 2010, there was too much stimulus in the emerging world and in 2011 we had an inflation problem so we started to tighten just as all this new capacity is coming on stream and so you get a collapse in profitability because there is a lack of pricing power and then we should have exited that tightening cycle around 2013 but on May 22, 2013, the Fed published the tapering minutes and that capped the tightening cycle going for some countries for longer including India.
The other overlay we had was a fall in commodity prices which is very much an issue of too much supply than necessarily a lack of demand and as commodity prices fell, the terms of trades for many of the emerging countries deteriorated and their currencies fell. So those were sort of big factors.
We are now turning around and I think what is very interesting is just how cautious the corporate sector is across emerging markets and that is because they have been through quite a protracted downturn. We could get a dynamic that is similar to what we saw in United States where you have got good corporate profitability rising RoEs but perhaps the economists are commenting in a more negative way saying that corporate capex is not picking up as we wanted.
For us, as providers of capital that environment can actually be quite good if companies are cautious. Although ultimately in the longer-term, we do need people to believe in growth, we do need the corporates to invest.
Latha: Within corporate earnings, which is the sector that you think will outshine or lead the recovery?
A: I think financials should be leading to recovery. An early stage of that will be lower credit costs and credit cost has been a big theme for the last couple of years when it comes to the financials. We have also got the interesting dynamics of trying to work out what is going to be the normal net interest margin (NIM) with the demonetisation effect and having more money in the formal system.
However, to get the profit growing, we need to get loan growth above 5 percent and that is something we need to focus on here. Then if we look at the consumer space, also there is optimism around that but again we have got some of the dynamics of demonetisation - that perhaps would generally a lot of growth because you are comparing it with sort of easy final quarter. Building materials is also another area. India has probably been through a five-six year downturn in the real estate industry. So when we look at presales, they have been weak and in some markets - nationwide it is down 40 percent from its 2007 peak.
So a turnaround in the real estate industry and how that then helps a consolidating building materials industry also looks fairly interesting. So these will be the types of cyclical areas to look at.
Latha: You spoke about credit cost, you must have seen a lot of countries grappling with this bad loan issue, are you confident that you are going to see lower credit cost this year and would you therefore go to the big corporate lenders Axis Bank, ICICI Bank, State Bank of India (SBI), Bank of Baroda (BoB)?
A: I am confident that the distress in borrowers is improving. Remember often that credit costs are a lagging indicator. A particular example, we are doing work on five of the big overcapacity industries in China and we estimate that between 2015 and 2017 their free cash flows improved by 1.1 trillion renminbi.
Latha: That include steel, does it?
A: It does include steel, its petrochemicals, cement. So there is dramatic improvement in profitability. We have this theme about the end of PPI deflation, in India's case wholesale price index (WPI) and the improvement in PPI, WPI is hand-in-hand with improvement in pricing power on profit margins. So for the industries in India whether it has been a big focus on credit cost or high credit cost, we see a turnaround in places like China, which is probably very important in terms of a price setter that should be good news for India. So it is possible that banks charge of more but the forward looking indicators that market should focus on are moving in the right direction.
Sonia: Do you still have a year-end Nifty target range of 9,300 to 9,600 if I am not wrong, is the reason for that because you expect the markets not to move at all considering that some of the more heavier sectors like banks etc have issues or is this some other bigger concern?
A: We set our index targets shortly after the US presidential election and we set them with a series of scenarios for a base case, a bear case and a bull case. So our bull case, the Nifty equivalent is about 10,500. So part of what is going on in India is consistent with the bull case.
What is currently not consistent with the bull case is the macroeconomic data specifically issues like corporate investment and we would need to see those data points coming through to be comfortable to say that it is reasonable in terms of a valuation target to have the Nifty finishing this calendar year at 10,500.
As a market we are going to become much more dependent on the macro data proving that there is an acceleration going on. An acceleration going on in the underlying numbers not in the real GDP number, which does not seem to be correlated with the profits on a turnover of many of the companies on the Nifty.
Latha: Let me ask you the financial sector questions, while credit cost will impact the P&Ls of the corporate lenders, there is the non-bank area, which is picking up a lot of speed. In fact Sonia was referring to the 4 percent loan growth. That is bank loan growth. Bank loan growth as a percentage of total loans that India lent to the commercial sector is to be as high as 85 up until two years ago, last year it dropped to 75, now it is 73, 27 percent is occupied by the bond markets. Therefore the NBFCs, how do you like them?
A: We do like some of the housing finance companies as an example of NBFCs that we do cover and I think there is an opportunity here and a big part of that opportunity is delivered by the constraints on the capital of the PSU banks. The other thing is focusing on the housing finance where you have had relatively strong loan demand that has tended to be with the consumer.
Latha: Government of India (GoI), the Prime Minister had announced housing for all scheme, a low cost, affordable housing scheme where the government picks up a large part of the bill – almost 3-4 percent of the interest cost on houses up to about 110 square meters, small houses basically, is that a motor enough to push up a lot of stocks, would you bet on that theme and therefore with stocks?
A: This is something we should explore with DLF because they had moved into mid-range housing and then sort of moved back out to higher-end housing. It is only in a place like Mexico that I have seen a business model of listed companies where they are into low cost housing. So it is quite a difficult environment for the private sector and it is very policy dependent and obviously a change in the government policy, how much discounts they are going to give on mortgages, can have a profound impact on a business model.
Sonia: Do you see the market sort of test our patients a bit more before it gets above that 30,000 zone on the Sensex?
A: If we look at what is going on globally, we had a very big run up in PMIs so indicating a surprise, the economy is much better than people were expecting and then PMIs peak around February and have come down a little bit in March and then in April, they are still very much in the expansion zone, we do not have this surprise for the markets, so we have moved into this sort of steady growth environment for the economy. There are uncertainties around US policy implementation. Actually I have quite a lot of confidence in terms of fiscal stimulus. We then have military action in Syria, which is drawing people’s attention to this ongoing problem in North Korea.
Sonia: Do you think it is a global-led problem?
A: I think it is a global-led problem and I would also throw in April 23, which is the first round of the French presidential election and not so much with Marine Le Pen but some of the other opinion poll moves have been surprising for the market. And the lesson from last to last year is try not to predict politics because you will probably get it wrong.
We have made money in markets for quite a few months. We are going to have a consolidation phase and India will not be immune to that type of environment but think of it as consolidation, don’t think we need to sell now aggressively, it is more that you get a period of consolidation.
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