We are excited about India, maintain overweight, says Morgan Stanley's Garner

Commenting on the FPI positioning, "We (Morgan Stanley) have gone from record overweight positioning about 3 years ago to a position which is still overweight but at the low end of the range."

It looks like foreign investors are re-allocating towards North Asia now. So, who is buying equities in the Indian market? Well, that is domestic mutual funds which are continuously pouring funds into Indian equities thanks to macro stability & low inflation.

Hopefully, going forward, we should be able to persuade foreign investors to build positions in Indian markets. The only other country where domestic flows are strong is China.

Macro stability is important for India and over the past few weeks crude oil has jumped over $63/bbl which could pose as a strain on macros.

We have to watch out for crude oil especially for a country like India because a 10 percent jump in oil will widen the country’s current account deficit (CAD) by 30 bps of GDP, said Garner.

It will also put pressure on inflation. So, certainly, it is a macro risk factor. But, that said, oil prices are roughly where they should be on the basis of Brent.

At present, oil is definitely not that big a risk which could overshadow all the other positives listed above for India, explains Garner.

Below is an excerpt of the interview.

Q: Let me straightaway ask you about your overweight position in India. You have recently authored a report saying that you are getting more and more optimistic about the Indian market. What is at the core of that overweight stance?

A: What we are seeing India is probably uniquely amongst emerging markets (EM). It has a very clear reform agenda to address long standing issues particularly around infrastructure spending. We have also seen, I have been waiting for it for 20 years, the implementation of the goods and services tax (GST) this year. We have seen the recapitalisation of the PSU banks. That is something again that we have been waiting for some considerable time. And we think, we are cyclically at the beginning of an upswing in activity and in credit growth and therefore in corporate earnings. So look at corporate earnings growth. We should be getting at least high teens year-on-year (Y-o-Y) earnings growth for the next two years running.

And that certainly compensates for valuations that are above the average in EM but far from being expensive. So in a nutshell, that is why we are excited about India now.

Q: But what do you hear when you speak to a lot of the investors into India because we have not seen great flows from foreign institutional investors (FII). Do you hear more scepticism and would you say the positioning does not reflect the kind of optimism that you are talking about?

A: That is a great question. If you look at foreign investor positioning, we have gone from record overweight positioning on India about three years ago to a position that is still overweight, but definitely at the low end of the range. And what you have seen is investors reallocating towards North Asia. Now you may then ask, if foreigners have broadly not been constructive on India, who has been buying the market? And that is to do with the inflows to domestic mutual funds and in turn, that has related to the better macro balance in India. So much lower inflation and interest rates and that kind of self-help story in relation to domestic buying is something that is quite attractive.

Only one other major market that I cover, China, has strong persistent local flows into its equity market. So hopefully it will persuade foreign investors to start to rebuild positions in India now and that is an attractive proposition in our mind.

Q: You just spoke about the macro stability factor. That has come under a little bit of a cloud over the last couple of weeks with crude moving higher, with the current account deficit showing some signs of strain and we have seen reflections of that in bond yield prices which have gone up, bond yields which have gone up in India and the rupee which is also straining a little bit. Does this worry you that there is a little touch of grey to the macroeconomic story?

A: Yes, we always have to watch oil carefully in respect to India because we do have an oil import to gross domestic product (GDP) ratio of about 2 percent of GDP. If we were to get a 10 percent jump in oil, that tends to widen the current account deficit by about 30 basis points of GDP. It also puts upward pressure on inflation. So it is certainly a macro risk factor. Now that said, oil has gotten roughly to where our analysts think it should be on the basis of Brent. We still have a supply dynamic globally that is far more flexible than in the past. It is true there has been an inventory draw down and that is partly why oil prices have firmed. But for the time being, I do not think it is a significant enough risk to take away from the other positives that I mentioned earlier. But definitely worth monitoring.

Q: But you are cognisant of that risk because in one of your reports, you do point out that India tends to underperform during periods when crude prices are on the boil compared to other emerging markets.

A: As a single factor, if that was all you were looking at, that would be a negative. But I mentioned four or five other factors earlier on in this interview that are positives and in our mind outweigh that potential negative.

Q: So this domestic inflow factor that you just touched upon, do you think it is just a cyclical factor because stock markets have performed pretty well or is there a structural construct to that this time around where you do not see flows petering off at the first sign of any correction or volatility in the market?

A: The running at about USD 1 billion per month and that is higher than we have seen before and they are more persistent than before. It is partly to do with this structural reduction in inflation and in interest rates and we do not think interest rates are going to back up that much going forward. It may also in part, be a payoff from the demonetisation programme which is obviously being controversial but clearly that has led to a formalisation of cash that was previously held outside of formal financial institutions. So that arguably would be a one off factor. But we have been nicely surprised by the persistence of these flows and we think there is something important going on there.

Q: To come back to the foreign institutional flows. In December, the general expectation is that the Fed will raise interest rates again. Do you see that as a defining aspect of how emerging markets will do compared to developed markets over the next few months or is that risk or prospect fully baked in to expectations?    

A: I think expectations are reasonably clear that the Fed is going to continue to raise interest rates. The point that we would make is that the real interest rate cushion on average that emerging markets enjoy is far higher than in the 2013 taper tantrum episode. There are countries that still have external vulnerabilities or relatively high inflation. We would Turkey and South Africa into that group. But I do not think India is anywhere near as vulnerable to Fed raising rates as it was 4-5 years ago. That said, it is not running a structural current account surplus unlike countries like Taiwan or China. So, it has moved from being a country that was more at risk than the average in relation to the Fed 4-5 years ago to being in roughly the middle of the group in relation to the Fed.

Q: So you are saying that that should not necessarily inject a lot of volatility into global equities because we have had a remarkable year, in a sense, with such low volatility, we have not seen, in recent memory. Do you see that continuing or is there complacency in global equities now?

A: The Fed has been at pains to be forward looking and to be endogenous to the system, as it were, not to shock the system with overly rapid rate rises. Obviously were we to get inflation surprising on the upside in the US and the Fed were to become more aggressive and that might become more of a risk factor. But there is a lot of discussion about the central banks, but we always have to come back to the synchronised global economic upswing and just how strong corporate earnings growth is on a global basis. India has been a little late joining the party for various reasons to this global story, but it is about to, if we are right, to join the party in quite a big way with pretty significant earnings growth going forward.

Q: Some analysts contend that maybe economies which are more export driven actually stand in better stead in a globally synchronised recovery and I think our own exporters have not done very well over the last couple of years, our IT sector or the pharmaceutical sector have been saddled with their problems. The recent export numbers have also not been great. How do you contend with such an argument that we are not such a strong export economy?

A: I think you are right to highlight that. That is a weak point. We are not currently enthusiastic about Indian IT or healthcare names and in fact, they are likely to still be a real drag on the index from an earnings growth perspective going forward. That is both to very specific issues to their business models and also to the fact that the rupee has been reasonably strong. So yes, it is true, you have not got something like the Korean or Taiwanese DRAM supercycle ongoing that would positively affect you in the export side.

But that said, I think you do still have a very strong story from a domestic growth perspective, domestic cyclicals that we touched earlier in this interview on the financial sector reform. I think we can expect that what you are starting to see in two-wheeler sales and heavy truck sales which translate to really quite a buoyant environment in consumer discretionary, in domestically facing industrials and in the financials going forward. So there is a lot of heterogeneity by sector in the outlook for India. Telcos domestically again is a sector that I would say is not a particularly bright spot now, but there is enough in it to mean in aggregate, as I said at the start of this interview, we can be looking at easily high teens earnings growth Y-o-Y next two years.

Q: What would drive that earnings growth because it has been very dispared, the earnings picture over the last couple of years? Some sectors have continued to do well, some have disappointed. To talk about 15-17 percent kind of earnings growth over the next 2-3 years, what would be the key drivers?

A: If we look at it, we have got consumer discretionary at around 16 percent, staples about 10 percent, we have got energy, the oil price there isn't that much upstream in the index at about 8.5 percent, we have got financials really beginning to move higher at something like 20 percent Y-o-Y, we have got healthcare down, as I said earlier, down about 16 percent, we have got telecom down, we have got IT broadly flat. We have got materials bouncing back very nicely which is a globally influenced sector, so materials up something like 40 percent. So there is a very wide disparity in earnings growth, but it adds up, as I said to a mid-teens number when you add up all the different sectors.

Q: That is the index, but a very large part of the discussion back in India is about midcaps and smallcaps which seems to have caught the imagination of a lot of the retail investors and domestic investors who have walked into the market. How do you rate valuations there in those pockets which are outside the largecap index?

A: It is not an area that I am that familiar with because I mainly talk to large global institutional investors who are not active in small and midcaps. My understanding from my colleague Ridham is that the valuations on some of the smaller midcaps are somewhat high and somewhat more elevated relative to largecaps. What I would say on smaller midcaps is they tend to face off more this domestic story, this domestic growth story which is more interesting than let us say, as we touched on earlier, the story in IT and pharma in the bigcaps.

For the full interview, watch accompanying videos...