India is at a cyclical low and investors need to be patient as the policies of the new government will take time to show results, says Ajay Kapur, Asia Pacific Equity Strategist and Global Emerging Markets Strategist at BofA Merrill Lynch.
In an interview with CNBC-TV18’s Shereen Bhan, Kapur says Merrill’s clients have booked profits in India and reallocated funds to China.
He sees weak earnings as a major concern for Indian markets. Rising crude oil prices, likely rate hike by the US Federal Reserve, and a strong dollar are major hurdles for emerging markets in general, says Kapur.
Back home, he says corporate earnings growth could be hurt if the RBI is unable to reduce interest rates.
Kapur is bullish on banks, automobiles, and construction companies. He says private sector financial services firms look expensive. As for public sector banks, he says investors can look at them only if they have a big risk appetite.
Kapur says balance sheets of infrastructure companies continue to look stretched, and the government will find it tough to resolve issues relating to the sector.
He says business confidence is the private sector is low, and this is evident from the reluctance to spend on capex.
On the issue of Minimum Alternate Tax claims on FIIs, Kapur says the government cannot surprise foreign investors with random tax demands.
On China, Kapur says the stock market there has diverged massively from the monetary policy and economy.
He expects China’s stock market to rally further if the country’s central bank decides to cut interest rates aggressively.
At the same time, Chinese equities is vulnerable to the central bank not delivering on monetary easing as expected widely.
Below is verbatim transcript of the interview:
Q: Let me start by asking you about the view on India at this point in time and the camp seems to be divided that India is caught between hope and reality while the government has made efforts to sort of speed up the reform process, the economy continues to be sluggish. The recovery in the cyclical’s hasn’t exactly taken place at this point in time. How do you view India today?
A: I have been overweight on India since September of 2013 when my old classmate and friend Raghuram Rajan took over the central bank.
India has a lot going for it, one is, the quality of leadership is excellent between Prime Minister Modi and Raghuram Rajan.
Number two, India has had a cyclical low, it is seeing trough earnings, trough RoEs, trough EBIT margins and so you just need to be a little patient for these things to begin to move up.
Q: Are you surprised by the degree of impatience? It has been 12 months that this government has been in office and expectations did run ahead of reality and fundamentals but at this point in time question on whether enough has been done, whether they could do more as far as reforms are concerned and whether capital is actually going to go looking for the other hot emerging market. Are you surprised by the degree of impatience?
A: No I am not. We guys in finance are pretty impatient people, it is just the way we are, it is just the nature of the beast. I think you have got this government and the central bank governor lot more time because it is a federal structure and it is not easy to get policy making down to the state level, you need the cooperation of the states and I think it is very early days.
I was reading something in The Economist over the weekend where some guys at Harvard have this thing called the Economic Complexities Score and what it means is that it will look at your export basket and see how diverse it is and that is apparently a very good predictor of economic growth.
I think it is pretty creative and India comes out number one with a projection of growth over the next few years of about 7-8 percent which is the highest in the emerging world. So, India has a lot going for it and so I am structurally bullish and this recent correction is a pretty good excuse to add more.
Q: What would you attribute the recent correction to? Some say that money is being taken out to put into markets like China for instance or other emerging markets where now people are suddenly overweight or it could be just the factor of what is happening domestically because of the sort of lack of enthusiasm with what the government has been able to push through as far as policy is concerned and add to that the vexed issue of taxation related to MAT and FIIs, what would you attribute the current correction to?
A: I think it is all of the above. Our clients are very overweight on India and they were quite underweight in China. In fact in China they were overweight the wrong stocks mainly in technology and this has been really a very financials driven rally in China.
So, they have very quickly had to take profits where they had some which was India and then chase China and that has been going on for the last I would say two months and so now the gap between Indian equities which are down about 10 percent and Chinese equities which are up about 30 percent is about 40 percent.
So, to me this is a pretty good time to actually do the reverse.
Q: Which is move money back into India?
A: Yes.
Q: What is looking good to you at this point in time as far as India is concerned, which sectors do you believe look vulnerable, which are the sectors that you believe we could perhaps see significant upside from these levels?
A: Our analysts like the banking sector, we also like the autos. I also like the, not the home building sector but anything to do with construction and dwellings.
India is going to add about 200 million people to the workforce by 2030, that’s the entire population of Brazil and so these guys are going to need homes to live in, they will need air-conditioners, they will need lifts and elevators, they will need ceiling fans and furniture.
So that sector to me looks very attractive.
Q: Valuations a cause for concern across any of these sectors specifically I would imagine private sector financials?
A: Those valuations have looked expensive. I remember in 1998 someone told me the same thing that they look very expensive. So, they just tend to look expensive because they are high RoE companies.
Q: Would you look at the public sector banks at all?
A: It really depends on your risk appetite. If you have a huge risk appetite and you think they might be recapitalised or they might be given some sort of reform oriented managers, whether they could probably lower their NPLs in case the infrastructure sector begins to do well. So, there are a lot of if’s and but’s for that sector. It really depends on your risk appetite.
Q: Talking of if’s and but’s, one of the big if’s is how the monsoon is going to play out for India, what that is going to mean as far as rural consumption is concerned and how that then translates into sectors like auto and revival as far as auto sector is concerned. What would you consider the number one risk for Indian equities today?
A: The risk is that the earnings numbers just don’t kick-in. I don’t worry about the monsoons because who knows but the earnings numbers at some point will need to bottom out. The last earnings season was not good.
Q: This one hasn’t been particularly better either.
A: Right, so at some point the market will need to see a trough and actual pickup in the earnings numbers.
Q: Do you believe we have troughed out as far as earnings are concerned?
A: You can never really pin point the quarter but I think we are near the trough. Who knows what the exact trough is, I am not that smart but I think we are probably at the lows.
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Q: In terms of recovery as far as the capex cycle is concerned, the cyclical recovery, do you anticipate the second half of the year is when we will probably start to see that kick-in because it has been slower than what most people had anticipated?
A: Again I don’t know, we are in for a five-year capex cycle and I don’t know which quarter is going to be the low. Business confidence, especially in the private sector, need to pick up.
Q: Are you seeing signs of that, when you talk to people?
A: No, we are not. In March we had our India conference and while the politicians, the bureaucrats were talking a pretty powerful positive game, when we talk to the companies they were suggesting that things on the ground hasn’t real changed. They hadn’t seen any pick-up and that their confidence was not that high. They were looking for more policies to put in place. It is in a shock or surprise that the private sector hasn’t really put its cash flow to work in terms of capex.
Q: How much of that is also a problem related to just leveraged balance sheet at this point in time especially as far as the infrastructure side is concerned?
A: You are right, the infrastructure companies, handful of them account for most of the leverage in the system. I don’t know how that is going to be fixed, I really don’t know. However, apart from those infrastructure companies the Indian corporate sector has very powerful positive free cash flow balance sheet. So, it really is a handful, say about 12 companies that constitute the bulk of that debt. It is really up to them to figure out how they are going to solve that. Just getting their projects off the ground and started which will get them some cash flow I think will be began to heel things.
Q: Slower-than-anticipated recovery in corporate earnings is a key risk, what are the other headwinds that you foresee for the markets in the short-term?
A: If oil prices begin to go up again and as they have re-bounded quite strongly so if that continues, if oil prices get even stronger I think that it will be a bit of a headwind. If the Fed begins to raise by the end of this year and continues to raise and it is not a shallow raise but a steep raise that will be an issue for emerging markets. If the dollar gets a lot stronger that is always an issue for emerging markets so those are kind of risk that we worry about.
Q: In terms of the Fed action September or December when do you see the Fed taking off?
A: I have no idea; this change is every day.
Q: Whether it is September or December the impact on emerging market flows and the impact on just how sharp we are likely to see outflows? Priced in, discounted?
A: The market is looking for a 25-basis-point hike by the end of the year and even after that the trajectory is very shallow. I don’t think that is such a big deal. What worries me is that where the Fed’s mindset is, it is way higher than the market and so the fed actually does what it says it might do. I think the market will be surprised because there is massive gap between those two expectations.
Q: Do you believe that India could be less vulnerable in the emerging market basket even if the Fed were to translate into reality its thoughts so this point in time?
A: I would say yes because the Indian current account deficit is not a big deal. Indian remittances are very strong, Indian foreign direct investment (FDI) potential prospects are very strong. India needs to be a little bit careful about randomly taxing foreign companies.
Q: How much of worry is that, when you talk to people today is this the number one deterrent from putting fresh money for instance into India?
A: It is not the number one deterrent but it just creates a pattern of randomness, but they it just seems to come from nowhere. It is the law of the land, it is not exactly issue to be in a surprise but people do tend to get surprised and I just think it is unnecessary.
Q: The surprise is unnecessary or the acting on surprise is unnecessary on the part of foreign institutional investor (FIIs) and foreign portfolio investors (FPI)?
A: The government has to prosecute the law of the land; there is no doubt about it. However, it seems to come out of nowhere because no one was talking about this. It was an interpretation that was pursued and is being pursued and that is what creates the uncertainty. This is a one of the features of India that it tends to sometimes negative surprise investors.
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Q: Let me take a break on India and ask you what your sense is about China. You say China is not so calm any more. We have seen the Chinese central bank going for a third rate cut in less than six months. Do you believe that that is largely responsible for driving the equity market rally?
A: The Chinese markets have diverged massively from both monetary policy as well as the economy. The economy is growing about six percent real, about five and half percent nominal. So this is growing about 20 percent nominal before the crisis. So the growth rates really have decelerated and there is nothing wrong with that. That is just the way they are getting older and they have already had a huge capex boom.
So, equity markets can normally respond to very aggressive monetary easing and my view is that China has tightened the policy. It seems like it has eased but actually if you look at loan growth, if you look at real interest rates, interest rates minus inflation these things are a lot tighter today than they were six months ago. So if you just look at, oh they have cut rates and they have cut the RRR that to me is an illusion actually because you are looking at normal terms.
Policy is actually quite tight, the market obviously has done exceptionally well and so it is anticipating a humungous easing of policy and it is actually a reasonably rational market in the past that when policies ease it has done well and vice versa. This time around however there is a massive chasm that has opened up between how tight policy is and when the equity market is. So the Chinese central bank does better deliver on these massive expectations.
Q: And if it doesn’t?
A: Well if it doesn’t then the market is quite vulnerable.
Q: What kind of downside risk would you say?
A: Well market has doubled, so we really need to see some very severe and serious interest rate cuts for it to sustain itself.
Q: And this business about QE kind of stimulus being provided by the Chinese central bank, we don’t know what shape, form or size it could take. What are your expectations on what could then that do as far as the equity market rally is concerned?
A: The Chinese central bank has said it pretty categorically that they are not into QE and they don’t need to because the policy rears 5.1 percent and they can take it all the way to zero. The RRR is about 18 percent they can take it down to 7 or 8. So there really is no need for QE. I guess the need for QE occurs when you get into liquidity trap where despite cutting interest rates and RRRs no one borrows money well then the central bank and the government’s balance sheet needs to come into play but we are quite far from that.
Q: But even in terms of corporate earnings and in terms of leverage some of the common factors that both the Chinese side as well as India is suffering from today and do you anticipate revival as far as both corporate earnings as well as consumption in china is concerned?
A: No, Chinese debt I leverage is a massive number, it is about 290 percent of GDP, it is higher than the US. India doesn’t come close. India is a very under leveraged country except for the government…
Q: In comparison?
A: Right, in comparison. The Indian government has a high leverage number. the Chinese government has about 55 percent, India is higher but the Indian household sector and except for those 10 or 12 companies that we talked about the corporate leverage isn’t that higher and neither is financial leverage. So they are two completely different beasts. What was the follow up to that on leverage?
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Q: When do you anticipate a pick-up as far as the earnings in China are concerned?
A: The nominal growth numbers as I said have gone from 20 percent in 2006 to about 5.5 percent and they are going to go lower highly likely. So you are going to get very little topline growth. There is a lot of pressure on margins through high land cost, high labour cost and a very strong currency. So, getting profit growth is going to be exceptionally difficult.
There are certain sectors, the new growth areas like technology, the internet, healthcare, education, vanity – these sectors will be growing earnings quite substantially but they are not that large except for technology. So, the sources of earnings growth are going to be quite different going forward.
Q: And yet you see a significant amount of money going into China?
A: A lot of money is going to China because people are very underweight. So, while the A-share markets were rallying, foreign investors couldn’t be bothered because it wasn’t in their benchmarks. It is only when some of the local domestic Chinese money percolated into Hong Kong equities, which are in the benchmark where our clients are underweight that all of a sudden they had to chase this rally.
Q: Going back to India and you talked about the Governor, what is the outlook as far as the interest rates are concerned? Do you believe that the central bank has wiggle room to do anything more than 25 bps for the year or do you believe that 25 bps is perhaps the best that we could possibly see in terms of rates?
A: I don’t know if it is 25 bps or 50 bps and I am not an economist but I am sure Raghuram Rajan is looking at where the monsoon goes, where oil prices go and where inflation goes. I think there is enough slack in the Indian economy, it is quite shocking that Producer Price Index (PPI) is negative and consumer price index (CPI) is about 4-5 percent. These are pretty low numbers. As you pointed out, the private sector capex demand is very weak and so you need to kind of get the animal spirits for the economy going. I think there is probably more scope for interest rate cuts.
Q: But without, if we do not see actual aggressive intervention from the Central Bank. Do you believe that the earnings recovery will be pushed back even further?
A: Yes, because real rates are on the higher side in India because inflation has just collapsed and normal rates really have not. So, you do have a part of the corporate sector that is levered up and it is high real rates are obviously problematic. And also for the consumer cycle, higher real rates are an issue for property buying and for auto purchase.
Q: So, at this point in time, given the fact that we have already seen a correction of about 10 percent as far as the Nifty is concerned and you believe that this could be perhaps an opportunity to allocate more capital to India. What kind of upsides do you see at least in the near-term, perhaps by the end of the year? What kind of upside that we are looking at as far as Indian equities are concerned?
A: The multiple is probably fair. It is about 15-16 times forward. The earnings number as they grow about 10-15, that is probably what you should look for.
Q: Do you think there is a downside risk to the 10-15 percent number?
A: Quite possibly, yes.
Q: How much lower could it be?
A: Again, I do not really know what the specifics are. Look at India, I urge you not to look at this on a monthly basis. All I know, that is what you need to do. You have got to look at it as a five year story because the Indian earnings numbers we think can compound about 20 percent per annum. That said, the economy should probably grow a trend by about nine percent or so. The EBITDA margin should go from about 16 to about 19-20 percent which is a long-term average. And if you get those two things, then your earnings compound 20 percent per year which means it almost doubles in about four or five years. So, keeping the same multiple, 15-16, you should double your money. So, what I tell; my clients is do not look at India too deeply, because ‘a’ you are going to get disappointed and frustrated and surprised and ‘b’ you will sell, but then you will regret it. So, sometimes being lazy is a better option than being hyper-kinetic.
Q: So, be lazy is a better option at this point in time, but in terms of reforms and in terms of policy action because you believe India is a five year story. It is not a 12 month story. What more would investors like to see? We have seen further liberalisation whether it is defence, we have seen the government make efforts to provide a better business environment, ease of doing business, make in India and so on and so forth. In terms of actual reforms, what is it that investors are looking for?
A: They are looking for a better investment climate where you can get access to land, where you get access to power, water and labour.
Q: So, it is the infrastructure deficits that?
A: It is all the factors of production. Land is not per se infrastructure, you just need to be able to get it. You need power for sure. There is enough coal in India. It needs to be dug out and more importantly transported properly. You do need a work force that is quite strained and educated and that is going to be a challenge.
Q: So, we do have the demographic advantage but not necessarily the skilled people that we need to add to the workforce?
A: That is right. Yes.
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Q: On the infrastructure side, we have seen this government allocate substantial amounts of money whether it is the roads sector or the railway sector. They are also talking about attracting foreign investment into both roads as well as railways. How excited are you about the government spending on infrastructure and about these stories in specific?
A: I am super excited by it if it happens.
Q: Yes, because the track record is poor especially as far as roads is concerned.
A: It is below average. But it can get better.
Q: You are being kinder.
A: Yes. Because I have seen what it has done in China. They have gone from a pretty low level of railroad intensity to one of the world’s biggest, most modern railway networks and likewise for roads. So, they have been at it for about 15 years and they have accomplished it. They have kind of done it. There is a little bit left on the sides. And so, actually India should really engage with China and import its expertise in these two areas.
Q: The infrastructure story is being particularly exciting from a Chinese investment point of view because look at what they are doing with Pakistan, the Pakistan-China economic corridor, USD 46 billion. Of course it has India worried at this point in time. But do you see significant engagement between the two countries as far as the infrastructure is concerned?
A: Yes. If India wants it, absolutely.
Q: Feasibility studies on for the bullet train. China is doing that at this point but do you see that moving beyond?
A: It depends on Indian policy makers whether they actually want this or not because China is a low cost efficient provider of infrastructure services to the developing world. So, China is going to industrialise the developing world. You want turbines, you want machinery, you want a power plant, they can do it for you at a cheap price point and do it efficiently. So, this is the ball is really in India’s court whether India wants this at a cheap price point or not.
Q: let me get back and end with India, because you said that it is a five year story and one should not judge it every month or every quarter, perhaps even every year. But specifically if I were to narrow you down to 2015, because we have had a great year as far as the equity markets are concerned in 2014, up almost 30 percent, up 16 percent post the electoral results, how much upside do you believe in 2015 the Indian markets could enjoy?
A: We could see about 15 percent or so from here.
Q; From these levels?
A: Yes, which is primarily earnings growth and a little bit of multiple expansion.
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