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India to slow down further in short-to-medium term: MS
Published on Thu, May 29, 2008 at 11:35 , Updated at Sat, May 31, 2008 at 13:52
Source : CNBC-TV18
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Indian economy is likely to slow down further in short-medium term, he added. He expects Indian market to be lower than current levels by year-end.
The big equity emerging markets will depend on internal drivers of consumption and infrastructure investment, he said. There is a correlation between emerging markets and US equity markets that still exist, he added. Garner said that China is back to equal weight. However India is still expensive because it is trading at 17000-18000 mark, and he will be looking at a further under-performance. He said that the correction in Indian market could happen relatively fast. The higher inflation and slower growth will signal stagflation in India. He said that structurally people are still underweight emerging market equities. According to Garner the global environment looks tougher to attract equity inflows. The dollar rally is unsustainable, because of secular strength in the Asian, emerging market currencies, he added. He is bullish on the telecom sector. He feels it is on a high growth, but valuations will be at a premium. IT services look good but relatively low valuations versus previous performance, he said. Infrastructure is also good theme, but valuations will be challenging, according to Garner.
Excerpts from CNBC-TV18’s exclusive interview with Jonathan Garner: Q: How are you describing what has gone on in 2008 so far? Would you say it is the 12-13th big correction run which started from 2003 or do you think we tipped over to a bear market? A: We are in a secular bull market in emerging equity markets, but the strong market conditions of 2006 have abated. There are more headwinds in the asset class than before, most notably the fact that we think we are in a US recession. Q: So, you are not in the camp that believes that US might avert a recession after all?
A: No, though the Q1 GDP numbers on the face of it were a plus, domestic demand was negative. Net exports and a very strong inventory build up, was what drove that. So, we think we are in a recession in the US. The European environment is also darkening right now. Ultimately, on the emerging markets side, our economists believe in decoupling and so do I. Economic decoupling, strength in consumption and infrastructure investment should ultimately drive the stock market decoupling. Q. Will the numbers in Q2 and Q3 be negative in the US?
A: They will not be negative in Q3, where we get the fiscal payment, but in Q2, Q4, and Q1 of next year where we will be going back to a difficult growth environment. Our chief economist has cut US GDP growth forecast for 2009 from 2% to 1.4%. We are looking at two years of slow growth in the US, dipping in and out of recession. Q. What convinces you that this may not be start of a bear market across global equities? Is it a pause in bull market? A: Big emerging market economies now have their own internal growth drivers of consumption and infrastructure investment. They are mostly domestically funded from higher domestic savings. Emerging markets trade much more among each other than in the past. So, within the overall export performance, we see this pronounced decoupling underway weakness in exports to the US and strength in exports to each other. But, the stock market is where you have an impact. There is a correlation between emerging equities and US. If US equities move in lower multiples then in the short-term you have a negative beta effect. In the longer term, our secular bull market exists as what we have an alpha, which reflects the superior economic growth, and return on equity in the emerging world. Q. How long can this pause last then? Some people say that it might not get over as soon as we would like and might drag on through 2008. Do you think it will be that long a pause? A: Some emerging equity markets like Brazil, and Taiwan are substantially up. We had to navigate de-rating from really near bubble like conditions in India, and China, which were a quarter of our asset class last October, something which we were explicit about at Morgan Stanley. So, we had quarter of emerging markets equities that had excessive valuations, 75% did not. The quarter did have to go quite rightly, a multiple contraction has performed poorly this year.
Q. You were quite bearish on India and China at the end of last year. It has played out according to that script. Do you think most of that de-rating is over or is there more to come? A: In the case of China, we have come back to equal-weight recommendation. The valuations there are slightly above the long run average and peer group relationship to the rest of the asset class. But, India is trading at 17-18 times consensus forward price to earnings. It is still expensive as the rest of emerging market is trading at 12.5 times. So, we are looking at further underperformance in the case of India. Q. Will it be a price wise or time wise correction? A: It could happen relatively quickly. We see signs of stagflation developing in India, persistently higher inflation and slowing growth. That’s not the case in some other emerging countries that we prefer. It depends how that pans out, as sometimes market adjustments can be quite quick. Q. Can India be one of the worst performing emerging markets this year? A: Yes, its problems are not unique. There are other emerging market countries where the growth rate has temporarily exceeded aggregate supply like South Africa and Turkey. In India's case we are suffering from lack of infrastructure investment historically. Plenty is going to be done going forward but it means that the economy has started to slow and it has further to slow in the short- to medium-term.
Q. What is the bigger problem in India? Is it sharp deceleration in growth or spike in inflation? A: It will be a combination. The central bank is in tightening mode and yet economic activity is decelerating. That is not a good mix from an equity perspective. Other emerging markets like Brazil, where inflation rate is very modest to history and to EM peers, will embark on a modest rate hike cycle.
In Russia, authorities are not that concerned about inflation, which is quite high, but growth is accelerating. But they have a benign sector composition to both their stock market and economies in this environment. They are substantial producers of upstream commodities.
Q. Is it fair to say that India and China, which seemed last year as hot favourites, should now be a ‘would have been’ replaced by Brazil and Russia? A: Brazil is our preferred focus within Latin America and Russia is top pick in emerging markets overall. We are underweight on India and equal-weighted on China.
Q. What kind of PE multiple will you be comfortable with in India, given the kind of macro conditions we have right now? A: If you look at corporate return on equity, which is higher than the average in emerging markets over the cycle, they deserve small PE premium with something of the order like 14-times compared to rest of the asset class.
Q. Is 14,000 on the Sensex a good bottom for our market? A: I don’t tend to think of it in terms of absolute index targets for individual countries. For overall emerging markets, it is currently less than 5% upside to our year-end target. Indian markets are expected not to be up but down from current levels by end of the year.
Q: Do you say the same of China? A: China is equal-weight, so we would expect a small upside to China.
Q: Do you think inflation will climb higher during the course of the year? So far RBI this year has desisted from raising the interest rate but do you think they have to? A: That again is something our economic team is highlighting as a risk. Certainly, in the current environment, with very high food prices globally and given India's reliance on internally imported commodities, generally on the oil side, the subsidy regime that exists, we are looking at an inflation and fiscal issue there. So, it’s not a strong situation, unlike the key commodity producers like Russia, Brazil and Middle East countries.
Q. What do you see happening to liquidity flows in emerging markets this year? Do you see some markets being singled out for punishment in terms of withdrawals and would India be one of them? A: If we look at data right now on India specifically, global emerging equity market managers are slightly overweight, which is very different from the position that we would have and it is obviously challenged by the performance year-to-date. So, there is scope for those fund managers to reduce holdings
Q. You think many of those fund managers will turn underweight by the time the market bottoms out in India? A: It is hard to say how the situation will be in the future. Being underweight is a thing we use as a contrarian indicator for a buy. Taiwan, which was our top pick at the start of the year, is up substantially. One of the reasons we liked it was that it was unusually cheap to history. It was very underowned with a positive economic and political catalyst. That’s the sort of thing we look for in our overweights.
Q. How do you read risk appetite now? Do think things stabilised now or are people still running quite skittish? A: The VIX has fallen 32% from middle of March down to 19% now, I will not characterize that as outright complacency. Its not 10-12% but shows that people are more relaxed than they should be, like it is given that the economic issues in US are far from over and we are in the European side in Morgan, seeing more problems from the macro perspective and corporate earnings.
Q. Do you see a lot of money coming into emerging market equities this year or will it be a much cooler year? A: Structurally, people are still massive underweight on emerging market equities. Only 2% of US equity MF assets are in emerging market equity strike Asia, excluding Japan.
There is a huge home bias: 75% of whole equity MF assets in the US are still in US equities. Given that emerging markets are more than 30% of the global economy, that is a good argument for secular inflows.
In terms of equities globally this year, this kind of global environment is much more difficult to attract equity inflows than the environment we had in 2006-2007. So, I am not sure where equity flows to emerging markets will be for this year as a whole. At the moment, they are still in the net outflows camp and one can hope they get back to equilibrium or marginally positive.
Q: Would the currency play any significant role as the dollar has bounced back a bit and Asian currencies have started depreciating? Will that play any kind of influencing role for global investors? A: A stronger trade rated dollar is inversely related to performance of the MSCI Emerging Market Index quite simply because the domestic parts of the stock market, enjoying local currency earnings in banks, telecom, and retailers, what have you, the dollar value of those earnings streams falls with the rising dollar. I don’t think the rally in the dollar will be sustained for very long. I think the weakness in the US economy and strength in emerging markets point to secular strength in Asian and emerging market currencies. At the moment, we are getting a counter trend in the dollar, based on perception that the Fed is on hold. That is an incremental minor negative for emerging market equities. Q: Will the dollars strength be short-lived or will it see sharp pullbacks as it has underperformed for so many years now? A: The dollars strength will be relatively short-lived. Most reversals are in relation to the euro zone where the growth outlook is deteriorating. The strength of growth particularly in China, Brazil and Russia is funded by domestic savings, hence those three currencies will structurally be very strong Q: Half the problems with equities have been to do with the commodity spikes, not Brazil and Russia but other markets. Do you see this ballistic trend in commodities persisting through the year? A: I have been a long-standing bull on oil, iron ore, and coal. The issues there are on the demand and supply side. What is happening is of no surprise to me whatsoever. If you look at emerging equities, we have a very high sector concentration of stocks from energy and materials. As an asset class, those are actually the two largest sectors. The price rise in agricultural crops has surprised others and me. It is short-term in nature. The underlying supply response in terms of time lag could be much quicker in agriculture, where you are planting cash crops on an annual basis. Q: By when do you think this supply can come in for global food inflation to ease of? A: In about 18-months to two-years. Q: That is very long, not before that? A: I mean a major reversal in trend. There are some positive indications already this year, if you look at crop plantings in North America for example. For a strong declining trend in food prices, one will have to wait for 18 months to 2 years. There is very little chance of a mean reversal at all in oil. Q: Have you read the USD 200 Goldman Sachs report and do you agree with that? A: I haven't read that report but it won’t surprise me. I can pretty well guess what their thinking would be. In the emerging market equity side, I have been bullish on oil and oil related equities since 2002. If you look at the performance since 1999, emerging market equities have been led by the resources complex overall. Q: Given what you are saying of oil and how long it will take to cool food inflation down, what do you think the Fed will do for the next 3-4 quarters? A: Our firm view is that the Fed is on hold now, at least for a period of time. But its policy will be an evolution and depend on the growth trajectory and whether the financial crisis is actually over or not. We will have further problems in the US banking sector over the summer months. The problem is far from being confined to sub-prime. If you look at the tendency in foreclosures and delinquencies on the prime mortgage side as well as other areas of consumer finance in the US, then there is unfortunately more bad news to come over the summer. Q: How do you read then the recent US market strength which has baffled a lot of people as the lesson that we learnt throughout the last four years was sell US and buy emerging markets, which as a trade played out very well, and suddenly the US started outperforming emerging markets? Do you think this is an aberration or temporary one, or will it last for a while? A: Complexities arose because China and India had to come off major equity bubbles. In some parts like Taiwan and Brazil the equity asset class is doing well this year as those did not re-rate to a major PE premium in 2006-07. So, you have got to look at it in detail. But I take some comfort in that. The beta we calculate for the S&P is actually about one now. It can fall below one over the short-term, which is potentially very positive for the asset class, if the S&P can find a level. On whether to sell US and European equities, our European and US strategist feel they are overbought in the short-term and not pricing in the earnings short falls to come in those markets. So, they would expect further weakness. In emerging markets, we have a much better overall earnings growth outlook. Our consensus is that EPS growth is at 15% for 2008. It is modestly down with negative revisions on the downside. That is a much better situation than the collapse in the earnings outlook that we have at least in relation to financials in US and Europe. It could certainly happen in Europe where the Euro's strength is causing a problem on earnings for the market. Q: Do you then see significant divergences between different emerging market equity performances this year? In the last 4-5 years, there has been difference in the degree of outperformance, but the general rising tide has lifted all boards. Do you think we could have a period where some markets can actually go down when others go up? A: Yes, we could. There is always a question of degrees. Last year, Mexico rose 4%, which was the same as S&P. In the same period, emerging market equities rose 40%. So, there is a possibility for rotation strategies. Mexico is not currently our preferred areas of focus, but there was a generalized bull market in EM. Some markets rose more than the others and you continue to get a significant divergence in performance, that is why we think you can add a lot of value through country selection. Our top pick markets are Brazil and Russia, and Korea and Taiwan within Asia. Q: Do you think we can have bear markets in India and China while many other emerging markets do well or is that an extreme case? A: It depends on what is you are definition of a bear market. If you look at a peaked trough move of 20% or more, then we have already had it. If it is a long-term 2-3 year slump, then we haven't. In case of China, there is relatively little chance of that. We expect China's economic growth to be around 10% this year, and think the policy cycle in terms of rate hike is coming to an end. In India's case, it is less certain. There are many positive features in the longer-term for India but we need to de-rate the market more and that requires price falls so that the earnings can take time to evolve and we don’t have too much further slowing in the economy. Q: Would it be fair to say that India is one of the markets where you are most bearish on? A: Yes. In the country quants model, it comes 17 out of 20. It is not right at the bottom, but it is one of the countries were we are bearish on. Q: Which are the three countries that are worse than India? A: Argentina, Mexico, and Indonesia. We have evaluated these countries across valuations, economic momentum, political risk, and other factors Q: Are there any sectoral themes or economic strata that you are bullish on? A: The telecom sector is interesting. It is a high growth sector and valuations are trading at a premium to the rest of emerging markets. But that may be warranted in that case. Funny enough, the IT services outsourcing sector has underperformed and has had very low valuations. So, that’s also worth taking a look at, though it is challenged by the environment in Western financial services firms. But if you look at IT services firms, they are at low multiples compared to history now. Q: Do you think the bubbles of 2007 have cooled enough in pockets like infrastructure or do they remain extremely challenging in terms of valuations? A: We like the infrastructure as an economic theme and prefer to play it in a focused group of stocks. For example, we own in our portfolio a Korean wind turbine manufacturer, UAE construction contractor, Chinese wastewater treatment firm, and are looking for a niche technology providers on reasonable valuations to tap into the infrastructure growth theme. Unfortunately, that was one of the key parts of the Indian market where we had a problem last year, the other is banks. Q: When do you see roaring equity conditions coming back globally, not necessarily like the last quarter of 2007 but an average of 2003? A: You need to be sure that you are in the trough of the global economic cycle. You are looking at a situation where earnings momentum is starting to move forward again. Emerging markets are different from developed markets. Energy, mining, telecom, and parts of the industrials and infrastructure complex still have these characteristics, telecom. But developed markets are a long way from being that attractive on the earnings cycle. |
Jonathan Garner
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