This year, Indian equity markets have been one of the top performers. Christopher Wood, managing director and equity strategist at CLSA, while sharing his views with Puneet Wadhwa, says despite the rally, on the basis of valuations, Indian markets aren’t too expensive, if one believes the investment cycle has resumed. He adds he is waiting for a correction to raise CLSA’s Asia Pacific ex-Japan asset portfolio allocation from 18 per cent to 21 per cent. Prime Minister Narendra Modi’s most interesting announcement so far has been doing away with the Planning Commission, a legacy of British-style socialism, he says. Excerpts:
What do you think of the economic data on major economies such as the US, China and Japan, and the consequent policy action by their respective central banks?
The consensus this year is that US monetary policy will normalise and the US will raise rates next year. I have a different opinion. While people are saying quantitative easing (QE) is in the process of ending, I think that’s nonsense.
In my view, the ECB (European Central Bank) will most likely engage in full scale QE in the first quarter of next year. I expect the ECB’s balance sheet to expand again. We have just seen Japan launch a surprise increase in its QE programme, a surprise to me and, more important, a surprise for the market. That’s why the yen has weakened.
It is true the US Federal Reserve (US Fed) will start raising rates next year. Once we see that happen, my base case is the US Fed is more likely to resume QE rather than raise rates next year. However, if I am wrong and they try to raise rates or they do raise rates, I expect financial markets to exhibit distress to the prospect.
The simplest way to look at this is viewing QE as a drug addiction — a physical addiction, not a mental one. If you have a physical drug addiction and try to stop it, you go through withdrawal symptoms, or what we call ‘cold turkey’. That’s what financial markets will go through if they (US Fed) started raising rates. The withdrawal symptoms will be manifested by rising credit spreads.
My base case is when presented with ‘cold turkey’, the US Fed will not want to take the pain and, therefore, I believe they will back off. Evidence of the way central banks react when markets are exposed to stress shows they back off. That’s why they won’t be able to normalise the monetary policy. If my view is correct, the central bank will be trapped.
Till when will these economies be supported by liquidity injection?
I am taking a year at a time. But since 2009, my base case is they (US Fed) wouldn’t raise rates. The interesting point is no one is expecting them to raise rates. The moment of truth will come next year.
Do you think the disparate economic growth in Europe could be a catalyst for the Euro zone to disintegrate through the next three-five years?
Maybe; it’s possible. But my base case is it’s not disintegrating now because it remains a big political commitment, especially in Germany, to maintain the European Union. The German political consensus is 100 per cent behind retaining the Euro zone’s form. That’s why the track record is when the data gets worse, pressure grows to bail out the periphery and when the pressure is on, Merkel makes a concession.
That’s why I think if there is renewed financial stress in the Euro zone, the Germans will sanction a more aggressive form of QE.
But down the road, if we get rising representation of political parties of Euro sceptics or anti-euro, the chances of a break-up increase. My base case for the Euro zone is of a more aggressive QE, not a break-up.
Some countries in the Euro zone such as Greece, Spain and Ireland have shown progress in the way they have restructured their economies. The least progress in the Euro zone has been in the case of France and Italy, two big economies.
How does India stack up against its global peers in terms of its economy, markets and the road ahead?
To most global investors, India looks expensive. But within the context of its own history, India is just trading at the average forward PE (price-to-earnings). My view is Indian markets aren’t too expensive; they are reasonably valued, if you believe the investment cycle is resuming.
If it isn’t, India appears expensive. Another big positive is Indian markets are not distorted by ‘funny money QE’. The yield curve is not distorted. There is a conservative central bank and a conventional yield curve; that, to me, is a big positive.
What is the biggest risk to Indian markets?
The biggest risk to the markets is something happening to the prime minister; that’s a far bigger risk than US rate rises or China slowing. These are almost irrelevant in that case. The longer Mr Modi is around to change the direction, other things become less important. The key is to set the changes in motion.
What is your weightage on India in the global portfolio?
In the MCSI AC Asia Pacific ex-Japan, the benchmark of India was seven per cent last week. My allocation in India is 18 per cent; so, I am 11 percentage points overweight. I would ideally like to get to 21 per cent. I have been waiting for India to underperform so that I can increase the allocation, but it hasn’t. All foreign investors have been waiting for a pullback (in the markets) since Narendra Modi was elected PM, but this hasn’t happened.
My recommendation to global equity investors is to be neutral to Asian EMs in their global equity portfolios. India remains the most attractive market in the EM world and the most attractive market globally from a five-year perspective.
How long do you think this rally will continue? What are the risks?
I have got a five-year view here. A lot depends on the investment cycle recovery but it will not be a V-shaped recovery. I have another portfolio, which is not driven by benchmarks. It has just 25 stocks in Asia linked to macro themes. In that portfolio, I have got much more in India. In that portfolio, I have got 42 per cent in India and that's not benchmark related. There will be a lot of portfolio managers who will not be allowed to be so overweight India in the context of the benchmark. I went more overweight on India post the election results, which were much more conclusive that what most people were anticipating.
Which other EMs will investors put their money in?
India is the main area. They do like Mexico, but all commodity-related areas are under pressure because of the strong dollar and China’s slowing demand for commodity consumption. Apart from China, markets such as Brazil, South Africa, Indonesia and Russia are viewed as commodity-sensitive. So, EMs are obviously benefiting from weaker oil prices, as is India.
In the long term, if Modi succeeds in getting the investment cycle going and recording about nine per cent growth, India will become a source of demand for commodities, which will be good news for commodity producers. But it is too early to talk about that. One needs to see these growth rates and a visible improvement.
Another issue for India is the gas prices. I believe that people have been disappointed that the gas prices have not been increased and the fact that the gas prices have not been increased as much as people were hoping. So that's one area where one can get some positive newflow going ahead. My guess is why the government has not raised the gas prices as much as people were hoping initially is because he doesn't want to be seen favouring one particular corporate group. But that doesn't mean he will never raise gas prices. It just means that he will do it with a delay.
What are the Indian stocks in your portfolio?
The Asia ex-Japan thematic portfolio for long-only absolute return investors has HDFC Bank, IndusInd Bank and ICICI Bank in the banking space; Grasim Industries in cement; Titan Industries in consumer; HDFC and GRUH Finance in housing finance; Larsen and Toubro in infrastructure; Zee Entertainment in media; Prestige Estates in property and Just Dial in the search engine sector.
In Indian markets, what are your top ‘sell’ recommendations? Are there any stocks or sectors you advise investors to stay away from/avoid?
I don’t have one. That’s why I have Titan in my portfolio. The world thinks the gold bull market is over. I don’t.
What makes you so positive on the banking sector?
The area in which policy can make the biggest difference is state-owned banks and this relates to whether we can see action to clean up the banking sector. This is because if we see really strong positive action to clean up state-owned banks, these will become more interesting investments than private ones.
I don’t expect a lot of companies to be privatised; I don’t think that’s Modi’s policy. The issue is whether he will create a more incentivised environment. But that’s a bottom-up approach. If global investors ask me where to invest in India for the next five years, I would say private banks.
What about defensive sector stocks like pharmaceuticals and information technology (IT)?
They were great areas to own when the rupee was under pressure. They both have quality companies and that's very much a bottom-up issue. I don't think the rupee will be the positive headwind for them as it was in the last five years. In an environment where the dollar is rallying and commodities are selling off, which we are seeing right now, the rupee will be one of the better EM currencies to own.
Is there any stock that you would want to add in the e-commerce segment that many believe will see better days ahead?
We have just a few listed players in India. It is quite clear that in the next five - ten years, the e-commerce story should kick-in in India as smartphones become affordable just like it has happened in China in the last five - ten years. The big difference between China and India in e-ecommerce is that China has the physical infrastructure, which India doesn't that makes e-commerce more practical.
Besides banks, do you like any other sector?
I think cement is quite attractive. Infrastructure companies that are not too leveraged and didn't blow up in the last cycle should do well. The property sector has to be an obvious beneficiary of rate cuts. So do commercial vehicles (CVs). And then there is the high beta area of e-commerce where we have only three existing listed players. They seem expensive but from a five-year view, I see a lot of activity in terms of companies in this area coming to the market.
Does anything in the mid-cap segment interest you?
Mid-caps have run up a lot. This time last year, it was a segment to buy because it was very cheap. But they aren’t overheated. All the cheap valuations have been removed; that was where the real opportunity existed this time last year. The issue now is bottom-up and about seeing who is recording an earnings pick-up. Last year, one could buy all small-caps as they were cheap, which is no longer the case. Things are getting more stock specific now.
How do you rate the first few months of the new government?
I am completely happy with the government’s performance. Many say the government hasn’t done enough. I don’t understand that. I think Modi has a five-ten-year view. I think there have been a lot of interesting policy announcements. Symbolically, one of the most important developments was his decision to abolish the Planning Commission, a legacy of British-style socialism.
While this is not related to GDP (gross domestic product) growth, I think it sent a very important symbolic message. So to me the single most interesting thing Mr Modi has announced since he became the Prime Minister was to abolish the Planning Commission, which is a legacy of British-style socialism.
What are your expectations and what are the specific things you want the government to address through the next three, six and 12 months?
The key thing Modi has been addressing is attracting foreign direct investment (FDI). I think the Indian economy was bottoming anyway. The last government did a lot in its last year in office; it cleared a lot of blockages in projects. So, to me, that was already happening. Then we had a Supreme Court decision on coal block allocations. I think it is good to announce a clear auction process.
In terms of legislation, the key is to make the bureaucracy work --- it doesn’t require laws. Another important thing is the GST (Goods and Services Tax) implementation. I am hoping from a two-year perspective, GST is passed. I don’t expect it to be passed in six months because it requires a buy-in from states.
What are your expectations from the government's next Union Budget in 2015?
I haven't got specific expectations but the markets do have expectations. One does need to see progress on land clearance laws etc.
Is corporate India decisively out of the woods? What are your expectations for growth in earnings?
I am convinced the economy and earnings downgrades have bottomed out; I am convinced one will see a big, meaningful pick-up in earnings. However, from a 12-month perspective, if we don’t see a pick-up in earnings, the markets are likely to see a pullback. I don’t think this will be a V-shaped recovery because the rates are still quite high.
My guess is the Reserve Bank of India (RBI) doesn’t cut rates aggressively quickly because of the base effect. The central bank will be cautious about cutting rates because it thinks the base effect will cause inflation to pick up. I will be amazed if we don’t see rate cuts in 2015; I think it will be in the first quarter of 2015.
Will that be a token cut or do you foresee a series of rate cuts?
The longer RBI stays on hold, the more potential there is for rate cuts to fall dramatically. India remains attractive from both debt and equity market perspectives. We are already seeing investment projects picking up. But I wouldn’t bet everything on the upward trajectory being continued for the next three months. I have greater confidence on a 12-month perspective than a three-month one.
Do you have any ballpark estimates of GDP growth in India through the next two years?
If we get the investment cycle back, Indian GDP has the potential go from four-five per cent to six-nine per cent through the next five years. And, I don’t see why this shouldn’t happen. That’s what Modi will be trying to do. A key variable here is attracting FDI. That’s why he made this point when he went to the US and Japan.
Which sectors, in your opinion, will attract a chunk of this FDI?
One of the potential and key areas will be infrastructure. Obviously, it could come into the automobile sector. But one big issue is to get the bureaucracy to approve the investment approval process and that's why it was interesting to see Mr Modi announce the special unit to fast track investment from Japan. But I think the first key area will have everything to do with infrastructure.
What about gold as an asset class, considering the fall we have seen this year?
For gold to bottom out and rally, the markets have to realise the US Fed can’t normalise monetary policy and that’s going to happen next year. My guess is gold bottoms out at $1,010-1,050 levels. I still like gold, but for gold to get a bid, people have to realise the US is not leaving the QE world.
Do you think that the crude oil prices have bottomed out?
Well, that comes down to the Saudi policies. But my guess is Saudis will be comfortable with oil around $80/barrel, in which case, it may have bottomed. But we could get an overshoot on the down side. It remained a mystery to me why oil remained above $100 in the last few years. It should have corrected to $80 years ago on increased supply of shale (gas).
But it appears to be the case that the Saudi's, after the so called Arab spring, decided that they needed oil above $100 to fund increase in welfare spending that increased dramatically to keep its population docile. So that's been the case from the last few years. Whatever reasons, the Saudi's now clearly decided that in order to retain market share, it needs to let the oil go down and fundamentally, oil should go down.
Allowing oil to go down, they're making shale (gas) less attractive. So that's one reason to do it. The second obvious reason is weaker oil puts pressure on Iraq and Russia.
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