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India better off among emerging markets, but expensive: UBS

FY16 will be a tough year for the Indian market as valuations have moved ahead of the country’s growth reality, said Bhanu Baweja, Head – Research & EM strategy, UBS.

He however does not see Indian market collapsing as it is “largely driven by foreign institutional investors (FIIs)”, which places it relatively in a better position than other emerging markets.

Baweja expects fund flows to continue to shift from emerging markets and feels the EMs may underperform developed markets in the coming months. He also expects India to get impacted when US Fed hikes rates.

Below is the transcript of Bhanu Baweja’s interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.

Latha: Indian markets have been hugely volatile in the last few weeks. What is your view, after that 30 percent rally we had last fiscal, the one that ended a week ago, can this year do even half as good?

A: I think this is going to be a much harder year, that is not difficult after such a strong year last year. I think the base is so strong, it is an easy statement to make that this year will be lower. We have got to recognise that it wasn’t just the political mandate which was responsible for equities doing as well as they did, it was also the fact that global rates declined precipitously. US dollar rallied and many people think that it is a difficult environment but the truth is that including the US but particularly in Europe, rates declined aggressively and it was an environment of also lower volatility, which has been good for asset markets across the board.

So both risk premia and also rates came down, which meant that your cost of equity was falling. So that helped the markets last year. That is going to change this year and it is going to change at the time when valuations have run ahead of the growth reality. The growth reality in India has not changed much — if you look at private sector investment, that is not picking up and in fact it could be down again this year only public sector investment is improving and the sentiment on consumption is lukewarm at best.

Exports are not in a very strong position at all. So I am not sure how we are getting the numbers of sort of 7.5-8 percent, I think the growth reality is much weaker. In terms of sales and earnings, I think we should be getting numbers on high single digits, I think the consensus is slightly higher than that. So I do think that there is a room for the consensus to be disappointed.

Having said that, the reason why we won’t see a likely collapse in this market is because this market at this minute is being driven by foreign institutional investors (FIIs) and the key point at this minute strangely is not just what happens to land acquisition or what happens to rural wages or what happens to labour market reform in Rajasthan and Madhya Pradesh (MP) — the key point right now is what is the opportunity cost for these FIIs and therein lies the good news for India. Ironically, it is nothing to do with India. It is the fact that other emerging markets are in much worse shape if anything. You have got to say that India — this may sound strange to listeners in India but India is sort of the poster child of reforms globally and it is regarded as such.

I think investors get a little over-enthused with the reform in India but it is true that relatively speaking, India is in a better position. People don’t want to leave that trade, they may take some chips off the table but I find it difficult to believe that they will sell India and buy other emerging markets because by comparison India is better. It is a weak relative story. In absolute terms, I am not sure that there is a lot of joy here. 

Sonia: Lately we have seen Chinese stocks do much better that Indian markets, so what is your take on fund flows to India and to emerging markets in general? Will developed market equities be preferred or will emerging markets rule? And within emerging markets what will the pecking order look like?

A: Yes, in order of those questions, yes and no. I do expect fund flows to continue to shift away from emerging markets. See the cap between developed market earnings and emerging market earnings is narrowing but not because emerging market earnings are picking up, it is because developed market earnings have come off a long way, especially in the US. So, I do think that the gap is narrowing but even so, as US rates rise and I think that is a very big change, as US rates rise, emerging market credit spreads and the risk premium in emerging markets (EM) do pick up. That is not an environment in which emerging markets that are especially exposed on the earnings side to China and for the cost of equity to the US, that is not a very healthy combination.

So, bottom line I do continue to expect emerging markets as a whole to underperform developed markets and I do think that you will see more outflows from EM into developed markets (DM). Now, as far as the pecking order goes, your question was, China has performed much better than India, is it possible that people will move towards China rather than India? There is a perception out there also that China is easing aggressively and India is not easing so aggressively. I think both of these are wrong because China is a very domestic market unlike India which is driven by foreign institutional investors (FII) the Chinese market is driven entirely by the locals. And the reason the market has run up out there is despite much more weak growth than in fact you have in India is because there is an asset allocation shift away from credit products and investments in the property market towards the equity market in China. It is a local phenomenon. I do not think FIIs understand a lot about them and I do not think they have the confidence that this market is going to go up in a secular fashion. We do think the Chinese equity market is probably the single worst representation of a negative view on China. We do not think you do it through the Equity market but even so, at these levels it is difficult to go chasing that market. So, I do think that the pecking order within EM is unlikely to change and therein lies the good news for India if any. As I said it is a relative case, it is not an absolute case.

Latha: Actually that is really, because it looked like there was migration of funds from India to China. But now to the big event of the year; the nonfarm payroll numbers have been pretty rattling. When do you think the Fed hikes rates and what will be the impact on India whenever that happens?

A: Much less so than the rest in EM. But let us not kid ourselves. India will be impacted. Especially as your curve is not as steep as it is in the US. We have no risk premium in the fixed income market. We are pretending that we can manage the entire yield curve based entirely on inflation which by the way has been notoriously difficult to forecast for everyone. 46 percent of that is food, a lot of that is energy and both these are elements that the markets has been particularly inept at forecasting. So, will we be genuinely getting a 4 percent inflation print in 2018? It will depend a lot on what the formation of that MPC is and how much independence the RBI genuinely has, but I personally think that it will be slightly higher than that. More near-term, I do not think that the yield curve can stay completely stable when the Fed is hiking in India. But the good news is that when I compare it with some other places which are much more levered in Dollar terms than India is and Turkey comes to mind. Indonesia is another market that comes to mind. It is difficult for me to see why India is not a pareto superior alternative, why India is not in relative terms better. And again the fact that Governor Rajan is insisting that we need a positive real rate and let us bear in mind why he is doing that. If we have any pretence of being a 10 percent growth economy or a 8-10 percent growth economy, we need higher savings because we have to get there through higher investment, we cannot rely on the globe for investments especially when the real interest rate in the world is rising.

We need our own savings and if we have to get our own savings, we have to sell gold and buy a bank deposit. Why would you sell gold and buy a bank deposit if you have positive real rates? So that in a sense is where I think the RBI and governor Rajan in particular is coming from which I certainly think is the right policy for the long haul even if it means growth is compromised in the near-term. I think he is avoiding being penny-wise pound foolish which I celebrate as a bond investor. So, that is why people will still remain comfortable with long-term holding of India debt. It will impact the cost of equity especially as credit spreads at this minute are also too tight and can widen out. So it will impact the cost of equity, India is not an island, it is not going to be immune. The best that can be hoped and therein lies the positive case for equities relative to the rest is that Indian debt markets will be less hurt than a Turkey or an Indonesia or a South Africa.

Sonia: I was going to ask you about India’s macros. I mean we are just less than 24 hours away from a credit policy. What are you expecting from the Reserve Bank this time?

A: Our official view is that they will go for more rate hikes where we think that 50 basis points is likely, but we do think that this needs to come sooner rather than later. And the reason it probably does need to come is because so far we have not seen the transmission from lower RBI into lower borrowing costs for corporates and we do think that cyclically and I stress cyclically, inflation will actually weaker for longer than most people expect and we also think that growth in India is not as stronger footing as some people expect. So, that does give Governor Rajan room for the near-term to try and stimulate the economy without necessarily compromising his longer term inflation credentials. But make no mistake the inflation credentials are what are more important if we do get a positive real rate in the long-term even if that compromises the growth cycle in the short-term, the savings rate goes up which is the bigger picture that he focused on.

Latha: Finally, can India enjoy this advantage of low commodity prices for say the next 12-24 months? Does this look like the commodities cycle is going to remain as bearish?

A: Yes, we can because crude and other commodities will stay relatively well-behaved. We are not expecting a very big pick up in either over the next 12 months. Especially non-crude commodities, we are not looking for a big pick up in base metals at all. Crude can find a base and move slightly higher but it is not expected to head well towards 100. I do think that India will benefit from that. Food prices within India are a slightly different call. They do depend on international prices considerably but there is a strong local element as well. How the demand for protein pans out depends on how rural wages pan out so all these issues become quite important. But I do think that commodities will help India and in fact even the decline in commodities so far may not have yet helped India in a big way and that might come through with a lag. It is possible that the calendar year Q2 and Q3 numbers, both in the US elsewhere in the world and also in India, perhaps, when consumers see that this decline is not just for two or three weeks, this decline is for real, they rather than saving that temporary, the game which they regard as temporary, they go and spend that, that is quite important. So, I do think that from that perspective, India will benefit again. But that is luck. We are hoping to rely on a little bit more if we have to be long-term bullish on India, we have to rely on hard work, we have to rely on tough reform. The political economy of India does not necessarily lend itself that easily to tough reform but global investors take a much kinder view than I do on that.


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