BackWhen reform is sequenced properly, it gathers pace: Michael Kurtz
The global head of equity strategy at Nomura on why he is bullish on India and the three potential risks that could derail the India story
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Singapore: Nomura has upgraded Indian equities to 4% overweight for 2015, its biggest overweight in the region, and expects Indian equities to deliver gains of 20% or more over the next 12 months, Michael Kurtz, global head of equity strategy for the Japanese financial firm, said in an interaction.
Kurtz said he was bullish on the India story, but warned three potential risks could derail it—the country’s vulnerability to capital outflows, resistance from Indian bureaucracy and states to implement Prime Minister Narendra Modi’s economic reform process, and political risks because of the rise of Hindu nationalist elements in the Bharatiya Janata Party (BJP). Edited excerpts:
Most analysts believe the US Federal Reserve won’t raise rates until June. What is your view? Many countries, including India, are worried about the West’s easy monetary policy and Reserve Bank of India (RBI) governor Raghuram Rajan has repeatedly warned over its spillover effects on emerging countries. Do you agree?
We think the Fed will begin to hike rates in the third quarter of 2015. Right now, we are gravitating more towards September than July because lower oil prices have further reduced inflation numbers in the US and globally. There is no strong inflationary rationale for hiking at the moment.
I have a great deal of respect for Rajan and everything he has done, attempting to structurally bring down inflation and inflationary expectations in India and, I think, that project is as important to the Indian market outlook as structural reforms by Prime Minister Narendra Modi and the central government. Rajan has been a great success as far as domestic monetary policy is concerned.
On the specific issue of dollar monetary policy and emerging market currencies and emerging market monetary policy, I think his (Rajan’s) comments are misplaced. The reason being the Fed’s only statutory obligation is to guard against US inflation and to try to promote stable US aggregate demand growth.
The US Fed has no obligation to be the central bank to the world. If the US central bank were recalibrating monetary policy based on what is right for the Indian economy, they would be mis-serving their own constituency, which is the US economy. On top of that, you don’t hear emerging markets central banks complaining about Fed policy when it is helping them, when the dollar is weaker and foreign central banks are able to accumulate dollar reserves and produce lots of relatively easy domestic credit and money supply, and when emerging markets are growing rapidly without paying substantial costs domestically. When US monetary policy is working in their favour, everybody seems to be perfectly fine with that.
But, inevitability, when the US gets to the point in its business cycle where it has to tighten, suddenly everyone is crying the Fed needs to take their concerns into consideration. To be perfectly honest, this strikes me as somewhat disingenuous. The fact is that central banks around the world have to consider tightening policy when the moment comes that the Fed underpins the dollar and creates pressure for capital outflows that central banks may not wish to see. They have the choice between raising domestic interest rates and preserving the attractiveness of their economies for capital flows, or allowing capital to flow out and putting some downward pressure on their currencies—that is a discretionary decision they make. But to say somehow the Fed is forcing this upon them is insufficiently respectful of the fact that the Fed has a job to do.
How do you see 2015 for Indian equities?
We think 2015 will be another strong year for Indian equities. In my outlook for 2015, I have increased my overweight to Indian stocks. Proud to say we were overweight on India already going into 2014—our overweight recommendation has captured the outperformance in the Indian market. In the next year, we have upgraded from a 1% overweight to now a 4% overweight—this makes India our biggest overweight in the region.
Where we think the outperformance comes from is primarily on the earnings front and I will point to two factors. The first is the bolstered business and consumer confidence in India since the change in government is underpinning an upcoming upswing in GDP (gross domestic product) growth from the dismal rates of the past two to three years back to levels at nearly 7% by 2016. We are at 6.8% growth in 2016, which means that India through its next year is on its way to surpassing China in its GDP growth rates. That will underpin a pick-up in topline sales growth for the companies.
In addition, India is one of the biggest beneficiaries from declining energy and commodity prices—that is both at the macro level and at the corporate level. At the macro level, you get an improvement in your trade balance, a decline in your current account deficit, you get structural declines in inflation pressures, which gives room for RBI to cut interest rates next year, and we have two rate cuts in our forecast for India for next year. At the corporate level, lower commodity and lower energy prices feed directly into profit margins, and India, given that there is a very large component of industrials and consumer discretionary stocks, downstream commodity using sectors do get a very direct boost to the corporate bottom line even as GDP growth is going to be lifting the corporate top line.
All this is my way of saying that even if one assumed no increase in the PE (price-to-earnings) multiples on the Indian market, India should still be capable of outperforming. We are expecting that it will give at least mid-teens, if not close to 20% earnings growth next year. On a constant multiple basis, that already makes India an outperformer; we have the region overall at 11% earnings growth.
As for whether or not Indian multiples are capable of expanding, I would say that at 16.6 to 17 times, India is just slightly more expensive than its long-term average. India is currently selling at 0.8 standard deviations above its long-term average, and what we found in recent years is that the market has been willing to sustain for multi-year periods, premiums of up to 1.5 or even 2 standard deviations for what are seen as good reform stories.
The Philippines, Indonesia, Mexico, South Africa have all been priced at 1.5 to 2 standard deviations above long-term averages. If over the next six months we see enough delivery on the reforms promised by the Modi administration, and enough structural subside in inflation pressure in India, both of that would argue for a further re-rating of Indian equity multiples. Therefore, when we take an already robust earnings story, and we layer into that some possibility of some modest additional multiple re-rating, what you end up with is an outlook for Indian equities to deliver 20% or more over the next 12 months.
Will 2015 provide the best opportunity for Modi to undertake reforms because of a slew of unique factors—oil prices are at five-year lows, commodity prices are down, inflation is easing off, current account deficit is coming down, no big state elections are around the corner and he has a majority in the lower House. Rarely has so many things come together for an Indian Prime Minister. Can he use this luck to his advantage?
Even without all the luck, as you put it, Modi and the BJP have been given a clear mandate from the voter and, therefore, I would think he will continue to log significant reform progress even without the other factors. When reform is sequenced properly, it gathers momentum. In other words, it is not like you are starting with a finite amount of political capital and you just use it up, spending it on one reform initiative after the other.
If done right, reforms will generate new sources of growth; new constituencies will benefit, and those beneficiaries will be brought into the coalition for more reforms. Done properly, Modi should be able to take the historic mandate the Indian voter gave the BJP and convert that into a certain amount of momentum, particularly when there are so many fixes that could be applied to the Indian economy that will have manifest benefits and should continue to produce substantial growth upside.
One of the other lucky factors is the simple fact that the BJP came to power at a decade low for Indian GDP growth; the downside risks to growth are arguably minimal, while the upside potential, relative to where we are starting from, is again quite massive. If you throw in the other lucky factors like oil prices, and things get even easier for Modi. I almost want to say, he (Modi) may want things to be the other way around.
Let us hypothetically assume that rather than inflation having been helped by lower commodity prices, let us say that India had a terrible monsoon and vegetable prices were sky-high right now, this may have helped him to do more aggressive work to try and weed out the middlemen bottlenecks in the food distribution system. It would have become a more pressing emergency to deal with that.
In some sense, I almost think that things are too easy. You know the old expression, never let a good crisis go to waste, and there is no crisis in India now. The urgency is off due to lower oil prices. I am not saying Modi is going to have a bad innings. I think the most important background reality in India right now is overwhelming majority of the population have voted for the BJP. Presumably because the population demographically is very young. For me, the Indian voter made a smart choice.
So what are the risks to the bullish India story?
There are three risks at the minimum. One of that: if the hot money flows that have come to India in recent years proves more fickle. If you look at India superficially based on its current account balance and the relatively high domestic yields on Indian bonds, it looks like the kind of market that is very vulnerable to money outflows. You will recall that during the taper tantrum of the summer of 2013, the Indian rupee was extraordinarily volatile. Fortunately, the rupee and Indian markets were not particularly volatile during the September-October 2014 volatility episode. There seems to be a change in market sentiments since 2013.
But I don’t think one can entirely rule out the possibility that if treasury is also moving higher quickly, or hypothetically that the Fed is forced to do a much more rapid interest rate increase—not a comfortable 25 basis points (bps), but a hasty catch and 50 bps hike (one basis point is one-hundredth of a percentage point)—then we can’t assume the Indian rupee or the capital flow story is going to remain as stable as it has been. So there is always going to be room I think because of India’s twin deficits—it will be vulnerable to capital outflows, depending on how quickly the Fed is tightening.
A more mundane risk is Modi’s efforts to reform get diffused and weakened by the vast self-interested power of the Indian bureaucracy, as well as the gap that exists in terms of policy transmission between the central and state governments. Modi can only do so much; all the reform needs to be transmitted down through a bureaucracy and to the state level as well. There is a lot of potential natural opposition to his well-meaning intentions to change things in the system. Even with the kind of mandate they received in May, it is not clear to me if any reformer is going to able to push for through that level of resistance. The bureaucracy in India is schooled for centuries in the art of self-preservation.
The third, I dare say, is the political risks. The prospect of a strengthened India that is more nationalistic will potentially come as a perceived threat to other powers in the region, and one never knows how those powers may configure themselves in order to ward against that kind of growth in momentum of Indian nationalism. The rise of the Hindu nationalist elements in the BJP is something we need to watch out for as well.
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