After seeing negative returns in the last quarter of FY18, what should be the realistic expectations of Indian equity investors? Can India sustain its equities rally without corporate earnings coming back?
We are positive on Indian equities. While it is not our most preferred market in Asia ex-Japan at this time, we are mindful of the context that we are likely in the late stage of the current global economic growth cycle. Late-stage, equities tend to deliver very strong returns across most regions, so assuming our late-stage view is correct, it would likely take exceptional circumstances for Indian equities to buck this trend, especially since we expect Asia ex-Japan equities to outperform most other regions.
Having said that, underlying market fundamentals always matter. Prior to the recent correction, one of our main concerns was elevated valuations. This is dissipated to some extent following the correction, which makes us more comfortable on the investment return outlook from here. The other concern, of course, is earnings. However, here it would be unfair to say earnings are absent—actually, earnings growth has been strong—consensus expects over 15% earnings growth in 2018—and the growth rate has accelerated recently. This is supportive for equities and the numbers themselves are not far off from the market’s long-term rate of return.
How are foreign investors like you looking at the Indian story now? What has changed from last year?
Our global investment committee meets every month to review our views on Asian equity markets—as indeed it does to review our full suite of asset allocation views—so our views on Indian equities relative to other markets in Asia is something we look at on a very regular basis.
One approach we take focuses on how our view on global asset classes feeds through to our views on Indian equities. Our current view is that we are late in the economic cycle, a period in which equities tend to deliver strong returns and emerging markets do well, especially if the US dollar weakens further. This thinking, at a very simplified level, forms the basis for our view that Asia ex-Japan equities will outperform most other regions. Within Asia ex-Japan, North Asian equities tend to be more cyclical and trade-driven in nature; this is why China is our most preferred market in Asia at the moment, for example, though trade tensions is one reason why this is also been a more volatile part of Asian equities. Indian equities’ behaviour is interesting in that we have seen periods where Indian and Chinese equity performance mirrors each other—when one is outperforming, the other is not. Indian equities are also more diversified from a sector composition point of view while many other country equity markets tend to be dominated by one or very few sectors.
From last year, our view is that economic and market indicators have largely improved. Most indicators of growth have improved somewhat—such as industrial production or PMIs—while CPI inflation has remained relatively contained. These are both supportive for bond markets, though supply here remains a risk. For equities, the acceleration in earnings growth is undoubtedly a positive and a lot of bad news appears priced particularly in the banking sector. On balance, the majority of indicators have shifted positively from last year, in our view.
Beyond political and policy concerns, are Indian equities likely to continue to struggle for the next few months anyway, as earnings expectations and valuations are still high? Where does India stand vis-à-vis other emerging markets?
We expect Indian equities to perform in line with the broader Asian equities universe, but expect outperformance relative to emerging markets outside Asia. The rationale for this stems from relatively basic fundamentals. Asian—including Indian—equities offer relatively more attractive valuations, especially when considered relative to developed markets, and greater visibility on earnings growth. Broad equity market drivers are also important here.
One risk with emerging markets outside of Asia is their relative sensitivity on a single sector or commodity—copper prices for Brazilian equities, for example. Major emerging markets outside of Asia also face more significant political uncertainty. Asian equities offer relatively greater sector diversification, with Indian equities offering greater diversification than most. Finally, there is the aspect of cyclicality. North Asian equities tend to be more pro-cyclical, growth-oriented and trade-sensitive. This means one should expect them to outperform during periods of strong equity market returns, though they are likely to be more volatile in response to trade tensions, for example.
This line of thinking leads us to prefer Chinese equities across Asia ex-Japan at this time, especially because of the last factor. Relative to this backdrop, we expect Indian equities to perform in line with Asia ex-Japan equities because we believe many of the positive fundamentals do hold—improved valuations following the pullback and accelerating earnings growth. However, we believe the global late-cycle backdrop is more positive for North Asian equity markets relative to the rest of the region; hence, our preference for Chinese equities at this time.
Small and mid cap stocks have seen price erosion in the range of 25% and 40% in the last month. What should be the better way to invest in this space?
For us, the choice is often between taking our India equity exposure via large caps, or add exposure to small and mid cap segments. At this time, we have a preference for large cap equities over small and mid cap.
As a generalization, it would be fair to expect small and mid cap equities to outperform large cap equities over a long enough time horizon. However, we do not believe now is the time to favour small and mid cap for two reasons.
First, relative value favours large cap equities now, in our opinion. Even though markets have corrected somewhat earlier in the year, small and mid cap valuations still appear expensive relative to large cap equities. Second, while we do expect strong equity market performance late in the global business cycle, we also believe managing risk is equally important now. Large cap equities offer a less volatile way to gain equity market exposure relative to small and mid cap equities, which can be much more volatile.
India’s monsoon rains are likely to be 97% of their long-term average in 2018, its meteorological department has said —how big a relief is this for Modi and India?
A good monsoon will undoubtedly help economic growth—it remains one key driver of agriculture-sourced GDP growth and rural incomes which, in turn, remain a key source of final consumer demand. A successful monsoon would likely make itself visible for financial market investors via improved economic growth data and, eventually equity market earnings growth.
Having said that, forecasting weather events beyond just a few days’ time is a notoriously difficult exercise in any part of the world. According to an Indian Met Department report, monsoon forecasts have been qualitatively correct in 90% of years since 1988. However, the gap between actual and forecast rainfall has been wider than 10% in some years. Hence, while the forecast of a ‘normal’ monsoon is undoubtedly a positive, one must keep in mind the likely risk of a surprise on this factor.
The possibility of long-term trade wars between the US, China and other developed nations is impacting investors’ confidence globally. How does it impact Indian companies?
We remain cautiously optimistic that recent trade tensions will not boil over into a conflict that directly impacts Indian equities for two reasons.
First, we continue to believe a lot of what we are witnessing is posturing ahead of negotiations. Many of the tariffs announced by both the US and China come with either a delay in terms of the time they kick in, or have focused on symbolic items as opposed to those with the largest dollar values. Public comments by the political leadership on all sides has also left a fair amount of room for reaching a negotiated settlement.
Second, a lot of the tensions are focused directly on US-China trade relations. One can see this both via exemptions—on many tariff measures, for example, a number of US allies were exempted—and the basis for tariff announcements—with many focused specifically China based on allegations of intellectual property violations, as opposed to measures that applied to all trade partners globally. One can argue that an escalation can have negative effects for most trading nations, but both these factors cause us to believe that the main risk from any further escalation in trade tensions is likely to be limited for Indian financial markets.
The Reserve Bank of India (RBI) has left interest rates unchanged in the recent monetary policy review. What would be the expected rate action in India when the US rates are expected to go up? How should investors align their bond portfolios to ensure a better risk-reward?
Global policy rates may be partially correlated, but Indian policy rates are ultimately likely to be led by inflation and growth developments in India much more so than where the Fed goes specifically.
On the positive side, CPI inflation has remained relatively contained, which has helped mitigate concerns that the RBI may have had to raise rates proactively in order to avoid a significant rise in inflation. Having said that, the oil price outlook will be key as this poses both a significant risk to inflation and also to the currency via its impact on external balances. We also note that ‘real’ interest rates and bond yields in India—ie. rates and yields net of inflation—remain very high both relative to history as well as relative to other emerging market peers, again suggesting relatively limited need for yet higher rates. For investors, we believe this reminds us that an attractive investment opportunity exists in bond markets as well, not just in equities. We believe these levels are attractive for adding to bond market exposure at a relatively high real yield.
For global investors, the currency is also a risk when adding to INR-denominated bonds. However, we take comfort from the fact that high ‘real’ rates have historically tended to be supportive for the currency, especially if we are correct on our view of long-term US dollar weakness. Hence, we are comfortable adding to INR-denominated bonds at this time.