Despite the Indian markets being at a record high, it is not too late to invest in it, and one will still be able to selectively find attractively valued stocks, Chetan Sehgal, director of global emerging markets (EMs) and small cap strategies, Templeton Emerging Markets Group, said in an interaction.
“Strong reform measures and political stability has led to improved business sentiment towards India and within India. We expect this trend to continue over the longer-term, filtering through to corporate earnings," he added. Edited excerpts:
Where does India stand in your EM preference? While you are of the view that EMs are still attractive, is not India very expensive?
First, among EMs, if you are taking a very, very long-term view, then India has all the ingredients. It is one of the stellar performers. You have a strong political backing for the current government, and policies are being put in place that will enable long-term growth. Second, India in the past decade spent a lot on infrastructure, especially on the power side, and even today, many of these facilities are underutilized—you still have power plants that are running at 30% or 35% utilization.
The capacity for the country to grow with the stimulus is quite good and, therefore, we are very positive about India. It then comes down to valuations—we think earnings improvement will happen, during the course of the next 1-2 years. The real question is what are the kind of valuations you are willing to pay for these stocks? At this juncture, liquidity is finding its way into the market, and you can see subscriptions to local mutual funds going up.
As we are in a period where Indian industry can grow without putting in too much capital, there is a lot of surplus liquidity, and this surplus liquidity is going into the markets. We will see a more normalized market about a year-and-a-half from now, and probably that will be the time to take call on India in terms of valuations. At this point of time, the momentum is rock solid, and we are finding it difficult to find value.
Our Asia funds are quite invested in India—we think that it is a land of opportunities. India is very sentiment driven, and when things go down, they go down quite a lot, because the local investors are now moving the market more than global investors, especially on the small cap side, and we use that as opportunities to buy into the market. In our positions, we’ve not really had the need to reassess them, despite the fact that some of them have gone up quite a lot. But this is a very small segment of the market rather than a broad assessment of the market—we think liquidity is still good for the foreseeable future and there should be a correction when the economy starts picking up.
With Indian stocks having witnessed a record surge, have investors who failed to participate missed the bus? Is it too late to join the party?
We do not believe it is too late to invest in India—we are still able to selectively find attractively valued stocks. Strong reforms measures and political stability have led to improved business sentiment towards India and within India. We expect this trend to continue over the longer-term, filtering through to corporate earnings. Macroeconomic parameters have also strengthened—fiscal deficit, current account deficit and inflation are all under control, while foreign inflows have been strong.
What are the key risks to this rally?
We are mindful of potential volatility, and remain watchful for risks such as further increases in US interest rates and potential currency moves. Potential changes to the US trade policy also remain a source of uncertainty to global markets. However, we believe India is relatively more insulated since the economy is more dependent on domestic dynamics.
Which sectors are you overweight and underweight?
We believe Indian companies in consumer-related sectors are particularly attractive. These can provide an effective means to gain exposure to domestic economic expansion and, in particular, access to growth in spending as rising wealth fuels a burgeoning consumer class. With low commodity and energy prices, as compared to the peaks achieved in the previous decade, we also feel that select commodity shares remain attractively valued.
For India, what will it take to kick-start infrastructure spending?
India infrastructure investment is already picking up as a result of increasing financial flexibility of the government. We see tax reforms and greater clarity in policies based on government legislation and court pronouncements; hence, we are very positive on the long-term growth prospects of India. In addition, we have exposure to domestic cement companies which would benefit from housing and infrastructure spend.
There has been a lot of talk about increased protectionism in EMs, and the current US regime does not appear to abandon its protectionist stance. So, is US trade protectionism still the key risk for world economy?
The trade between EMs has picked up much more than trade with the US. The US essentially is a services driven economy, and now they are trying to get manufacturing up. But trade linkages that have already been established over the past couple of decades are very, very difficult to change. It is very interesting that even investments that are happening in the US, based on Trump’s announcements, are being made from EM firms.
The likes of Foxconn are now setting up manufacturing facilities in the US—the firms that initially benefitted from outsourcing, have all now developed capabilities, and it is very difficult to displace them as they are well entrenched. We own some of them in our portfolio. Many of these companies started with just assembling, but now they have built intellectual capacity, and many of them are replacing workers with robots. About 15 years back, the EMs accounted for 10-15% of the world’s patents; but now it is nearly 45%. The next leg of growth will be fought based on intellectual capacity, patents, and how you are up the technology curve and, therefore, protectionism, which was important for trade earlier, is no longer so much a factor today. For example, take a company like Baidu that is testing autonomous cars—they are doing that in China as well as in the US—that is the level of maturity EM firms have gained.
Outside tech, when it comes to other manufacturing sectors like say apparel, while these may be very important to EM economies, these are not a big part of the index in terms of market cap. Second, in many of these industries, even the frontier markets have picked up—for example, for textiles, while China is still a major player, a lot of work has shifted to Bangladesh and Vietnam. In fact, China is outsourcing to these countries. When this THAAD Missile Defense System crisis (where the US has installed this facility in South Korea) came up, the companies most impacted were Korean ones exporting to China, and not the ones exporting and trading with the US. Outsourcing is not just taking place from the West, but from China, too. The firms in this space are far more diversified, and they don’t need to depend so much on the US—they can depend on Europe and China and other EMs, and that will be the new engine for growth.
How do you see EMs as a whole—what are the trends you are seeing?
First thing to look at EMs is to look at long-term trends, and these trends have been very secular over the past several years. People ask us, ‘why did EMs have such a tough time in the 4-5 years leading to 2015’? What happens is, over a period of time, as confidence grows in EMs, their currencies get overvalued, and we saw a lot of EM currencies in 2012 were overvalued. In 2016, they had become severely undervalued, and that is why we found a lot opportunity in EMs.
Even now, we feel EM currencies are undervalued on a long-term basis. It is quite important to purchase securities when at least one leg of valuation is in your favour, and in this case, it is currencies. About 10-15 years ago, in terms of trade, EMs’ dependence on the West and Europe was great; now, inter-Asia trade has increased a lot. The trade between EMs is more important than their trade with the West, and the markets are discounting trade barriers and protectionist barriers that are coming up. It is very interesting that the call for openness is now being led by China, rather than the West. Unlike 15 years ago, China has now become the demand centre, rather then the supply centre. It (China) is drawing in a lot of trade. If you look at earnings in EMs, 2012 to 2015 was a disappointment, but now exports, commodity prices and earnings are all improving.
EM companies are now generating more cash flows—they went through a huge investment phase, and so free cash flow generation for firms within Asia has gone up, and that is another positive sign—that allows for restructuring to take place as companies start generating more cash, they can deleverage their balance sheets—so they can be less risky in terms of financial leverage, and there is also an improvement in earnings that is taking place in line with the world index. EM valuations continue to trade at a discount to the world, but the return on equity, which is a very important measure of profitability, of MSCI-Emerging Market vs MSCI-World is not too different—there is this perception that EM companies are less profitable than those in the rest of the world, but that is actually not the case. Returns are similar, whereas the valuations are at a discount. Since the global financial crisis of 2007, one trend to notice is the rise of technology and consumer in EMs—this is a good sign because it makes for less volatility. Over the past couple of years, EMs have increased the capital to assets ratio—banking systems are far more stable, and the ability to absorb shocks is much better now compared with the past. If you have a stable banking system, you have undervalued currencies, diversified index, and we think it makes for very stable fundamentals of EMs as compared to the past.
Key issues to watch out for are US polices, trade and stimulus—we answer that by saying EMs were dependent on the West in the past, but now inter-EMs trade is more important. Second is sensitivity to Fed rate hikes—but as banking systems are liquid and the interest rates are positive, with low currencies, we think sensitivity to Fed rate hikes will not be that significant.
The political event in Korea is important. We believe it needs to get resolved in a way that is amicable—while this is a risk issue, we are confident that better sense will prevail.
Last is the adjustment process in China... China today is over 25% of the EM index, but in terms of dependency of many countries to China, that has increased quite a lot. We believe policymakers in China want stability ahead of liberalization and changes—the entire process of trying to recognize assets on to bank balance sheets and deleverage is actually a move to get more stability in the system so that risks are well recognized. We think Chinese policymakers over many years have positively surprised Street expectations, and we continue to believe China will be able to manage the process.
We may have a period of volatility—EMs are up 20% year to date in US dollar terms, and we may have issues of volatility that may come in, but EMs are well equipped to cope with this adjustment process and volatility, and they deserve investors attention all over again.