As the weightage of China-listed shares in the MSCI Emerging Markets Index goes up beginning May, India may see outflows of $3.5-6.5 billion in a phased manner, said Rohit Arora, emerging markets strategist at UBS AG Singapore. Index provider MSCI has said it will increase the weightage of Chinese A shares in the index in three steps, from the current 0.72% to 3.3% in November 2019. Growth, rather than inflation, is the problem for emerging markets (EMs), Arora said. The rupee is pricing about 1.5-2% of election risk premium, despite the late February-early March rebound, he said. Edited excerpts from an interview:
After China’s increase in weightage in the MSCI EM index, what is your estimate on outflow of funds from markets such as India?
We believe India’s weighting in the MSCI will decline by around 50 basis points between the May and November re-balancing, with the increase in the index’s exposure to China accounting for 50% of the reduction and the inclusion of Saudi Arabia or Argentina accounting for the rest.
However, estimating the inflow or outflow of funds is more of an art than science because active investors, who make up about 75% of total assets under management (AUM) benchmarked to MSCI indices, may opt to rotate only partially and take into account a variety of other factors such as the outlook for growth and current over/under weightings. Nonetheless, it is reasonable to assume that, given such a large shift in weights, active rotation will take place. As a base case, we estimate between $3.5 billion and $6.5 billion of outflows from India over the three tranches.
What are current headwinds for EM equities for 2019?
Growth and cost of equity. If 2018’s de-rating was a function of a higher cost of capital, market expectations for further earnings downgrades may be a source of de-rating over the next three-six months.
Consensus EM earnings per share (EPS) growth for 2019 has already been cut by 300 basis points year to date, and our bottom-up UBS GEM Inc forecast of 4.0% EPS growth in 2019 points to further downward revisions.
At the same time, our US team thinks the tailwind from US treasury may have already peaked, and the US Federal Reserve may be on course to raise the policy rate once in Q3 FY19. Moreover, the valuation case for EM equities, in aggregate, does not necessarily reflect cheapness in growth-oriented stocks as the de-rating has been driven by value-heavy sectors.
On a sector-neutral basis, which we define as an equal-weighted average of individual P/E multiples of 10 GICS sectors, EM’s 12-month forward price to earnings discount to developed markets after the recent US sell-off has virtually closed for the first time since January 2013. In this environment, we are tactically overweight EM value relative to growth, and specifically to EM Financials and Energy, as over 75% of the market cap of each of the two sectors is allocated to value investment. We prefer China, Korea and Brazil among the larger EMs, and Indonesia and Peru within the smaller markets.
Do you think EMs’ economic growth will outpace that of developed markets this year?
The sharp slowdown in global trade over the past couple of months has been driven, in part, by softening of domestic demand and, in part, by trade disruption. With the trade tensions showing signs of normalization—at least from suggestions that both the US and China are eager to come to a resolution—it is very likely that the trade-driven softening in EM growth will normalize to some degree in Q2. Moreover, a pick-up in China’s easing on both the monetary and fiscal front should also support the EM growth dynamics in the second half of 2019. Accordingly, we expect EM gross domestic product growth and its spread over DM to bottom out in early Q2 and improve over the course of the year. While this trajectory (of improvement) is the complete opposite of that in 2018, the level of growth (and spread over DM) that is likely to be reached will be in the bottom decile of the past five-year range.
Among EM equities, India was sidelined by foreign investors earlier this year. Why so? Do you see a change in stance post elections?
India has not been sidelined by investors. In fact, since late February, even before the escalation in tensions over Kashmir, portfolio inflows have increased by around $3 billion - which is in contrast to the modest outflows seen in some of the tech-heavy cyclical markets, like Korea and Taiwan, over the same period. The underperformance of the Nifty has primarily been a function of valuations, liquidity and (lack of) expectations around the private capex pick-up. Uncertainty regarding the imminent elections is of concern to investors, but none that we have spoken to expect a fragmented government or complete policy discontinuity. Nonetheless, once the event risk has passed without any disruption, there should be some unwinding of risk premium. However, the quantum of the rebound will largely depend on global growth dynamics, Nifty valuations, RBI’s easing cycle and capex expectations. Our India equity strategist sees earnings growing at 16% in FY20 - much below consensus expectations.
Most economists argue that EM inflation especially in China, India, Brazil, and Russia will remain benign in 2019; what are your expectations on EM central banks interest rate decision this year? What will be the possible impact on liquidity and currency in these markets?
Growth rather than inflation is the problem for EM. Overall, CPI inflation in EM remains in check at a median level of 2.3%; the 17th percentile of its 20-year distribution. At the beginning of 2019, sequential inflation in most countries, and particularly in Asia, was reported below the respective year-on-year figures, suggesting downward room for headline inflation. As such, it is fair to assume that central banks in EMs will attempt opportunistically to support growth - especially if forex weakness and higher energy prices are not adding to the inflationary pressures. We expect the People’s Bank of China (PBoC) to ease the RRR by more than 200 bps this year, and see the RBI’s easing cycle as possibly 75-100 bps deep. While this could reduce the risks to growth (depending on policy transmission), it could pose further challenges for currencies. With the recent deterioration in EM carry, which has fallen to 20th/16th percentile (GBI/MSCI weighted) of its 10-year range or 1.7/4.5% below the January 2016 level, further monetary easing may have repercussions for EM currencies.
What is your outlook on EM currencies for this year? How much will US-China trade war impact?
Twelve months is a long time for currencies - especially in the context of uncertainties surrounding the depth of Chinese stimulus and the rising probability of a US recession. Nonetheless, we believe the window for EM FX appreciation into the year-end remains open. Not because of easing of US-China trade risks - which we think are largely known and priced; but because of an ongoing acceleration in China’s monetary/fiscal easing. Our analysis has shown that stronger global or rest-of-the-world growth vis-à-vis the US tends to be a much stronger driver of the dollar than Fed policy guidance - China stimulus has the potential to prompt a rebound. Not only might this help drive growth in China, but it may also result in a stronger Eurozone growth and a stronger EUR which, in turn, could drive a modest appreciation in EMFX in the latter half of 2019.
What is your outlook on rupee for 2019? What will be the impact on rupee if external EM risks ease further?
The rupee is a countercyclical currency, which tends to do better in an environment of slowing EM growth - especially versus some of the other commodity exporting (high-yielding) EM currencies. However, so far, this year has not adhered to this macro script - mostly due to the election uncertainty and fiscal slippage risks. We estimate that despite the late February-early March rebound, the rupee is pricing about 1.5-2% of election risk premium. If opinion polls suggest a maintenance of the status quo or no policy disruption as the most likely election outcome, then markets may price out risk premia even further in the near term. However, the downside in USDINR is probably very limited because: (1) With USDINR forward implied vols already coming off sharply, the easy INR appreciation may have largely run its course; (2) The impact from MSCI EM re-balancings, which for a basic balance deficit economy is a large hit; (3) A combination of aggressive monetary easing and easier fiscal policy; (4) Our expectations that, as and when, EM sentiment turns around, the RBI will opt to rebuild its FX reserves rather than allow the currency to appreciate significantly. We forecast USDINR at 72 at end-FY20.
As US Federal Reserve has slowed down pace of raising interest rates this year, do you think FIIs will stay in EMs especially India?
A dovish Fed is a necessary but not a sufficient condition for the rebound in EM sentiment. We see portfolio flows into EM in the context of two key drivers - G3 central bank’s policy bias as a push factor, and EM’s own growth dynamics as a pull factor. While the Fed’s balance sheet reduction and exceptionally strong growth in US weighed on EM’s financial conditions and market sentiment, they fail to completely account for worst EM outflows (since the GFC) in 2018. China’s focus on financial de-leveraging and economy’s softening of investment growth has been the largest drag on EM sentiment/global growth. This driver is still weighing on EM sentiment, and may continue to keep portfolio flows soft possibly until Q2 2019. The other seismic force affecting portfolio flows, which has been underway since 2018, is the ongoing liberalization of China’s financial markets which, in turn, is attracting more inflows from the rest of EM - particularly Asia. That is the heavy bill of CNY stabilization (forthcoming MSCI EM re-balancings included) - the cost of which, the rest of the EMFX must pay.