Like its peers, the Indian equity market too is facing rough weather. But Ridham Desai, Managing Director and Head of India Research, Morgan Stanley, is optimistic about the country’s and the market’s prospects. Edited excerpts of an interview with the market maven:
Many investors would be wanting to buy stocks in the ongoing correction. Which are the themes or the sectors that they can bet on?
I would isolate this into two discussion buckets. For the market, there are three key themes that we are debating. First, India was a strong outperformer in 2015. It ended the year as the third-best-performing market in the emerging world. I think this was a reflection of India’s enhanced macro-stability driven by monetary and fiscal actions and thus India’s beta of correlation with the world has almost halved.
We are now sitting on correlations which are actually at decade lows. In 2007-08, India’s correlation with the emerging market (EM) basket was over 90 per cent. Today, that correlation has dropped into the 50s. Therefore, if other asset classes face challenges, India should actually do quite well on a relative basis.
Our expectation is that if the mean return for equity globally is going to be a low double-digit number in 2016, it is very hard for India to do significantly better than that. We cannot lose sight of the fact that India is now the eighth-largest market in the world.
One of the biggest factors supporting India’s performance is what we call the domestic liquidity super-cycle. We’ve been writing about this for two years now. We think there has been an inflexion point in household savings behaviour towards equities and 2015 has underscored that very nicely. We’ve had record inflows into equity mutual funds. We think this is a continuing theme for the next several years. And that will support the demand for stocks in India. Even though it is quite possible that foreign flows may not be as robust because global markets are challenged. So, that’s the first theme – low-beta market, so India outperforms low-return world. Now, just in case something happens and the world equity markets rally hard, then I think as a consequence, India would under-perform, though, obviously absolute returns in India will improve.
The second theme is that we think there is a turn in the earnings cycle. We expected it to happen in 2015. The reason why that did not happen was because of sluggish global growth, tight fiscal policy and WPI in deflation territory, which hurt earnings. Our macro-models are all pointing towards double-digit growth. And base effect is very favourable. Say, if you go back one year, earnings growth was actually minus 20 per cent. So, we are entering into a favourable base effect. Hence, we have an optimistic view on earnings for the next 12-18 months.
The third thing is we think policy makers will be fairly active in 2016. We expect the government to continue to focus on building infrastructure. They have delivered at 20 odd per cent growth in infrastructure spending this year; that number could accelerate. We could also see some tax reforms — both direct and indirect — finally going through. We also think the RBI will lower interest rates, at least once, before the end of this fiscal and maybe a bit more later on.
So, those are the three themes on which our macro rests.
From a portfolio perspective, revival is likely in rural consumption. In addition to that, urban consumption, which has already started turning, will gain strength. So, overall, we are certainly bullish on consumption, both rural and urban.
The second category of stocks we like are companies that will benefit from high infrastructure spending.
The third is GST plays. Because at some point in time, we think GST will get cleared this year. So, there are a bunch of large companies that will benefit from GST. The fourth is the US dollar. We are bullish on the US dollar. So, companies that benefit from a strong USD are also part of our focus list.
And the last theme is rate-sensitives as rates could fall further from here. So, private sector banks particularly, I think, will continue with their performance. So, these are the five portfolio themes that are there, backed by the three macro themes that I explained.
The rupee is dredging new lows every day. What is your view on the Indian currency?
Among all the currencies in the world, we expect the dollar to be the strongest performer, followed by the yen. In the emerging market basket, our currency strategists are fairly bullish on the rupee. While the rupee may lose ground against the dollar, it likely won’t against the euro or other currencies. They are actually bullish on the rupee. That’s exactly what the rupee did in 2015. It will be a continuation of the 2015 trade, which is that the rupee was one of the best-performing currencies in the world. The headline depreciation against the US dollar was largely due to the dollar rising rather than the rupee falling.
What are your earnings projections for this fiscal and FY17?
We are expecting earnings growth to accelerate over the next four quarters. We think that earnings growth could be in the mid-teens. Of course, there are caveats to that. There is an assumption on global growth and there is an assumption with respect to global commodity prices. Using our assumptions that the world doesn’t slip into recession and China doesn’t suffer a hard landing, I think Indian companies should be able to grow their earnings in about mid-teens for FY17.
Do you think the Sensex right now is rightly priced or is it expensive?
We use a residual income model in order to judge fair value. Based on our model which obviously has assumptions around long-term earnings growth, terminal value and what we think is the expected return on the equity asset class, the Sensex is under-valued.
The return that you should get has to be slightly better than the cost of equity that we have assumed in computing this fair value. In our base case scenario, we assume the cost of equity of about 13.7 per cent. And where the market is right now, on a one-year forward basis, it’s about 4,000 points below fair value.
There is some disconnect between corporate earnings growth and GDP growth. What explains this?
That’s a very good question. The disconnect arises because earnings are measured in nominal terms whereas output for the economy as a whole is a real number. To put it in layman terms, in the last decade when GDP growth was around 7 per cent, average inflation was around 5 or 6 per cent, therefore nominal growth was 12-13 per cent. And that is the factor that influences earnings growth. Earnings growth correlates a lot more with nominal growth than with real growth. Right now, we have a situation where GDP growth is around 6 per cent but the GDP deflator is bordering in the negative territory. So, nominal growth is actually less than 6 per cent, less than the real growth and less than half of what it used to be. Therefore, the earnings growth looks sluggish.
You look at corporate results today — revenue growth is declining year-on-year, margins are expanding because raw material costs are declining and therefore profit growth is actually flat or up 2 per cent or something. If the PPI deflation were to turn around, then what is looking like negative revenue growth today will actually become positive revenue growth, and the profit growth will surge because of operating leverage. So, the disconnect that appears between GDP growth and profit growth is largely to do with the PPI deflation.
What is your view on China? Will there be a hard landing and how long will the adjustment process take?
Our view is that China is more likely to be a Japan-style outcome rather than a hard landing. It will probably struggle for the next few years as it adjusts excess capacity in the system because of over-investment of several years and excess debt. Yes, there is a deflation problem in China which is hurting a lot of economies dependent on it. Demand from China is feeble, which is, in turn, affecting commodity prices as well. And this may be a process that may take time to adjust.
What is your outlook on crude oil? Will it continue to remain subdued or will it take off this year?
That, as you know, is a very hard number to predict. But if oil fell any further, it would not be in India’s interest anymore. Because when oil went from $100 to $40, we gained about, say, $60-70 billion in macro terms. If oil goes from $40 to $20, the gains to us are only about $20 billion. But it could cost us a lot more because you should not forget that we have big inflows from West Asia. A further fall in oil prices may create a squeeze in West Asian spending and job losses there. This will hurt India rather than benefit India. I have always said that the relationship that India has with oil is concave in nature. That is, up to a certain point, India benefits. And after that, if oil falls, actually India starts losing. It would be symptomatic of a global growth problem that can reduce flows into India. I think we are well-placed and protected against a rise in oil prices versus at any point in time in the last 10-12 years because of the adjustments that we have done in the macro. And that I think is why investors globally are rewarding India with better equity market valuation.
There is all this talk about companies borrowing in dollars. Will they suffer as the rates in US go higher?
Yes, but India’s dollar borrowing is unchanged in the last two years. So, we are actually ok. I am not saying that some companies may not have a problem but on a macro basis, we are ok. Other emerging markets don’t have that luxury because they have borrowed a lot more in dollar terms.
After the crisis, global debt has actually gone up perceptibly, led by China. India has not had the same borrowing binge. We’ve had some scattered problems with, say, 50 or 100 companies which obviously has created enough of our issues in the banking sector. On a relative basis, India looks ok. It’s a phrase I’ve used before — that India is a good house in a bad neighbourhood.
One of the reasons for improvement in our current account deficit is that our imports are actually falling sharper than our exports. But isn’t the sharp dip in exports a concern?
Fundamentally, the current account is the gap between the investment rate and the savings rate. When the investment rate is higher than the savings rate, the current account will be in deficit. Because then you will have to import savings from the rest of the world to fund your investment. If the current account balance is lower, it means that the gap is smaller. It can happen either because the investment rate drops or your savings rate rises.
In the last 12 to 18 months, we have had a rise in real rates. And that has been the biggest policy adjustment in India in the last 18 months — highly under-appreciated at large. That is why we have got a savings response from the economy. There was a problem with the saving mix also, with a tilt towards physical savings. Even that behaviour has now started adjusting. You can see that in successive months of fall in gold imports. That’s our biggest policy achievement and that’s why our current account deficit has gone down. Now, what can happen in the next 18-24 months is that our investment rate arguably should rise, and it could probably rise a bit faster than our savings rate. To that extent, there is a possibility that the current account deficit may widen a bit.
But we are in comfort zone. I think a current account deficit of 2 per cent is healthy for India. Because it will boost growth rate by about 50 basis points. We import savings and that helps our growth rate. That’s not such a bad thing. Imports and exports going down are only symptoms of the investment and the savings rate, and not the reason why the current account deficit moves. Now, one caveat here. There has been a big shift in terms of trade, probably the biggest in a whole decade. Because our import prices have fallen very sharply, that has in turn helped us to save more. While real rates are one part of the savings equation, the other part is our import prices have fallen. At the peak in 2012, net commodity imports for India were almost around 11 per cent of GDP, that number is now down to around 6-7 per cent. That 5 per cent swing is the shift in terms of trade. So, the prices of imports have gone down, but to that extent, the prices of exports have also gone down. What you are seeing in terms of exports and imports are again nominal numbers. If you deflate those by the change in price, actually the number is slightly better than the worst in the world. Don’t forget that global trade had collapsed in 2015, so it was not just an India-specific issue. If you look at import-export numbers for any country in the world, everything is down. It is not idiosyncratic to India.
Are you happy with the pace of reforms undertaken so far? What are the reforms that you expect in the future?
I think this government has achieved two big successes. One is the fiscal adjustment which has aided in bringing down inflation and therefore its expectation. Second is the work done on stalled projects. And that I think will have an impact on capital productivity and therefore growth. There are a lot of other things that the government has initiated but most of it is work-in-progress.
Starting with, say, Swachh Bharat, which I think is a very impactful campaign because India has a very large disease burden, amongst the largest in the world. Or, for example, the skilling project that the Prime Minister has started. In order to accrue our demographic dividend, we need healthy and skilled people. I think a lot of these are long-duration, long-gestation projects which will take time to accrue benefits.
Where I think we could have done better is with respect to state-owned (SOE) banks which inherited a very large problem. I see the government’s point of view which is that they are trying to induce a cultural change in the SOE banks. Every time there is a cycle, SOE banks lend a bit recklessly and then they lose capital and then successive governments have used taxpayers money and recapitalised them. This government has taken a slightly more long-term view that we don’t want to recapitalise these banks, we want to force a culture change so that in the next cycle we don’t get a repeat of the previous cycle. I think that’s a very honourable intention and for the long term, that’s an extremely sound approach. But unfortunately, in the short run, it is creating pain in the economy and there could have been another approach.
Another area where they could have hopefully got more success was in getting the GST Bill passed. These are the two things I would have hoped could have happened a bit differently from what has happened so far.