India is “definitely an overweight” along with China and Malaysia, said Morgan Stanley's Jonathan Garner, while cautioning against excessive optimism on the equity market. He was speaking to BloombergQuint's Niraj Shah against the sidelines of the Morgan Stanley Annual India Summit.
India has shown great returns and macroeconomic stability but a few pieces of the puzzle are still missing, said the chief Asian and emerging markets equity strategist for the investment banking firm. For one, corporate earnings in India for financial year 2016-17 came as a disappointment, Garner said.
We should get some further performance from India but not as much as the last six months.Jonathan Garner, Chief Asian & Emerging Markets Equity Strategist, Morgan Stanley
Despite the letdown in FY17, Garner expects Indian businesses to deliver “high-teens” earnings growth for the current financial year.
What is the mood like? Were clients falling over each other to buy India?
I think people are already buying India this year. The markets had a good year. It's not unique in emerging markets in having that but it's a good cyclical story to tell here. We think we are on the cusp of, what my colleague Chetan Ahya talks about, the economic firing on all cylinders. So export recovery, consumer moving forward and hopefully even moving towards a private capex cycle.
Last year you guys had an overweight on India somewhere around April-May. But year-to-date India has significantly outperformed a bunch of other markets. Is that not a potential hurdle if we look at India vis-à-vis the rest?
We run a process where we set 27 countries against each other in a range of quantitative factors, and house inputs on the macro side or political risk analysis. If you look at the valuation bucket, the forward PE premium is pretty close to the long-run average level. So normal valuation premium on that metric. However, the dividend yield or payout for India has improved significantly relative to the rest of the emerging markets, which is interesting. Versus some of our underweights, the return on equity has held up much better than places like Australia or South Africa which had a big drop in RoE.
In terms of the earnings though, India's earnings have not come through as strongly as in the case of China. So there are bits of the jigsaw puzzle that must fall into place. Hopefully, actual earnings revisions will pick up with the macro story that I just mentioned and then we should get some further performance from India but not much as the last six months. If you look at the Sensex target - 34,000 and our rupee forecast of 63 to dollar, it stacks up to about high single digit dollar returns. We are coming off about 20 percent YTD.
Morgan Stanley is a lot more optimistic on earnings recovery happening in a big way in FY18, compared to the Street?
Yeah, we are more bullish than consensus on earnings for India. We expect high-teens earning growth for FY18. But actually, that 16.5 forward is a target forward PE. It's where we think our forward PE will be a year from now. If we look at EMs overall, its trading right now, on our earnings numbers at about 12 times forward and at our earnings numbers, India's trading at about 17-17.5.
Aside of India, what other markets do you think present an equal or slightly less than India opportunity and would fund flows be a problem for a country like India? Do you believe there is enough liquidity globally to satisfy the appetite for almost all EMs?
We've had about $35 billion of fund inflows to EM equities YTD. It's a strong year though not the strongest that we've ever seen. Most of that is coming in ETF form. So a good 80 percent of that is in ETFs. So India gets its share of the passive ETF money - it's about a 7 percent weight in that. So it's not the largest market – that's China – and there's also a larger weighting in markets like Korea and Taiwan. So those flows typically have some seasonality. They tend to drop off in the summer and maybe we should be expecting that.
Overall, our view on equities is very strong earnings growth globally this year and allocation out of bonds and into stocks, given our view of a synchronized global expansion.
Coming back again to what I said about the target returns, we're exiting the period when flows are typically strongest and into a more difficult period for the next four-five months. But there's still more to play for.
Does the domestic flow story aid that picture?
Yes, one of our other key overweights China also has that characteristic. Particularly, shifting from Mainland China to Hong Kong. But in India's case, it's all related to much better macro balance. So, inflation is far more under control than in the past, current account is essentially balanced, we've got a much lower fiscal deficit. And so 10-year bond yields have come down to 6.5 or so, they may be have further room to fall and that sets up a very good bond yield-earnings yield story for rotation into equities. So you're right, those domestic flows are a really important reason to be bullish.
One key reason you upgraded upgrading India in 2016 was also the low beta nature of the market. On technical factors like beta, how does India stack up?
India used to be a high beta market. During the taper tantrum of 2013, it was one of a group of countries that were quite vulnerable at that time. The current account was far more of a constraint than it is now. But, over the last 52 weeks, India's become a low beta market. It's beta to the EM index is well below 1. So that's actually quite an attractive characteristic. It's related to the better macro situation.
How vulnerable could the Indian markets to be to a pause in global liquidity?
I talked about the direct form of liquidity in terms of fund flows. But if were to try and look at your question in another way, it would be around the Fed. So the Fed ultimately sets the global discount rate. If we're right, the Fed moves reasonably slowly and the 10-year bond yield in the U.S. is rangebound between 2.2 and 2.4 percent or so. If we're wrong, and the Fed is more aggressive, and the 10-year yield in the U.S. goes up to about 3 percent, that makes the reduction in Indian bond yields difficult. Ultimately, the global cost of capital is something that we're observing, but over the recent months it's been quite advantageous from the perspective that the 10-year bond yield's have been flat to down and that's been associated with the dollar being very rangebond. And that's quite a good environment for emerging markets.
What would positively surprise you? You guys are amongst the most bullish on the Street. Could India surpass your GDP or earnings forecasts?
There is of course a chance. Formally, we do both bear case and bull case scenario analysis. It could happen. But we already have this view that earnings are going to recover quite strongly and they haven't come through yet. So I would caution against getting too optimistic. We are coming out of a very strong period for returns. But we think India is definitely an overweight along with China and Malaysia.
For the last two-three years analysts have entered into a year thinking that we'll get an earnings growth of 15-20 percent. In India's case, we've had to revise it downwards. Why will this year be any different?
Yes, there's some very specific shocks that hit late last year. The demonetisation, the problem around global trade and then the fiscal tightening that was done early on in the Modi administration, that was needed. But we think we're exiting that period now and we're poised for a synchronised recovery across many sectors in India.
Also Read: Valuations Are High But Stocks Are Headed Higher, Ridham Desai To BloombergQuint
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