View on India can change significantly if the poll mandate is highly fractured: Mark McFarland
Interview with Global Chief Economist, Coutts
 "View on India can change significantly if the poll mandate is highly fractured: Mark McFarland")
It has been an eventful fortnight for global economies and markets, given the developments in Ukraine and Russia. India is going through a general election to elect a new government. In this backdrop, Mark McFarland, global chief economist at Coutts, one of the world’s oldest banks, now wholly-owned by the Royal Bank of Scotland Group, talks to Puneet Wadhwa on these developments and why they remain overweight on India. Edited excerpts:
How do you see the key global economies shaping in the backdrop of geopolitical developments? Is there a cause for concern?
It is a cause for concern if one looks at Russia. The developments (there) have the potential to disrupt the flow of capital from the developed world to emerging markets (EMs).
A recent report from the International Monetary Fund suggests the Russian economy is in recession. What are the implications for the rest of the world?
Yes, the recession is already there. This will be a problem if Europeans are no longer able to access Russian gas. It will have implications for industrial growth in the second half of calendar year 2014 (CY14).
How do you see the European economy doing, especially Ukraine?
Provided everyone backs off, the European economy is recovering reasonably well. This implies as much to Eastern Europe as to Western Europe. Between Russia, the United States and the European Union, if Russia is antagonised enough to cut supplies to Germany, this will have a material impact on Europe. Nearly half the gas in Europe is supplied by Russia.
What does it mean for oil and gas prices in the short to medium term?
We attach a 55 per cent probability that things will improve with Ukraine. There is a 35 per cent chance of internal conflict in Ukraine and a 10 per cent chance of military intervention by Russia into Ukraine, that has the potential to become a military standoff between NATO and Russia. In that case, oil and gas prices will rise significantly from current levels.
What are your readings for India within the EM, BRIC pack?
Among BRIC (Brazil, Russia, India and China) countries, China is slowing. We see growth in China in the range of 6.75–7.25 per cent. Brazil is likely to experience slow growth of one to two per cent, despite investment in infrastructure ahead of the World Cup and the Olympics. Their export sector will find it difficult to pick up momentum if there is a slowdown in China. Russia is now in a recession.
Given this backdrop, in India, even if one does not get the Narendra Modi-led National Democratic Alliance in power, there is enough evidence that the Indian economy is bottoming out and we are getting closer to the point where growth will start to accelerate and be around 5-5.5 per cent in 2015–16. Our pecking order based on pure economic growth projections would be China, India, Brazil and Russia. However, based on pure preference, it would be India, China, Brazil and Russia.
As regards India, all hopes are high on a pro-reform, pro-business party coming into power post May 16. How are you approaching India now as an investment destination?
We remain overweight on India. We think the banking sector is strong enough to withstand shocks. The industrial sector should pick up, given the global growth, especially cyclicals. This is a good reason to be optimistic about the equity market.
What is the broad view of foreign investors when they look at India now?
Non-resident Indians (NRIs) are very positive about India. NRI businessmen in Asia would like to put more money into India, if there is a strong and a stable government at the Centre led by Narendra Modi.
So, what is the incremental flow that could come in if Modi wins and is able to form a stable government?
It is difficult to put a number to it. However, the overall mood is positive and there is willingness to put in more money into India if that happens.
What if it is a fractured mandate? Would it change your investment strategy significantly, in the light of how economic and business policies play out?
Yes, it could change our strategy significantly. Indian markets are expensive. Investment in India has been very poor. The banks still have reasonably high non-performing assets (NPAs). So, there are some concerns.
How do you see the key global economies shaping in the backdrop of geopolitical developments? Is there a cause for concern?
It is a cause for concern if one looks at Russia. The developments (there) have the potential to disrupt the flow of capital from the developed world to emerging markets (EMs).
A recent report from the International Monetary Fund suggests the Russian economy is in recession. What are the implications for the rest of the world?
Yes, the recession is already there. This will be a problem if Europeans are no longer able to access Russian gas. It will have implications for industrial growth in the second half of calendar year 2014 (CY14).
How do you see the European economy doing, especially Ukraine?
Provided everyone backs off, the European economy is recovering reasonably well. This implies as much to Eastern Europe as to Western Europe. Between Russia, the United States and the European Union, if Russia is antagonised enough to cut supplies to Germany, this will have a material impact on Europe. Nearly half the gas in Europe is supplied by Russia.
What does it mean for oil and gas prices in the short to medium term?
We attach a 55 per cent probability that things will improve with Ukraine. There is a 35 per cent chance of internal conflict in Ukraine and a 10 per cent chance of military intervention by Russia into Ukraine, that has the potential to become a military standoff between NATO and Russia. In that case, oil and gas prices will rise significantly from current levels.
What are your readings for India within the EM, BRIC pack?
Among BRIC (Brazil, Russia, India and China) countries, China is slowing. We see growth in China in the range of 6.75–7.25 per cent. Brazil is likely to experience slow growth of one to two per cent, despite investment in infrastructure ahead of the World Cup and the Olympics. Their export sector will find it difficult to pick up momentum if there is a slowdown in China. Russia is now in a recession.
Given this backdrop, in India, even if one does not get the Narendra Modi-led National Democratic Alliance in power, there is enough evidence that the Indian economy is bottoming out and we are getting closer to the point where growth will start to accelerate and be around 5-5.5 per cent in 2015–16. Our pecking order based on pure economic growth projections would be China, India, Brazil and Russia. However, based on pure preference, it would be India, China, Brazil and Russia.
As regards India, all hopes are high on a pro-reform, pro-business party coming into power post May 16. How are you approaching India now as an investment destination?
We remain overweight on India. We think the banking sector is strong enough to withstand shocks. The industrial sector should pick up, given the global growth, especially cyclicals. This is a good reason to be optimistic about the equity market.
What is the broad view of foreign investors when they look at India now?
Non-resident Indians (NRIs) are very positive about India. NRI businessmen in Asia would like to put more money into India, if there is a strong and a stable government at the Centre led by Narendra Modi.
So, what is the incremental flow that could come in if Modi wins and is able to form a stable government?
It is difficult to put a number to it. However, the overall mood is positive and there is willingness to put in more money into India if that happens.
What if it is a fractured mandate? Would it change your investment strategy significantly, in the light of how economic and business policies play out?
Yes, it could change our strategy significantly. Indian markets are expensive. Investment in India has been very poor. The banks still have reasonably high non-performing assets (NPAs). So, there are some concerns.
... And the reason(s) for lower expectations?
It is difficult to get far reaching reforms in case a coalition government has too many partners. Banking sector NPAs are an issue. There is a lack of investment with supply-side bottlenecks and inflation. These are some of the issues that need to see change.
What is the nature of money that you see coming into India now? Is it more of hot money wanting to play the elections or is it long funds that are hopeful of an economic recovery irrespective of the poll outcome?
A fair amount of this is hot money. However, there is money that has come in from the foreign institutional investors (FIIs), which seems to be for the long duration. Majority of the sellers, off-late, have been retail / domestic players.
What is the best and worst we can see in terms of foreign institutional (FII) flows in calendar year 2014 (CY14) in the light of the election outcome?
A lot of foreign investors have already invested up to their maximum limits in quality companies and stocks. The Sensex's ability to absorb more FII money is now limited to some extent; unless they are willing to make investments in Tier II stocks. So going ahead, the incremental flow of money is likely to flow into the mid-Tier companies and stocks.
Don't you think cyclicals have run up too much?
Yes, they are expensive. But one has to bear in mind that the economic growth rate and the corporate earnings have not accelerated. So, in case the corporate earnings do show an improvement, the valuations will not look expensive.
How do you see the earnings trajectory panning out for India Inc?
We believe earnings growth will improve going ahead. Among the EMs we follow i.e. the MSCI Emerging Markets, India Inc's earnings potential seems to be improving quite quickly. A lot of analysts are now upgrading the earnings estimates for the next 12 months. However, I'd like to caution that when one has optimistic election euphoria, the upgrades are also too optimistic.
Do you think the markets are completely ignoring the likely El-Nino impact? How do you think the Reserve Bank of India (RBI) will react to all this over the next few months?
Governor Rajan is in a difficult space. When inflation is dependant in monsoons, traditional banking methods of reducing inflation don't seem to be effective. He has to try to talk it down rather than strangling the economy. So he needs to communicate effectively with the markets and the consumers regarding this. Raising rates will be his last resort.
How do you see the inflation, bond rates and the rupee's trajectory over the next 6 - 12 months?
We see inflation hover around the same levels. I don't see much change there. As regards interest rates, there can be a 50 basis point (bps) increase over 12 months. In my view, the 10-year bond yield could be around 8.8% by the end of the year.
Which key policies and reform measures do you expect will get priority going ahead? Which sectors would be the most likely beneficiaries?
Assuming Narendra Modi wins and gets a cracking mandate, he could initiate agricultural reforms, initiate reform of land ownership rights, reform of infrastructure procurement, tendering and realty programmes. He could also look at doing away with red tape and closing down unviable businesses. Introducing taxation reforms and cutting down the budgetary deficit should also be on his priority list.
Infrastructure sector should benefit the most from these policies, especially more transparent bidding and tending processes. And I think this is what India needs most.
Will you revise lower your estimates of gross domestic product (GDP) and earnings growth for India Inc if the poll outcome is different from what the opinion polls suggest?
The impact will not be felt immediately but over the next three - four years. It would surely reduce the potential growth rate. I think a lot of the economic policies will have to happen / be implemented and most economists and political parties recognise that.
However, a lot will then depend on how much the mandate is fractured. If it is fractured to a small degree, it wouldn't impact things too much and there can be a slowdown in the reform programme. If it is a highly fractured mandate, the economy will be where it is right now.