We are cautious on EMs in the short term: Geoffrey Dennis

Interview with Head of global emerging markets strategy, UBS Securities

The possibility of a rate increase in September by the US Federal Reserve sent the global equity markets into a tailspin last week. Geoffrey Dennis, head of global emerging markets strategy at UBS Securities, tells Puneet Wadhwa he maintains an overweight rating on India, it being the best growth story among emerging markets. Edited excerpts:

What is your interpretation of the statements from the US Fed?  

In our view, the markets were previously pricing in a Fed hike for September but weaker-than-expected early data for August has now pushed the expectations out to December for the next rate move. UBS view has always been December. There is more chance of a further market pause into the US Fed hike than a big sell-off afterwards. We expect two more hikes in 2017.

How are you viewing emerging markets (EMs), including India?

We are cautious about EMs for the short term on US rate fears and high valuations but we are mildly bullish long-term, given: i) improving profitability (higher return on equity or ROE);

ii) light investor positioning; and

iii) attractive valuations versus developed markets (DMs).

We are overweight India within our global EM portfolio; we see India as the best growth story in EMs and, yet, it is much more defensive now than previously, given a lower current account deficit and more prudent monetary policy. India should outperform in any near-term pullback in EMs.

Where do you see the Nifty by March?

Our Indian strategists’ extant year-end forecast on the Nifty is 7,700, with an upside target of 8,600, based on earnings improvements and a policy-induced boost to Indian growth.

What are the likely triggers for a rally from here? What could play spoilsport?

Triggers for a further rally include:

i) benevolent global liquidity environment remains in place; ii) Indian earnings per share (EPS) growth surprises to the upside; iii) gross domestic product  growth surprises to the upside; iv) further progress on structural reforms.

An overt shift of monetary policy to a more inflationary stance (pro-growth) under the new Reserve Bank chief; ii) major global bond sell-off; iii) Dollar rally/fall in the rupee; iv) sharp rebound in oil prices; v) major earnings disappointments in India are the factors that can trigger a correction.

How do the Indian markets’ valuations seem at this stage?

The Indian market is expensive but has been for some time; it trades at 18.2 times forward earnings versus a long-term average of 14.6 times, from recent data, assuming a 15 per cent per annum EPS growth in dollars in 2016-17. However, India trades in line with its recent average at a P/BV (price to book value) of 3.2 times but with average ROEs that are below their historical averages (14.4 per cent versus 17.8 per cent). India is also expensive versus EMs, which trade at 12.5 times forward (India premium of 46 per cent) and 1.54 times BV (India premium of 108 per cent), although the ROE premium (14.4 per cent versus EM at 10.4 per cent) is 38 per cent.

What is your outlook for interest rates and the rupee?

UBS expects interest (repo) rates in India to fall by 25 basis points (bps) to 6.25 per cent by the end of 2016, and then stay at that level in 2017. We expect the rupee to fall to 68.5 by end-2016 to the dollar, and to 74 levels at end-2017.

How are FIIs viewing the India story?

India is still viewed as a 'darling' equity market by EM equity investors. We believe it is a consensus overweight for them, as it has been for several years, although we think the size of this overweight in India might have fallen in the past 18 months.

What more would you like to see from the government in terms of reforms and policy initiatives?

Investors mainly want to see more structural reforms (especially land reform) and more infrastructure spending, a pick-up in economic growth, more progress in restructuring of banks' balance sheets, more broad-based and consistent SOE (state-owned enterprises) reform, and ongoing prudent monetary policy.

Which sectors are you currently overweight and underweight on in the Indian context?

Our overweights include automobile parts/ancillaries, coal, media, oil & gas/ petrochemicals, retail private banks, non-banking financial companies and telecom. We are neutral on automobiles (four-wheelers), consumer discretionary/staples, materials, power utilities, real estate and state-owned banks. Our underweights include automobiles (two-wheelers), corporate private banks, infrastructure & capital goods, information technology services, the small and mid-cap segments.

By when do you see a meaningful recovery in India Inc’s capex cycle?

After slowing from 4.9% growth in FY14, UBS expects real investment growth to pick up from 3.9% (in FY16) to 5.5% in (FY17) and 7% (FY18). This would be the highest growth rate of capex since FY12. Investment growth will likely stay moderate until the balance sheet repair process is more advanced. There are still headwinds such as non-performing loans, possible foreign borrowing difficulties, and profits recession. More time for balance sheet repair is probably needed but the authorities' focus in this area will help. Overall, we expect rising capacity utilisation on lower capex levels to lift returns on capital – this is bullish for the stock market.