We expect markets to consolidate gains in Sept quarter: Lewis, Gupta

India has been among the best-performing markets globally in 2017, say Geoff Lewis, Rana B Gupta

Hong Kong-based Geoff Lewis, senior strategist for Asia at Manulife Asset Management, and Rana B Gupta, its managing director for India equities, tell Puneet Wadhwa the risk to a global equities rally could come from central banks in major economies turning hawkish. Edited excerpts:

The US Fed chair sounded dovish in its latest testimony to the Congress. How many rate hikes do you expect over the next one year?

LEWIS: Last month, the US Federal Reserve raised its policy target rate by 25 basis points and provided more details on how it intends to gradually wind down the large, post-QE balance sheet. Markets are now looking for an announcement on implementation in September.  One more rate hike is from the US Fed is expected this year. The balance of probabilities has shifted from September to December, as most observers believe the Fed will not wish to begin balance sheet reduction and hike interest rates at the same meeting.  At her Humphrey-Hawkins testimony to Congress in July, Chairwoman Janet Yellen soothed market fears by acknowledging the recent dip in inflation as a factor to be taken into consideration in the Fed's future policy deliberations. Until then, the Fed had argued the recent drop in inflation as being mainly due to one-off factors and thus something they could 'look through.' 

We do not think Janet Yellen's testimony signals a big concession to inflation doves, however.  From recent speeches and FOMC minutes, senior Fed officials clearly feel a need for on-going policy normalization, given they have a "normal" economy.  It is now difficult to justify Fed funds below the rate of inflation rate (ie negative real short rates) since the economy is close to full employment.  

Future rate hikes will nevertheless remain gradual. We think the Fed will find it difficult to implement all three rate hikes in 2018 implied by the June FOMC economic forecasts. For one thing, the Trump administration has been unable to deliver on its promise of pro-growth policy stimulus in 2017, with no obvious progress after six months on tax reform, infrastructure spending, or de-regulation. The US is likely to remain a '2+2' economy in 2018 (i.e. 2% trend GDP growth and 2% core inflation).  We therefore expect one, at most two, 25bp increases in the Fed funds rate in 2018. 

India has been the best performing equity market across the globe thus far in calendar year 2017 (CY17). Do you expect this outperformance to continue in the second half of CY 17 as well?

LEWIS: India's equity market returns (NIFTY50 in USD terms) have been solid for H1 CY2017 and it is one of the better performing markets, globally. We note that among Emerging Markets, Mexico in the Americas, Greece and Poland in Emerging Europe, and South Korea in Asia have given higher returns for H1 CY2017.  Common factors among these markets were strength in their financials and materials sectors. With respect to South Korea, technology shares also made a significant contribution. 

Looking forward to the second half, we expect Indian markets to consolidate their gains in Q3 CY2017.  Markets need to digest the impact of several transformational laws now taking effect, notably the GST (Goods and Services Tax) and RERA (Real Estate Regulatory Act). Our sense is that there has been significant de-stocking before the new laws took effect, and re-stocking is taking some time. However, we expect activity to revive in Q4 CY2017, led by lean inventories and better festive season demand. A benign base in Q4 will also help comparisons. 

How concerned are you about the valuations at this stage? What are the key risks (domestic and global) to the rally?

GUPTA: As on 30th June 2017, Indian equities (NIFTY50) were trading on a 16.7x PE ratio, based on FY2019 earnings. Whilst this is 10% above the long term median valuation of the market, we have often seen the market sustaining higher-than-median valuations in periods when earning growth exceeded 15%. We are expecting market earnings growth in the mid-teens (CAGR for FY17 - FY19E).  Should that come through, then earnings multiples could be sustained. 

Since better earnings expectations are a key driver for Indian equities, one needs to be careful of the trajectory. We remain confident over the medium to longer term positive outlook for earnings growth in India, led by game-changing reforms to formalise the economy. The latter should build on efficiency, improve revenue collection and in turn investments by the government. In the short term, however, there could be some transient volatility as key transformative laws may take time to have effect.  

Risk to the global equities rally could come from central banks in major economies like the US, UK and Eurozone turning hawkish. If financial conditions tighten globally, there could well be some impact on EM equities. The actual impact will depend on a particular EM country's balance sheet strength. On that count, India looks better placed than most, with high real rates, Forex reserves and a moderating fiscal deficit. That said, the recent spike in India's trade deficit, led by gold and precious stones, needs to be monitored carefully in this context. We expect it to normalise as the spike could have been driven by buyers accumulating gold and precious stones before GST implementation. 

What do you expect from the government in its remaining tenure? Do you see populist measures take centre stage with 2019 general elections in mind? How are the markets likely to react to this?

GUPTA: We have not seen any major populist measure from Central Government. On the other hand, we have been encouraged to see the Modi Administration sticking to its timeline for GST implementation. We are also increasingly confident that this government will push ahead with its disinvestment plans. These are important pragmatic steps. These efforts will give the government additional spending power for priority areas like infrastructure and rural development, but not at the cost of larger fiscal deficits. 

Apart from spending on infrastructure, rural developments and major initiatives like the GST, India's Central Government has also undertaken several other measures such as the Jan Dhan Yojna (JDY), digitalisation and PM Awas Yojna (PMAY), which are focused on realising some of the huge potential at bottom of pyramid. We expect further deepening and broadening of such measures creating substantial opportunity for equity investors. 

Although we have seen some populist measures at State Government level, we understand that they have been asked to fund them within their budget while keeping to the deficit targets. While it may have some short term impact on State Government driven capex, it should not impact the consolidated fiscal deficit.

Will the developed markets score over the emerging markets in terms of allocation by foreign institutional investors as we go ahead in CY17? What about India?

LEWIS: In a still broadly encouraging macro environment, FIIs in 2017 are continuing to put more of their cash to work, with broadly comparable amounts YTD flowing into global bond funds and global equity funds (according to EPFR data), while money market funds have witnessed outflows.  Flows into EM – both debt and equity – have been strong YTD before tapering off as mid-year approached. India has attracted its fair share – net buying of USD8.3bn to mid-July, versus inflows of USD10.3bn for Korea, USD9.0bn for Taiwan and around USD4.0bn for ASEAN.  

The volume of portfolio inflows to India in 2017 does not look excessive to us when set against historical trends. FIIs also appreciate that the Indian stock market has returned to favour with domestic mutual fund investors, providing further underpinning to the market. 

We have seen in 1H how good the global synchronised upswing/weak US dollar combination is for Emerging Markets.  These favourable market conditions are expected to continue in the second half of the year and into 2018, though after such strong first half returns markets may pause and consolidate.  Unlike in 2016, EM equities can no longer be thought of as a contrarian trade. That said, the case for increasing exposure remains a strong one, particularly buying into any near term correction. Most gauges of international risk appetite are not at extreme levels, but are more consistent with a cautious approach to risk taking. 

In China, the Renminbi (both onshore and offshore) has appreciated YoY, which this could prove an important pivot factor for Emerging Market equities overall.  Following Moody’s downgrade of China's sovereign rating, Beijing realised the need to control expectations of RMB weakness in the FX market. They have done a good job in turning sentiment around, while the increased emphasis on financial deleveraging at the Financial Work Conference last weekend will provide further support for the Renminbi. 

In our view, the most important financial events in the Emerging Market space recently were the inclusion of China’s A-shares by MSCI their key indices on 20 June and the introduction of the “Bond Connect” scheme in early July.  We believe MSCI's decision has major implications for China’s equity markets, their place in the international financial system, and the way global equity money is managed over the medium to long term. The move should also raise the country's profile with global investors, and encourage domestic markets to meet international standards.  

The Bond Connect Scheme underscores Beijing’s wish to give the RMB bond markets a much bigger role and to reduce China's overdependence on bank lending as a source of finance.  We do not view these developments as in any sense a zero-sum game for EM.  China opening up and encouraging much greater FII participation in her domestic markets will draw attention to the EM asset class and the strong investment opportunities that it offers. 

What is your current exposure (value terms) to Indian equities, and are you looking to hike / trim this over the next 12 months?

GUPTA: We are overweight on Indian equities. We are optimistic on the formalisation theme, which will make businesses more efficient. We also think formalisation will drive the Government's revenue collection, which, in turn will be invested in infrastructure and rural development. Besides this, the various steps being taken on financial inclusion, housing etc should also create large opportunity for investors. 

Formalisation and the crackdown on cash is also bringing more of India's household savings in to formal channels like bank deposits, insurance and mutual funds. Lower inflation translating into higher real rates is also encouraging more financial savings.  This is at a time when Government borrowing is growing at a moderate pace. All this put together means more savings are becoming available for productive investment at a cheaper rate. 

These are powerful themes, and we believe we are at the beginning of this journey. We also need to highlight risks to our thesis. In the short term, there could be some disruption as some of these transformational changes begin to take effect. Such transient volatility should be seen as opportunities for investors with a medium to long term view.  Implementation at ground level and key macro indicators such as inflation and the current account and fiscal deficits will need to be monitored. The situation on both these counts remains comfortable as of now. 

Which sectors and stocks are you overweight and underweight on in the Indian context? Any contrarian bets?

GUPTA: We are bullish on the growth in household financial savings, which should keep interest rates lower for longer. Key beneficiaries will be mid-sized private banks, as they are likely to experience a bigger drop in the cost of funds. Also on the lending side, substantial opportunity has opened up in the retail and SME segments as large SOE banks are struggling due to legacy NPL issues. We also like Indian wealth management and insurance companies which have a strong franchise. They will also be a direct beneficiary of rising savings.  

We like the formalisation theme. Our stance is not necessarily contrarian, but is much more nuanced. The consensus view is that the organised sector will gain market share over the unorganised or informal sector. We think that's only partly true. In businesses with low entry barriers, informal businesses will in the near future move to formalise, improve their products or services and give more competition to incumbents e.g. electrical goods, diagnostics etc. 

On the other hand, where entry barriers are higher (e.g. more capital intensive) or where the informal segment has thrived on access to cash, or where it was too fragmented - there we do think the organised sector will gain market share e.g. jewellery, building chemicals, plastics and real estate. 

We are underweight on health care and information technology among export-oriented sectors. Among domestic sectors, we are UW on utilities and telecom. 

Have you revised FY18 and FY19 earnings estimates for India Inc post goods and services tax (GST) bill implementation?

GUPTA: As highlighted earlier there are some short-term disruptions due to the implementation of GST. While the channels had de-stocked ahead of GST, re-stocking is currently running behind expectations. This can lead to some earning downgrade for F18. However, we expect normalisation in earnings from September onwards, and have not made any significant changes to our F19 earnings forecasts. In all likelihood, F19 could be a good year for earnings, as it will reflect the positive fundamental changes that are taking place now.