Two Risks That Morgan Stanley’s Ridham Desai Sees For Indian Markets

RIDHAM DESAI: Absolutely. I mean, everybody knows Covid-19 cases are back up and they’ve hit a new high. In some parts of the country, I dare say the medical infrastructure is under strain reminiscent of what we saw last year between June and September. While the case fatality rate has not risen as sharply, it does have a bit of a lag. So, the metric I’m tracking is the seven-day moving average CFR with a 14-day lag, which the underlying assumption is it takes 14 days for an infection to unwrap. It is a simplistic assumption, but that number has gone up by about 50 basis points. So it’s gone from around 0.7% to 1.2%. So, I think there is a threat of course and what we have learned from epidemiologists and biologists is that in some parts there’s a double mutant, like in Maharashtra, it has got the ability to escape the immune system. It has got clear protein spikes and it kind of transmits more easily. So the virus is doing what it always does, which is, its urge to survive and we will have to act against it. So, the risk is that certain parts of the country may go into short-term lockdowns or have to impose restrictions. They have to impose restrictions on activities like Maharashtra has already done a bit of that and then we’ll have to, as they say, “break the chain” to make sure that the new transmission stops. So this essentially is a little bit negative for growth in the short run. If the things get out of control, then there would be some more risk to growth. If it spreads to other parts of the country, then again there is risk.

Now, nothing of what I’m saying isn’t obvious and it’s so hard to forecast this virus. I know there are people making a forecast based on models but as we have seen these models have got limitations, they use the latest trailing data to make some forecasts and maybe they’re not reliable. So the market will react on a day-to-day basis depending on how the virus unfolds. As we can see over the weekend, it’s not been very pretty, the market is reacting to it. Now, keeping this in mind and assuming—this is a very aggressive assumption some may say, but assuming that the virus does not really cause a crisis and the reason for me to believe that it will not cause a crisis is because I think administration is better equipped than last year. We have some medicines available to stem the infection impact, there is a vaccination programme that’s going on which will also temper some of the impact. So, it’s I think fair to say that it may not be as bad as it was last summer, then I think this may just provide an opportunity for medium term investors to buy stocks. So, stocks have been a little bit overdone for a while and we’ve all been hoping that there would be some near-term correction wondering what the trigger would be.

The underlying thing is that the economy is actually entering into a new growth cycle. Policy, in fact will be aided by this, ironically, so we’ve seen the RBI come in and assert its dovish stance surprising the market on the upside, saying we’re here to take care of this and we won’t back off until growth comes back and in fact, we have a new newly designed program to keep the 10-year under check. The government will launch more policies, receive more production-led incentives, that number has now totalled to about $15 billion, which is 50 basis points of GDP. So, it’s a pretty large transfer of public resources to the private sector. So clearly there is impetus on growth. This may provide an opportunity for investors to be engaged.

RIDHAM DESAI: That actually depends on other cumulative factors. So, if other things start happening around this then of course the correction can get deeper. I’ll quickly remind viewers that bull markets can have 20% corrections, and in the 2003-2007 cycle, which was the last really big bull market we saw we had a couple of corrections that went as steep as 25%. 25% is a lot and markets can correct that much. It’s hard to actually make that call at the moment, because if it’s only the virus that is the new stroll, then I think this will get bought into more quickly. As I said before, we are better equipped than we were in the last year to handle this.

I think administrations understand that we can do some big fixes like what we’re seeing in Mumbai right now. Now of course these may be early days and maybe famous last words but the restriction on activities that were imposed last week, seems to be now causing kind of a flattening of the curve. It’s still too early to judge that but maybe another week of this and the spread starts stemming. There is more evidence emerging that the biggest reason for this spread is human contact and to the extent that we can remind people of masks and of social distancing which I think people kind of forgot in February, because everything had quietened down and there’s obviously a pent-up urge to interact, then again we should be okay. In the meanwhile, hopefully the vaccination programme which by the way is now accelerating quite fast, reaches a new level in the next month or so. So, these are the reasons why Covid on its own may not be enough but if a few other things happened around this, if there’s another wave of inflation threat, if the western hemisphere goes through another Covid wave etc., if a few other things happen around this, then obviously the correction could get deeper. Remember the SPX is still at all-time highs, and if anything, it is still being built. That’s the backdrop under which we can’t really correct that much but if the SPX will start falling for their reasons, then of course, there will be a deeper correction. So, for those who want to trade in this market I think they need to keep all these things in mind, making these short-term forecasts is beyond my competence, actually.

RIDHAM DESAI: While the focus is a lot on the Nifty, I think what may happen is underneath, we will get a lot of rotation, like we’ve got over the past couple of months during which Nifty has really not made much headway but underneath, we’ve got a lot of rotation and a lot of stuff that was underperforming earlier like the so-called factor stocks and cyclicals which did very well. Maybe some of that actually gives up now, and people in the interim, shift towards more defensive stocks, like you can see on the screen today. Underneath the Nifty you could get a little bit more bigger shifts than what the Nifty may suggest.

RIDHAM DESAI: The global market is not one homogeneous place. Europe is doing its own thing; the U.S. is on a different track and emerging markets are on a different one. So, let’s talk only about the U.S. I can’t make the comment across the globe. The U.S., in our view is undergoing a lot of rotation. The U.S. is slightly opening up and I think what the market is telling us, and this is the opinion of my U.S. strategist Mike Wilson, what the market is saying is that it may not be as smooth as we all wanted it to be, the opening up of the economy. It may cause a bit more heartburn and therefore there is a distinct shift away from small caps to large caps and back into the so-called quality stocks which Mike has already done in the news recommended portfolio three weeks ago in anticipation to how the market will trade ahead of opening up.

So, the U.S. has got a slight lead over the rest of the world because it seems to have put its Covid peak behind with its vaccination program achieving some momentum and now it’s heading into opening up. During this phase, he calls it the mid cycle phase, we actually go back to quality, away from cyclicals and we go back to large caps away from small caps. So, I think that’s the nature of advice he provides to his investors. It’s not like that the market is peaking out and all hell is breaking loose and we’re entering into a bear market and a sell off. I think the underlying cover that might keep saying is I’m a committed bull, but within the context of a committed bull market, there are lots of things happening in the market, especially for those who have a shorter-term horizon, and they need to create those opportunities as they come along. So, we are in that mix of once a time opportunity in the U.S.

So, what could upset this, and clearly what could upset this is that if the threat of inflation emerges and the market starts believing that the Fed is falling behind the curve and we discussed this in our previous interaction as well, remains I think the biggest overarching risk to this bull market that we are in the midst of. If that doesn’t happen then I think we should probably be okay but if that happens then I think there’ll be greater disruption and will flow to India as well. Now, on the India front, there are two things that we need to know. First is we have an RBI that’s very committed at the long end. So, despite all the supply of paper that the government is going to put into the market, due to its higher fiscal deficit, the 10-year is very well behaved. The Indian 10-year bond has outperformed the U.S. bond even while the yields in the U.S. have gone up, which is quite unusual. Usually, the Indian bond yields tend to rise faster when the yields are rising in the rest of the U.S. The second is that we have an event which is the potential inclusion of India into bond indices globally. So, if that happens, it is billions of dollars of inflow and if you notice in the bond market over the past few weeks, there has been a turn in sentiment from foreign investors and they’ve been buying bonds, not last week, of course, but prior to that and it could be some positioning ahead of this event. Now these are technical factors that are favouring the 10-year in India. So, the yield disruption in India has not been felt at all, but absolutely if inflation risks emerge, then that is I think one thing that could disrupt the U.S. bull market and then reverberate into the rest of the world.

RIDHAM DESAI: Internally, I think we need the growth cycle back and if the growth cycle comes back faster, then of course the RBI will step up to it because I think it seems like the RBI is very committed to the growth cycle. I don’t expect sustained inflation pressures when growth is weak. The other thing is of course what happens externally. If you get a big rise in commodity prices, then of course this will change the RBI’s view. That supply-side inflation would be a big risk, which is what we just discussed, and it will obviously cause a dent into India’s growth story, because then you will have to lift interest rates even while growth is not at potential and depress the growth rate in order to counter the rise in supply side inflation. So, these are the obvious things that may hamper the RBI. For now, they are not things that are in play and so the RBI is willing to say I’m committed to get growth back and I’m committed to keep the 10-year in check.

RIDHAM DESAI: See, top-down, it has less of an impact because some sectors face raw material cost increases and there are other sectors that benefit from that. So, the big picture kind of neutralises and the margin compression is not as much but at the individual sector level, there could be a temporary margin disruption. Companies are still gaining from higher demand and higher operating leverage but have to overcome the cost push. Ultimately, as the cycle progresses, companies gain pricing power and we call that inflation and that’s what basically causes the rates to go up and ultimately for growth to slow so that’s how the typical cycle happens. We’re still very early days in this and therefore, I think there will be a few inter sector margin impact that may come through and some of it may already be priced in, I think the market is forward looking and may have already detected this say, in the auto sector and it will fade away after a while. But again it goes back to our conversation a few moments ago which is the biggest risk is that this sustains and the market globally starts believing that we are in for a cost push inflation arising from stronger than expected demands which means, the Fed has fallen behind the curve. Then, of course, P/E multiples fall, and things get harrowing for equity investors.

RIDHAM DESAI: I have to admit because this was a poor call that I had made, tech companies, I should say first have done significantly better than what I thought and they seem to be continuing to deliver performance. There seems to be a structural undertone to their earnings progression. The call that I have in my head is one that is relative, which is that if India’s growth cycle is coming back, then the steady growth that tech companies are likely to deliver will underperform the cyclical uplift that will happen to earnings through domestic sectors. So, we’re still hanging in with that call and we want to be in Covid domestic sectors versus tech because the relative earnings growth will favour domestic sectors. The risk factor is that domestic growth does not come back for all the reasons that we have already discussed, and then of course tech stocks continue to perform well. You can see that when the market is going through a sharper correction, technology outperforms, and this is exactly the reason because the relative growth shifts in favour of tech companies but I have to say that the tech companies have done very well and they seem to be set for a better medium term growth outlook than what seemed to be the case two or three years ago.

RIDHAM DESAI: Absolutely. One of the conversations that we’ve been having with institutional investors over the past few months is the lack of new listings in India, new business model listings in India that India has really not had any new business model listed—the type of stuff that we saw in China say 10 years ago. But investors don’t appreciate that India is more than 10 years behind China and is at 1/6 the per capita GDP of China. So, China is at a different level and then that per capita GDP has got newer business models that emerge. Nevertheless, India has also actually done quite well in this regard and there is a big pipeline of such listings that are happening. Hopefully in India some of them will probably be listed in the U.S., but they will be India related businesses that are listing with private equity investors looking for an exit in some cases and in other cases where these companies are trying to raise capital for their next work path. So, it does look very exciting.

I have to say that if I quote Nandan Nilekani, India’s internet sector has progressed a little differently from the U.S. and from China because of the Aadhar superstructure. We have a transaction-based internet economy, where I think internet companies are going to be able to realise earnings very differently from what we’ve said. Now, if I make a sweeping statement for example, the U.S. e-commerce businesses or tech companies are largely advertising models, whereas in India I think they are largely transaction oriented. So, it looks very interesting. There are some very exciting businesses out there which hopefully get listed and will give more choices to investors over the course of the next few months.

RIDHAM DESAI: DXY is the indicator which tells us what the world is thinking about inflation and interest rates. So, the DXY remains a very important metric for people to track and if it is appreciating that’s not good news if it’s depreciating it’s good news for India. India tends to do very well when the DXY is depreciating. I’m not going to go into all the mechanics, but the simple thing is, it allows room for policymakers at home to drive a domestic policy, we’re not then anchored to what happens globally and therefore we have greater flexibility in choices we make. For example, if the DXY is depreciating, the RBI can comfortably keep rates low and drive for higher growth.

RIDHAM DESAI: I don’t have very strong thoughts around that and it’s not a strong view that we hold globally either way. It is premised on the U.S. growth cycle and the inflation outlook in America. So, come 2022, I think things will get trickier because inflation will be a little bit of a bigger problem and then I think this may feed into a bit on the U.S. dollar. I think during the current calendar year, we should be fine. On your question on oil, as I’ve said in the past, oil matters to India, when it is rising relative to copper prices. The reason I say this is because it should be a supply driven event in oil for India to suffer in macro terms. Oil and copper both go up when global demand is strong, both bring intrinsic commodities for the industrial economies of the world. But if oil is also facing additional supply side pressures, then it will tend to outperform copper. For India’s BOP or for India’s macro stability, what matters then is, when oil and copper are both going up, India is also receiving very strong inflows where the BOP actually tends to be in a good shape as we are seeing right now. So, oil is not outperforming copper and therefore rising oil prices is not automatically bad for India. That’s the framework to follow. That’s how we judge the impact of oil on both, the stock markets as well as macro stability.

RIDHAM DESAI: India remains at the low end of its historical range. Essentially what markets are saying on a relative basis, India’s unlikely to go back to its premium return on equity that it earned over the past 20 years. The template is going to be more like the last five-seven years when the ROE gap has been contracting. It has gone down to about 200 basis points, that is India’s ROE minus EM ROE. It used to be 500. Now if it goes back to 500 then India should regain some of its valuation premium that it has lost over the last five-seven years. I dare say that the ROE premium will rise in the coming months. I think India’s growth cycle seems in a better place than the EM world and therefore India’s relative valuation to EMs should also rise. So, India may have put a trough on relative performance versus EMs back in April last year. Since then, it has tended to outperform more than underperform but it’s not a straight line up. There’s still a lot of doubt out there about India’s ability to deliver a sustained rising ROE and only the coming months will show that. Just quickly on valuations, while we are on that point, it’s not also rosy when you look at absolute valuations. These metrics have risen considerably over the past 12 months and clearly the market is a forward-looking animal. So, it is anticipating better growth and it goes back all the way to the starting point of our conversation, that if there is something out there happens to challenge that growth view, then some of these valuation metrics will have to undergo a steeper than a tactical correction. So, keep a watch on that because as you very rightly said, we’re no longer at 1.9x book as we were in the spring of last year. We’re more in the three and a half region and the tolerance to a negative growth shock will not be as good as it was then. Now, not that we’re expecting a big negative growth shock but we have to keep that in mind.

RIDHAM DESAI: So, we’re not assuming in our estimates that there will be a one month or a two-month lockdown. If we get into a situation where five large states have to go through a one-month lockdown, then there will be a little bit of a trimming of estimates that will happen. So, it has to be a bit extending and it has to be a little bit more widespread. Maharashtra doing a two-week lockdown may not have such a big impact because what will take place is that yes of course there will be a little bit basis points of growth that goes away immediately after the lockdown is opened up, then the pent-up demand comes right back as we have seen from last year.

There’s very little permanent loss of demand that happens except for certain services which you can’t regain. So, some sectors will suffer but it won’t have a top-down impact on the economy. However, if it starts spreading and then in a few more states, especially the larger ones with a bigger economic activity, start seeing that impact and need to then lockdown to break the chain, then I think we’ll probably have to re-evaluate. We’ve not done that as yet because we’re not expecting that. I don’t mean the market also is expecting that. So, then the market also going back to your point, will have to actually go through a slightly more extended correction.