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Why Morgan Stanley Thinks India Won’t Feel The Emerging Market Pain

Morgan Stanley remains bullish on India even as it sees developing economies on the cusp of a bear market.

A cyclical pick-up in the business cycle coupled with rising earnings expectations drives the optimism of the brokerage, which maintains its ‘Overweight’ rating on India.

“India is at a very different stage of the business cycle compared to its peers in Asia,” Jonathan Garner, Morgan Stanley’s Asia emerging market equity strategist, told BloombergQuint in an interview. He recommends consumer discretionary and capital goods stocks.

Tough Days Ahead For Emerging Markets

The MSCI EM Index is, however, on the cusp of a bear market, he said. Morgan Stanley revised its price target on the index, projecting another 8 percent downside.

“We expect the strength in the U.S. dollar to continue,” Garner said. “It’s this strength that will keep fund flows away from Emerging Markets for quite some time.”

Garner expects domestic fund flows to keep the Indian market afloat even as foreign fund outflows continue from emerging markets.

RBI Rate Hikes Helped Rupee

Garner praised the Reserve Bank of India for ‘preemptively’ hiking interest rates at a time when the global economy, except the U.S., is witnessing a slowdown.

Calling the two successive rate hikes a “wise move”, Garner said the path adopted by India’s central bank is preventing further weakness in the local currency. “Had they not hiked rates the way they did, the rupee would have seen further weakness,” he said.

While he doesn’t expect U.S. Federal Reserve Chair Jerome Powell to say anything substantial at the Jackson Hole symposium this week, Garner does anticipate two more rate hikes from the Fed in 2018—in September and December.

Watch the full interview here:

Edited transcripts of the interview

Why do you think that the MSCI emerging market rally that we have seen for the last two years is going to end and we will be giving it all back?

Garner: If we look at the rally it peaked out as long ago as the end of January and MSCI EM index is down around 20 percent from peak. So, it is on the cusp of entering a bear market. Our new target price indicates that it will correct and fall another 8 percent by June of next year. So, that would make a peak to trough move of almost 30 percent.

We saw something larger than that as recently as 2015-16, and we saw something again, around a 35 percent decline in 2011. So, if you look at what caused those prior bear markets, we think we see something similar today. We see a significant slowdown in global economy outside the US, particularly in China and North Asia. We see a decline in commodity prices, most notably copper which always correlates with EM on the downside. We are coming off very high valuations, so at the end of January we were trading almost 14 times forward PE for EM which is 95th percentile of the long run range. So, we have negative macro catalysts in market which was quite overvalued. If we are right, earnings estimates are going to need to come down. They have already started to fall but have materially further to fall. Though this has been a bear trend since the end of January, it is only around certain months old and are little short of thinking that this will come to an end anytime soon.

In Asia EM, if you look at 12-month price to earnings, India seems to be expensive and stretched out at this point. But that doesn’t seem to be stopping the rally that we are seeing in markets. Do you see that as a problem?

Garner: We are overweight on India. We are underweight on a market like Korea which has underperformed India substantially. The key point of India is that it is in a very different stage as compared to the business cycle from particularly markets in North Asia.

So, India had an extremely weak economic environment through demonetisation, GST reforms, fiscal tightening. Now, you are getting a cyclical pick up and that is allowing market’s earnings profile to move forward whereas earnings expectations are coming down in other markets, particularly the more trade and global economic sensitive markets and sectors like autos and tech hardware across Asia. We are not seeing that in India. So, we are able to recommend to clients the consumer discretionary and capital goods stocks in India which were are not recommending in broader region. India is not that exposed to global trade. It is somewhat exposed to oil and some of the developments going on in sovereign risks elsewhere in asset class. We have had a couple of rate hikes in India. But our overall judgement is that India is a sufficiently strong macro and micro story now to justify an overweightness as it has outperformed.

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From a foreign fund flow point of view, EM and EM Asia basket as a whole has been seeing thin flows over the recent past and not too much of money and equity allocation coming this way. Do you see that changing anytime soon?

Garner: We track weekly all flows to and from emerging equity markets and recently we have had some large outflows totalling over $20 billion in the last three months or so. However, prior to that we had a period of very strong near euphoric inflows that ended at the end of January when the market peaked. Only around 20 percent of the money that came in last year and in first month of this year has left as of now, and our judgement is both from the equity and the debt side its likely that the recent trend outflows continues and that’s one of the reasons we think that we have further downside in the markets here.

What you think of the triggers could be which could see some of this money coming back into this basket? In India, while we have been creating record highs in indexes, the allocations are very thin, and we have been doing it at the back of what is happening domestically. So, are the domestic cues supporting these moves?

Garner: Yes, indeed and it is good that India has domestic flows engine to support the market here. Typically, flows to EMs are strong when the dollar is weak. But this year the dollar has been strengthening against most currencies and that is one overarching issue. Then we have the part of Fed tightening. The Fed is tightening at a time when economic conditions in many EM countries will indicate that they should be cutting rates. But what we are actually getting is a handful of countries are able to do move their rates lower. For example, China is in the slowing economy but some of like Indonesia are highlighting has done four rate hikes this year. India has done couple of preemptive hikes but it hasn’t been able to derail its economic recovery story. So, I think the interplay between the dollar, the Fed, the earnings cycle where the commodity prices are and where the underlying trajectory of growth is outside the U.S. They are the kind of things that typically drive the cycles of emerging equities.

How far do you see the strengthening in the dollar continuing? What’s the outlook for emerging markets, be that weaker economic data points coming out from China, pressure on emerging market currencies. What’s the outlook there and where do you see that reversal coming in as dollar strength seems to be unabated?

Garner: My base case is that the dollar will continue to strengthen from here against the EM currencies. It may weaken somewhat against the Yen in risk aversion trade but we don’t have enough real interest rate cushion for countries who are running significant current account deficit, or large amount of fixed debt coming due to withstand these adjustments which we are going through. We are a seeing an adjustment, a crises similar to the taper tantrum phase and even has that case of 97-98.

One of the things that may turn this around is growth from China itself. China is easing but it is not obvious that easing will gain traction. In particular I would like to highlight that the consumer confidence is falling in China from a 20-year high. And so, the consumer service economy which has been the big engine of recent growth in China has not performing as well as it was previously. Certainly, not well as last year. So, we tend to think it’s going to be a tough environment for quite a while longer and that’s why we took our target price down on Friday and as I said we have seen an 8 percent downside to June 2019 target, that’s quite material.

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We have got $34 billion worth of tariff duties imposed. $16 billion slated to go off on Aug. 23. There are talks of another $500 billion worth of goods and tariffs on that which is 10 percent tariffs. What are the implications of it? Do you see major collateral damage across emerging markets?

Garner: We have been writing about this all year and it is a key risk factor. If you look at what is on the table now, is U.S. is going through a public consultation process of about an additional $200 billion. President depending on the process will make his decision in early September. If it does go through, then it will increase the amount of Chinese goods which are subject to tariffs from $50 billion to $250 billion and it could be almost half of the Chinese exports to the US.

A lot of these exports are coming from U.S. multinationals. So, this consultation process is throwing up a lot of issues from U.S. multinationals sourcing from China. But it’s probably the case that this is on the current trajectory likely to happen and in terms of modelling the impact on global growth and Chinese growth, it is not overwhelming, but it will knock about 0.4 percentage points of base case China growth numbers. When you look at broader impact by sector then it is IT and autos which challenged in any case by cyclical forces in terms of weak end use demands which will be most impacted. So, that the two sectors that we are lot more cautious on in late last year and cyclical sectors which we don’t want to own in a falling market as well.

Going by the report and the scenarios of trade war and the escalation that happens and the incremental impact on global growth, growth on China. Can you highlight those numbers and give us the different scenarios on how it could impact global growth?

Garner: There is status quo scenario where we stop at the $50 billion and that would have a very marginal impact. The one that I just gave you is moving forward on $200 billion and some areas which will also be impacted including auto and tariffs. Then we have worked through two additional more negative scenarios where we begin to get all countries putting tariff restrictions on each other. Some of those scenarios, particularly the most extreme ones are sufficient to cause a material slowdown in global growth pretty well everywhere next year and that’s obviously the most adverse scenario.

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There is a meeting which will happen in Washington on trade. Do you think they will find a common ground? What is the expectation?

Garner: I think that’s a relatively junior level meeting and I don’t think it will lead to any likely significant outcome. I suspect we are moving towards more heightened trade tensions, particularly in relation to the action which we just talked about in early September. I think this is an attempt to restart talks but the senior level talks broke down 4-5 months ago and I don’t think this will lead to any breakthrough.

You mention commodities and especially copper which has entered in bear market. We are seeing commodity market putting sentimental pressure across emerging markets. What do you read into this?

Garner: Copper price correlates very well with consumption and investment spending within economies worldwide. That is why it is known as metal with the PhD, Dr Copper. It is always correlated very well with emerging equities and performance. We highlighted as long as last November that it was likely peaking out. It’s been falling all year but in last two weeks it has fallen at a faster rate. That does suggest one of the key points that we have been making about slowdown and growth outside US is absolutely validated with what we have been seeing in commodity markets. So again, we would be very cautious on growth outside the US. When we look at what copper is doing and also the market with the PhD, Korea that is full of mid cycle cyclicals which is also doing very poorly.

Coming to what has been happening in Turkey and the pressure on the Lira causing a pressure on other emerging market currencies. For us here in India, we hit a record low for the rupee versus the dollar and we have our own other internal pressures as well. How are you reading these macro data points or the setbacks for India?

Garner: If you look at the Turkish situation, it is not a unique situation. It does have very high inflation compared to other countries but other countries share the issue of current account deficit and they also share the issue of relatively limited reserve coverage of external debt coming due. Turkey is the most significant but we pointed out that about 6 percent of market cap in EM has less than one year reserve coverage of external debt coming due and about 30 percent in less than 2 years due which includes India. It doesn’t mean that we are looking at any outright crises situation, but I do think the RBI in India was very wise to do these preemptive rate hikes because even with those preemptive rate hikes, we have actually seen the rupee weakening. If the RBI had not done those rate hikes, then the rupee would have weakened even more.

We have got the Jackson Hole symposium now. What do you expect to hear from the Fed Chief?

Garner: I don’t think we will hear anything of any great significance. It would be nice to hear about how they are thinking about trade discussions but I think the Fed thinking on that is quite at an early stage. I doubt very much that we are going to hear anything particularly market moving. My base case is that the Fed does hikes two times this year in September and December meetings.