CLSA’s Adrian Mowat Sees A ‘Pretty Decent’ 2020 For Emerging Markets
“We have an environment where investors are long on equities due to need rather than due to greed,” CLSA’s Adrian Mowat says.
Investors are settling for equities due to the “need and fear” environment even as markets trade at premium valuations in India and the U.S. That’s according to Adrian Mowat, chief strategist at CLSA.
“Investors require a higher return as the one that is available in fixed income products is too low to meet one’s liabilities,” Mowat told BloombergQuint in an interview. “So we have an environment where investors are long on equities due to need rather than due to greed.”
Emerging markets are expected to outperform the developed markets with 15 percent returns in earnings for 2020, Mowat said. “We see upside risks coming out of tech and financial stocks.”
“Emerging markets in the last decade was a significant underperformer as it grew only 3.6 percent in terms of earnings versus 8 percent for developed markets,” Mowat said. “I’m expecting a good inflow into emerging markets’ equities, which will be about repositioning after substantial period of underperformance. It’s going to be a pretty decent 2020 for emerging markets."
Gold As An Alternative Investment Strategy?
Gold, according to Mowat, doesn’t have any particular feature in 2020 that proves to be a defensive investment over equities. “You are better off sticking to where you can forecast cash flows and it is much easier from equity than a bar of bullion,” he said.
That comes when gold as a commodity ended with 18.8 percent higher in 2019—its highest yearly returns since 2010. The precious metal’s fortunes in 2019 were shaped both by more accommodative monetary policies from central banks globally as well as the ebb and flow of the U.S.-China trade war.
Watch| CLSA’s Adrian Mowat on FDI norms for India’s mining sector
Edited excerpts from the conversation:
Devina: I’m going to just start off first by getting your view on how do you expect 2020 as a year to be for equities and how supportive an environment do you think we are in? Some believe that excess money has chased equities in the U.S. markets and emerging markets without any change in fundamentals and that’s a very risky bet. What’s your take?
Adrian Mowat: I think 2020 would be a very good year for emerging markets. Still an up year for developed markets including the U.S. equity markets. We’ve been spending a lot of time looking at the earnings forecast in both developed and emerging markets. So, the forecast for this year for developed markets is around 9 percent EPS growth and for emerging markets, around 15 percent. When we look at the developed market numbers, we see perhaps a risk in industrials. But generally, the numbers look reasonably robust.
It is important when you look at equity markets to understand what the main stocks in those markets are and what really drives them. Overtime, since the global financial crisis, we’ve evolved into having equity markets with a bias towards secular growth rather than cyclical stocks. So, you think about some of the big names in the U.S. whether in the internet space, the tech space, e-commerce etc. These are really important things rather than your old industrial stocks that perhaps a few decades ago, you would focus on. We’ve got the U.S. economy slowing a bit into 2020 which is just 1 percent GDP growth. Even with those numbers, I think we will see earnings growth in U.S. equities. Valuations are high, we are just under 19 times forward on the S&P, that is a two-decade high. Not the quite 24 we got in the late 1990s and first quarter of 2000.
The context of that high valuation is a stock market with a bias towards secular growth. Much more importantly, is an environment of what we define is need and fear. Investors require a return. If you have a pension fund, an insurance product, the return that’s available in a fixed income market is too low to meet your liabilities. Equity is looking inexpensive versus fixed income. So, to have an environment where investors are long on equities due to need rather than greed.
When we move to the emerging market story in the last decade in 2010-19, it was a significant underperformer compared to the developed market. That was all about earnings growth. Developed market EPS growth compounded in 8 percent in the last decade. It was only 3.6 percent compounded EPS growth from emerging markets. So, it’s hardly surprising that it has underperformed. It is hardly surprising that weighting towards emerging market is very low. Looking forward, the number for 15 percent EPS growth in 2020 for EM, I think is reasonably robust with upside risk coming out of tech and financials. I am expecting a good inflows in the emerging market equities which would be about repositioning after a substantial period of underperformance. So, it is going to be, in my view, a pretty decent 2020.
What gives at this point? We been in more than a decade-long bull run. Money is coming in cheap and easy. Monetary and fiscal have also come in which has also led to the equity market rally. Do you feel at any point that you want to see growth starting to bottom out particularly with countries like India?
Mowat: I dispute the hypothesis around the central banks easing growth in balance sheet is a whole story for the move in equity markets. The compounded EPS growth rate for over a decade been over 8 percent for developed markets. That is the prime reason that they have gone up. The U.S. earnings per share performance have outperformed. So, this is a story of, yes, a little bit of the PE re-rating, which has probably got much to do with where interest rates are, and interest rates are low because growth is low and inflation pressures are low. So the question is, can this continue? Well, the trend is in place. I don’t see an inflection point that causes the trend to deviate around as of now.
Aside from that, the tricky spot that we are in right now is with regards to the geo-political risk. Do you feel that continues to remain an overhang for equities? Or the markets have digested that and it is put on the side for the time being?
Mowat: So, the phrase ‘geo-political’ risks will cover a lot of events. To me, the dominant risk to economies and earnings has been the trade dispute.
There are no winners in a trade dispute. The anxiety around the market with the U.S.-China trade relations, economic relations started to build dramatically in May 2018. We had three rounds of tariff increases. A policy was being pursued that makes investors nervous. The Phase 1 trade deal is a very significant inflection point in my opinion.Adrian Mowat
It means that trade as a dominant policy for the equity market fades. I think the risk premium that’s built in the last 18 months is probably underappreciated.
So, I am quite optimistic about the policy and geopolitical impact on equity markets in 2020. The events that happened in Iraq with regards to assassination of the Islamic Revolutionary Guard Corps. chief just reminded us again that the world is awash with oil and that the oil price barely reacts to events that if they had happened 15 years ago, would have got a very big move in the oil price.
It’s a rather sad thing to say but unfortunately, we’ve had instability in the Middle East for a protracted period of time. Other events going on there, humanitarianly awful events. They don’t seem to be having an impact on the global economy and I think this is why, the events in Iraq/Iran have faded quite quickly from market concerns.Adrian Mowat
On the back of that, the idea is to have prudent risk-management and asset-allocation strategies. Do you feel that it’s time to look at some amount of asset allocation in gold which has also done well and even with treasuries for that matter?
Adrian Mowat: No, I don’t see a compelling argument to switch out of equities which are delivering earnings growth into an asset which we dig out of the ground and put back underground as Mr Buffet often refers to. I don’t think it has any particular features in 2020, that it proves to be a defensive, diversifying asset. You’re better off sticking where you can forecast cash flows and I can show you, it’s much easier to work out cash flows from an equity than it is from a bar of bullion.
The last time that we spoke in November, you guys were underweighted on India. North Asia was the pocket to be. You said that it’s not that if you are underweight, you are selling the country, or you are selling Indian equities. It’s just that you are making better returns elsewhere. Is that something you are still going to see in 2020, because there are no meaningful strains of change right now?
Mowat: Yes. That’s the strategy we had in place since October and India has significantly lagged in this rally. Despite the fact that Nifty is close to all-time highs. This just emphasises on why I was so bullish on EMs as an asset class. I think you can make good money out of Indian equities as you can of Asian equities.
It’s just that I am going to make more money at the moment out of North Asian equities. It is driven by e-commerce, technology of consumer discretionary in Korea and these are the places where earnings growth is high, and we have got positive earnings revisions. The Indian equity market continues to offer some really high growth investment stories. The economic backdrop is cyclically weaker than what most people have hoped for. These high quality stocks, particularly in the financial sector, continue to be at the crossroads despite a cyclically weak environment.
Specifically, with regards to growth we spoke about the 5 percent GDP. Inflation has started to move higher and there are some murmurs and chatter on whether or not we could see a period of stagflation. Do you see that as an imminent threat?
Stagflation is quite provocative. I think the danger in using that phrase is people will extrapolate it. The effects that we think is most likely here is that the big move vegetable prices are a short-term, a temporary reflection on production of the crop availability etc. as opposed a structural story that you going to have high vegetable prices.Adrian Mowat
Mowat: Short term, what that means is that Indian households will have less money to spend on other purchases as more money goes into paying for the groceries. I think this will add to a further concern about demand for discretionary products- whether they will be of high or low value.
So, let's just recognise that this is a short-term impact on the growth in discretionary income as opposed to using words like stagflation. Stagflation to really be appropriately used, you will need to see pricing power across the industrial groups. You are not pricing power, you are simply seeing an impact on higher food prices, particularly vegetable prices.
So, lets come down to the fact that consumption is still an issue. We have not seen a spur in consumption activity for some time now. Now, this aspect, be it temporary in nature is still going to take away from the spending power into other discretionaries as well. Do you feel that consumption will continue to lag for some more time before some active measures are taken by the government?
Mowat: I think the overriding issue has been relatively weak house income growth. So, if we look at the minimum support prices of the rural sector, those have been going up much slowly than they have in the past. The policy has been put in place that a particular margin given to the farmers. Yes, we are going to higher agricultural prices at the moment, but I think the beneficiaries of that in the rural area would be quite limited. If we look at the urban household, because the demand has been weaker than expected, a business investment is weaker and there is less job creation.
Household urban income growth is also weak. So, the answer, the challenge to the governments and policymakers is how do you boost that? At the moment, I really don’t see any near-term policy. I would also just remind everyone that when you think about policy in India around the election cycle, the current administration has a very strong mandate. They won a significant majority in the Lok Sabha and this stage of administration, the more likely it is to be focused on longer-term reform policy as opposed to short-term cyclical boost which typically in a democracy, occur closer to the next election.
Any measures that the Government in their own scope can take to make sure that they help lift this growth number from 5 percent and get it back to the earlier days where you probably saw some 7 or 8 percent growth.
Mowat: It comes back to how do you actually achieve that. If that is achieved through reform that reduces the cost of operating a business, makes productivity higher, if it is ensuring that a talented and well-educated labour force is available, it’s very easy to get FDI in. Then I think that will be welcomed. If it is predominantly fiscal, then investors will have more of a medium-term concern about fiscal stability.
Finally, if we look at the monetary dynamics, there would be two things I would look out there. Inflation has moved higher, so that has reduced the Reserve Bank’s flexibility. India continues to run a current account deficit. So, there is a funding requirement that limits how much interest rates can go down by. Then, we’ve got a practical plumbing issue which is post the events we had in the non-banking finance companies which effectively got a credit crunch in place and what the policy makers would be better off doing, is really focusing on improving the plumbing. Helping out some these issues in the non-banking finance companies, making sure that the major banks have sufficient capital so that, they can fill the gap.
Then ultimately, Indian industries start to benefit from lower interest rates and Indian savers aren’t being penalised too much because there is a slight inequality in terms of other banks that they are willing to save at. So, it’s not an easy story for the government here. I don't think international investors are looking for the easy fix. I think they will be happy if they see an ongoing reform. They continue to pay reasonably high valuations directions for Indian equity market and there are a host of high-quality stocks that still sit as core positions my clients’ portfolios.
What about the fact that they are opening up new industries and inviting FDIs into certain sectors? They have opened up the coal mining industry and are making some changes to the act as well. You’ve got reduced tax incentives as well for setting up of manufacturing units that we spoke about a few months ago. Are these factors enough?
Mowat: All of this helps in terms of opening up industries that can create jobs and thereby, create demand to capital globally rather than restricting it to Indian capital. I think in the manufacturing sector, that’s going to be fine. Coal mining, I don’t think so. There is a story that’s very significant in terms of people’s concern about the environment. Most of my European clients have moved to an ESG benchmark. There is also an important economic story here. Producing electricity with thermal coal, is more expensive than producing electricity using renewables.
If we look at the dynamics of this, 70 percent of the world’s coal is burnt in Asia. India and China dominate that. Building new thermal coal plants is probably a bad investment decision. What I think you might find is, yes, you may open up sectors like coal, but you are not going to find international capital moving into that.Adrian Mowat
We are currently in an environment where you are watching these wildfires in Australia, a major coal-exporting country and it is really a good wake up call to the environmental damage that is going on. But I think, when you combine the ESG story, with an economic story which is a very clear one, this is an area that investors are not going to be interested in.
If you were to make an investment in India, what are the sectors that you would be looking at?
Mowat: The biggest sector in the market, which is financials, and which is dominated by high quality private banks I think will continue to outperform. We do like a cement and cement fits in with what we expect to see—some recovery in housing construction which for a long period of time is trying to deal with excess inventory. The sector positioning is quite narrow. So high quality private banks, insurance we think are going to be outperformers. So, in my regional portfolio, I am neutral on those and underweight on the balance sectors in the market.