CLSA’s Adrian Mowat Sees Stock-Specific, Cyclical Opportunities In India
WATCH | Chief Strategist Adrian Mowat On Why CLSA Is Underweight On India
The economic growth indicators flashed red and earnings estimates were revised downwards in the last few quarters. But market veteran Adrian Mowat expects recovery in select cyclical sectors.
“We have been seeing some of the auto stocks recovering from very low price levels. There’s a chance of positive revisions coming out of the cement sector as well,” Mowat, chief strategist at CLSA, said. “As interest rates have moved lower, we should see a pickup in demand for housing. Hopefully, that helps clear some of the housing inventory and then leads to new construction activity. The government has been very effective at building infrastructure and that will continue. So, I think there are some cyclical opportunities, but they are very selective.”
Mowat also thinks that the Indian market is certainly not overvalued. India may look highly valued by price-to-earnings, but the market is trading closer to averages compared with other parameters like earnings yield versus bond yields, he said.
To be sure, the Nifty 50 Index has run up 10 percent this year and traded at 21 times its 12-month forward price-to-earnings ratio compared to 22.1 times the five-year average.
The Challenge And The Catalyst
Trade tensions are an issue, according to Mowat. “There are incentives for companies to move manufacturing capacity from China. However, moving to India is not an obvious destination because unfortunately, trade tensions in India and the U.S. also exist,” Mowat said. “We are seeing probably a preference for places like Vietnam.”
India is also losing out to its Asean peers, he said, adding within the Asean regions, Taiwan, Korea and even China would give better returns relative to India, at least until the first half of next year.
But what would encourage investors to come back in India, according to Mowat, would be positive economic surprises. India already cut corporate tax rates, which Mowat said brought India on a par with other countries and helped the nation move up the lead table in the ease of doing business. A boost to rural household income and urban job creation would be additional catalysts, he said.
Watch | Adrian Mowat on why CLSA is underweight on India
Here are the edited excerpts from the interview...
A decade-long bull run for the U.S. equity markets, it doesn’t look like investors believe that there is a setback in this extremely liquid environment that we are in. Even though there are fears of a recession, what’s your take on the sentiment and why do you think that this equity market rally has sustained so long?
I actually think that investors are quite pessimistic about the outlook, but they feel trapped in country-owned bonds because bond yields are so low. Particularly in Europe where they are negative. So, they have a need to make a return for their savers whether it be pensioners or owners of insurance products etc. So, the end up owning equities because the earnings yield looks attractive related to bond yields. So, think of them as hostages as opposed to someone who is making an aggressive positive view on capital markets. They are really trapped in this as an asset class. So, the S&P has moved up to a new record high. It’s now about 5 or 6 percent above its high in January last year so it has been quite a slow climb out of the debts of the December 2018 woes. So, don’t interpret the S&P at an all-time high as investors being optimistic. They are concerned about macro-economic data as they should be. Look at the ISM data for the U.S., particularly the official manufacturing data still below 50. Yes, we have a little bit of a bounce in the non-manufacturing numbers. The U.S. consumption data is quite weak. The PC numbers are something like plus 0.2 percent—so very weak first off what you’d expect with a strong labour market. If we look at indices outside the U.S., the Developed World Ex-U.S. is still about 10 percent below its January 2018 highs and emerging markets are some 18 percent below the January 2018 highs. So, yes, there’s a bull market in the U.S. but I think it’s a bull market generated by QE and central bank activity forcing investors into equities as the only acceptable one. The acronym is TINA- there is no alternative.
So, most asset classes are trading above their intrinsic value. Would you say that markets somewhat are at the brink of being in a bubble or it’s just a very advanced stage of a bull run that we are in and that still probably has a headroom to go?
I am not sure if I would concur with the view that we are above intrinsic value. One can look at value in different ways; you can get value versus history. The problem with that is, you don’t have a time machine. You cannot go back and buy an equity four or five years ago, wish you could, it would be very profitable. But what you can do is say how does this asset class compare with my other opportunities? And you keep on coming back to the conclusion that equities are quite good value, in some cases very good value versus bonds. If you look at it in the Indian context, we are about average when you look at earnings yield versus bond yields. So, I certainly wouldn’t conclude that the market is overvalued related to other assets that I can buy today. Certainly, it might be a PE that is higher than we’ve had in history.
In light of that, how do we talk about the overall environment when you have the possibility of a recession and you have negative interest yields. How does one put all these things into perspective and take an investment call?
So, we are using the R word- Recession. If we reflect back to what were recessions in the 70s and 80s, it would be a central bank deciding that the inflation was too high, or the output gap was too narrow. They would reduce demand by pushing up the interest rates. We certainly are in that type of an environment and typically, when the central bank did that, they would force demand to go down. Just as companies were about to open their new factories that they optimistically invested in at the top of the cycle. So, I don’t have inflation, I don’t have a corporate sector overinvesting. If anything, then we are frustrated that they are not investing more. So, is it a recession similar to what we saw in 2000 and then in 2008, when an asset bubble burst? No, it’s not. What it looks like to me is that if the U.S. does slip into a recession which is Erik Fishwick, he is our chief economist. It is going to be very much like we saw in Germany this year where you slip into a technical recession and then you slip out again. And there is very low growth environment. When we start to look at details in terms of earnings, there are quite a number of sectors in the U.S. where earnings contracted in 2019. So, we are already reflecting that in the valuations, in the PEs. So, as I look at next year, I am not particularly anxious as an equity investor about this recession because I don’t think it’s going to be that damaging to the earnings yield. Earnings growth in the U.S. this year is basically flat. Next year, the consensus forecasts about 9 percent. I think that’s a bit high, but I bet that you would get the earnings growth next year.
We just had a word with Mahesh earlier and he spoke about how the optimism is around the fact that the government is listening, they are taking proactive measures. They reduced the corporate tax which reflected in the second quarter results of most of the companies and the bottom lines shot up. But that doesn’t inherently address the question of the weak demand scenario, the weak top line growth that we are seeing. So, how can one probably take a call and say, I want to put my money in India at about 17 or 18 times even though I am not seeing much growth.
I think It’s back to what the opportunities for the domestic investor are. So, the domestic investor is generally being rewarded by buying from the equity markets. They are doing it in a very consistent way, and you can see it through the inflows into SIPs. Our forecast is that interest rates will be falling globally including in India. You typically get a pick-up in demand in the mutual funds as fixed deposit rates fall. So, I think the cash flow dynamics are for the equity market where (the question is) will you get net demand (and will it) look quite good just based upon the domestic investor?When I step back and look at the Indian situation versus some opportunities that I have got elsewhere, what we are seeing in North Asia is some very high-growth story and some positive earnings revisions. If they are coming through in a semi-conductor space, which is a very large part of the benchmark in Korea and Taiwan. That’s really driven by the tech story. So, we have got a big earnings growth in the tech demi-cycle turns. Earnings revisions are positive, I think valuations are attractive. So that’s where I think you are going to see the leading performance in emerging markets. Then, if we look at China, there are some very high growth sectors in China like e-commerce. So, e-commerce and the consumer discretionary sector of China is 7.9 percent of the total emerging market benchmark; that’s almost the same weighting as India- as a whole country. So, these are the opportunities, and this is where are advising clients to be overweight if we want them to outperform the emerging market indices. Then, we are funding that with India and in the ASEAN region. I think you’d be making money in the ASEAN region but in the first half of 2020, I think you’ll make more money in North Asia.
Let’s talk about the underweight in India. We’ve seen the Moody’s change its outlook as well. Moody’s has probably brought it at par with what the other rating agencies have done. But your reasoning with the underweight in India and how long can this continue?
So, my reasoning is, I can make more money elsewhere. People often understand that overweight and underweight is a proxy for buy or sell or a statement that if you are underweight, the market’s going down. I am advising investors in emerging markets or Asia Pacific extra pan benchmark on how to outperform their benchmark. So, where do I get the higher return and as I look at it, we are getting a higher return in North Asia. Now, it’s quite possible that it often happens in stock markets is that the discounting is very rapid. So, Korea and Taiwan outperform considerably over the next quarter, then we may be reviewing the situation thinking about relative returns for the balance of the year. So, that could result in money flowing back into India without any changes in the underlying fundamental dynamics of India. Now, what would encourage investors to come back here would be positive economic surprises. So, evidence that the corporate tax cuts led to a pickup in business investment. I think that would be a very positive sign. If the government can do a little bit more to boost household real income, particularly in the rural sector, we’ve had very low increases in the minimum support price. So yes, there the agricultural sector has become more efficient, output in terms of volumes of agricultural products has gone up but the pricing effect that they used to enjoy is much more modest. We can see in the anecdotal data that rural demand is weak. The other area where we need to think about is urban job creation. India doesn’t have particularly robust statistics around employment and consumption. So, we are reliant on anecdotes. So unfortunately, a big employer which is the auto industry and the auto and the auto ancillaries, according to the automobile association of India, five million contract workers, or about 10 percent of them, have lost their jobs this year. So, we would like to see a turnaround in manufacturing and employment. See an increase in the service sector employment so you can see a boost in real urban household income. Remember India is a consumption economy. It is not an export economy; it is not a manufacture economy. So, you always need to go back to what’s happening at the household level because that will determine your growth rate through consumption.
The government has given a boost to set up manufacturing units in India with a tax rate of 17 odd percent and that’s not a bad deal. Have you seen India making up most of it? Making its place in the global manufacturing supply chain?
So, the overall corporate tax rates brings India in line with the other countries which is great. There’s no point in being competitively disadvantaged. India has the benefit over a huge domestic economy. Quite often, the most competitive exporters are those that say that 10 or 20 percent of their production and the balance is for the domestic market, they have these big economies at scale. So, India continues to offer that attraction for global investors. I think bringing down the tax rate, moving India up the lead table in the ease of doing business. These are all reforms that are going to have a good, long-term, beneficial effect. In short term—the issue for business investment comes back to your question about the weak demand environment. So why would I build a factory? First thing is, there has to be a demand for that product. If there is demand for that product and the tax rate has come down, then my financial threshold will be lower, right? But ultimately, I must have the end demand. At the moment, I’m struggling to think there’ll be industries in which there is a lack of capacity where business investment and manufacturing investment makes sense at this point. The other issue that we need to think about here is, the trade tensions. So, clearly there are incentives for companies to move manufacturing capacity from China to get around the issues with trade disputes in China and the U.S. However, moving to India is not an obvious destination because unfortunately, trade tensions in India and the U.S. also exist. So, I think it’s not a clear decision point, if anything, we are seeing probably a preference for places like Vietnam.
The earnings growth has been slow. We’ve been seeing the earnings estimate coming down from 25 percent to low teens. Now settling down somewhere post the corporate tax cuts to 17 or 18 odd percent. What’s your sense in earnings for India in particular and do they justify the valuations?
I definitely think there are risks to these earnings numbers coming down. But it’s important that we now talk about the stock market to understand that the composition of the stock market has a big bias towards financials; particularly the private sector financials. To some extent, well-run private sector financials effectively benefit from the problems in the financial system. They can grow their share of the pie because the PSU banks don’t have sufficient capital, maybe don’t have the risk-taking appetite that you really need to run a financial business. The issues with the NBFCs also play in favour of the better-run NBFCs whether they are in housing finance or just broad NBFCs.
So, I think you can have quite good earnings growth, but it’s really a stock story rather a broad story.
The question is, are we going to see good earnings growth in the cyclical sectors after such an awful year for quarters globally; maybe you get a better recovery. We have been seeing some of the auto stocks recovering from very low-price levels. There is a chance of positive revisions coming out of the cement sector. As interest rates have moved lower, we should see a pickup in demand for housing. Hopefully, that helps clear some of the housing inventory and then leads to new construction activity. The government in here has been very effective at building infrastructure and that will continue. So, I think there are some cyclical opportunities, but they are very selective.
So, during the budget announcement there was a whole talk of a push for infrastructure and capex from the government. But now, that comes into question with the dole out of the corporate tax concession that they have given and the fiscal strain that is going to be put on them. So, they don’t have that much headroom to go with a big-ticket capital expenditure. Is that what will be a big deal of a set back?
I think they’ll still go ahead, and they’ll take a view that they’ll be willing to earn a bigger fiscal deficit. The thesis behind a corporate tax cut is that yes, initially you’ve got lots of revenue, but that reform ultimately gives you a higher potential GDP growth and that higher potential GDP growth then replenishes the coffers of the ministry of finance.
There was this excitement at the time of the election verdict and the anticipation was that the same government has come with a stronger mandate. They won with a better margin than last time, but it didn’t result in a lot of money coming our way and that was the initial feel that we got but it didn’t transit much. If anything, post the surcharge being announced, a lot of money went out, started to come back and slowly. Do you see foreigners really being interested in India?
So, we need to first look at this from the perspective of global mutual fund flows. So, we’ve seen outflows from actively managed developed funds as well as emerging market funds. A lot of mutual funds are run passively versus benchmarks. So, India is seeing outflows as the rest of the emerging markets. So, let’s have that as a context. I think that’s probably been a more important driver than necessarily the local conditions in India. I’ve been looking at India for many decades and have spent an ordinate amount of time and usually wasted money around getting tax advice in India. India is the only emerging market that charges capital gains tax on wholesale investors. So, wholesale investors are mutual funds and insurance companies. Their end-investors pay tax. So India, for some reason, wants to give itself a competitive big disadvantage and the shock around the budget announcement on the capital gains tax does have an impact on people’s medium-term confidence on making a capital decision in India. So, my advice on this is that we need a clear statement that wholesale investors will not pay capital gains tax. You can charge them, as many countries do, withholding tax on dividends. But India does need to wake up to it being an exception with this. I think clearing that would be a very useful thing to do. Remember, at some point, the Indian savings pool will have some international diversification. They don’t want to be at a tax disadvantage when that is happening.
We spoke to Mahesh as well and the last thing he said that will do well is real estate. What else do you feel one can look at from an overweight standpoint within India, with many sectors?
I just shared a slide of my presentation looking at how consistent stocks appear in the top 10 of the Nifty over the last 11 years and to some extent, India remains a run your winner’s story. So, you remain in your key private sector banks, private sector NBFCs that are doing well. That is the story and it’s a portfolio that doesn’t change. They have compounded a pretty decent growth rate and yes, they look expensive but, in a world, where growth is in a chronic short supply, a consistent growth company deserves a premium.