Adrian Mowat on why CLSA is underweight on India within EMs


India will underperform next year and my advice is that the initial outperformance in the EM is going to be led by North Asia and that is where I want to allocate capital, says Adrian Mowat, Chief Strategist, CLSA. Excerpts from an interview with ETNOW.

What is the sentiment like at the CLSA Annual Investor Conference?
We have had clients going around India before the forum looking at different industries. Particular focus may be on the financial sector. There was quite a bit of concern about how the problems in the NBFCs are causing a lack of credit in the Indian economy and you can see that coming through may be an auto sales, two wheeler sales.

Which has started rebounding. Near the festive season we have started seeing the green shoots and the turnaround.
That is a very early data point and certainly, the anecdotal evidence that people were being given was that credit availability is an issue. It is an issue for consumer goods, industrial goods and farmers as well. There is a concern about the economic outlook and so the mood is quite downbeat around what would be happening to earnings.

Earnings remain a sticky point. Corporate India does not want to increase its capex despite the corporate tax rate cut bonanza. Are investors cognisant of government action or do they think it is not good enough?
Investors certainly appreciate that the government is looking at the issues and is making decisions. It is terrific that India has brought its corporate tax rate down to 25% which makes it on par with most other countries that we look at. There is no point in disadvantaging Indian industry with a higher corporate tax rate.

If you make a business investment, the first thing you need to do is be confident about demand. That is why you would expand your factory and a lot of businesses we were talking to, are operating below full capacity at this point so they do not really have a need to invest in new plants or machinery. Ultimately, what we got in India is not so much a business investment issue, we have a demand issue and this is a consumption driven economy. We need to be looking at what is happening at the household level — whether that is in rural India or urban India.

When we talk about India and Bharat — urban and rural India — what you are telling me are domestic issues. I have not even gone into extraneous like the trade war or the Brexit. Are those going to make it worse or is that an opportunity?
I do not think the trade war or Brexit are an issue for the Indian economy. Brexit specifically may be an issue for businesses that have exposure to the United Kingdom but I do not think that is an issue that is driving the Indian economy.

When we look at trade war, it definitely will hit China and North Asia where the economies are more open, more exposed. When you look at the city state of Hong Kong and Singapore where trade is a big part of their economy, their GDP numbers are contracting because of the trade war. It is not a big issue for India. In many ways, it is a relative advantage.

Yes, in that investors have been hiding out in India and Indonesia because they view these are high growth thematic markets. They are willing to pay high PE multiples because these economies are growing stronger than they are seeing elsewhere. The problem is they are not growing as fast as we thought they were going to grow. Both India and Indonesia were sitting in this camp where investors are paid a high multiple for high growth and the GDP numbers that are coming out, the earnings numbers are coming out are well below expectations.

So they are not buying this entire argument that has put out that India is still one of the fastest growing economies, but it cannot be isolated as world growth is coming down. They are not buying any of that?
Well they bought it and then the growth rates are lower than they expected. I think there is a degree of disappointment.

This is an expectation problem.
India is still is growing relatively fast versus other economies. Global growth is particularly weak at the moment but it is perhaps not growing as strongly as the forecast had been three months ago or six months ago and certainly not 12 months.

We look at it from that perspective and with global growth still being under pressure, would it be too much to expect India to remain the darling?
Well, let us step back a minute. Emerging markets are certainly not the darling. Emerging markets have consistently underperformed for a decade now. India has performed bang in line with the emerging markets indices over the last 10 years. You have made 2.5 times the returns in the United States than you have in emerging markets over the last 10 years! This is a big issue.

India is still is growing relatively fast versus other economies. Global growth is particularly weak at the moment but it is perhaps not growing as strongly as the forecast had been three months ago or six months ago and certainly not 12 months.

-Adrian Mowat

The belief in emerging markets as a growth story has almost disappeared with the global investors and what has failed to deliver in these countries has been earnings growth. The earnings growth out of India has been just over 7% compounded, United States has delivered earnings growth of over 8%. I am at a stage where I am trying to reassure investors that emerging market stories is not dead. That is the starting point.

So what happens to emerging markets as an asset class?
The idea of emerging markets as an asset class is very much under threat and a lot of money goes through passive products. India get its share of outflows and inflows based upon its 8.2% weighting in the indices and often people sitting and looking at FII flows think oh! this is all about India. No, it is not. This is about emerging markets and the story this year has been outflows from passive and active EM funds. India had the status as did Indonesia as I was highlighting earlier in which people thought while this is a more insulated domestic growth story, the problem at the moment is the domestic consumption demand is much weaker than people were expecting.

Going into the New Year, are you expecting newer allocations for EMs? Should India also start fearing flight of capital?
Well, we have already had flights of capital.

Do you see it getting worse?
Well strangely, it is going to get better. The perspective is so bearish, so pessimistic that global funds are already underweight EM. Now, we are trying to persuade them that things are quite as bad as they are going to be. I think earnings growth in EMs next year is going to be above 10%. US earnings growth will be sub that and this will be the first time in many years where EM EPS growth outpaces the US. But it is going to be driven by North Asia. There is a big turnaround going on in semiconductors which is driving the markets of Korea and Taiwan, which are very heavily exposed to tech.

In China, you have e-commerce companies which are growing at nearly 30% EPS next year after growing 40% this year. Their forward valuation is 21 times for the consumer discretionary sector in China that is actually a very attractive growth value trade-off. We have also got tech we can buy in China. This is going to lead EM to outperform.

But India does not feature in that…
India will underperform that and my advice is that the initial outperformance in the EM is going to be North Asia and that is where I want to allocate capital.

So what is CLSA’s position for India?
So we are underweight India within emerging markets and Asia Pacific portfolio. We think the Indian equity markets will go up but it will not go up as much as North Asia is going to go up.

The India data points have made investors more cautious. Some of the people who had turned up at the conference with may be a more optimistic view about finding good investment ideas, have found the data poorer than they were expecting.

This is also at a time when the Government of India and the Central Exchequer have come out with this very ambitious programme of selling PSU companies, what we call family silver. A lot of paper is going to be out there but you are telling that the appetite for India is quite bad and this is going to be competing with the private sector as well?
Yes, but if the EM surprises positively next year from these incredibly low expectations, then as you do get passive money, India will see inflows despite the issues around the fundamentals here. So there will be some demand.

We are privatising oil companies.
Well it is interesting. You said privatising because we used to call this divestment. There is a huge trend going on with investment these days which is ESG and the G their stands for governance and basically PSUs (called state-owned enterprises in China and parastatals in South Africa), have low governance scores because the minority shareholder is often secondary to government policy. So, if you want to get a good valuation, it has to be a proper privatisation, you want a good board of directors that is very independent and it is not part of the government policy set up. There is demand for good assets with good governance, but I do not think there is demand for a modest divestment.

And this mood is also not going to change unless we see consumption coming back and for that, we need the financial sector to get its act together?
Yes. I think you got some real strength in parts of the financial sector and these good businesses are getting a bigger share but we still need to deal with the NBFC issue. PSU banks perhaps have sufficient capital now but they really do not have a risk-taking appetite at this point which is an issue. But the big issue for the Indian economy is the non-bank finance companies. If one business cannot get financing, then demand for other businesses gets hit and you start to have this sort of cumulative feedback.

We are in the midst of a telecom crisis. Has there been any change in policy flip-flop or judicial activism as far as foreign investors go with respect to India?
When you say policy flip-flop you mean with regards to taxation of foreigners?

Taxation on foreigners; there have been a whole host of issues with e-commerce. Could there be objections to the way an Amazon or a Flipkart is treated by the Indian government?
That is an important point to bring up. You price in a higher policy risk when these things go on. Let us give the government credit when it comes to the taxation of foreign investors. They realised that there is an issue and they did reversed it although this is an ongoing saga in India. This is the only country in the emerging market world that charges capital gains tax to wholesale investors! I have no idea why India wants to disadvantage companies by doing that to wholesale investors? Mutual funds, pension funds, insurance companies do not pay capital gains tax anywhere in the world, their end investors do.

I have been trying to explain this for decades that India needs to move away from this complication of FII taxation. You make accountants and lawyers rich and you disadvantage Indian industry. I bet hardly any money flows into the exchequer.

The central exchequer realises that it is a booster shot that is needed for the equity markets and that would be on top of your list as far as corporate India is concerned?
Just get rid of it. Just say wholesale investors will not be charged capital gains tax, they will not have this administrative burden.

At least they are making capital gains, could be the other way to look at it.
Well that mean yes you obviously have to make capital gains.


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