We are in the middle of a summer storm, says Julius Baer's Mark Matthews

India is a buy-and-hold market for us. We don’t approach India on a tactical basis. Buy it, put it away, and don’t think about it. It is a must-have in the global portfolio and one needs to own it for a long time: Matthews
Fears over rising oil prices and trade wars have created nervousness across the global markets in the recent weeks. Given the headwinds, MARK MATTHEWS, managing director and head of research for Asia at Julius Baer, tells Puneet Wadhwa that he does not expect the Indian markets to rally. But, with 15 per cent earnings growth in FY19, India would become attractive again by next March. Edited excerpts:

Do you think that the global equity markets are headed higher over the next six – 12 months? 

We are in the middle of a ‘summer storm’ and this happens once every few years. The last one was in 2011 – the summer of the Greek crisis. Rising interest rates, a stronger dollar, trade wars, Chinese deleveraging have suddenly taken more significance. That apart, it appears the Angela Merkel government may not survive, as her key coalition ally is threatening to abandon ship. So Europe is going through a lot of turbulence too. 

There have been (political) developments in emerging markets (EMs) as well, with important elections Turkey and Mexico. So all these things have created a ‘summer storm’. And it should be added, the markets do behave seasonally if you average them out over time, with the beginning and the end of the calendar year the best phases, while the middle of the year is on average the weakest time. Putting it all together, the next few months for the global markets should, at best, see sideways movement, and if not that, then the likelihood is we go down rather than up.

How soon can the US markets top out?

The one market which has been able to withstand these forces till now is the US market. However, the US market is also showing signs of weakness. The world markets have broken their 200-day moving average (DMA) for the first time since December 2016. The one thing that will protect the market from going down a lot is the Tax Cuts and Jobs Act. Because of it, earnings growth for the 500 companies listed on the S&P 500 index was 25% in the first quarter, and should be 20% for the full year. 

And, companies flush with overseas cash are repatriating it to take advantage of lower taxes, so companies will buy back some $650 billion in stock this year, an all-time high, and this should continue for a few years to come, as in aggregate US companies have $2.8 trillion dollars of cash and investment holdings overseas.

Some experts believe Hang Seng, Topix, APxJ and MSCI China could come close to entering a bear phase. Do you think this could be a reality? What is the likely impact on global markets?

The big surprise this year has been the significant collapse in the Shanghai market. The Shanghai market has already slipped around 20% from its high at the end of January. This is is being blamed on Donald Trump’s policies and trade war rhetoric. However, Chinese stocks get only five per cent of their  revenues from the US. This is much lower to the European countries, where US revenues are in the teens. China’s exports to the US, as a whole, are also quite small (around 5 per cent) as a proportion to their gross domestic product (GDP). 

If the United States imposes a 25% tariff on USD60 billion worth of Chinese imports and follows through with another 10% on USD200 billion, the combined amount represents USD36 billion. A large number on its own, it is not so large compared to a Chinese economy that will be over USD13 trillion in size by the end of this year. 

Are the trade war fears back on the table?

China has been a huge beneficiary of the current world order and has developed a huge export base, while has protected imports. But the fall in the Shanghai market, actually, is due to the fact that China is a self-induced credit tightening, a corollary of President Xi Jinping’s “de-leveraging” (debt reduction) program, targeted mainly at local governments. But so far only one local government firm has defaulted. To stop at that would make the government look like a “paper tiger” like the Americans in 2008, so it will likely allow more to fail.

Can the next financial crisis across the globe be triggered by China?

The 2008 financial crisis was caused by sub-prime mortgages, mortgages that should have never been given. I don’t think the Chinese would allow a crisis of that proportion, and because the credit there is largely from one pocket to another (from banks owned by the government to local governments), it should be controllable.

To prevent collateral damage, the central bank cut some banks’ reserve requirement ratios late last month. This monetary loosening, at the same time as the Federal Reserve continues to guide for higher interest rates in the United States, helps explain why the renminbi is down 3.6% in the past two weeks. Although it should be noted, some say the renminbi is just catching up to the drop in the euro/dollar in the previous month. Beijing may also be sending a subtle message to Washington that it is willing to allow currency weakness to buffer the impact of the tariffs. 

What are your views on the Indian equity markets?

India is a “buy and hold” market for us. We don’t approach India on a tactical basis. Buy it, put it away, and don’t think about it. It is a ‘must have’ in the global portfolio and one needs to own it for a long time. Three key things working in India’s favour. First is the demographics – the growth profile of the country is obvious. Second, large-cap companies that are well run and are likely going to do well going ahead. Lastly, subject to the outcome of the next year’s general elections, continuation of reforms will accelerate economic growth. All this augurs well for India.

There are pros and cons for India. The trade war talk will not have much impact on the Indian economy. Though the rise in oil prices is bad, the government has been able to pass it on to the consumers. The GST (goods and services tax) confusion seems to be settling down. The bad part of the implementation is over and we can now look to the structural benefits in terms of enhancing the structural trade flow through the states. The way non-performing asset (NPA) problem also has probably peaked. And the flow to the local funds (mutual funds) in calendar year 2017 (CY17) has been good. 

On the flip side, interest rates are rising. The Reserve Bank of India (RBI) is likely to raise rates again in August. Oil prices can also impact inflation and the current account deficit. We are not seeing the kind of wage growth that we should be seeing in India. It is also a mystery why the capacity utilisation remains in the low 70s across industry. And I don’t see the Indian markets go up in this kind of global backdrop. The current valuations are steep, but with 15 per cent earnings growth in financial year 2018 – 19 (FY19), they could become attractive again around March next year. 

What is a bigger threat to the Indian equity story over the next 12 – 1 8 months –earnings not picking up or a hung Parliament?

The biggest risk to the Indian equity markets is the outcome of the general election scheduled for 2019. The opposition is now figuring out how to be more unified. The Karnataka assembly election is a classic example. If the opposition can get its act together at the federal level, then there is a real risk that the election could go to them. This is much harder to do than at a state level, though. 

A coalition government isn’t  always bad for the economy or policy making, but in this case, the opposition would a very broad coalition. The current government is very strong and has undertaken a number of important reforms. In case a new government assumes power next year, these reforms may not be followed through. In case the Bharatiya Janata Party (BJP) wins, they may also form the government with more partners than they have now. But is it the Prime Minister’s style to work with many different partners? 

Foreign investors have been trimming India exposure over the past few months. What are their key concerns?

While foreigners have sold, the quantum is not too huge. The success of the recent IPOs such as RITES Limited and the subscription levels from foreigners indicate they are looking to enter India via this route. That said, the foreigners are not in a hurry to rush back in. The prospect of Narendra Modi losing the next general election is worrying them, because for the last four years, brokers have told them how great this government is. So they have come to believe it. 

Which sectors / stocks in the Indian context are still worthy of investment?

I like State Bank of India (SBI). Stock prices most public sector banks have factored in the scandals and the NPA issues. Among private sector banks, ICICI Bank is a good bet. NPA resolution should be faster and stringer in these two banks. I also like Larsen & Toubro. Pharma sector has lost a lot of value last year. It will benefit from the currency movement as well. Dr Reddy’s is a good stock to invest in. 

How are you interpreting the macro economic data from India? What are the chances that the markets will react sharply to any fiscal slippages?

The market is quite aware of the trajectory key economic indicators will take over the next few months. A rise in oil price and its impact has already been factored into the stock values. The market knows that inflation will be higher in six months from now. I don’t think there are nasty surprises on the horizon. The RBI has also made that very obvious.

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