The global markets are in a period of extreme volatility, as the dollar is strengthening on growth that is coming through, but coming through in-line with expectations, said Bryony Deuchars of Aviva Investors.
Countries now have stronger growth, stronger external balances, fiscal deficits that are under control, foreign exchange reserves are being rebuilt, that is not across the board, but by and large most countries are now looking much stronger than they were five years ago, he added.
Earnings growth is perhaps one of the issues that has come through in India and why the market has not performed as well as it might. However, that again is a function of relatively sedate for India GDP growth, Deuchars added.
"You have seen the reforms that Modi has put through, both of which in terms of the demonetization and the GST introduction, were bottlenecks to growth and certainly slowed GDP growth down which then filtered through into the earnings growth, Deuchars said, speaking about India.
Watch More: Earnings growth one of the major issues in India, says Aviva Investors Edited Excerpts: Q: Where do you stand with your India positioning relative to emerging markets now in your overall GM portfolio? A: In our emerging markets, global emerging market income fund, we are roughly neutral in India at the moment and that is the function of two things in the sense that we like the top down picture in India. Growth is recovering, inflation is well controlled, current account and fiscal deficit are both much better than they have been in the past. The issue we have is that India is expensive.
It has always been expensive. So for us it is very much finding the opportunity from a bottom-up position. Leading on from that, I guess the way you look at the breakdown of the Indian economy and the importance of the consumer to that economy, that is a sector where we can see considerable growth, you can see support coming through on the fiscal side as well as the favourable demographics that India benefits from with a large growing middle class rising real incomes. The drive for consumption is strong so we particularly like the consumer sector within it.
Q: Are you convinced that we are on our trajectory of improving earnings or has that disappointed you over the last couple of years? A: I think earnings growth is perhaps one of the issues that has come through in India and why the market has not performed as well as it might. However, that again is a function of relatively sedate for India GDP growth.
You have seen the reforms that Modi has put through, both of which in terms of the demonetization and the GST introduction, were bottlenecks to growth and certainly slowed GDP growth down which then filtered through into the earnings growth. Having said that and perhaps why India has not rebounded is, you have not seen that come through- a derating and valuations have not come off as much as one might have expected in that environment.
Q: Are you confident that it is about to happen because at least the last couple of years, people have expected it to come through but for one reason or the other as you said, it has not come through. Now with the effects of GST also beginning to wane, do you think this fiscal year we might have better earnings? A: I certainly hope so. We have got the added benefit this year in terms of the recapitalization of the public banks. It just helps confidence. Confidence is a big driver of economic growth and the economy is expected to recover this year.
On top of that we have got a general election coming in 2019 and arguably you would expect a level of fiscal support that comes with that, the Budget was relatively contained, only 2% growth this year, but let us see what happens in the upcoming state elections and whether there is an acceleration from the fiscal side to support the consumer.
Q: How important determinant of overall returns do you think will be politics over the next 12 months? A: It is very hard to say. I think politics certainly influences sentiment and you have seen that around emerging markets. We have had the Russian elections; that was pretty much as expected. The Malaysian election was a big surprise for everybody and yet the market has taken that in its stride and performed relatively well. So I actually think it is very difficult to say surprise election results is becoming the norm both in developed markets and emerging markets.
So I think if we get a surprise election result, that will have an immediate impact on the market. Typically though in the long run it is the economic fundamentals that will come through and drive market performance.
Q: You spoke about consumption names in India, are you comfortable with the valuations in that sector because while there is growth out there, valuations are not quite cheap?
A: I agree, valuations are not cheap, but I do think they are supported by the growth that is coming through and the potential growth to come through. If the reforms that are being put in place, are the building blocks for a faster growing, more stable economy then 3-5 years down the line which is our investment horizon then those earnings growth should come through to justify those valuations. Q: What are your biggest worries about the Indian market now? We have had crude which is flirting with $80 per barrel which is a headwind for us. The rupee has had a bit of a tumble off late against the dollar, do these worry you as a long terms investor?
A: I can certainly see that they are risks and had you asked me what the risks were to the Indian market this year, I would have said the oil price. India was one of the fragile five but you can see what they have done to turn that around. The current account deficit is now much smaller than it was, the fiscal deficit is relatively well controlled. So obviously the oil price and in particular Indian rupee will put pressure on the current account. Has it yet got to a stage where it perhaps impacts the investment case for India? That I am not convinced about only because if you look at the economic growth cycle that it is in, growth has bottomed, inflation is well contained and you have got growing real incomes which is the big driver of the economy. So I cannot see it being a roadblock to growth at current levels. The next step is obviously the local elections that we have got coming towards the end of this year and how the market interprets that in terms of what it means for the election next year which as I said is sentiment, but I still think the economics will win through in the end. Q: The biggest sector in terms of weight in India is financials and a lot of large investors choose to play the consumption theme through the financial space. Where do you stand on that? A: I think financials are an opportunity within India but there is also a risk. We know that the public banks are in a mess, the government is working to rectify that, recapitalize, the bankruptcy law comes through, one would hope that that enables the financial sector as a whole to move forward. It is a two-speed market, state owned banks growing 5 percent, private sector banks growing 15-20 percent.
So the growth is very different and you can see that come through in the credit growth numbers for India, I mean it is high, 10 percent in consumption or consumer related loans as well as the commercial loans. So there are certainly opportunities within that. On the other hand, what we need to watch is the cost of funding, liquidity is tightening in India and the cost of funding is growing. So, you have to be very careful looking at banks balance sheet, how they are funded, what proportion is wholesale funding, what proportion is deposit funding.
Q: What about the export sectors which are not quite India focused because there was a time a few years back where large global investors would have their funds quite full within Indian exporters but that seems to have changed a bit in the last couple of years. How have you approached the exporters, IT or pharmaceutical? A: Let us take the IT sector, near term it has had obvious headwinds, Trump has come in, he has been relatively hostile, you can understand why they derated.
Similarly their business model whilst core to a lot of operations and businesses are just that -their core and not the fast growing cloud based digitalized data and arguably the sector as a whole is racing to catch up with that shift to digital and it is not quite there yet. So I think there is disparity within the performance within the sector but largely those trends are hindering them to some extent. You can see costs going up, they are going to have to employ in the US, it is not because clear cut story that it was in the past.
Q: Overall emerging markets, where is it in the cycle you think? Some believe we have started a five-six year cycle, we are just two years into it. Others caution that if the developed markets cycle starts to slip off, emerging markets cannot perform against in the face of that. Are you convinced that we are onto a five-six year kind of a cycle out here? A: I think a long term fundamental argument for emerging market is most definitely intact. We are in a period of extreme volatility, the US dollar is strengthening on growth that is coming through, but coming through in-line with expectations.
You saw the US treasury yields spike through 3 percent on retail sales numbers which were in line with expectations. This obviously is a headwind to emerging markets. Arguably a short term headwind and again I think it highlights the changes that we have seen in emerging markets. You now have the structural reform that they have put in place across emerging markets.
We are looking at country’s now that have stronger growth, stronger external balances, fiscal deficits that are under control, FX reserve are being rebuilt, that is not across the board, but by and large most countries are now looking much stronger than they were five years ago.
You can see those that are not – Turkey and Argentina are clear examples, Argentina could not shore its currency up with 700 basis points of rate increases, it is now talking to the IMF. So those that are struggling with mounting debt and slower growth are the victims of the sentiment change that we are seeing now. However, stepping back from that and looking at what are the drivers of the emerging markets, India and China are the two biggest emerging markets, have a combined population of 3.7 million people, most of which are young income earners.
You have got this emerging middle class that is coming through, they are growing richer, they want to spend, those growth dynamics coupled with the stronger economic fundamentals, look good for emerging markets.
Adding to that, you can’t ignore valuation and although you saw a rapid rise in emerging markets in 2017, the discount to developed markets is still substantial and positioning is light. You look at funds, their global positioning to emerging markets, it is still underweight and much lower than it has been in the past.
Q: Do you sense that when you speak to some of your end investors that they are still cautious about improving their or increasing their weightage towards EMs given that they might have been stung badly in the past?
A: I think there is an element of caution and positioning shows that but given the performance that the market saw last year, we are up in excess of 30 percent, that suggests that there are flows coming into emerging markets, people are now warming to them.
Q: Of the two you mentioned – Turkey and Argentina which do you worry more about because sometimes in EMs while the overall story is strong you just need one accident to derail the story for a while. Do you worry that Turkey or Argentina could have the potential of doing something like that?
A: Turkey is most definitely a concern. You have seen the currency depreciate again on the back of President Erdogan’s comments. I think we need to wait and see what happens in the elections on 24 June, it is not so far away. One has to question the independence of the central bank and what they need to do to shore up the currency, inflation is already very high, real rates are just about positive but that could quickly be undone with the inflation that comes through on the back of the depreciation that we have seen in the lira so far this year.
However the fundamentals again, you look at Turkey as a market, it has got that demographic dividend, it looks fundamentally very good, unfortunately it has structural imbalances and large proportion of FX debt, 70% of which sits with the corporates. It is uncomfortable. It is very easy to explain why the currency and the market has done what it has done this year.
Q: Overall do you think emerging markets will deal okay with the shrinking liquidity in the world? It is a well-advertised fact, so do you think the reset has happened already in terms of a psychological shift or do you think that will be a headwind that will be difficult to swim against, I mean central bank tightening across the world?
A: Arguably yes but the US has been tightening for some time now and the dollar has been relatively weak against that. You have got a fair amount of fiscal stimulus coming through in the US which offsets some of that tightening.
We are seeing central banks in the emerging markets follow suit. However the growth is strong, ultimately what matters for emerging markets is global trade. Global trade has been stronger than expected and it still held up well into the beginning of this year. Similarly commodity prices extremely important for emerging markets and they have been exceptionally strong, oil is up 22% this year already. Obviously there have been other issues amongst the commodity complex, aluminium is case in point but all of which is quite good for emerging markets.
US growth is sucking in imports, again you can see the underpin for emerging markets. So, you can make the argument that they can buck the trend this year against tighter global liquidity.
Q: Do you worry about trade wars or do you think this is more hype than reality or could it have the potential to derail the EM story?
A: I think you have to be cognizant of the issue of trade wars and protectionism and one can’t get away from it. So, far the US has been very vocal, you have seen the tariffs on steel, solar panels, washing machines, so it is a growing trend.
What is perhaps more concerning is the more recent developments where it has been stock specific, like ZTE in China. They have backtracked on that but were they to have blocked the supply of components, that would have materially hurt the business.
The same in the Russian case with the sanctions on Oleg Deripaska and how that then had implications for his companies and the wider implications that we saw in terms of the aluminium price and other commodity producers having to think about their supply of aluminium, whether they can deal with Rusal and where it is coming from.
So, there were wider ramifications and I think that took most people by surprise. This then leads to the risk that who is next, what is next and that is not predictable.
Similarly you have got the NAFTA negotiations which are rumbling on. So, I think there is a growing trend and what does it to, is put roadblocks in the way to global trade which is the life blood of emerging markets. At the moment we just have to hope for a relatively benign and sensible outcome because it is not a zero-sum game, ultimately everybody suffers in a protectionist world.
Q: What is the situation with regards to fund flows into emerging markets right now? 2017 had no volatility to speak of and the performance was great but in 2018 we have had volatility, has that scared off some of your investors, are they putting less money to work this year?
In February volatility crept back into the market and fund flows have reflected that. However I do think that is probably a symptom of fast money. Those that have a longer term view on emerging markets and are invested in funds with a longer term horizon, 3-5 years, are not seeing huge flows.
A: Fund flows have been more volatile this year and that is understandable. January saw a continuation of 2017, it was an incredibly smooth run month on month in all markets both developed and emerging markets.