Equity investors are underestimating earnings growth in India and asset prices still have a considerable upside even as the benchmarks are at a record high, according to Morgan Stanley's Ridham Desai.
“Right now, the market is still not in that camp that we’re going to get a big positive growth on earnings over the next 12 months,” Desai, managing director at Morgan Stanley India, told BloombergQuint’s Niraj Shah in an interview. “The market is pricing in close to 0% growth in earnings going forward in the next 12 months. I think the number could be between 10% and 15%.”
Desai said corporate India has actually used the pandemic to resolve a lot of existing issues that were bogging their earnings down. And that’s where his optimism stems from.
“If you look at corporate data of the last four to five months—mergers and acquisitions, restructuring, capital raising a lot of these things are running at multi-year highs,” he said. “So what companies did was, they used the pandemic to consolidate, to revisit businesses that are not working out, to get more focused on core areas. And that lends itself to some sort of earnings upside which I don’t think is still in the estimates or in the market.”
The recent recovery in corporate earnings is encouraging, Desai said, but that is largely due to companies reacting to the pandemic and reducing costs. A more solid revival is yet to come. “We are yet to see a recovery in revenue growth but I think that’s in the pipeline and it will come in the next few quarters.”
That said, Desai also cautioned that he has often overestimated earnings growth. “I’ve been guilty of being too optimistic on earnings for the past four or five years and every time I’ve had to cut my earnings (estimates),” he said. “So, it’s not like I have made some great calls on the earnings cycle, but this time it does feel like we may get a more robust recovery.”
It looks very bullish out there. Of course, share prices have gone up and gone up a lot. But I think they may have a lot more room to go before we are done and dusted with this bull market.Ridham Desai, Managing Director, Morgan Stanley India
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No Worries About Inflation
Central banks across the world pumped over $28 billion as a response to the coronavirus pandemic. While that has led to asset inflation, there are concerns that inflation would eventually seep into prices, ending the current rally.
Desai is not worried though. “We have been calling for an inflation upsurge in the U.S. now for a while. It’s good to have that little bit of inflation.”
The equity strategist explained that price inflation is always preceded by asset inflation, which is the stage of the cycle we are at right now. The problem arises when the U.S. Federal Reserve fails to foresee this coming inflation, becomes delayed in its action and triggers a selloff, at which point the bull market ends at its peak, he said.
“This is not negative for equities; it’s actually positive for equities, at least until we come to that moment where the Fed falls behind the curve,” he said. Besides, Desai noted that the Fed has now committed that it actually wants higher inflation. “So, that’s the risk but it’s actually also good for equities and we’re looking at both things.”
Watch Morgan Stanley’s Ridham Desai's full interview with BloombergQuint here.
Here’s an edited transcript of the conversation...
Do you think it will be a ‘Mubarak Saal’ indeed? The cues are kind of starting to turn around, how do you feel about the setup?
Ridham Desai: I like to be optimistic. There’s no point in being pessimistic but it does seem like we’re set up for a great year ahead. So, the coming Samvat may just be a fantastic year. Let’s say all the cards are lined up favourably. So, let’s see how the you know how the deck performs but I would be optimistic going into the next year.
Why do you say so, when you refer to the all the cards being decked up? What do you mean, can you elaborate a bit?
The pandemic basically, pushed the western hemisphere to respond in a manner which we have not seen in the history of the world, in terms of stimulus. We got coordinated stimulus from the government and the central bank plus its size is just gigantic. It is multiple times bigger than what we got in response to the global financial crisis, which was an economic crisis, this wasn’t one. This was an external agent that was hampering the economy, that crippled the economy and to overcome that various governments across the world, especially in the developed world, responded in a fashion that we’ve not seen before. So, two things about it. There was synchronicity between governments and central banks. Then there was a synchronicity across geographic borders. From the U.S. to Japan, everybody acted. All that stimulus is now sitting there and as the pandemic wanes this stimulus will find its way into the real economic world. Mind it is already found its way into the stock market, it has found its way into gold prices and it may even find its way into property. As usually this happens, when we come out of a recession, we get a liquidity boost which then goes into financial assets and then into real assets and then into the real economy. So, the markets are anticipating some recovery in the economy. I dare say that recovery is going to be better than what the market is currently pricing in and therefore there is more upside to share prices. Now there’s one part of it that’s what happens in the immediate future. I think this is also the start of possible multi-year turn, potentially for emerging markets which have had a terrible decade and therefore for India, which has also had a terrible decade. Now on top of this you lay what India is doing the pandemic has clearly egged the government to do stuff that it would have ordinarily not done in such a hurry. So, we have new farm laws which to me prima facie appears like the 1991 moment for the industrial economy—to the agricultural economy. Then we have new labour laws, we have these manufacturing incentives. We have a host of government policy response which promises to lift growth in India as well. So, it looks very bullish out there. Of course, share prices have gone up and gone up a lot. I think we’re up more than 50% from the March lows but I think they may have a lot more room to go before we are done and dusted with this bull market.
Do you reckon that the emerging markets uptick that you spoke about could happen even if the U.S. markets or other western markets, for whatever reason, go through a bout of underperformance maybe due to tax raises, maybe due to rising Covid cases and sentiment souring there? Can that happen concurrently? Just a word on the currency as well what if the dollar were to weaken, how would that shape up for us?
Our base case view, from our U.S. strategist is that we are in a big bull market, we are in a long-term bull market, which of course will have intervening corrections. Remember, a while back, we had the Nifty go down from circa 11,800 to 10,800 it was a swift quick correction which brought down several share prices by between 10 and 30%. We will keep getting those type of corrections and maybe we get one now because the market has rallied significantly from 10,800 to 12,600 in India and the SPX has done a similar big move. Going into the next two months, there may be some uncertainty about U.S. policy and about how the U.S. Senate gets elected and maybe the markets take a little bit of a breather. That’s always possible. But the undertone is, and just to quote my U.S. strategist Mike Wilson, and he’s a committed bull, we have a bull market in the U.S., and it’s not our base case that the U.S. stock market is going to falter. The second point that you raised is a more interesting aspect of this and how this could feed into emerging markets if it does, which is that if the dollar depreciates that will be godsend for emerging markets. Remember the period between 2003 and 2008 or more precisely 2004 in 2008 was a depreciating DXY period. What a depreciating DXY does is three things: it allows emerging markets to run policy without fearing errors in policy, it causes accumulation of foreign exchange reserves—you’re seeing signs of that in India already. What that means is that the central bank is busy buying U.S. dollars because it has to keep intervening in the currency markets because it doesn’t want major appreciation of the currency. And as a consequence domestic liquidity tends to be very strong. The third thing is that international managers sitting in the U.S., as a consequence of a falling dollar start looking to buy assets abroad and emerging markets is one place that they go to. So, it actually feeds extremely well into an EM bull story if that were to happen.
One can keep looking at risks and go about the investment process or one can keep on looking at what the upsides could be because of various reasons and then do this investment. Are you paying more attention to the risks or are you paying more attention to the upsides that could possibly come in because of this EM super-cycle of sorts that you spoke about?
Not EM super-cycle but I think both. So, we have been calling for an inflation upsurge in the U.S. now for a while. I think the call was made way back in May. So, the seeds have been sown for a shift in the inflation dynamic. So how the inflation dynamic plays out is first you go into reflation, which is very good for financial assets and then eventually you get inflation and there is an accompanying policy mistake that the U.S. Fed makes where it fails to see the coming inflation and therefore becomes lagged in its behaviour and that triggers a sell-off and that’s the peak of the bull market. So this is into the next several quarters, I mean we’re yet to get to the point where we get inflation but this is the base case forecast at our global economist is making, which is that there is a shift happening in inflation. This is not negative for equities it’s actually positive for equities, at least until we come to that moment where the Fed falls behind the curve. Mind you the Fed is committed to this because in the last previous conference of the Fed, the Fed said it wants inflation, it is willing to err on the side of higher inflation because the U.S. has been struggling to get inflation back and their 2% target has not been achieved. So, it’s running very low which is why bond yields in the U.S. are running so low. So, it’s good to have that little bit of inflation. So, that’s the risk but it’s actually also good for equities and we’re looking at both things. There are other things also that we should look at. I mean we’re not done and dusted with Covid. The recent surge of Covid cases in Europe and the U.S. tells us that the virus is still not nailed and there is no reason for us to get complacent about it. We should not be complacent about it in India as well. I mean, of course active cases are down 50%, the daily cases are down 50% from the top actually more than 50% but the fact is we are entering the winter months especially North India temperatures will fall a lot. We’re entering into a period where there are more festivals, so people are going to gather around. There’s anyway a lot of fatigue with staying at home so people have started moving around. The third thing is that pollution is coming back because economic activity is picking up and pollution tends to hamper the functioning of the lungs which is precisely where the virus goes in and attacks. So, I’m not willing to call victory on the virus and I think you should keep that as a risk factor as well. In fact, if the political dynamics in the U.S. plays out such that policy response slows down or is lagged or is a reaction function rather than an anticipatory function then that creates a bit of risk in the stock markets. So, there are of course risks on the horizon. In fact, the market is full of uncertainties and that’s the nature of markets. So, we keep those risks around and we keep focusing on them and whenever stocks overdo things in the short run, you bring those risks to the fore and take a backseat and wait for shares to correct. But the undertone is that, borrowing Mike Wilson’s phrase is, we are committed bulls and you have to buy these corrections because there’s a lot more to go in this cycle before we are done. Nominal growth will go a lot higher which is great for corporate earnings and which is very good for equities before all this is done and dusted.
One of the conversations that we did in the last maybe two years, I asked you about whether you think that the earnings are setting up the stage for growth and you had mentioned this line that I remember you said earnings may not be conducive but prices are because the markets have corrected them. Are you happily surprised with the earnings performance and do you reckon that for the first time, it might actually be surprising on the upside and that that’s also a bit of a pillar for the market performance?
No, ultimately they will have to deliver earnings, otherwise this will prove to be a fake hand and markets will sell offlike they have recurringly done so over the past few years. We’ve had many fierce rallies; big ones and they have not been followed with fundamentals. So, fundamentals have to come back. At any point in time the market is looking forward. It’s a forward-looking animal as we know it’s anticipating a recovery in earnings and those earnings have to be beaten. What’s priced in has to bebeaten for the market to make further headway. If those earnings don’t come then of course the market will be disappointed. Now on your point on what’s happened is, fortunately we made a more bullish call on the economy in May, when we were looking at what was happening, we didn’t think that there would be a permanent destruction of demand in India. We would also anchor to our global call which was for a V-shaped recovery around the world and the combination meant that we were a little bit or I would say substantially more bullish than the street. So, while the street is on an average forecasting a 10% drop in GDP for FY21, we are at about -4.7%. So, to that extent the incoming data has not surprised us as much. The element of the incoming data that has surprised me is that the labour markets are recovering faster than what I would have thought. Now for a moment when I reflect on this, maybe it’s because this was not a plain vanilla recession. It wasn’t a macro-led recession, it was a recession caused by the external agent, the virus. As soon as the virus started fading, labour employment started coming back. So, usually jobs is a big lagging indicator. It lags the economy by anywhere between 6 and 12 months, the economy recovers and then thejobs come. Right now, it’s behaving more concurrently and I think that may bethe explanation but that’s probably the surprise that we’ve got. Not the other data, I think that’s coming in line with our expectations. The earnings are also coming in quite strong as you rightly point out. For the moment it’s largely because companies have reacted to the pandemic and cut costs. We are yet to see a robust recovery in revenue growth but I think that’s in the pipeline and it will come in the next few quarters. I do suspect that the consensus will have to lift estimates which is a big shift from where we have been for the past few years—which is that earnings estimates have only gone down. So hopefully that turns out to be true. I’ve been guilty of being too optimistic on earnings for the past four or five years and every time I’ve had to come and cut my earnings. So, it’s not like I have made some great calls on the earnings cycle, but thi stime it does feel like we may get a more robust recovery in earnings. I may quickly add here that corporate India has responded very well to the pandemic. So, if you look at corporate data of the last four to five months—mergers and acquisitions, restructuring, capital raising a lot of these things are running at multi-year highs. So what companies did was, they used the pandemic to consolidate, to revisit businesses that are not working out to get more focused on core areas and that lends itself to some sort of earnings upside which I don’t think is still in the estimates or in the market. That’s more important what’s priced in. So, I still don’t think it’s priced in. Let’s see how that goes. My guesstimate is and using the earnings yield gap model that we work, the market is pricing in close to 0% growth in earnings, going forward in the next 12 months. I think the number could be between 10 and 15%. So that’s good because if I’m right, then we have a considerable upside left for shares pricing that type of growth. So right now, the market is still not in that camp that we’re going to get a big positive growth on earnings over the next 12 months.
We’ve seen some tangible evidence of large flows, foreign flows hitting Indian shores in the secondary market data that we publish almost every evening. Is this finally the global money getting to work into India consistently and do you think that the wall of money might stay? Or is it something else? How do you decipher in your mind the foreign versus domestic flow impact or evidence of that in the last two odd months?
To me, this looks more India-centric than EM. My anecdotes are that people are getting more interested in India for the first time since 2013-14. There was a huge amount of interest on the back of the taper tantrum fall that had happened in the summer of 2013. A lot of foreign flows came in. India did spectacularly well from September 2013 right until the early part of 2015. In fact, by then, India was trading it twice the EM multiple. Then from there, we derated significantly and at the bottom in March earlier this year we had halved in terms of relative valuations. So, there was a significant derating that India had suffered versus emerging markets. I think that interest is now coming back. So, what are the factors driving it? So firstly is of course, relative valuations. India looks a whole lot better than it has. In fact, it’s near its long-term bottom. The second is we’ve seen some interesting policy action from the government—stuff that may boost India’s long-term growth rate. If you look at the trailing 10 years GDP growth, India is running a growth rate that is well below its estimated potential growth rate. We estimate India’s potential growth rate to be around 6.5-7%. We’re averaging maybe a full percentage point below that. So now there is a possibility that we may go back to that trend line growth and that I think is what is exciting investors. I think that’s what’s pulling in the flows. The EM story is playing a minor part in this. I think it is a more India centric story and that’s good news because if it’s EM-centric, then it will also fade away with the EM. If it’s more India centric, then I think you get more sustenance because then it depends on what India does. Also, I think I should quickly add here that EM portfolios are running their lowest position in India since 2010 if I remember correctly. So, there is not much positioning on India either. So, that’s a good technical factor to have in your favour.
Some thoughts on the China plus one narrative? I hear corporate India singing different kinds of tunes here. What is your understanding of how this may benefit Indian corporates?
We wrote about this I think four or five months ago. It’s the multi-polar world that is evolving right now. So, in large part and making this very simple, we were in a bipolar world where China was the production centre and the U.S. was the consumption centre of the world. Because of the events that have unfolded and the trade war that has erupted between U.S. and China, we’re seen the signs of a multi-polar world getting created. A multi-polar world is a great opportunity for India because multi-national companies will be looking to diversify production away from China into other places. India is a natural place for them to go to. Hitherto, it was not happening because of various constraints India has lacked adequate infrastructure to be a viable destination for exporting, labour laws were a problem, land acquisition was a problem. Overall, the bureaucratic hurdles to setting up greenfield plans used to frighten multinational companies. So, the nature of FDI in India over the last five six years and we’ve had a FDI boom—so, let’s not understate that. That has been largely to buy existing businesses because multinational companies definitely one footprint in India. If, for nothing, the consumption that India offers the opportunity that India offers is the marketplace. The way they were doing it was buying existing businesses, so they don’t have to deal with the system to set up greenfield plants. So, that was the way in which FDI was happening. I see a shift now coming because of an accumulation of several factors. So, the overarching multipolar theme as multinationals start to look to diversify and mind you, they will only diversify incrementally. It is going to be very difficult to move lock, stock and barrel out of China. You can’t do that because the size of China is massive but incrementally, you can say that India is a place that I want to set up manufacturing. Now, that being backed by some big changes that the government has done on its side, which is labour laws, you know this land bank thing that they are doing and the manufacturing incentive scheme. So, when you add all that up, I think we have the prospects of fresh investments and then of course, let’s not forget last September we had a big rate cut for corporate taxes especially for new investments. India is more competitive than it has ever been I dare say the most competitive place in this part of the world in terms of taxes. So, when you add all this up, I think what we can see in the coming few years is manufacturing investments that we have not had. I know earlier you mentioned about the manufacturing note—this is exactly what the manufacturing note is about. It’s all hooked up to these changes that are happening in the world. We think these are fairly sustainable changes. This may surprise investors on the upside as to how much investment India can get in the manufacturing sector with real production facilities getting set up and greenfield capex taking place over the next three four years.
So, how does an equity investor benefit out of this because services’ companies are actually singing a very fine tune currently. Your report suggests that it will be a decade of manufacturing and please correct me if I’m misquoting you but I think I’m not. Do you think an equity investor benefits relatively disproportionately out of making a larger investment in select manufacturing-led themes or could services like BFSI, IT dominate?
There are many facets to this. Firstly, the investment cycle that can come will boost overall growth. So, all boats will be lifted. So what India needs is higher headline growth. Higher headline growth means better consumption, better investments and better profits. Now how that higher headline growth comes is not that important. Of course, you can position portfolios to reflect the beneficiaries directly but just the fact that India could run higher growth rates is I think sufficient for portfolios. So that’s one. Second is that services to the extent that they are domestic facing, I think will do very well as a consequence of higher growth. So, there is no let-up to that. To the extent that they’re external facing, they may underperform because if India’s growth rate does revert to its trendline then the likelihood is that services which are being exported out of the country may not grow as much. So, they may underperform. The third thing that I will quickly add here is let’s not forget agriculture in the mix. Let’s step back a bit. Over the last 30 years, we’ve had big underperformance from industry and agriculture, relative to services. So, services have gained share in GDP and manufacturing and agriculture have lost share. These are the two places where we’ve seen reforms over the last few months. These are the two places where I think growth accelerates relative to services. So it’s quite plausible over the next 10 years that services loses share in the economy because manufacturing and agriculture have to regain some of their lost share—not back to the where they were in 1990s but at least somewhere in the middle. To that extent, services loses some share. This is a very tough thing to envisage and to imagine because when GDP growth goes up, the services economy will be very buoyant but there may be a period when it actually loses share only to regain it after that. So, I think this is how I would think about the setup and how this informs portfolios is that you need to be domestic, you need to be cyclically oriented and that’s how I think money can be made. Therefore, we are underweight exporters, and we are overweight domestic cyclicals. Now, domestic cyclicals can either be consumer cyclicals or they can be industrial cyclicals. We like both. But that’s how I would say would be the big picture orientation of an equity portfolio.
Therefore, what’s that big call for you? Over the last five-six years that you’ve spoken you have at times given calls which the street probably didn’t quite believe in. So, what’s your big call wherein you might be anti-consensus?
So, I think the big call is that financials has lost its market leadership. That’s the sector that has done very well over the last seven years. I think it’s poised to do very well over the next few months because it’s derated significantly since March-April, but I don’t think it will lead the market. The leadership is moving. It’s probably moving into discretionary consumption and industrials. I’m thinking about beaten up sectors or sub sectors of the last 10 years. I think those are the sectors that may assume leadership and some of the big outperformers of the last 10 years may lose their leadership over the next few years. So, I think that’s the big call and this will require a major shift in anchoring because we, including myself, are all anchored to the outperformance of the last few years. Momentum is a wonderful thing. It always works—only, it stops working when it does and you get those big inflection points in momentum once in a while and I think we may be at that inflection point going into 2021 where there is a big shift in sector performance. So, let’s see if this call works out but I think the outperformers of the past 10 years are going to give up to the underperformers and we’ll see new sectoral leadership in the coming years.
You had spoken in the past about how the broader market under performance was completely neglected over a 10-year period maybe the broader markets had not done anything per se, just come back to the same levels. Do you reckon that we are starting to see a shift in the fundamental performance of the non-Nifty, non-largecap names and could that be recognised by the market and could there be a bigger alpha there?
Absolutely. If you’re a believer in a broadening economic cycle as I am, then it goes without saying that the broad market will outperform the narrow market. The interesting thing is that concentration is at peak levels which is the share of the total market cap of Sensex companies and the share of profits of Sensex companies in total profits. Both these numbers are running well over 50% and it’s a mean reverting variable. So, when it hits that peak then the next thing is that it starts going down. I think it just made the peak and we’re at the start of a cycle where they will lose share in the overall market and that means the broad market outperforms the Sensex. So, I think mid- and small-cap stocks will do very well in the coming two years. The two-year bear market or two and a half year, maybe longer, actually is over. We should be looking at those stocks.
Leave us with something that the last six months I’ve taught you anything about health, any tip or any advice—even multiple ones are okay.
This may sound very grim but it’s not but I think there’s a wonderful book and I’ve not read the full book I’ve only read a third of it but the title itself is enticing. It’s titled ‘Preparing For Death’ and it’s by the illustrious Arun Shourie. Going by what I’ve read, I think this is a very promising book. I think we have to all prepare for death. I think that’s the biggest learning of the last six months. Maybe this book will culminate that learning into some serious points but I think that’s what I’m doing right now.
Maybe some other time, end of the year or otherwise we’ll talk about some eating habits as well, because I know you’re a fitness fanatic. So would love to have those too
Let me quickly add to that. I’m not the expert but it’s not very complicated. I think simple living, simple food, moving the body around—the body is designed to move. It’s not designed to sit in one place and it’s not designed to sleep all day. Whatever those movements are, not overdoing it, not following an extreme regime, either side. Whether with food or with sleep or with exercise I think works very well. That’s the discipline you need to bring in and that’s even what this book is also about but ultimately that’s the secret of health as I have learned it. It is just to be moderate on all fronts and not to do extreme stuff on either side.
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