Taimur Baig Says Emerging Market Valuations Far More Favourable Than U.S. Multiples
From a long-term perspective, the U.S. stock market does not look at very good value, says Baig.
Valuation in emerging markets is “far more favourable” than in the U.S. even as the EM peers are yet to price in all the negatives, according to Taimur Baig.
“U.S. equity markets even after the recent selloff looks exceptionally highly valued. We are talking about CAPE-Shiller price-earnings ratio on a cyclical-adjusted basis in the high 20s. These sorts of PEs historically have been associated with weak forward-looking returns,” said Baig, chief economist and managing director at DBS Group Research.
“Meaning, if today we have very high PE, over the next 10 years, I will expect fairly ordinary returns. That means from a long-term perspective, the U.S. stock market does not look at very good value.”
The EM equities, however, didn’t follow the U.S. stock market during the massive Covid-19 recovery seen in the last two years, Baig said on the 'Navigating Through Uncertainty' series. They are only beginning to reopen this year, while in the case of the U.S. and Europe, “that’s a 2021 story”.
“So, the valuation in emerging markets is far more favourable than in the U.S. The U.S. cycle is good 12 months ahead of the EM in terms of reopening. There’s certainly something constructive to be said about EMs, notwithstanding the headwinds coming from interest rates and the current volatility.”
‘Golden Opportunity’
The Indian economy, Baig said, has taken a number of shocks over the last five years such as the demonetisation, the implementation of the goods and services tax, and then the pandemic.
“…But, I think, these shocks have a way of strengthening an economy’s backbone.”
“As the economy reopens, stores reopen, and India takes advantage of the geopolitical dynamic, in which many western companies would like to diversify their supply chain, the opportunity is golden for them, both from a short-term and medium-term perspective.”
Watch the full interview here:
Here are the edited excerpts from the interview:
I start off with a basic question which would have an impact on economics as well as markets. A report says in the past episodes of more than 300 basis points of rate hikes in the US, only in the 1993-95 period the tightening episode did not trigger a recession. Is your base case of a recession in the U.S.? What is the corresponding effect or the cascading effect on the world economy?
Taimur Baig; The base case is of a short slowdown, not an outright recession. I will tell you, why we don't think it's the case but it's sort of thin edge. A recession is not a trivial scenario, it can happen as well. But the base case, let's say with 45% or a 30% likelihood to have a recession, and 20% likelihood of things getting better. Even then is not the odds are in favour for a recession?
The most likely scenario in our view is one where the U.S. economy slows quite sharply across the board. Consumption gets hit by high interest rates, businesses stop adding to capex but start adding in your inventory amid expectations of weak demand.
The public sector right now is actually running a surplus, it's not adding to GDP, it's actually subtracting from it. So, the consumer spending and the government spending and the investment by businesses parts of the GDP of the economy are all slow. The net exports part of the economy have also started to weaken simply because there is a very strong dollar. This is why we can expect a pronounced slowdown, sequential growth rate of maybe zero, or maybe just a little more positive than that. But that too, is more like a 2023 scenario, not in 2022.
I think there's enough sufficient momentum in the US economy, whether it is from consumption or from business spending. Things can be okay in the 2% to 3% growth trajectory for the remainder of the year.
Let me give you a couple of better examples to illustrate my point. The first one is companies are not naturally scaling back on hiring. We have seen very early signs of some degree of nervousness on the employment side, but nothing that can be taken as a sign of the economy beginning to contract or heading towards recession. Unemployment remains at exceptionally low levels. We still have companies hiring, wage growth is substantial but when we talk about the forward looking part of the economy, the doom and gloom would immediately cause companies to stop giving wage hikes or even start firing people. You take that in the context of the fact that the company has made an exceptional amount of money in the last few years, despite the pandemic. We have a large chunk of the economy, which has tremendous earnings, very good profitability, and therefore giving a 5%-to-7% wage increase this year. This is not that big deal as employees actually expect this because they know how well the companies have performed.
The second, is the issue of overall consumption balance sheet or the health of consumer balance sheet. The net debt in the U.S. on the consumer side is about zero. People have seen strong pickup in their wealth gains over the last decade. Housing has done very well, and equity market a few months ago was doing well. More importantly, they have cut back on their debt, credit card, housing, personal loans in all areas, things are nowhere as dire as they were before the global financial crisis in 2008-2009. So, from a balance sheet perspective, this ability of the consumers to take high interest rates or some degree of headwinds is significantly greater than it was in the lead up to the global financial crisis. This is why, as yet, we are not painting a recessionary scenario.
If that is how the events unfold, what's the impact on the APEC or the EM region?
Taimur Baig: Unfortunately, we don't need a recession in the west to have major headwinds in our part of the world.
Interest rates have gone up, they are going up much more than they have so far in the second half of the year. I think that can be said with a high degree of confidence. We probably will see 50 or 75 basis points rate hike next month in the U.S., and then follow that up with another few chunky interest rates increases in the remaining year. This is a big shock. U.S. inflation right now is running at about 8.50% thanks to base effect. That inflation rate will have to work 5% or 4% depending on how things turns by the end of this year. So that's 300 basis points of disinflation, we are looking at, during which we're talking about another 300bps of interest rate increase. This means real interest rate increase by 600bps in the span of half-a-year. That is an extraordinary amount of delta for the global economy to absorb.
Already, we are seeing currencies under pressure in the region. We are seeing capital flows dry up. We have looked at the equity market basically on an upswing in the last few months, and same with bonds. We are seeing corporate credit spreads widen and these are all reaction to what has happened in the U.S. So, you can only imagine what will happen in the next six months with respect to spreads and effects, and so on.
If indeed, we are going to have this 600bps of real interest rate increase in the US vis-à-vis the rest of the world.
That's a telling number. When you look at the APEC markets circa 20-25% fall, sentiments are overwhelmingly negative. Maybe there are a few green shoots here and there, but some technical indicators are saying that the markets in an oversold range and therefore people are evaluating if there is a sustained or a short-term bounce back, imminent. What is your sense tactically?
Taimur Baig: I began my earlier question by painting a dark picture for the emerging markets, I argued that, high interest rates are a harbinger for lots of bad things like widening of spreads and currency volatility. But, these sort of issues cut both ways. We have to think about in the U.S. context and then I'll bring it into the EM context. U.S. equity markets even after the recent sell off looks exceptionally highly valued. We are talking about Cape Shiller price earnings ratio on a cyclical adjusted basis in the high 20s. These sorts of PEs historically have been associated with weak forward-looking returns. Meaning, if today we have very high PE, over the next 10 years, I will expect fairly ordinary returns. Now, that means from a long-term perspective, the U.S. stock market does not look at very good value. Where do we find value on interest rates? It will take a very brave person to lock up rates right now. You probably need a little more clarity before we start going long duration.
The next thing in my view is the emerging market equities, because emerging market equities simply do not follow the U.S. stock market during the massive Covid recovery period that we saw in the last two years. You could argue India has had some buoyancy. You could argue for the markets, but emerging markets have not done very well because most have not really recovered from the pandemic. They are only beginning to experience reopening this year. They are beginning to see tourists come back and confidence in the population of dealing with the pandemic, is only firming this year. Whereas in the case of the U.S. and Europe, that's a 2021 story.
So, the valuation in emerging markets is far more favourable than in the U.S. The fact that the U.S. cycle is good 12 months ahead of the EM in terms of reopening. I think there's certainly something constructive to be said about emerging markets, notwithstanding the headwinds coming from interest rates and the current volatility.
Are you saying that a lot of negatives are in the price or are you saying that though there is a downtrend right now, there could be a short-term bounce before the downtrend resumes?
Taimur Baig: It seems to me the global portfolio managers are not very forgiving of emerging markets. So, the moment they see interest rates go up in the U.S., immediately they start selling across emerging markets.
They sell everything and as a result, a country like India gets lumped together with all other emerging markets and then the selloff is substantial. But then you see the offsets coming from the domestic side. If an economy is really fragile, not only the foreigners sell, but the domestic will sell too.
In the case of India, we are not seeing that. The foreigner sold, but the domestic haven't really sold. So, there is a cushion up there, as far as Indian equities are concerned. Has the markets priced in all the negatives? I think the market is still struggling... We still have a lot of uncertainty with respect to inflation. I think inflation goes to 4% by the end of the year in the U.S. , but I have been wrong in the past with respect to inflation. I will not be shocked, if I am wrong again. But from an analyst perspective, from a forecaster's perspective, from a price taker or price makers perspective, that uncertainty will hold back confidence and therefore the idea that all of the negatives have been priced in and therefore the market is ripe for a bounce back, I think it is a rather courageous claim to make right now.
As we saw in the span of the 2007-2008 crisis, there were many false starts. The market, you though once Bear Stearns was out of the way or once Lehman was out of the way everything would work out. But, it took a good six months for the market to come to the conclusion that the Fed was here to stay. That no further downside risk was going to manifest. Then we saw a very powerful rally by the second half of 2008 and that led the economic recovery substantially.
So again, this time will be no exception, long before the economy turns around and markets rally. We are not quite there yet. Notwithstanding a couple of dead cat bounces or bear market rallies.
Small positive that I mean, even the conflict is raging. China is not quite opened up and therefore supply chain stance is unsorted. We are seeing the commodities come off quite meaningfully and now oil has started to come off. I think that a few people have penciled in that an oil price reversion is almost inevitable in the case of a recession like scenario. If that were to happen. What are your thoughts about oil and commodities at large? Do you think that's a tailwind? What is your view on commodities?
Taimur Baig: I think that lower energy is always a tailwind for the oil importing part of the world and most of the world is oil importing. This high price of oil has certainly dented consumer expectations, so price going low will help on the margin.
But levels are high. We are still talking about $100 plus oil. In nominally and in real terms, this does not mimic the altar of the 70s. But let's hope and pray that we will have to deal with the 70s. This is painful.
Now the commodity market view. I think that the western strategy around oil initially was a bit misguided, but now it's working out correctly. Which don't get in the way of Russia selling discounted oil to India, China, and others. But make sure the producers in the west, ramp up their production as well as the producers in the midwest and the Middle East. And this is going to happen. So on the supply side, cheap oil from Russia continues to flow. Russia’s earnings from the oil is not very high. The windfall is not that big but is not somewhat lower either. But there's a strong supply response in the rest of the world and that balances out the Russian deal.
Before the pandemic, the U.S. was cruising 13 and a half million barrels a day. After the pandemic, it went down by almost 30% to 10 and a half million barrels a day. The U.S. certainly has the capacity to produce much more, though there are some frictions with respect to manpower, with respect to the rig supply. Also, there is some degree of lack of confidence on the part of oil producers in the U.S. because they have seen very sharp swings in the bull and bear side of the market.
But I think $100 plus oil month over month, have a magical effect on their willingness to go ahead and start getting rig comes up. Start hiring workers even if it has a high cost because it's profitable for them. That's why I think that in the near term, the recession fear and the correction of the strategy of the west with respect to sanctions, bodes well for the oil market as as from all-consumers perspective.
From a long-term perspective, one does want relatively high price on fossil fuel, if there is going to be a green transition. It will not happen with $30 on oil, because then it doesn't make any sense to switch.
So, whether it is through regulation or through taxes or for whatever reason, if we have high prices of commodities, then we will want to switch to solar and wind and so on. So, in some ways you probably want oil prices not to crash...
Paul Rotter is saying that oil is the new data and these days could belong to oil. You reckon that we are slated for higher prices for long period or do you believe that may not necessarily be the case?
Taimur Baig: This crisis has been a massive galvanising clarion call to all importers of the world that energy security is paramount and one cannot be held hostage to one or two exporters. But, this does not necessarily mean that we're going to double up on oil exploration and oil refining.
What will happen is there will be a doubling down on efforts to come up with alternative sources of energy.
I have already mentioned solar and wind, but also green hydrogen, or perhaps even re-looking at the issue of nuclear. I think that's where the future lies, and therefore, regardless of short-term dynamic.
The issue is there is a major shortage of refining capacity in the world with respect to oil, and that could conspire to keep oil prices high for a while. But beyond that near-term issue, for the long term I would not be a big bull on oil because I do think that climate transition related activities will be a damper on fossil fuel industry.
If the recent correction in commodities auger well, sustained inflows from retail, the tax collections, never mind what happened in May, that was a small blip but it's still about 1.4 trillion, which is great, and a bunch of FTAs that India has signed with key regions in the world. What do you think about India, the economy and the Indian market?
Taimur Baig: I think the economy has taken a number of shocks over the last five years, going all the way back to the demonetisation, the implementation of GST, and then the pandemic. These have hurt the economy and has perhaps scaled back the scenario in which we are going to have three trillion, four trillion, five trillion trajectories in the course of this decade. Maybe those things get slowed down, but I think these shocks have a way of strengthening an economy’s backbone.
It is like I have taken some punches but I have not not fallen on my back. I am still standing. As the economy reopens, stores reopens, and as India takes advantage of the geopolitical dynamic, which in many western companies would like to diversify their supply chain. I think the opportunities is golden for them, both from a short-term and medium-term perspective. It is not an easy to build a chip fab in India. It would require herculean efforts because the sort of supply chain, the technical know how as well as manpower, which China can supply, I really don't think any country is capable of matching it right away. It will take time. It will take a lot of sweat and tears to build high tech capabilities. It ought to be there to build a path for the future, because the window is substantial. The gains to be had is also substantial, because the work required to get that done is also substantial.
India's promoting the PFI schemes to boost manufacturing. There's a tailwind because of China plus one. Prime Minister Modi's tweet yesterday about Foxconn and Foxconn responding "Oh! We might look". I don't know if a semiconductor manufacturing facility comes or not but at least there is noise around that from their side. Does this give a boost to manufacturing and in your talks around the world do you get a sense that some bit of this China plus one hype is actually for real?
Taimur Baig: If you will have this discussion two, three years ago, I would have said it's largely hype. I would have said that the supply chain of China is extremely hard to mimic. I have seen the balance shift on this issue substantially in the last 36 to 48 months. I think the drive towards efficiency took us to China. But now we are basically saying that efficiency on its own is not a panacea. That resiliency and security are equally important dimensions as well. This means more costs of production. It also means greater friction in the supply chain. So, life will not be as easy as it was three years ago, but I don't think politically we are ever going back to three years ago. Hence, this China plus one and India being a potential beneficiary, I have shifted away from becoming overly dismissive of the idea. To see that as a real possibility. To paraphrase an old American movie: You have to build it, they will come !
There's some conversation of inflation, index bonds, you know, a third attempt of sorts being made in India. We have never succeeded, but some of the other countries have. What's your view on this?
Taimur Baig: I think it has its place in capital market development, but as we have seen in the case, the U.S. it's not a panacea. It's not like the fact that the U.S. has had tips type instruments for the last decade and a half, has allowed the corporate sector or U.S. consumers to tax their exports in inflation.
What happens is when inflation is low for a long time, these products have no demand and then when it's high, it's a lot of demand and then neither case you can actually take advantage of it unless you see these things coming a long time ago and I think these 12 months that we have seen with inflation, tells us that you know, our understanding of the efficient process, our ability to project inflation, not that good and we economists, as well as financial market participants are all to gain. You look at what projections were 12 months ago, Fed projection, street projection, economy projection, nobody saw this coming right. So therefore, nobody suggested these tips 12 months ago either, maybe one or two brave souls and they are laughing their way to the bank, but by and large, I think that having these things are good for a market development perspective. They have a role to play. I don't think they will necessarily add to building RBIs credibility or bringing inflation down because people will have their own do not panic. I think those things work in theory experienced on the western market with respect to inflation, Index bonds, just that there is only a limited likelihood of success are those very ambitious goals.