Do you think that the risk adjustment in the world is over?
As far as emerging markets go, I don’t think it’s over yet because for the next three to six months, the first three months of the first half, we have to deal with another major event that we’re getting into starting in June. It is quantitative tightening by the Fed. This is something I have talked about extensively and I would like to reiterate that the next episode of QT is likely to be more severe than what we have seen in the past.
We had seen QT throughout 2017, around October 2017 to July 2019. But at the time about 15% to 16% of the size of the Fed’s balance sheet was trimmed. This time the Fed is talking about shrinking the balance sheet by nearly 30% and that’s somewhere between $80 billion and $90 billion. Various types of securities, mostly Treasuries and MBS (mortgage-backed securities) are being sold or removed from the Fed’s balance sheet. This type of situation, particularly early QT, is always a distressing situation for the markets. emerging in terms of liquidity. It’s something we have to deal with. We have to hold on tight to our seats during this period.
How do you see things going forward for emerging market valuations? Has a 15% reduction already occurred and another 10% is coming?
It’s hard to put a number on it. If I look at the valuations, during the periods that I’m talking about, there is a significant degree of reduced liquidity. If I take MSCI Asia ex-Japan valuations, they are down to a 10.5-11% range. We’ve seen it in 2018 and before that in early 2016. The GFC was obviously an outlier where it dropped to around eight times or so.
I really don’t expect that level of correction right now. Today the one-year forward price for earnings is somewhere around 12-12.5%, which would tell us if we hit those previous cases of valuations and they’re now 8-10% in Asia, I’m talking about goods that are still in the cards. Obviously, the more expensive markets could be more exposed to this type of correction. Therefore, there is a short-term risk for the Indian market.
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What is the outlook because that stock has just been in a very listless range of Rs 825-920? It was a pretty weak listing, but we are seeing a sell-off throughout the market, as well as across the board. How has the action behaved?
I can’t comment on stock specifics but, in general, there are two things to consider, as far as this discussion goes. Number one, the life insurance industry in general and number two, the recent history of IPOs. The entire episode would have two impacts; on two different levels, it could impact the market and that’s number one. We should expect future IPOs to be more reasonably priced, leaving the most significant upside on the table for secondary market investors. We have seen IPOs underperforming the market and not just from the insurance sector. Many of the first were from the technology sector. Second, investors are also beginning to question the assumption that insurance in India is underpenetrated. There are comments that we have come across that speak not only to the absolute level of insurance penetration, but also in relation to income per capita. On that parameter, some commentators have argued that the Indian insurance market is not really as poorly penetrated as one might argue. So some of the questions are coming to light and we have to deal with them in the future.
When we talked to you in March, you said that buying anything right now is like standing in front of a moving train. The fear seems to have calmed down quite significantly from what we witnessed in February. Do you think there are lucrative buying opportunities when there are significant declines in the markets? If so, what would you look at that could generate great value?
As I just said, for the next quarter or so, through the summer, I would remain cautious on emerging markets, including India, primarily due to the likelihood of a severe liquidity squeeze from central market banks. developed.
When it comes to buying, maybe after the dust settles around August, September or so, there are two or three themes that we’re focusing on and that’s Asia and emerging markets. First of all, these are the beneficiaries of the inflation of the yields. Yields are obviously going up and that is a direct positive consequence for the net interest margins of the banks in this region.
In the case of Indian banks, in private sector banks, there is this phenomenon of asset quality improvement. We could also see a slight improvement in credit growth, if not this year, then possibly in the first half of next year. So I would definitely choose, I would select private sector banks, first choice.
Second, we remain positive on sectors benefiting from currency depreciation in Asia. Indian IT services, some of the Indian pharmaceutical stocks fit that bill.
Thirdly, the whole energy and fuel complex where we are playing both conglomerates and pure game energy explorers. So these are the sectors I would continue to pick in the event of a significant correction. I would likely stay away from consumers, particularly discretionary consumers, who would likely continue to face margin pressures over the foreseeable time horizon as a result of input costs being inappropriately passed on.
What happens when China opens up? Are we facing a rebound in crude oil and everything is changing?
Some degree of increase in the prices of materials, say metals or iron ore, would be inevitable when China opens up. At the same time, it’s also worth noting that some of this economic downturn and some of this consumer weakness that we’re seeing in China is also structural. It has undoubtedly been driven by Covid-related restrictions. but it may not return to pre-Covid levels quickly.
So while fuel prices would continue to be strong, it is partly due to the geological stresses that we are seeing and it would not be wise to jump into the materials sector. You’d have to be cautious there and, in particular, we’re seeing the trend of governments, across the emerging and developed world, trying to control the consequences of inflation in different ways. We have seen the imposition of export taxes on steel, the ban on wheat exports, several similar initiatives in Southeast Asia, such as the ban on the export of palm oil from Indonesia. This regulatory impact of governments trying to control inflationary pressure internally is something that investors would have to navigate and could emerge as one of the central themes going forward.
What could be the next big trigger that could drive the next stage or scare the bears away altogether?
When it comes to positive triggers, we need to see the combination of inflation and recession concerns or, in other words, the narrative of stagflation concerns to change. It’s hard to answer when that narrative would change, but one could think year-on-year inflation, commodity price inflation about to plateau in the developed world and possibly we’ll get better indications after the summer, closer to the fourth quarter of this year.
So that’s the time frame I would possibly look at. By that time, interest rates in the US, the Fed rate, would also be close to 2% or so because we’re expecting four 50bp hikes, one of which has already happened. So until September, there could be three more. At that point, the Fed rate would also be at a reasonably high level of around 2.25%. That could be the period where the worst of the news is possibly behind us.
Now there is plenty of risk in this market. For example, we still don’t expect a recession in the US, although we do expect growth to slow significantly to around 2.7% this year, perhaps closer to 2% next year. If we have a situation of stagflation in Europe and possibly much lower growth than we expect in the United States, then a lot of the drivers in Asian equities would possibly disappoint us and we would see more cuts in Asian earnings estimates and we would have to get ready. For that.
While you said you were very selective when it came to the consumer space, don’t you think normal monsoon is really picking up in terms of demand? Could this be the silver lining when it comes to the FMCG space?
It could be, but there are also some headwinds to demand. We’ve seen wage growth slow and level off, and furthermore, the significant increases in input costs that most consumer businesses have faced have yet to be fully passed through, and the best illustration of that is the difference between WPI inflation and CPI inflation.
There is about 7-8% difference between them. It clearly shows that the inputs, the prices of raw materials have increased much more than the prices of final consumer goods. There are some companies that are market leaders and have a massive reach across the market and therefore greater pricing power. They have been able to partially pass through these cost increases and may be relatively insulated from the margin pressure that we are starting to see.
So when I say selectively, I mean the market leaders, the guys with pricing power in each of the consumer niches I’m talking about. But beyond that, the broader universe of consumer discretionary and consumer staples should arguably be avoidable now for investors.