Foreign investors will continue to sell Indian equities: Geoffrey Dennis

The biggest risks to EM equities this year are coming from sharply higher US yields as inflation breaks out, forcing more Fed action, says Dennis

With the markets already correcting nearly 10 per cent from their peak levels seen in January 2018, Geoffrey Dennis, head of global emerging markets equity strategy at UBS, tells Puneet Wadhwa the company downgraded India from overweight to neutral earlier this year. The concern, he says, was very high valuations. Edited excerpts:
 
What are the key takeaways from the US Federal Reserve meet?
 
The US Fed is responding to a stronger economy, the risk of higher inflation, and the recent US fiscal expansion with this week’s rate hike. UBS expects four rate hikes this year, still above the three hikes expected by the US Fed, and we expect three hikes in 2019.

 

Do you expect a full-scale trade war?
 
The trade action taken so far by the White House (tariffs on washing machines, solar panels, steel and aluminium) will have little effect in isolation. From here, there will be two key issues. First, will there be a retaliation? The answer, given the action taken so far, is likely negative. Second, what other action may be taken by the US? Here, the concern is much bigger action still to come from the US (in the field of intellectual property) against China, which could lead to a retaliation. However, a full-scale trade war remains unlikely.

 
Are the global financial markets pricing this in?
 
At a 10-year US bond yield of 2.9 per cent, we believe that four rate hikes are almost entirely priced in US markets. Our view for some time has been that, as the US Fed hikes rates in 2018, the yield curve will flatten markedly. However, we do not think this discounting process has been completed in Europe, where we expect the government bond yields to rise over the rest of 2018.
 
What is your market outlook against this backdrop?
 
We are bullish on EM equities with a projected gain this year of 17 per cent in dollars (after 34 per cent gain in 2017). My colleagues in the US, Europe and Japan similarly expect strong equity market gains in 2018 of 15-20 per cent in dollar terms. The biggest risks to EM equities this year are coming from sharply higher US yields as inflation breaks out, forcing more Fed action; rally in the US dollar; a sharper-than-expected slowdown in China; and a full-fledged trade war.

 
What is your outlook for foreign flows into India?
 
We believe that foreign investors will continue to be net sellers of the Indian equity market as they seek (given weaker fundamentals) to cut the size of their long-standing net overweights in India. By contrast, we expect flows into EM equities as a whole to be strong in 2018. Already, this year, just over $40 billion has come into EM equity funds (based on EPFR data), which is over 80 per cent higher at this stage of the year for any previous year and compares to $65 billion for 2017 as a whole. We have no formal view as to whether EM outperforms developed market (DM) in 2018, although year-to-date EM is up 4.4 per cent and DM by just 0.4 per cent.

 
How do the valuations look after the correction seen this year?
 
We have already downgraded India from overweight to neutral in January 2018. Our concern was very high valuations (currently 17.4x forward versus a long-term average of 14.8x), which were driven up last year by domestic flows into the equity market, even as earnings forecasts were being cut and foreigners were selling. Even today, we think that the consensus Indian earnings per share (EPS) growth forecast for 2018 of 21 per cent is too high by around 800 basis points (bps), which would make true valuations even higher. Meanwhile, the economy has slowed, although Q4 GDP showed a good bounce, inflation has picked up recently, oil prices have been strong and the budget is under pressure. India is not an overweight market at present.

 
Your overweight/underweight sectors in the Indian context?
 
We like private banks in India, which implies that we think that the recent incidence of fraud at a particular bank is unlikely to become a broad system-wide problem. We are neutral in state-owned enterprises (SOEs) and non-banking finance companies (NBFCs). We also like auto parts, IT services, oil/gas, property and telecoms/media.
 
What are your expectations from the Modi government?
 
The main reforms of this Modi term are largely over. In the run-up to the next year’s elections, rather than any grandiose government initiatives or a major (populist) expansion of fiscal spending, we expect smaller initiatives such as an increase in agricultural support programmes, progress on bank recaps and anti-corruption measures, all set against the background of ongoing solid and prudent monetary policy.