'Market rally shifting from being liquidity-driven to earnings-driven'

If GST won't lead to disruptions in economic activity, we should see earnings recovery: John Praveen

John Praveen, managing director and chief investment strategist at Pramerica International Investments, tells Vishal Chhabria the recent stock market correction is due to high valuations, strong year-to-date market gains, geopolitical tension and profit-booking by investors. However, the trend remains positive. Edited excerpts:

Markets globally have corrected recently. Do you see a further decline? 

Global stock markets sold off in early August amidst heightened geo-political tensions between the US and North Korea. Additionally, President Trump’s political troubles have increased, which in turn have raised doubts about whether the Trump reflation agenda (tax cuts, reduced regulations and increased infrastructure spending) might get delayed or completely derailed.

Further, equity valuations are expensive in most markets with P/E multiples above long-term averages. Finally, June to September is seasonally a slower period for stock markets. Global stock markets have posted strong gains in 2017 year-to-date to August. Thus, investors appear to be taking some profits.

Stocks have since rebounded and by mid-August are back close to end-July levels as geo-political tensions appeared to ease. We still expect bouts of volatility in stock markets especially with the US and South Korea expected to hold their joint war games in late August. However, we expect the increased tensions in early August to gradually ease as the US works with China in de-escalating the situation in the Korean peninsula. Easing tensions should help global stock markets to remain in an uptrend, supported by strong earnings growth, improved global GDP growth, QE (quantitative easing) buying by Japan and rate cuts in some EMs (emerging markets). 

A lot of contrasting views have come on how US Fed rates will move. How do you see them moving? 

There is no reason to believe that the Fed is going to be more aggressive in raising rates. There is no need for them to be aggressive as inflation is still quite low, and below Fed’s two per cent target. We expect one more rate hike this year, and some balance sheet reduction or normalisation but at a very gradual pace. It’s not that they are not buying bonds anymore, but what they are doing is that they are not reinvesting the bonds/papers that are maturing. So, it’s more of a passive approach towards normalisation.

The ECB (European Central Bank) is also talking of reducing QE. So, put together what impact do you see on markets?

We have had liquidity tailwinds with QE by the ECB and Bank of Japan (BoJ) in last few years. Even though the Fed has stopped QE, there was a low interest rate environment. These were supporting financial markets. So, the Fed has now started to raise rates and then will do balance sheet normalisation. The ECB is probably going to start QE tapering sometime later this year, while BoJ is likely to continue QE. So, the tailwinds are not going away, but we will have less tail winds from developed market central banks. In contrast, emerging markets’ central banks are all still cutting rates as inflation is under control. So, there are still liquidity tailwinds, from the EMs and the BoJ.

Coming back to the developed markets, the central bankers’ moves reflect confidence in the economy. Bringing back rates to a normal level, will give them ammunition to cut rates in case there is another downturn. This is interest rate normalisation, and not tightening. At the end of 2018 the Fed fund rates would likely be at neutral level. I don’t see this as a big negative.

Look at other factors, growth is improving in the US. Recent China data was a positive surprise. For India, the demonetisation impact is fading and once GST hiccups go, then its growth should pick up. After a long time, Europe and Japan are actually growing at above trend pace. So, the global growth picture is quite positive and hence you don’t need so much of central bank stimulus.  

With global growth improving, will it not hurt inflation?

Not necessarily. Inflation is right now still very much under control. In fact, it is actually surprising on the downside. Commodity prices have recovered but are still struggling including crude oil. Wages in the US are growing at only 2 to 2.5 per cent. Other structural factors (like e-Commerce) are actually putting downward pressure on inflation. We do not anticipate an inflation problem either this year or next year.

As rates move up gradually and QE programs are wound up, do you think the liquidity flows will continue to EMs?

Liquidity is becoming less, but in the last couple of years’ earnings were quite weak across all markets. So, it was a liquidity driven rally. It looks like markets are transitioning from a liquidity driven rally to an earnings driven rally. Because you have good growth, you will have good corporate profits. So, markets will continue going up. However, fund flows are going to be driven much more by earnings rather than pure liquidity.

Will rising rates in developed markets and declining rates in EMs, make the latter an unattractive asset class?

Spreads are still wide and continue to narrow. But, even though the US 10-year treasury yield is now around 2.3, it is not likely to go up significantly. We see it at around 2.5 per cent in late 2017, and likely to touch 3 per cent next year, which is still quite low, and below levels in early-2015. You probably need US 10-year Treasury yields to go higher like 4 per cent to make a big difference. Since this is unlikely, we may not see a big reversal in fund flows but there will likely be a negative reaction in the short-term like we saw during taper tantrums.

Any downside risks you see for markets? 

The downside risk is that valuations are expensive in all markets. But, we aren’t in bubble territory and I don't think it will trigger a crash like in 1999 when valuations went into bubble territory. The second risk is geo-political issues such as North Korea, Qatar-Saudi Arabia rift in the Middle East, etc. The third negative risk is if the central banks become more aggressive or hawkish. Right now, markets are pricing very gradual rate hikes and balance sheet normalisation. The fourth risk is that there is no progress on the Trump reflation agenda (tax cuts, reduced regulation and increased infrastructure spending).

Corporate earnings in India have disappointed in the last three years. This year also expectations are high at over 15 per cent growth. What is your take? 

The demonetisation impact is probably behind us and so if the GST is not going to lead to major disruptions in the supply chain and in economic activity, then we should probably see earnings recovering. Maybe, the earnings expectations are a little on the higher side at 15 - 16 per cent so there may be some disappointments which is a risk because we have had a big rally and markets are somewhat expensive. In that case, we may see some profit-taking and some consolidation in the market.

On an average, what return expectations you have from Indian equities for the next one year? 

If you look at 2016, the developed and emerging markets grew about 8 - 9 per cent. India, too, had seen similar gains but ended with 2 per cent returns entirely because of demonetisation. In 2017, year-to-date the market is already up by 20 per cent. Going ahead, there are two different scenarios. If the GST implementation goes without major hiccups with no significant negative impact upon earnings in the next 1-2 quarters, we should see good earnings growth. If earnings meet the 12 - 15 per cent expectation, we should get decent return of maybe 10 per cent from the market. On the flip side, in case of disappointment, say if earnings grow about 6 or 8 per cent, market returns would probably be about just 5 per cent.  

Some praise saying India is growing fast, while others complain about jobless growth. From a foreign investors’ perspective, what is your take? 

No, we don't have complaints about growth, but more about not meeting expectations. From 8 per cent levels, India’s GDP growth is now 6-6.5 per cent due to note ban last year. We have continued to see demonetisation impact this year as well. But, we are expecting growth to pick up led by lot of infrastructure spending, GST (it can add 1 per cent to growth) and continued reforms, to the 7 - 8 per cent range.

Looking at the events on resolving the insolvency cases at NCLT, how do you see these initiatives? Is it giving you enough comfort that things will get resolved soon? 

It is a good start, and it seems that the government is having a serious commitment to try to address some of these problems. We have to wait and see how far, how successful they are in trying to resolve some of the issues in the banking system. But if that gets resolved then I think that it will probably give another big boost to the economy.  

What are you advising to your investors and, where are you putting the money in India, in equities space? 

We have to look at India in the context of other emerging markets, where India has been an overweight for us and will continue to be. We had trimmed the overweight outlook after the demonetisation last November, but increased the overweight outlook in 2017, because India compares quite favourably relative to other markets. Within India, we still like the consumer companies even though they are more expensive, but you pay a premium for higher growth. We are also positive on the materials sector because of the infrastructure spending and also affordable housing drive should provide a lot of support to the materials sector. In financials, we like retail banking.  

Looking at the farm loan waivers, loans states are taking for SEBs, do you see risk to India’s consolidated fiscal math, and will that influence foreign investors? 

It is one of the key things on the risk side. Farm loan waiver is a bit of a populist measure. If a couple of states are doing, others will follow and that might probably lead to some fiscal slippage. However, if there are increased revenues coming from the GST side, you might be able to afford to pay for it. But still, it may have a negative impact upon the fiscal deficit and may be viewed as a negative. It won’t be enough to completely derail our outlook but it might be one of the negatives. But if it continues, then there will be some disappointment and then investors will perhaps re-evaluate the positive India story.