How investors view Emerging Markets

Despite the recent dip, most investors do not view the broader Indian markets as particularly cheap

I had the opportunity to spend last week in the US, meeting up with a bunch of global investors. A fascinating week amidst the turmoil roiling global markets. Some of the takeaways for me personally were as follows:

1. There is tremendous pain vis-a-vis Emerging Market (EM) assets. Most of the smartest and most-sophisticated investors have been reducing weights in US equities and increasing EM and non-US positions over the last few years. This has not worked. Investors have taken it on the chin this year with a dramatic divergence opening up between US and EM equities. The S&P 500 is still up 3 per cent this year (even after the recent sell-off) while non-Japan Asia is down over 20 per cent in dollar terms. In fact, US equities and cash are the only two financial assets in the positive territory this year. The outperformance of US equities has been relentless since May. From a cross-correlation rate of 0.9 between EM/EAFE (Europe, Australasia and the Far East) and the US that prevailed in the past three years, this correlation rate has now moved to -0.6 since May of this year. 

There is a huge pain in China, led by the tech titans, where Tencent, the most-owned stock in all of EM is down 40 per cent. Given its size, economic performance and quality of companies, China has been a large overweight for many. The overweight worked very well in 2017 but has really hurt this year.

Illustration by Ajay Mohanty

More worrying is that whatever data you look at, one-year, five-year or even 10-year numbers, US equities have outperformed EM equities and even global, ex-US. Just when the case to go underweight on the US is probably at its strongest, as is typical, it is the hardest time to actually implement this portfolio shift. There is a possibility that some asset allocators will be forced by their committees to throw in the towel and reverse their underweight US, overweight EM stance. The short-term outlook for EM flows did not appear to be robust.

2. There was tremendous interest in understanding the IL&FS default and its possible contagion. Most investors thought that India was a well regulated financial system and there was, therefore, surprise on the default. How was this company allowed to build this quantum of leverage? Or the asset-liability mismatch? It all seems to have fallen through the cracks. What were the management and the board doing? Clear governance failure. The less said on the rating agencies the better. There was an appreciation that the government taking control of IL&FS was probably the best way to short circuit further panic and position liquidation. 

This crisis simply reconfirmed many investors’ views that Indian infrastructure is a very tough place to make money — both for the developer and the financier. The question of who will fund Indian greenfield infrastructure is a million-dollar question. The government cannot build the infrastructure on its own. If we don’t get private money back into infrastructure, how will India grow at 8 per cent? A fair question, I thought. 

Everyone intuitively understood that the party for the non-banking finance companies (or NBFC) sector was over. The valuation correction made sense. New kids on the block here will find the going very tough. How will they raise capital and at what cost? More questions were around the implications of this. NBFCs were almost 30 per cent of incremental system credit in the last couple of years. If they slow down, would there be a domestic credit crunch? Can the private banks fill the breach? Will this potential credit shortage hurt the economy just as we were starting to see traction on the ground? More than any haircut the banks may have to take on the $13 billion IL&FS debt, the greater concern was on the possibility of a credit crunch domestically. 

3. While there were some concerns around the financialisation of savings reversing, most observed that other countries have gone through similar shocks to their debt markets. Financial savings, as a percentage of overall savings, should continue to rise. The IL&FS shock is unlikely to reverse this long-term trend. There was recognition that India now had a large and vibrant domestic institutional investor base. This should cushion the country from any EM sell-off. 

4. There was great interest in YES Bank. It is a stock owned by many global investors. It has caused a multi-billion dollar drawdown. Allocators were surprised by the Reserve Bank of India's (RBI’s) decision, given how well the bank has done, and worried about what does the RBI know that is not in the public domain. Given the precedent being set, most felt that the RBI would not have taken this decision lightly.

5. On India, there was recognition that the markets were down a lot once you go beyond the top eight stocks. Mid-cap indices are down 35 per cent and the small-cap indices almost 50 per cent in dollar terms. However, most still did not think that the broader markets were very cheap — pockets of opportunity exist, yes, but this was not the India of 2013 when everything was cheap. Quality remained very expensive. Everyone was waiting for earnings. The phase of multiple expansion for the Indian markets is over. With rising rates and a weakening macro, multiples if anything need to contract, not expand further. This market’s future direction will be determined entirely by earnings growth. Over the past five years, Indian corporate earnings have disappointed massively, compounding at less than 7 per cent. Until we get back to strong double-digit earnings growth, the markets will tread water here. 

There was also confusion as to why earnings have been so weak? Has something fundamentally changed? 

6. There was a concern around the US-China trade war. Most felt this was not only about trade. There was genuine geopolitical tension between these two giants. This will not go away in a hurry, and the Chinese economy will slow down. From an EM point of view, the biggest concern was the further depreciation of the Chinese currency. Most hoped that the rupee adjustment was done, though if the renminbi depreciates, it will take all other EM currencies with it. 

7. There was not much discussion around Indian politics. Most believed that the Bharatiya Janata Party and Prime Minister Narendra Modi will get re-elected. Most did not see an alternative. 

All in all, a fascinating week. We are clearly in interesting times. 

The writer is with Amansa Capital