'We are positive on India but...'

SMART TALK: Malcolm Wood

Malcolm Wood

Coming from Sir Don Bradman's hometown, Adelaide, Morgan Stanley's Asia-Pacific Strategist Malcolm Wood calls himself a cricket buff. But that can't probably be the only reason why he should be interested in India.

Currently, Indian stock markets are perhaps in better form than itscricket team is. Although Wood is worried about valuations in the emerging markets, including India, given the sharp run-up in stock prices over the past year or so, he and his team still keep faith in Indian equities.

Wood, who grew up in a farm in his early years, studied economics and law before venturing into the world of finance and investments. He has had a six-year stint with Morgan Stanley in various positions. Wood spoke about global markets, risk to equities and his views on India in a free-wheeling interview with The Smart Investor.

Do you think the global equity boom is sustainable?

I hold a positive outlook for equities except for the US markets. We are overweight on equities but underweight on bonds and cash. S&P 500 is expected to hit a target of 1400, clocking returns of 10 per cent in the current year. The earnings growth in the US is expected to be 8 per cent.

Do you see a global liquidity tightening?

The Fed rates have been rising for almost two years, and it looks like they will see a further hike. The European commercial banks are beginning to raise rates as well. Liquidity conditions are tightening in the global economy, and this will put pressure on markets, which are driven by liquidity flows.

But, we believe that the fundamentals are reasonably positive for much of Asia. We expect decent economic growth and, hence, double-digit earnings growth for companies.

What about India?

While in broader terms markets might come under pressure on the liquidity front, we are positive on the Indian markets in the long term. However, in the short term, we are slightly circumspect because the markets have gone up quite a bit, and valuations too seem to be on the higher side.

The advantages of demographic dividend, and globalisation initiatives that corporates in India have undertaken in the last few years, combined with the vibrant breadth in the market, should keep Indian equities in good stead.

What are your views on the emerging markets?

We hold a neutral rating on the emerging markets. We have pulled back from Brazil, China, eastern Europe and India. Though we believe in the strong macroeconomic fundamentals, from the valuation perspective, these stocks have already seen a substantial rise.

Emerging markets were trading at a discount of 40 per cent to the global markets three-four years ago. Today, the discount has moved down to under 20 per cent, which reduces the margin of safety.

On a relative scale , which emerging markets look attractive?

We expect a re-rating of Brazil. Currently, Brazil is trading at a P/E multiple of 10. One of the reasons for the low multiple is dramatically high interest rates that hover around 17 per cent. The medium-term prospects look bright.

Korea is an improving economy, but it has been significantly re-rated in the past year. A balanced economic performance is sure to drive good domestic demand.

Interest rates are low at 4 per cent (in the short term) and may see upside, but since the currency is strong there is no need to worry. We are overweight on Korea as the valuations, especially in the technology sector, look attractive.

The Chinese markets are quite similar to India's. Even China has experienced a prolonged bull run. There is much political pressure from the US to revalue the Chinese currency as it is massively undervalued.

But the Chinese government may actually choose to increase wages rather than revalue the currency as this will boost the domestic demand. Having said that, valuations are looking stretched and the consumer foods, finance and insurance companies are trading at P/E levels of around 20-30.

What could be the possible risks to your assessment?

Investors believe that emerging markets should be at a discount because of weak macroeconomic fundamentals, corporate governance issues, inefficient capital management and weak banking policies.

But then, there are major macroeconomic imbalances even in the US. The US is not crystal clear on the corporate governance after problems like Enron and WorldCom. Again, in countries such as Korea, capital management has improved considerably. Korea has debt-equity ratios similar to those in the west. We also see growing professionalism in these countries.

So, if investors turn around and say that they are willing to pay a premium for higher growth, these markets could surprise on the upside. Before the Mexican crisis, in the early nineties, markets experienced a huge run-up and a lot was because investors were paying a premium for growth.

There were cultural differences among countries, but the risks were ignored. Now, investors are again re-rating emerging markets. Considering the growth rates, there is reason to believe that this is not the end of the story. Asia will continue to see re-ratings.

Could there be a downside risk to your forecast?

On the downside, there could be some sort of supply shortage, particularly in the commodity markets like oil or a correction in the US bond market.

All these issues may threaten global markets. There is also the risk of a sharp decline in the housing prices in the US, if the interest rates rise way beyond 5 per cent. Similarly, if we see an early tightening of bank rates in Japan, it could lead to a sharp contraction.

What are your views on oil prices? Do you think this will bring about a deceleration?

Our energy analyst predicts oil prices to be around $57.5 in the current year. We expect them be around $50 in the long run. The impact of oil is usually felt very quick (not in India though) and the hit has already been taken.

With the outlook for US equities not so bright, do you think the US investors would channel funds into other asset classes instead of keeping faith in non-US markets?

In the last year, 77 per cent of the corpus in US equity funds was put into international funds. The long-term average till last year stood at 20-25 per cent. This indicates that there is growing confidence in global markets.