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Investors have been fine-tuning their strategies, given the possibility of the US Federal Reserve winding down its bond-buying programme. As a result, money has found its way into the developed world from the emerging markets (EMs). Philip Poole, global head of macro and investment strategy, HSBC Global Asset Management, tells Puneet Wadhwa in an interview Central and Eastern European countries are the most attractive among the EM pack on the basis of valuation. In the Indian context, he is overweight on financials, industrials and consumer discretionary spaces. Edited excerpts:
What is your interpretation of the last few statements by the US Fed? Is the recovery in the US sustainable enough for tapering off the bond-buying programme?
(Fed chairman) Ben Bernanke is trying to do a balancing act. The recent statement has been an extension of what was said earlier. I wouldn't say the last few statements have been deliberately contradictory, but there has been a difference in emphasis on the conditions. There are a number of conditions that have been mentioned, but the question is to the extent to which those things are either emphasised or not. So, there is a big difference between slowing the pace of QE (quantitative easing, as the bond-buying programme is called), or tapering of QE and raising interest rates.
Bernanke is very clear in arguing that an increase in interest rates is a long-long way away. He doesn't want the market basically to price in aggressive interest rate hikes too early. He became a lot clearer in the recent statement. The Fed's policy target is to maximise employment. So, one needs to look at the labour force participation rate as well before taking a call on tapering of QE. The inflation, too, is under-shooting the Fed's target, which if continues will be a problem. Deflation is something that the Fed will try to avoid at all costs.
So, if you put all of this together, in my view, we will see a tapering off of QE3 before the end of the year, but it is probably not going to be as soon as September, which is what the market was thinking. It is likely to end around the middle of next year. The first interest rate hike is likely around the end of the first quarter of 2015.
What should investors interpret from such statements?
Since there is ample liquidity in the global system, money can move very quickly between asset markets. Bernanke is trying to avoid a build-up of risk bubbles across asset markets and classes. While on the one hand, some of the emerging markets saw debt spreads come down, the US markets on the other hand reached all-time highs in terms of absolute valuations. Thus, from time-to-time, the Fed will emphasise perhaps a more hawkish stance and try to take out some of that froth from the market.
What has been your asset allocation strategy over the past one year and do you see this changing significantly over the next 12-18 months?
We are of the view that government bonds, treasuries, gilts, bunds, Japanese government Bonds (JGBs), etc were expensive. Hence, we have been underweight on all government bonds and overweight on corporates and emerging market debt up until the first quarter of this year.
In the longer term, equity markets offer more value than bond markets. Even with the treasury yields having moved up effectively, they are likely to go higher from here on. By the end of the year, we might have treasury yields up another 30-50 basis points (bps). The adjustment in the bond market has yet to play out.
Do you think EM equities still have value?
Equities still have value. Developed market equities have done quite well, particularly the US. EM equities, on the other hand, have underperformed. Defensive stocks, especially in EMs, have been the best performers, while cyclicals have underperformed. Thus, when we look at long-term value, we see more value in equities than in bonds and prefer cyclical sectors than defensives. And that's where our funds are positioned. Overall, EMs are not the engine of growth as compared to what was, say, three years ago. This has been reflected in a way how the stock markets have behaved.
What about India?
In India, our overweight position is on financials, industrials, consumer discretionary, materials, etc. We are underweight on sectors that are defensive bets such as pharmaceuticals / health care, consumer staples and information technology (IT). This is also a reflection of the asset allocation module we have in the Asian context.
Which geographies and asset classes could see a higher allocation? What are you advising clients at the current juncture?
If we look at markets from a price-to-book (P/B) versus return-on-equity (RoE) basis, the US markets loom expensive as they have already performed well; Europe looks relatively cheap, particularly Italy where the valuations are quite low; the UK also looks relatively cheap. Japan, on the other hand, looks expensive. Latin America, Asia (excluding Japan) and Eastern Europe look cheap. So, these are broadly the places where we see value.
Can you elaborate on your views on China, Japan?
China’s GDP figure at 7.5 per cent was broadly in-line with market expectation. I think there is some confusion about what the government is looking for and there have been some conflicting comments. In their five-year plan, they have a growth target of 7 per cent. Anything above this is a decent number. I think the markets, too, are toning down their expectation to more realistic levels of rather than the 8 – 9 per cent mark.
Japan is clearly the strongest as regards growth among the G7 nations probably for the first time in 20 years. The outcome of the stimulus has been positive and the recovery is coming through, data suggests. The challenge for Japan is to adopt structural economic reform and keep growth rates moving. This augurs well for other Asian economies and will help offset weaker demand from China.
Do you expect outflows from EMs to pick up pace?
I am not sure that we will see a dramatic outflow since we have already seen a good outflow. Overall, money has come into the equity market universe, but has found its way into the developed markets and left EMs. So, we have already seen a realignment.
I think there is real value in some of the BRIC (Brazil, Russia, India and China) markets from a long-term basis. Central and Eastern Europe are the most attractive among the EM pack on the basis of valuation. This is partly because most of these markets have been dragged down by a lot of problems in Europe. From a medium-term perspective, these are the markets where people will look to allocate funds to.
Would you expect this correction in EMs to also create a flutter in the EM currencies and bond yields as we trudge deeper into 2013?
Yes, there are a few things here that have been playing out simultaneously. One issue for currencies has been the current account deficit (CAD) problem. Countries with high CAD, especially India and Turkey, have suffered on account of this. These economies are dependent on external financing. So, when markets start to price in tighter liquidity conditions, these economies and markets tend to suffer. And then, there are growth-related issues with a country like India.
If we take the purchasing power parity to look at the structural differences in currencies in terms of their underlying purchasing power; then many Asian currencies, including the rupee, now look very cheap relative to developed market currencies. Swiss franc and yen are some of the currencies that still look over-valued vis-a-vis the US dollar.
Do you think the possibility of getting past all-time highs for the Indian equity markets over the next few months has become more challenging, given the macros and the political landscape?
Yes, I think it has become more difficult now. Twin deficits are an issue now for the foreign investors. There is election on the horizon that creates potential concern about policy/reforms. Currency weakness means that the Reserve Bank of India (RBI) will find it difficult to cut interest rates. The recent economic data, too, has not been encouraging. In this backdrop, it will be difficult for the markets to move higher unless we see a significant change in global sentiment. Indian factors are not particularly supportive.
How much worse can the growth rates get for India, going ahead? What numbers are you working with?
We don't have any particular target. If we think about the current policy, fiscal deficit will be around five per cent this year. Our growth forecast has come down and is certainly lower than what India was growing in the pre-crisis period. India needs to improve upon infrastructure to spur overall growth. I think post elections, we will see a renewed impetus.
On the other hand, the rupee's weakness should be helpful for exporters and their margins. However, elevated levels of oil will be a drag on the overall growth. One way of kick-starting growth will be to start the reform process. Hopefully, inflation levels should come down which should allow RBI to cut rates. A rate cut in the short-term, however, is ruled out.
Do you expect the mutual fund redemptions to pick up pace going ahead thereby putting more pressure on liquidity and the rupee’s trajectory?
As a result of the RBI’s action, the combination of a cheap rupee and higher yield will discourage additional outflows. The June (outflow) numbers have removed some of the froth from the market, improved technical position. I think that the market is now re-priced and has more value.
What are your views on the commodity space?
In case of gold, in case the price falls, people tend to buy more of this yellow metal. Gold prices have corrected partly because the Indian authorities have put curbs on imports. Central banks across the globe, especially Cyprus, had started selling their gold holdings earlier. More importantly it is weaker because the big picture risks that were considered problematic in 2012 (break-up of the euro-zone, US fiscal cliff) have become less problematic now. If treasury yields start to move up, gold prices could trend down. However, they will find trading range equilibrium around the current levels. I don’t expect a dramatic fall from these levels.
Metal prices have been under pressure due to weakness in demand and perspective on Chinese growth. China is the marginal driver of metal prices now globally. So, as long as Chinese growth is considered to be sub-par, then metal prices will continue to languish. Copper, aluminium could do well if China’s growth rates improve.
Oil again will find trading range equilibrium around the current levels. However, having said this, there are some geopolitical factors that are supportive of higher levels. For instance, the Arab Spring created a political change and that’s not over yet; Egypt has been a renewed flare up; inventory levels in the US have also dipped.
