The Hindu Business Line : ‘Emerging equities are a volatile asset class’

Mr Jonathan Garner, Head of Emerging Markets Strategy of Morgan Stanley, believes that India looks relatively unattractive versus Brazil, Russia, Turkey or Taiwan. He said that Morgan Stanley would be more comfortable with a Sensex P/E of 17-18 times.

Excerpts from the interview:

While all Asian markets have come off about 15 per cent from their recent highs, India has been less affected. What are your observations on this?

We certainly have become a lot more cautious over the last few weeks on emerging equities. So, we have reduced our overweight position to quite a minimal one compared to where we have been most of this year. I think the issues are an increasing evidence of economic slowdown in the US and problems spreading to the Euro zone. Now, classically of course, other Asian markets are much more geared into that through their export sectors than India is. That is one of the reasons why one is probably seeing a bigger correction elsewhere than in India.

But certainly emerging markets other than India, such as Latin America, have equally held out very well.

Can this out-performance continue or are you getting cautious about India because of its relative out-performance and valuation levels?

We evaluate markets through a disciplined, monthly quantitative process that I set in trend, after I arrived at Morgan Stanley about a year ago. Within that process, India looks relatively unattractive when compared to other large emerging markets such as Brazil, Russia, Turkey or indeed Taiwan. I think the issue is that the Indian corporate sector is delivering spectacularly in terms of return on equity.

Obviously, India, as well as some other emerging markets, has benefited from the twin influences of strong domestic mutual fund inflows and very strong foreign investor inflows, particularly from people who sought to diversify out of the US and Europe.

Now specifically from emerging equities next year, we are looking at a mid-teens US dollar return from here. What we expect to happen in India is probably a return of somewhere less than that because the aggregate market needs some PE multiple contraction; it needs the earnings essentially to catch up with the PE multiple in some cases. But there will be plenty of opportunities for stock picking in certain sectors.

How important are rate cuts by the Fed in that context for the entire emerging market universe?

Well, the Fed is very important in stimulating some of the fund inflows we have just had through the 50 basis point rate cuts in mid-August. But actually, if you look at the situation now, the Fed is signalling that they really don’t want to cut interest rates anymore, even though the credit crunch, in some respects, appears to be intensifying.

So, there is a little bit of a standoff developing there. And, that might, in fact, make it more difficult to generate further sustained flows towards the emerging market equities, certainly of the scale we had over the last three-four months. They are fairly unusual. That is why we have, when we did our downgrade on November 8, been significantly more cautious over the last couple of weeks. We are sensing that balanced risk between the deceleration in growth in the US, Europe and then the positive feature of this liquidity starting to shift more to the more dangerous scenario.

Are you expecting a bigger sell-off in emerging market equities?

Our best case is that we have some economic re-coupling next year — some limited downside re-coupling. That doesn’t mean that emerging markets are going to go into recession or anything like that; but some moderation in growth rates. Remember, some of the largest emerging countries are tightening policy.

The business cycle is, to some extent, quite mature in some of the emerging countries. At the same time, the export side in certain cases is likely to experience difficulties from what is happening in the US and the Euro zone.

Emerging equities are a volatile asset class. We have just had a very strong period of returns since mid-August, we had two big corrections already this year, one in July and a smaller one in February. At the moment we would generally be looking for better value to get re-involved again in emerging equities. So, yes, we do think that the risk in short term outweigh the potential returns.

But overall, we would still suggest that we are in a bull market for emerging equities. The asset class had many strong positive fundamentals underlying growth, superior forex reserve positions, low leverage in the household and corporate sector.

Is there a year-end Sensex level that you are working with right now?

It depends on how we grow into the current P/E multiple. But I would rather again get involved with the market when P/E multiples are 17-18 times next year’s earnings rather than 22 or so where it is on consensus for the year-end 2008.

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