Warning! Be wary of a December sell-off

Lokeshwarri SK Aarati Krishnan | Updated on August 04, 2014 Published on August 03, 2014


Geoff Lewis

Geoff Lewis

Global funds may cash out by year-end, preparing for the US to increase rates in the summer of 2015, says Geoff Lewis, Executive Director and Global Market Strategist, JP Morgan Asset Management

With the election and Budget behind us, global events such as Argentina’s debt default and the impending interest rate hike in the US are back on investors' radar. So we caught up with the forthright Geoff Lewis on his recent India trip to find out what is in store for global markets.

Lewis thinks India is in a Goldilocks situation and that equities, both from emerging markets and Europe, may outperform. But he also warns that bonds are best avoided.

Is the global economy on the mend? What does that mean for investors?

It has been quite a surprising first half of the year. Everybody expected US and global bond yields to move up. But they moved down. Year-to-date, the best performing asset class has been US REITs, followed by emerging market debt and commodities. If you asked anyone at the beginning of the year, they wouldn’t have expected this. So, the lesson from this is that investors should always be prepared for the unexpected; they should be diversified.

If you talk of what has changed, we don’t think the economic prospects have changed very much.

The US economy is normalising and becoming healthier. Europe is restructuring and the Japanese economy is becoming better. If you put all that together, the world economy is on an improving trajectory. You won’t get that impression if you watch Bloomberg or CNBC or read the Financial Times. They’re still talking of the end of tapering, deflation and so on.

It seems to us that the risks of a European collapse or US fiscal policy have been reduced. If you look at the Purchasing Managers Index (PMI) of all the leading economies, you find that they’re all getting much better.

One number can be misleading, but if all the PMIs are improving in tandem, that’s a strong signal.

Indians now have the option of investing in Asian, US or European stocks through mutual funds. So where would you put your money?

The big change between 2014 and 2015 will be that Japan’s earnings may moderate, while Europe is expected to come up.

So far, you can’t see it in the data for European earnings. When the inflection point comes, we should see European stock markets perform better than the US market.

We are not by any means negative on the US. In the US, we still have moderate earnings growth, low interest rates, strong margins and an economy that’s more visibly growing than Europe and has less structural problems. The US equity market is not overvalued in my view.

Have global investors really changed their view on India because of politics?

India had large outflows from its debt markets in line with other members of the Fragile Five. But the difference was that foreign participation in Indian debt markets was really low compared with the other markets, such as Taiwan.

There was a global risk-off. But if you notice, the money also came back pretty quickly. At the moment, I think it’s a Goldilocks situation, with $10 billion coming in last year and another $10 billion this year.

The problem for many emerging markets (EMs) seems to be that it is either famine or feast. But India’s fundamentals now are better relative to China and relative to other EMs.

A lot of investors were telling us earlier, ‘we’d like to wait for the Budget and see if there are outflows.’ But my view is that the portfolio inflows into India tend to be persistent. That suggests that they’re looking at India as a long-term investment opportunity. This also shows they’re probably not looking at India as a manufacturing base for exports but as a good domestic story.

When large foreign investors look at EMs, they’re looking for scalability. A large domestic consumer market provides that; India, Indonesia, China, Brazil and Russia provide that and not really anybody else.

A large pension fund in the US cannot deploy its money in, say, the Philippines. It is looking for a large economy to absorb that money.

Are foreign investors in Indian bonds short-term oriented compared with equity investors? That is the impression we got from outflows in 2013.

Yes and no. A lot of retail money has gone into emerging market debt mutual funds and ETFs. That is where the selling pressure came from. Retail investors in those funds tend to panic.

The institutional investors did not trigger the panic. Having said that, the Indian (bond) market appears fully valued. As we approach the first hike in interest rates in the US, there will be panic among investors.

Emerging market debt will prove to be a crowded space. You don’t want to be the last one left in the party.

So what will happen when US interest rates move up? Will we see another exodus from emerging markets?

It depends on how the rates are raised. If the US economy grows moderately, unemployment comes down gradually and the Fed raises on schedule, then everyone will be prepared and that is ok. If emerging market earnings also pick up, the positives will outweigh the gradual rate increase.

If rate increases happen with unemployment and wages increasing, inflation rising and investors think the Fed has left it too late, then there will be a global risk-off again. Money will move out of debt and equity and it will be painful for everybody.

My personal opinion is that nobody knows what will happen once interest rates start rising.

It is a watershed event. We have had seven years of easy monetary policy. This marks the end of that unconventional monetary policy in the US and elsewhere.

Will emerging market currencies be affected?

Financial markets tend to anticipate any event three to six months before it happens. And the weakness can continue for three months after that.

There will be a temporary sell-off in the equity market. It does not signal the end of the rally. They are hiking interest rates because economies are stronger and corporate profits are good. That is good for equities.

From January or February next year, the market will start factoring in the rate hike.

Many fund managers close their books in November or December. So the danger period is the closing months of this year and not opening months of next year. That said, there is very little value left in fixed income anywhere.

So you need to have quite a lot of cash instead of fixed income.

If there is a big correction in emerging markets, you can deploy some of that cash.

Gold technically looks as if it is due for a rebound. But it is a poor inflation hedge in the long run. As a portfolio diversifier, you can have 10 per cent in gold. Once interest rates start rising in real terms, it has normally been negative for gold.

Income is still growing strongly in India and China, where the gold demand does not go away.

Have you factored a weak monsoon into assessing India’s growth?

It is negative, but not a disaster.

A really bad monsoon, like 1992, does not seem likely. If you look back at data since 1848, El Ninos or the Southern oscillators have caused a poor monsoon only 50 per cent of the time. Most foreign investors would look at this as a short-term concern.

What’s your view of emerging markets as an investment?

Emerging markets had a very good recovery post-Lehman crisis, then they sort of rested on their laurels. There was really excessive credit growth in places such as Turkey.

Then we saw political risk play out in Thailand, Turkey, Brazil. But we have since seen the situation improve.

Current account deficits have improved across the board. Many of them have raised interest rates; here, India was much ahead of the others.

We have a very simple view of emerging markets. We think the story about EMs decoupling is basically nonsense. They haven’t decoupled from the global economy in any way.

This is clear from the fact that exports and industrial production for EMs track each other very closely. The last two years have been the worst period for EM exports since 1997.

As the European economy contracted, this hit EMs really hard. Thus, EM earnings have been falling.

So we take the simple view that if Europe picks up, EM exports will pick up and, therefore, their economies, too, will follow suit.

Published on August 03, 2014
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