Mark Matthews, who is head of research-Asia at multinational boutique bank Julius Baer, says there are no meaningful signs of a pickup in the Indian economy, but he expects to see a “trickle through coming in a quarter or so”. “No one expects a big rebound to the 8% we saw two years ago, but maybe the 5% y-o-y GDP growth can go to 6% by the year end,” he says.

Since the stock markets tend to “lead the economy by around six months the inference from its recent performance is that the economy is going to pick up”, says Matthews. The NIFTY index, that is close to a fresh high, is trading at 18x forward earnings, and Matthews states this makes valuation of Indian companies expensive at current levels. “There are only around 15 stocks driving the NIFTY index, and most are much lower than their life highs. So look at midcaps, but stick with the leaders there too,” he says.

Cuts in the corporate tax rate, coupled with some pick up in the current festive season may augur well for some companies. “We can expect 6% earnings growth for the full year” says Matthews. What about liquidity concerns? Matthews says “system wide liquidity is fine” although there are issues with NBFCs that rapidly grew over the past few years when banks were fixing the NPA problem. “I would expect that growth will be replaced by private sector banks, and the public sector banks that have been recapitalised,” he adds.

“Foreigners have turned more positive as they think India has lagged China and the government has suddenly become very proactive,” says Matthews. Since, “the dollar is unlikely to go down yet,” Matthews says Julius Baer’s investment portfolio is overweight on developed economies versus emerging economies. However, India is seen as less vulnerable to global challenges in comparison to many Asian peers.

On macro challenges and the global economy, Matthews says the U.S. presidential election in November next year is something to watch out for. Also, a major breakdown in the U.S-China trade relations is seen as a key threat to the global economy. “We don't foresee that, but we do foresee a gradual formation of two distinct blocks: a U.S. one and a China one,” says Matthews.

Here are edited excerpts from an interview with Matthews:

It looks like the domestic economy is hit by a double whammy. The investment engine is in low gear with no major signs of pickup, plus the outlook for consumer spending is weak. In fact, rural consumption hit a seven-year low as volume growth declined to 2% from 16% a year ago. How deep are the cracks?

It is true the two main engines that power the Indian economy are investment and consumption. Investment has been in low gear for several years. There was some hope it would pick up as capacity utilisation was trending upward from 71% in 2017 to 76% as of 2Q, but because of weak demand, it has since fallen back to 73%. And over the past year, the consumer engine has slowed too, probably due to the NBFC funding squeeze. Liquidity at NBFCs is still tight, and many consumer loans like cars, housing and white goods were financed by them over the last three years. Now companies are saying people are delaying purchases. Added to that, government spending slowed around the elections, and exports have declined because of global growth uncertainty and including services it is around 20% of GDP. Rural demand was hurt by the delayed monsoon in Q1, and when it did happen, there were floods in several locations. The hike in MSP for crops was not enough to offset those. The current festive season is critical to watch.

Are we looking at a prolonged period of recession, or do you expect a quick V-shaped recovery in economic activity in the next six months?

High frequency data hasn’t shown any meaningful signs of pickup yet, but we could be testing bottom in the overall economic environment. Drivers are interest rate cuts, the recent corporate tax cuts, monsoon rainfalls in the summer should mean a good rabi crop next year, from July the central government has accelerated spending, and electronic exports are up over 30% y-o-y. Putting those all together, we should see a trickle-through coming in a quarter or so. No one expects a big rebound to the 8% we saw two years ago. But maybe 5% y-o-y GDP growth can go to 6% by year end.

Did the wave of positive sentiment, following the historic election verdict in July, distract investors? Or is the current economic downturn on expected lines?

The growth slowdown was visible before the election, so I don’t think so. The seeds were sown in demonetisation and goods and services tax (GST). India has a huge SME [small and medium-sized enterprises] economy, and many people get their livelihood from what was a cash economy. It hasn’t gone, but it had to change, and anywhere in the world where such big changes have happened, there was a recessionary trend. But they are good long-term reforms to improve overall economy, making a much cleaner system in the future.

The interest rate is low and is likely to soften further, oil prices are low, and the bad loan crisis is largely behind us. Yet, to what extent have these factors helped boost confidence, since it seems the liquidity crunch has turned out to be a bigger and deeper challenge than anticipated?

It takes time for lower interest rates and the recent reform measures to move into the economy. System-wide, liquidity is fine, but there is an issue with a certain set of institutions, the non-banking finance companies, and they are the ones that saw big growth over the past few years, because the banks were busy cleaning up their NPAs. So, I would expect that growth will be replaced by private sector banks, and the public banks that have been recapitalised.

In the backdrop of liquidity woes, NBFCs, and the real estate and auto sectors remain under duress. While asset quality has improved, corporate credit flow has dried up by over 80% and banks continue to be seen as a weak link. Which are the pockets where you see value and potential for growth to sustain?

There will be some pickup in festive season. People were holding out for a GST cut in autos but the government said that’s not happening, and now anecdotally foot traffic is said to be improving. PSUs are 65% of system and don’t have capital to grow, apart from SBI. The government gives them enough to survive, but not enough to grow. So, private banks can continue to gain share from PSU banks. Some have also made significant headway in digital banking and putting their NPAs behind them, under new management.

Do you expect surprises this quarter on the earnings front? What’s your outlook for corporate earnings growth in the coming quarters?

The bottom-up forecasts put full year growth at 14% y-o-y, but that seems too high. Many banks have deferred tax assets they can write off with the lower corporate taxes. For other companies, the tax cuts will of course help. For the overall market, they will probably provide a boost of around 3%. So we can expect perhaps 6% earnings growth for the full year. Next year will be better because banks will have a big boost after their deferred tax write offs.

The gap between the real economy and the stock market appears to be relatively wide. What is cheering the Indian equity market? Do valuations look cheap at current price? What do you recommend investors to bet on amidst the volatility?

The NIFTY index is trading at 18x forward earnings, so it is still expensive. Optically, it looks good, and is close to an all-time high, but there are only around 15 stocks driving it, and most stocks are much lower than their life highs. So, look at midcaps, but stick with the leaders there too. AUM (assets under management) inflows into domestic mutual funds have been resilient, over $1 billion a month. Retail investors aren’t interested in property right now, interest in gold has come down over the years. Bonds should be attractive with the 10-year government bond yield at 6.5% and inflation only 3%-4%, but expectations for inflation are still 7%-8%. Foreigners have turned more positive as they think India has lagged China, and the government has become suddenly very proactive, with the finance minister hosting many briefings and announcing reform and stimulus to specific industries. The stock market tends to lead the economy by around six months, so the inference in its recent performance is that the economy is going to pick up. That we also sense in anecdotal evidence like channel checks in the automotive industry. And it just makes sense that all the recent measures, compounded, should combined produce a positive effect.

The dollar index is on the rise, economic slowdown in China is believed to have bottomed out, and India's growth projection has been cut to 6.1% for the current fiscal. In this light, how are foreign investors looking at India, in the short to medium term, in relation to major global economies?

Indians may view the June quarter’s 5% GDP print as low compared to the past few years, but it is still a very strong number compared to the 3.5% forecast for the world. And India’s economy is—rightly so—seen as having less to do with the rest of the world than most others in Asia. So it is certainly on peoples’ radar screens. What keeps the “big money” at bay is the dollar.

On the global stage, we have a little more clarity. There are concrete signs of easing in US-China trade relations, but the crucial decision on Brexit is expected later. What news can disrupt or shock the global economy after the slew of macro challenges in the past couple of years?

A major breakdown in U.S.-China relations would be the most obvious candidate to produce a global shock. We don’t foresee that, but we do foresee a gradual formation of two distinct blocks, a U.S. one and a Chinese one. For investors this should be embraced, as it means a large asset class that trades on its own fundamentals (China) will be there to provide diversification from the U.S. market. Another shock would be one of the left-wing Democratic candidates, i.e. Elizabeth Warren or Bernie Sanders, being elected president next November. History shows the outcome will depend mostly on the health of the U.S. economy and Americans’ sense of personal wealth. If the election were held tomorrow, Moody’s studies suggest Trump would win by a landslide. So if the economy and financial markets are around the same levels next year as they are now, a Democrat in the White House is very unlikely.

The U.S. is attracting a larger share of investors’ money. Europe is a top draw too, given that a rate hike is not expected until the second half of FY21. Is there a marked shift in investment allocations? Would you say your portfolio is overweight on developed economies at this point?

Yes, we are, and we won’t change that until we think the dollar is no longer in a secular bull market. But with the interest rate differential between the U.S. and almost every other developed market currency still so wide, the dollar is unlikely to go down yet.

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