Q&A: We're very much encouraged on the banks within the Indian market, says Timothy Moe of Goldman Sachs

 

Q: The Reserve Bank of India (RBI) governor said that we've seen the worst of inflation. About maybe a little over 10 days back, you put out a note in which you said, without the comfort of depressed valuations for markets to do well, we need to see the peak in inflation. So that remains, I'm assuming to your mind the big call for equities as we head into 2023. So let's just start there. What do you think? Have you seen the worst of inflation? Worst of high yields or not yet.

A: We may have seen the worst of inflation, but we think maybe following on director Das’ comments that we are expecting two more 25 basis point (bps) hikes for the RBI to have a peak repo rate of 6.75 percent. So we still think there's a little bit further tightening that we have to go even if the inflation is crested, there's still needs to be further tightening of monetary policy in order to make sure that inflation continues to subside. And if I could just extend that comment one point further, I think you mentioned in your question that there's an issue with valuations, if we get straight to the equity market. We are very optimistic about the prospects fundamentally in terms of growth and in terms of earnings and so forth, in absolute terms and also in comparison to other markets in the region. But the valuations are elevated, just given India's tremendous success in terms of how the equity market has done. So that plus further increases in rates suggests that it may be challenging for India to continue to outperform to the same extent that it did this year.

Q: I was going through your note where you are bullish on India's long term prospects, but you're wary of high valuations. And that seems to be the concern, not just particularly to India, but even if you compare it to peers, like say, China or other emerging markets. In that context, what would the ideal strategy be for an equity market investor here in India for 2023?

A: I guess, in a simple context, we can say that the longer-term strategic prospects for India and for the Indian stock market, we think, are actually among the best if not the best in Asia. Just to give a couple of numbers here, our long term view on gross domestic product (GDP) growth for India at 6 percent or a bit above, is one of the highest if not the highest in the region. You asked about China and our longer term view, there is more like 4 percent GDP growth and probably maybe some downward pressure there. So I think there's a gap opening up between the potential growth rates for these two very large and very populous economies. Now in terms of how the markets done and how things are priced, that's where things get a little bit more challenging for equity investors, because, of course, equity market is about both the fundamentals, but also about how much is priced into them. And in this case, the fundamentals are excellent. We have 15 percent, EPS growth for this coming year, and for 2024, as well. And that compound 15 percent growth is actually among the highest that we will see the region. We're actually looking for declines in parts of North Asia next year in 2023 because of their greater reliance on global sort of declare greater global cyclicality, and sensitivity and also very high concentration in the semiconductor space. And then there'll be a strong recovery in 2024, we think, but the compound growth will certainly be somewhat lower than we were expecting for India. So I think on a fundamental basis, from earning standpoint, India is really one of the leaders.

That being said, there's also a question of how much you're paying for that. And here, I think that the nod has to go towards some of the North Asian markets, particularly China and Korea and just to give, again, a bit of an elaboration of this, India is currently trading in round numbers at about 22 times forward earnings. That's at the very high end of its 20 year valuation range. It was at a 90 percent premium to the region with China having rallied in November that premium has come down but it's still at the high end of its longer term range and about 70 percent. So both in absolute relative terms - and third thing we can throw in is relative to domestic interest rates also the market is looking on the stress side ---not sure about this part in bold---- so it doesn't mean we're bearish far from it, but we just think that it may be tougher for India to outperform to the same very significant extent that it did in 2022, in the year to come. Just the final point I'd make, in contrast to that, in China's case, China having fallen so far, and even with a very robust recovery of actually the best month in November since July of 1999. So that's nearly 25 years ago, we had the best month, it's just this past month, we still think that coming off a very low level where China at its lowest was at 8.7 times forward earnings. Now we're about 10-10.5 times earnings, but we still think there's some further upside to fair valuation, plus some earnings recovery. So we still think there is further to go for the for China equities. That's why we're overweight there, at least to begin the year.

Q: How significant is that? As you said, longer term, you're very bullish on India and valuations maybe in the short term or a bit of a problem. On the same lines, if I were to ask you about China, is it the opposite there tactically, because valuations are very cheap - short term, medium term, maybe expect bounces, but long run there are there are issues there, property market and other issues politically as well if you have a view.

A: We have a lot of views on this. And we can dig into this a bit. So there are at least two or three key points we'd like to enumerate. The first is that having fallen very substantially, we do think that Chinese equities are undervalued. And with the clear and emerging catalyst of a reopening from the self-imposed zero COVID policy, which is suppressed growth this year to about 3 percent is what our full year 2022 GDP forecast is. We think that China as it gradually reopens and our timing, by the way for when reopening takes place will be we think it will really kick into gear in the second quarter of next year - for some reasons I can describe if you wish. But the key point as we think that growth in the early part of 2023 will be somewhat suppressed as you go through some of the challenges when you reopen, you tend to get an increase in cases and maybe some suppression of economic activity. But the second half, we think will actually be quite robust. And overall, we think China's GDP growth will accelerate to a full year number of about 4.5 percent next year, and that will also drive a pickup in earnings, which had been suppressed this year, we actually think earnings will probably be flat to down 2 percent this year for China. And next year, we're below consensus but still think we'll see a recovery to about 8 percent EPS growth, and then maybe some further increase into 2024.

As I mentioned just a few moments ago, the offshore stocks, the aggregate MSCI China index, valuations fell to about 8.7 times at the low. They've since recovered, given that very sharp recovery that we've seen for the market in November to about 10-105 times, but even accounting for some geopolitical risks, which I'll mention in just a moment we think fair value for the China market, offshore market is about 11 times earnings. So the point is that we still think we can see some moderate valuation expansion. Perhaps there could be some overshoot to that, and also some recovery in earnings. And the combination of those two can give us we think still sort of 15 percent to possibly even 20 percent upside from current levels, especially if the market corrects a bit of its rally in November, which it did today, offshore stocks down about 3 percent today. So that's really kind of the argument for the offshore stocks.

I do want to take just a moment, if I may, to clarify that we have quite different views in terms of the of the onshore China stocks, which are the so called A-shares, versus the offshore China stocks, which are colloquially known as the H-shares. The H-shares which I was just describing, we think have a very good recovery potential. But there are some challenges to your question going forward. Number one, is there some uncertainty about the degree of profits that private owned enterprises will be allowed or encouraged to produce? So in a recent reports, we've done some analysis, which assesses the extent to which private owned enterprise returns of equity may converge to those of the state enterprise.

Cutting through all the analysis, the punch line is that we think that overall the private-owned enterprise (POE) returns in equity may converge to the state-owned enterprises (SOE), which is about 12 percent. So that's kind of suggest that perhaps the longer term growth potential may be somewhat less than it has been before. And then secondly, in terms of valuation, we've actually formally introduced into our valuation models, a geopolitical risk elements that we have some statistical support for doing so. And the end result of that is that we have lowered our fair value for the China equity market from 12 times earnings to 11 times and that's how we get our offshore expectations.

The final point I want to make is that we have a much stronger strategic view on the onshore circle – A-shares. And the reason there's that a lot more of them are in the industries that are supported by government policy. And if there's one cardinal rule for investing in China is that you want to follow and be aligned with what the government policy is indicating, without going into too much detail. There are certain policies, which are very clear and have been enumerated by President Xi in the last 10 years, and we think will still remain in effect. Those include the common prosperity theme, the theme of dual circulation and the theme of technology upgrading the theme of import substitution. And we find that many of the stocks that are in the Asia market are aligned with that. And indeed, one of our favorite themes is the theme of the so called Little Giants, which are small to mid-cap companies in the technology space that have the over backing of the government in terms of driving their innovation. So that's really kind of a view on China. And that suggests that your question to wrap this up, that's for the offshore stocks, it's a bit more of a tactical overweight that we have, we think that there's a good recovery driven by the reopening. But if, if the market runs up too far, then we would perhaps be inclined to moderate some of the view there and then rotate elsewhere there may where there may be clear longer term growth opportunities, including India.

Q: You were talking to us about how you're bullish on India's long term prospects. But you're a little wary about valuations. In terms of individual sectors or pockets of interest, where do you see both valuation as well as growth headroom, particularly for India?

A: Well, within the market, we've got some very clear views which we've expressed in a recent report. I will just single out a few things. We're very much encouraged on the banks. We think it is a terrific story and our bank analyst in in Mumbai, has been very clear about his views there. I think the key story is that we are seeing clearly recovery in private credit issuance and private credit demand, the increase in rates that we've seen, which obviously has been discussed today, suggests that margins still have some potential to expand. And additionally, we are at the early stage of any sort of a credit cycle. So we're not at all worried about significant write-offs. So it's a pretty powerful combination of opportunities, we think, for the banks. So we're certainly very favorable there.

On the insurance sector, we have we've also significant positive views, and that I'd say that we have a broader a positive view on the industrial cyclicals, again, because of this recovery in investment and the need for continued investment in India. So we think there's lots of opportunity, at the more micro level when you start to drill down into different sectors, to different themes.

Q: Cement would be a part of that?

A: Absolutely. I didn't want to enumerate everything, but definitely cement is there and we've reaffirmed that - I was in Mumbai last week. We had our India Chief Investment Officer conference there and spent time with our analysts and with various business leaders, and certainly the bet that cement or part of that supply chain for infrastructure, investment and development, we think generally looks very attractive.

Q: Another space which Goldman has coverage on at least a few names is these New Age - maybe not all of them are platform companies. But names like Paytm, PB FinTech. Companies, which have come to the listed space a year to a year and a half ago all are down between 50 and 70 percent. Any thoughts? Valuations come off, we were looking at valuations and where they're trading compared to some of their global peers, listed both in China and the US. In many cases, valuations have come off. Any thoughts?

A: Absolutely and you've really hit the nail on the head in that. We have to separate between the fundamental growth outlook versus the valuation. And I think it's fair to say that the private sector valuations for many of these digital companies, which have been developed and India has produced the greatest number of unicorns in the private sector space, I believe, of any economy, we did a big report of that about a year or so ago. And at that point, India had developed 60 unicorns and that number swelled to close to 100 subsequently. So I think that there was kind of a gold rush, which took place in the private sector, and some of the companies actually got elevated valuations, particularly in an environment of low interest rates. Now, obviously, with interest rates rising globally, we've seen the so called long duration part of the market come off, and that would very much include some of these more early stage startup companies, which are being valued on their future growth prospects. So when rates go up, and your discount rate increases, then that tends to put greater pressure on those so called long duration assets and India was no different than what we've seen in the US or other areas where there is sort of high growth and sometimes not yet profitable growth part of the market came under significant pressure. So fast forward to today, when, as you said, we've had significant decline in valuation, I think it suggests there's an opportunity to reengage in the still very encouraging fundamental growth story.

Q: And one final question. You have pointed out to some risks in the near term, some cyclical issues in the Indian markets, whether it's higher inflation, whether it's RBI policy hikes and a weaker rupee as well. Do you think these are enough to derail the Indian equity markets? Or will the resilience continue despite all of these headwinds?

A: I think the resilience continues. I think these are just sort of headwinds or speed bumps along the way, but we don't think that they will deflect India from either fundamentally growing or the equity market from still having a very favorable, longer-term prospects. You've enumerated some of them. Higher oil prices are another thing, which we would point to, those have happily come off somewhat. But overall, there still are some cyclical issues that that we need to contend with. But I really think these are kind of more, speed bumps along the way, it's not something which will significantly derail the story given the flat pattern that we have.