The world is feeling very different. It is no longer a risk off. It is a risk-on situation. Everybody is worried about inflation and equity as an asset class. It reminds me of a phrase I used to use in a bear market that equity as an asset class has gone to butcher blocks.
You are right that the transitional nature of markets is a critical aspect to the conversation. Any time we go through a period of regime change, it creates significant volatility and that is very clearly overseen in markets. We are going through several areas of regime change; first from the monetary policy perspective.
You very rightly highlighted the views on inflation and monetary policy tightening that we are seeing in major economies like the US, but also somewhat surprisingly now, even the RBI action recently in India indicates a very different environment from macroeconomic policy. We are seeing a significant inflection in the nature of economic growth with significant slowdowns in markets like China and here in Asia.
Lastly in terms of the structure of global trade, we have had clear comments from people such as treasury secretary Yellen and ECB President Christine Lagarde who are indicating that the Washington consensus around free trade is effectively over and we are moving from an era of globalisation to one of regionalisation. We have these massive cross-currents across the range of issues right now, which are triggering the volatility that we are seeing in markets.
What is the right way of looking at this transition? How much of this transition is something that is already priced in?
One of the aspects of markets that I have always enjoyed is that the issue is not just a game of forecasting reality; it is a game of forecasting reality versus expectations and the expectations that you are highlighting are of critical importance. The inflation conversation is an interesting one. We are currently looking at long rates in the US as an example of above 3% for the first time in a very long time. That said, however, the traditional Taylor Rule of macroeconomic analysis would indicate that US rates will keep above 4.5%, which is very clearly not in anyone’s forecast but also not in market prices yet.
There are similar conversations regarding different underlying sectors like energy prices and the potential for changes in the price of oil to drive different outcomes to the market. At JP Morgan, we have run a piece of analysis that shows a 20% gap between global supply and demand within the energy complex on our estimates which will take over $1.7 trillion to close that supply demand gap.
As a result, we see very strong upward pricing pressure on oil, specifically for an extended period of time. If I take a step back, the short answer to your question is investors really need to take a very bottoms-up work at individual countries and sectors at this stage, rather than an overall asset allocation to equities as an asset class.
We have seen foreign investors selling fast and far. What do you make of that? Does India still demand a premium and is it going to continue to command that premium?
There are two incremental questions there; one, the outlook for India outperformance relative to the rest of the region; two, a conversation regarding valuations in India today for an outperformance perspective. India has outperformed. Within an Asia context, we have seen the ASEAN markets as critical drivers for the regional conversations with markets like Indonesia, Singapore, Thailand, and even the Philippines up until recently, showing very strong market performance off the reopening trade.
India has been an interesting conversation where we have seen a slowdown in economic growth. We have seen rising oil take its toll on current account conversations for the broader macroeconomic outlook for India. We have seen some compression in the margin cycle in India. It has really been a valuation conversation which drives the second leg of your question.
What is interesting to me is that economic and financial theory would argue that now that the RBI is starting to step up rates, it should be multiple compressive within an Indian context. What our analysis has shown is that actually has not been the case historically. Indian multiples have traded far more of global equity indices rather than local rates. There is still potential for downside pressure because we obviously have significant multiple compression occurring in global markets inclusive of the US.
So, at JP Morgan, we are taking a relatively cautious outlook for India as a whole. However, within that, this bottoms-up analysis is absolutely critical. We still see emerging strength as an example of the real consumer.
ET Now: If I look at a large investable market, I guess India has got everything going for itself. We are on an economic curve. We have a strong positioning in terms of political stability and also the way the capex cycle has started. At what point in time, have these factors become a unique advantage factor for India?
James Sullivan: It is a great question and one of the things I have been most interested to watch over the course of the past five plus years now are the changing policy dynamics that are at play within the administration of the Indian economy. We have seen very significant models of experimentation coming out of the current administration. You still have very clear policy changes that in my opinion could be made to drive incremental economic growth in India. And one of the reasons why we are seeing the valuation premiums in India relative to the rest of the region is that major economies like China are starting to see significant slowdown which is likely to continue going into the future.
One can still see India at very significant and high levels of economic growth. The premium that investors are going to pay for that moving forward is likely to increase because of the scarcity value of that economic growth.
A lot of institutional investors are of the view that India is a great story but China is attractive and that is where the underperformance is. So there is more bang for buck if one invests in China because there is a valuation comfort. What are your thoughts on that?
It is an interesting argument and ultimately the question is in China right now, what am I pricing in? Am I pricing in a return to historic normalcy or am I looking at a different regime and a different conversation moving forward? What is interesting to me in China right now is the fact that for the first time since China published their GDP growth forecast in 1999, we have very public disagreement from private sector forecasters, relative to that government provided forecast.
The Chinese government right now is at 5.5% GDP growth for this year. JP Morgan is at 4.6%. Broadly speaking, there are 70 out of 72 banks that forecast China’s GDP have put it below 5.5%. What is very clear from the commentary coming out of the Chinese government in my view is that they are changing focus from growth at all costs to this concept of common prosperity and more inclusive growth moving forward. It is likely to result in lower absolute levels of economic growth and we have to price in a different future and not this return to the historic past. Looking at historic trading ranges is less relevant than it might look at first
If foreign investors are not investing so much in China and Russia, should not India just become a hot destination as it is?
I think you were seeing that for most of last year. Obviously, with the FIIs selling year to date, that has been most of the story this year but my impression is that ASEAN has been a key beneficiary. However, I do think we have to take a step back and recognise that investors have a choice, they do not necessarily have to be in EM and in actual fact that is what we have seen.
We have seen EM as a percentage of global asset allocation go from 13% to 9% to current 6%. A lot of that drawdown has come out of China but we have seen overall asset allocation to EMs fall and one of the things we have to be cognisant of is the environment for the consumer in different countries around the world.
In Asia, the consumer has taken a hit, we have seen fall in consumption trends in many of the Asian economies and markets like the US. However, the underlying microeconomics look very different. JP Morgan estimates that we have about 13% of GDP in excess savings sitting in the bank accounts of the US consumer. They are not particularly confident and we are seeing consumer confidence surveys at their lowest since the ‘80s and in some cases, the ‘70s. Their confidence will be required to unlock those bank accounts.
We do have significant propensity to spend and so it is only the question where incremental asset allocation goes to developed markets (DM) with this very strong consumption story and this excess savings story or to emerging markets which so far has seen a significant drawdown in emerging markets allocation.
What is the outlook when it comes to individual sectors? Some pockets within energy and industrials remain a space where one can look closely. Could you just walk us through the overall thesis at a time where we are also seeing spikes of volatility within crude oil prices?
My first comment would be that we have to get used to current levels of volatility. As we started off the conversation, we are seeing several different elements of regime change all occurring at the same time, all of which drives the volatility spikes in multiple asset classes.
I do not think that that will go away in the short term. From a sector perspective, particularly in the Indian context, we have already talked about the energy complex where we have this 20% supply demand gap, $1.7 trillion of incremental capex to close that will take a significant amount of time.
We see a very well bid energy complex over the course of the next couple of years. The incremental question here is do you see a complete shutdown of Russian exports, particularly oil? JP Morgan forecast has that, taking oil prices to $185. That is not our base case to be clear but that is the analysis that we have run on that potentiality but still a very well bid energy sector moving forward.
A sector that we are spending increasing amounts of time on is actually agriculture both regionally as well as in India. The incremental storyline regarding food insecurity is the one that becomes front and centre in the debate going forward. About 275 million people globally will experience extreme food insecurity over the course of the next 12 months. We have seen very significant increases in the price of many agricultural goods as well as the cost of production that feed into those agricultural bids.
At JP Morgan, we have run some very detailed analysis to try to better understand the revenue implications of that for the Indian rural consumer and we have the overall income going up by over 13% on YTD basis. We actually see a significant turnaround in the rural demand and the rural consumption story in India.
What about the entire financial services sector?You said you are expecting the Reserve Bank rate hikes to overall compress valuations in the Indian context. But how would you look at the financial services space in light of this?
We are overweight on financial services in India. One of the arguments there is the fact that the overall credit cycle will be more benign than is currently forecast. Also the rate increase which we saw from the RBI is theoretically conducive to higher margins and higher net interest margins within financial services companies both in India as well as globally.
The fact that financial services have been underperforming in India, particularly relative to the high valuations that we are seeing for the index as a whole creates a very strong situation for outperformance moving forward. So we remain overweight on Indian financials.
They say that history does not repeat itself but it certainly rhymes and ends up becoming the biggest indicator for us to understand. If you have to draw a parallel in the last 10- 15 years, when do we see similar circumstances?
It is hard to see parallels within the last 10 to 15 years. For the inflation expectation and reality perspective, we have to go back to the 1970s. When we run analysis on current levels of wage growth in the United States and other countries around the world, we do not see this level of wage increase at any time after 1984. So, the analogies that we go back to are the 70s and 80s. We talked to the top segment on this regime change conversation.
One of the things that we have to do is to take a step back and realise that the most significant regime change that we are discussing right now globally is the shift in returns from capital to labour. We are seeing that in terms of interest. We are seeing that in terms of rising wages in multiple countries around the world. We have had 25 years of experience where the overall return structure has gone from labour to capital. It is now starting to reverse and that is critical in terms of our global view.
So what is in-store for an investor? There are phases in the market where if you do growth investing, it does well; there are phases in the market if you do value/dividend yield investing, that works. What kind of investing style we are in for the next three to five years?
So JPMorgan has views that value will outperform as a factor of investing not particularly here in Asia over the course of the next couple of years. It is predicated upon a rising rate cycle and again the shift in the overall return structure from capital back to labour and that is our expectation at this stage.
The one interesting thing about markets right now is that we are seeing very high levels of correlation across both factors as well as asset classes and so you get the type of environment that we have seen over the course of last couple of weeks where to risk-on everything or risk-off everything creates very significant issues for asset managers because you start to lose the diversification benefits across the asset portfolio. But we do think that is going to be the reality of where we are, as we work through these various elements of regime change.
At what point in time you would say that central bankers were first slow in tightening and now have overtightened? Everybody is now worried about inflation.
There are two components to my answer; one would be inflation expectations moving forward. We have seen a lot of supply chain disruption as a driver of the current inflationary conversation and that is absolutely correct. The bullish view on inflation is that supply chains will begin to start and we have already seen peak inflation.
The counter to that is that we are seeing significant upward structural pressure in both energy as well as agriculture as that will continue to keep inflation roughly at current levels for a reasonable period of time, potentially slightly lower than where we are right now but will not present an opportunity for a full reversal.
The changing structural nature of the drivers of inflation is an important part of our conversation and then second part is expectations versus reality. As we have discussed previously, the reality is at the moment that US rates are very stimulative because inflation is running at significant premiums to interest rates.
Negative real interest rates in the United States are stimulative in nature and so you put the two conversations together and it is a bit of a moving target in terms of where inflation goes. We have to take a step back and recognise that most rates as currently set by central banks around the world are still relatively stimulative. That is a problem given the inflationary environment that we currently occupy.