‘Debt to GDP ratio has become the key determinant of portfolio inflows’

FII flows into India are already at all-time highs, but Sanju Verma, MD & CEO of Centrum Broking, doesn’t see them slowing down anytime soon due to the easy monetary policy adopted by developed countries. Speaking to DNA, she  believes that the current rally in emerging markets has three legs to it - the currency arbitrage, the interest rate arbitrage and the third and a very important one — the debt to GDP ratio, where the emerging markets score over the developed markets hands down.

How do you see valuations at this point of time. Would it be fair to judge markets based on historical price-earning (PE) trends, especially when the economic growth has hit a different orbit in the last few years.
Going by the historical midcycle multiples, which have been 15-16 times, we are in overvalued zone. Going by the bull cycle multiples, we are still not done with the catch-up game. Historically, Indian markets have never peaked before hitting 25 times, so going by that logic, we have some more gains to be had.
However, speaking of price-earnings multiples is very misleading as there will always be PE expansion.

The value of any market is not only determined by PE multiples but the more sanguine parameter to judge markets would be return on equity (ROE). The ROE in developed markets is at 12-14%, while for companies in emerging markets is 18-20%, which is again a big differentiator. The PE expansion has not happened because of sudden decoupling between the developed and emerging markets. People, whether they believe in decoupling or not, will be looking at hard numbers like return on assets, return on equities and debt to GDP ratio before putting their money. And currently, emerging markets score over their developed counterparts on these parameters.

Though earnings growth is more or less the same in the emerging and US markets at 28-29%, the return on assets for the MSCI (Morgan Stanley Capital International) emerging and developed markets is also same at around 1.5-1.6, but the differential in debt to GDP ratio is huge - the emerging markets’ debt to GDP ratio is at least 50% lower than developed ones. Investors are now not looking at fiscal deficit, political problems or social hazards, the debt to GDP has become the single-biggest determinant of how much flows you can attract. So, in that sense, though PE is a criteria, it is less meaningful than what was the case as you rightly pointed out few years back.

How do you see the risk appetite of investors worldwide?
There is too much money sloshing all around in the globe thanks to easy monetary policy worldwide, which has led to negative real interest rates. Couple that with the fact that the recovery in the US has been a jobless one, where growth is weak and there is deflation.

In such a scenario, central bankers have no option but to pump in money, leading to excess liquidity, which will find its way into emerging markets. I can’t remember any instance in the last 10 years when almost all commodities — be it gold, crude, soybean, tin, copper, coffee — almost everything barring US treasuries — have been moving up. It’s a case of too much money chasing too few goods, which is leading to rise in all asset classes with no fundamental reason.

People might want to argue that risk aversion is still there, that’s why gold is moving the way it is. But I would like to say that gold is not moving because of risk aversion or threat of inflation because normally gold is considered as hedge against inflation.

But globally the problem currently is deflation and not inflation, which implies gold shouldn’t have gone up more than $800-900/ounce. The reason gold is moving up is that now it is a proxy to financial dislocation and uncertainty. It is acting as hedge against global sovereign crises erupting out of peripheral economies in Eurozone and also against a weakening dollar.

Every time the dollar has weakened over last one year gold has moved northwards. So, the fact of the matter is different asset classes may be moving for different reasons, but clearly it proves one thing that risk appetite is back. Even the inflows into US junk bonds have reached close to $200 billion, just short of highest-ever $220 billion seen in the pre-Lehman days - and at a time when the US economy is struggling to show meaningful signs of recovery. This clearly tells us that risk appetite is back.

Another example of this is the high-end luxury brand Prada looking to raise substantial amount by listing itself on the Hong Kong stock market. Now that’s not considered to be a great place for foreign listing, which suggests that there is enthusiasm among investors to buy papers.

Which are the sectors peaking out in terms of earnings growth?
For the September quarter, banks are expected to report good numbers driven by strong net interest income growth. However, going forward in the next 1-2 quarters, things may not be as rosy for Indian banks as not all of them would be able to pass on the hike in deposit rates. In the last three months, while the lending rates have gone up by 25-75 basis points (bps), the deposit rates have been up by 75-150 bps.

So only those banks having excellent CASA (current and savings account) will be able to weather the rising cost of deposits. Similarly for IT companies, the September quarter may be the last best one this fiscal as full impact of wage revisions, currency appreciation and so will be felt from next quarter onwards.

Which are the sectors where you still see some value at current levels?
One sector which we think is undervalued is the construction space where there is a huge opportunity in coming years. Looking at from purely valuations perspective, these companies, even after the run-up in recent weeks, are trading at 10-11 times one-year forward earnings, which is lower than what the benchmark indices are trading at currently, thereby providing for a decent upside. The other one is oil & gas, where some upstream companies would be further benefited by decrease in subsidy burden once the Kirit Parikh Committee recommendations gets implemented leading to accretion in earnings and re-rating.

And where do you see excessive valuations?
Despite weak performance in the recent times, many of the cement companies have recently touched new 52-week highs. Most of the cement companies are likely to report year on year decrease in earnings for the second quarter. Though prices have gone up, the cement capacity utilisations have come down and input costs have risen. Going by pure numbers, cement companies should not be trading at these crazy valuations, especially when these companies are nowhere near the peak of their business cycle.

What happens to the Indian markets in case there is Quantitative Easing 2 in the US?
The moment quantitative easing is announced, you will again see dollar depreciating and appreciation in emerging market currencies, leading to still more inflows. Also, in emerging markets, the central bankers are raising interest rates to curb inflationary expectations, which would also offer interest arbitrage opportunities for foreign players.

For instance, the Reserve Bank of India may raise the reverse repo interest rates to curb inflationary expectations and be able to curb inflation to 5.5 to 6.5% by March next year. But the flip side to that is that you have given an additional lever to foreign treasury heads, who are indulging in sell-buy currency swaps. That’s the other reason why you are seeing so much money in the system.

So if you are going to raise interest rates to curb inflation, which is an emerging markets problem currently, you are indirectly strengthening the currency and attracting still more flows in the form of dollars. Central bankers in emerging markets may try to manipulate their currencies but the cost of intervention is very high, and the emerging market governments can do very little to stop their currencies from appreciating.