The EM manager is cautious and bullish on India

Valerio Baselli: Hello and welcome to Morningstar. This week, we’re all about emerging markets. That’s why I’m joined today by a veteran fund manager, Michael Bourke. He is head of emerging markets equities at M&G Investments.

So Michael, emerging stocks as a whole haven’t had developed stocks for quite some time. And global investors have pulled $14 billion out of emerging market equity funds in the past year. Do you see a possible near-term return?

Michael Bourke: Good morning Valerio and good morning everyone. Yes. So when you look at the asset class over the last year, not just one year, but several years, it’s been affected by a couple of factors, namely China and US rates. Of course, the Chinese economic slowdown has directly fueled a contraction in earnings, which has hit stocks hard, leading to a roughly 50% reduction in Chinese stock returns. At the same time, of course, we’re seeing US rates at a very, very high level compared to certainly previous years where we’ve had very low rates. Historically, US rates have been associated with pressure on emerging markets in various areas, rightly so, as it raises the cost of borrowing for many vulnerable emerging markets.

Right now, we’re seeing some improvements in both of these factors. So, of course, the Chinese economic slowdown as a number of years, we moved a little further. There was some stimulus that went into the system. China’s central bank cut rates. So we see that there is some modest improvement in China, especially when we look at individual corporations. So we’re more bullish on China than we’ve been in a few years, especially when you look at stock valuations. At the same time, of course, we are one week away from the US Federal Reserve cutting rates. Therefore, they are expected to cut rates, which will ease pressure on emerging markets margins. Earnings this year are expected to rise by about 20% and into the early mid-teens next year. And indeed, the asset class has yet to react to this more positive earnings picture. So, broadly speaking, we’re looking at a much more constructive outlook for emerging market stocks.

Baselli: Correct. And of course this asset class is very heterogeneous and we should only look at the performance of the two emerging giants, China and India. So far in 2024, the Chinese stock market is down 11%. Meanwhile, India grew by 22%. So should we get used to India being the new emerging market powerhouse?

Bourke: So, Valerio, I’d like to make two brief points, if I may. I suspect, first of all, that the heterogeneity you refer to is the asset class’s greatest strength. It helps investors avoid trouble spots and avoid markets that are difficult, of course. And then active fund managers are able to navigate very well. We’re saying today’s index is heavily concentrated, right? When you look at China, India, Taiwan and Korea, that’s about 75% of the index. So it’s not a very balanced offering in terms of our benchmark today and active management to navigate around that.

Clearly, India is an economy that is doing incredibly well. And then one expects them to continue to do so. There have been a number of reforms under the leadership of the Prime Minister and the BJP party that have fueled this more productive and dynamic economy that we have seen in recent years. Hence, India has become much more resilient. And of course, with a very young population, we should expect this growth, compared to China, to grow faster for a number of years, if not decades, to come. But we should remember that we are investors, right? We are not economists. And so, at the end of the day, what matters to us is, of course, the profits that come with that growth. And here we are a bit more cautious in the sense that Chinese stocks are very, very cheap, while Indian stocks are much more expensive in comparison.

Baselli: All right. And I mean, given that particularly in the Indian stock market, of course, as you said, its value has been very strong over the last 18 months. Do you foresee a perhaps physiological correction going forward for Indian stocks? And overall, what’s your outlook?

Bourke: I guess no manager would ever forecast a correction, right? So I think when you look at the value, we put it in the context of Indian multiples going up a lot over the last few years. If you go back to a sort of pre-Covid time, Indian earnings multiples were roughly in the mid-teens, mid-teens. Today, and certainly since COVID, they are in their mid to early 20s. So take the 10-year average of India’s price to earnings of about 20 times. Today we are 28 times earnings. So clearly that’s a pretty high level of expectation built into the earnings multiples.

Of course, the earnings growth was very good. That’s what we should hope as an investor, given how much one pays to enter that market. We’re focused on the risk premium associated with that. Not much room for accidents in India, right? At that kind of earnings level and valuation, we have to be careful, because if there’s any slowdown or any even modest correction in those earnings, it’s going to be punished by the market because the market’s expectations are so high. So we would be just a little guarded. Currently, the long-term outlook is still quite rosy for India, but the short-term just a tad cautious.

Baselli: It is very interesting. Finally, I want to say, what are the most interesting sectors or companies in India today? And you have already partially answered, but where do you see the best opportunities and the main risks?

Bourke: Sure. So when you look at India, what’s been fascinating over the last 12 months to two years has been the emergence of the domestic investor as a real key player in the equity market locally. We see this coming through local mutual fund inflows in India. The beginning of this year was almost $7 billion per month. That’s a very, very high level of inflows, while foreigners were on average net sellers, right? So there’s an interesting dynamic at play here. You see this at the rating level as well. So the mid-caps in India are at much higher valuation levels than some of the large-caps in the index, which is an unusual feature, right? So what we see opportunities for valuation is, for example, with regard to some banks. In a way, some banks were a bit of a victim of the stock market riot, as about 10% of India’s financial savings came out of bank deposits and into the stock market.

So of course this affected the ability of banks to collect deposits and the cost of those deposits, which in itself led to a slowdown in credit growth. So, of course, it’s something that the policymakers, the central bank and the banks are very aware of, because in a way that could affect the economy itself, as the banks slow lending growth to match the tighter deposit growth. So we see opportunities here that actually some of the banks have been left behind in this rally and they look like areas of opportunity for us.

Baselli: Well, thanks a lot, Michael, for your time. For Morningstar, I’m Valerio Baselli. Thanks for watching.