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Are the Green Shoots of Recovery Finally Starting to Appear in the Eurozone Region?

¿Brotes verdes en la eurozona? — Photo: Moyan Brenn. Are the Green Shoots of Recovery Finally Starting to Appear in the Eurozone Region?

Cyprus is lovely this time of year. With the green shoots of spring starting to emerge from the winter months it’s a time of new beginnings. Perhaps fitting then that Mario Draghi, President of the European Central Bank (ECB), should choose the island to unveil his upgraded growth forecasts for the eurozone region. Following years of near economic stagnation, GDP growth is estimated to rise by 1.5% for this year and 1.9% for 2016, up from 1.0% and 1.5% respectively. Draghi’s key hope is that the re-appearance of growth will deflect the deflationary scare that pre-occupies markets and investors alike.

There are solid grounds for thinking those growth forecasts might be on the conservative side. The sharp decline in the oil price, the euro’s devaluation against the US dollar – over 20% at the time of writing since its peak in May 2014 – and Draghi’s attempt to reflate the eurozone’s balance sheet mean that the region has undergone seismic shifts since the beginning of the year. Shares have already priced in some of the good news. In February alone the MSCI Europe index rose by a heady 6.9% in local currency terms, although that reduces to a little over 3% in sterling terms.

The rise in eurozone cyclicals since the start of the year shows the market is already aware of the most obvious sectors to benefit from the double tailwinds of a weaker euro and oil price. Airlines, automobiles, food producers and retailers are the most obvious candidates, as well as financials and engineers. But where’s the real evidence that the green shoots of economic recovery are appearing? While the full extent of a devalued currency is yet to be fully known, export data look encouraging. According to Eurostat, the European Commission’s statistics bureau, exports for the eurozone region are up by 0.8% quarter-on-quarter. Year-on-year statistics show an impressive 4.1% for the fourth quarter ending 2014.

Yet, good news has not yet properly fed through to the analyst community. While the scribblers have been keen to downgrade the obvious company ‘victims’ – those oil majors directly hurt by Brent crude’s decline – the positives have yet to be fully reflected in earnings upgrades. This is largely due to the unquantifiable nature of by how much exactly a declining oil price and euro affect profitability. Yet, we do have some idea. According to estimates, a 10% drop in the euro (against other major currencies) could boost corporate earnings in the eurozone area by as much as 7%. That’s a very high correlation by any measure. Watch this space then, come April, when first quarter results, (especially for those companies where the cost base is in euros but sales are outside of the region) start to be unveiled.

What of the imminent headwinds for the region? Talk of a permanent deflationary spiral remains top of the list, with many investors still to be convinced that the eurozone will not follow Japan’s ‘lost decade’ period. Surplus capacity, particularly in Spain, and high levels of eurozone unemployment are still cause for concern, although Germany’s unemployment rate remains at a record low of 6.5%[2]. But signs of an improving consumer’s lot are already in evidence. This is particularly evident in the growth in European car sales – up 8% for February alone. Furthermore, real wages are increasing. IG Metall, Germany’s Industrial Union of Metalworkers, recently awarded their workers a pay rise of 3.4% – quite substantial given inflation in Germany is zero.

Of course, no one can permanently silence the bears on Europe – we’ve been used to their talk of anaemic growth and deflationary spirals for long enough. But if earnings revisions come through strongly in the spring and subsequent months, it should be sufficient to silence them for some time to come.

Kevin Lilley is portfolio manager of Old Mutual European Equity Fund, Old Mutual Global Investors

Variations on the Scarcity Theme

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Crecimiento, reformas, rentabilidad: 2015 será un año de escasez — CC-BY-SA-2.0, FlickrPhoto: Chris Potter. Variations on the Scarcity Theme

The first part of 2015 has confirmed the maxim we described in our January: global economic growth remains weak and vulnerable to deflationary pressures, but investors are suddenly regaining their appetite with stronger monetary intervention imminent, this time on the part of the European Central Bank.

It would be wrong for an asset manager to deprive his customers of a particularly enterprising central bank’s generosity. Our portfolios are taking full advantage of the Draghi effect, especially through our positioning in European bonds and the dollar, as well as increased exposure to European equities.

However, our analysis of long-term global economic trends leaves us convinced that market performance will remain linked to the rarity of growth, yields, reforms, political leadership and inflation, a scarcity counterbalanced by the abundance of debt and central banks’ liquidity injections. In addition to the tactical management of equity, fixed income and currency exposure levels, this diagnosis encourages us to hold a majority our investments in the few assets that offer predictable growth and a safe medium-term return.

Scarcity of growth

It is worth remembering the circular origin of the persistent growth deficit affecting most of the world’s leading economies: over- indebtedness is thwarting the recovery of private investment as well as any strong public stimulus measures, and the weak growth that results is preventing over- indebtedness from falling. The addition of often unfavourable demographic trends means that the long-term outlook for global growth remains mediocre.

The overall trend, which to varying degrees applies to Europe, Japan, the United States and emerging markets, does not rule out mini-cycles in the meantime. For example, the eurozone will go through a growth spurt in 2015 thanks to its weaker currency, lower energy costs, cheaper bank loans and slower fiscal tightening.

Economic growth forecasts for the eurozone this year could be corrected slightly upwards, while revisions had consistently been in downward direction in the last year. However, it is still very hard to imagine growth of much more than 1.5% this year, which would be insufficient to reduce the overall level of debt or improve the potential growth rate.

It is worth mentioning also that the euro’s weakness will first and foremost benefit the area’s biggest exporter, Germany, widening economic divergence within the eurozone. In the United States, the Fed’s discomfort is palpable as it prepares to tighten its monetary policy while the rest of the world is easing theirs. Should a Fed funds rate hike need to be quickly reversed because the US economy shows new signs of weakness, this would cast doubt on the credibility of Janet Yellen’s monetary guidance.

Meanwhile, China’s growth is at best stabilising at levels half as high as those seen five years ago, while Japan’s will be no more than 1% at most, compared with 0 last year. It is important to bear in mind that in a globalised economy, eurozone growth depends on worldwide growth, and attempts at stimulus through currency depreciation are ultimately a zero sum game. A sharp drop in the value of the euro due to the ECB’s quantitative easing would export deflationary pressures from the eurozone at the expense of nominal global growth.

Scarcity of reforms

For many countries, increasing potential economic growth means undertaking serious reforms. Progress is slow, especially in Europe. A few examples:

In France, although opinion polls showed that the public supported the Macron bill, neither the left nor the right wing of parliament had the political courage to vote for it.
Italy’s Jobs Act was passed, but the institutional reforms needed to stabilise the government are moving very slowly and will still have to make it through the Senate in March.
The requirement that Greece’s creditors have made of the new government to commit to reforms whose abandonment had been at the heart of the party’s winning manifesto raises the suspicion of blatant populism and pseudo reformism in equal measure.
China’s emphasis on fighting corruption in 2014 delayed the reform programme. But at least we can reasonably hope that reforms concerning public enterprises, real estate, the environment and Hukou status will gather pace in 2015.
The same applies in India where land purchase, mining and insurance deregulation reforms are due to be debated in parliament this year.

Scarcity of yield

Apart from the temporary drop in oil prices, global deflationary pressures result from persistently high debt, which increases the propensity to save. Added to this are more structural factors such as demographics, technological progress, globalisation, the distribution of wealth between labour and capital (Thomas Piketty would surely agree). Even in the United States, where job creation has picked up, the famous Phillips curve, which postulates that inflation automatically rises when unemployment falls, is no longer borne out by the facts. Bringing down interest rates, central banks’ massive bond buying adds to this general backdrop of disinflation.

With the ECB coming on board and the Bank of Japan continuing its intervention, these purchases will be even greater in 2015 than in 2014, despite the end of the Fed’s quantitative easing. This windfall for bond investors was unexpected and yields – already very low – will probably drop even further in 2015 with the ECB committed to buying EUR 60 billion of assets each month for at least two years, whatever the cost (an expression that comes into its own here). In this context, Nestlé and the German government have already managed to issue bonds with negative yields, guaranteeing investors a capital loss if the issues are held to maturity!

These market distortions make Mario Draghi the best friend of short-term investors in the eurozone, as he reduces the perception of risk while increasing the value of financial assets. As for us, we are being very careful to keep positions in all asset classes that balance portfolio risks, while reaping the short term benefits of this situation for our funds’ performance. Valuation levels made possible by extremely low discount rates and squeezed risk premiums are a big source of support for financial markets.

But they must not lure us into a false sense of security, as they can only last as long as confidence in central banks’ market impact remains intact. They therefore leave open the question of the exit from quantitative easing. A negative scenario, namely the admission of manifest failure of attempts at lasting improvement in nominal growth, would obviously have negative effects on credit and equity markets. Whereas a positive outcome, marked by widespread economic recovery, would see fixed income markets undergo a correction (this scenario has prompted several Fed members to call for an early hike in US Fed funds rates before the markets step in).

Although the ideal path between these two pitfalls is a narrow one, it might seem too early to worry about it while central banks remain on the move. But it seem wise to us to keep our eyes wide-open on the risks that accompany the markets’ enthusiasm at the beginning of this year. Lucidity is always too scarce.

Technical Support for European High Yield Bonds

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Contexto favorable para los bonos europeos high yield — Photo: Woodley Wonder Works. Technical Support for European High Yield Bonds

European high yield has started the year strongly, with the Bank of America Merrill Lynch European Currency High Yield Index up 3.1% in euro terms in the first two months of the year. The rise came almost exclusively from credit spread tightening, largely a result of the trickle down in demand from the announcement of quantitative easing (QE) as credit investors move further down the ratings spectrum in search of higher yields.

An improved macroeconomic backdrop has boosted sentiment towards the asset class given the stabilisation in crude oil prices, strong equity markets, and the stop-gap bailout extension for Greece.

Unlike US high yield bond markets, there is minimal leveraged energy exposure within the European universe. Earnings for the European high yield universe should be a net beneficiary of both lower oil prices and the falling euro.

Ampliar

Supply has started the year strongly but has been more than offset by a significant shift upwards in demand, as evidenced by industry data showing positive net fund flows. The high yield bonds that have come to market are dominated by relatively higher rated BB issuers and easily taken up by investors, with many investment grade investors hunting in BB for extra yield.

The rise in demand has implications lower down the credit spectrum. Traditional high yield investors are moving into single-B and CCC rated bonds where the yields are more attractive but there is simply not enough supply of these bonds to meet the inflows. We believe there could be a significant squeeze in these higher yielding assets over the coming months as demand outweighs supply.

Battling Fake Goods in China

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Luchando contra las falsificaciones chinas — CC-BY-SA-2.0, FlickrPhoto: Greg Walters. Battling Fake Goods in China

Following some recent state findings, Chinese officials have been cracking down on a prevalence of counterfeit goods sold in the country, and asking firms to enhance their technology to combat this.

China’s State Administration for Industry and Commerce recently revealed survey results indicating that some of its most popular e-commerce sites are rife with product listings that allegedly infringe on intellectual property rights. Chinese e-commerce sites have already spent hundreds of millions of dollars over the past couple years to try to fight this persisting problem.

This begs the question, if consumers are well aware of fake goods being sold online, why are China’s retail websites still growing at breakneck speeds? During our research trips across China, especially in smaller cities, the answer is painfully clear to us: Chinese consumers have even less faith in their local stores when it comes to recognizing counterfeit merchandise. Most shoppers we met in “lower tier,” or less developed, cities depend on popular e-commerce sites to research products as well as the credibility of merchants. A common bit of feedback is that with buying online, at least you have word of mouth to rely on and have the chance to get a refund if you are not satisfied with your purchase.

For those of us living in more developed countries, it may be difficult to imagine issues of trust while shopping at a Macy’s or Harrods. However, due to the rapid pace of urbanization in lower tier Chinese cities, many retail formats there are new to consumers, and thus lack credibility.

With the convenience and anonymity of the Internet, developed market consumers are also increasingly making purchases online, and are also at risk of purchasing counterfeit products.

The problem with counterfeit goods is not exclusive to China or Asia. In fact, it has become a global e-commerce issue. To gain perspective over the size of this problem, we reference the 2011 World Trade Organization (WTO) report. The WTO has estimated that 2% of all world trade involves counterfeit goods that value in the order of US$25 billion annually. Of these goods, 75% originated in China from 2008 through 2010.

This may not be surprising: the same Chinese factories that produced genuine goods often have access to the exact same material that would allow it to make the unauthorized fake goods. Production of such fakes, along with authentic goods, makes law enforcement difficult. Even if counterfeiting criminals are caught, they often escape jail time, and thus, such crime can continue. In China, unless the police can prove sales or inventory value above roughly US$8,000 for producers and approximately US$24,000 for traders, counterfeiters are subject to fines, rather than imprisonment.

This is why the problem of counterfeit goods persists in China. If it is difficult for law enforcement to punish counterfeiters to any effective extent, even the most complex fraud detection software may not be able to prevent such criminals from using other aliases to try their luck again. This is very different from the U.S. where counterfeiters face up to US$2 million in fines or 10 years imprisonment if convicted of violating trademark laws.

Perhaps in order to stem the root problem in China, tougher enforcement of trademark infringement laws and more severe penalties need to be in place. Weeding out fake goods listings on e-commerce websites simply isn’t enough.

Bank Loans Are the Tortoise, Not the Hare

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El crédito bancario es como la tortuga, no como la liebre — CC-BY-SA-2.0, FlickrPhoto: Mark B Schlemmer. Bank Loans Are the Tortoise, Not the Hare

The global financial crisis did not change the nature of bank loans.

Bank loans were specifically designed by bankers to resist the forces that drive volatility in most other asset classes. Bankers designed bank loans to reduce the volatility that comes along with changes in interest rates and company values, so they insisted that loans have floating coupons and that they be senior and secured.

Ampliar

History shows they did a very good job. 2008 was the only year since loan indices began when loans had a negative return. The 2008’s performance was not driven by credit quality but by a global leverage unwind that created many forced sellers and far fewer buyers in a very short period.

When the selling and rebound were finished, loans resumed their historically typical role: to be the tortoise rather than the hare.

Cheryl Stober is a vice president and a product manager for the bank loan team at Loomis, Sayles & Company, a subsidiary of Natixis Global AM

China’s Next Gen Consumers

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La próxima generación de consumidores chinos — Photo: Robert Huffstutter. China's Next Gen Consumers

The “Post-90s” generation, comprising those born in the 1990s, has emerged as China’s newest generation of consumers. Representing 15% of the total population and now in their 20s or entering their 20s, this segment of China’s young are embarking on their first jobs and even starting families of their own. While they do not yet have the purchasing power of older generations, they have already influenced how brands approach product development and marketing.

This generation was born amid the restrictions of China’s one child policy, which in many cases means that they have had a fairly comfortable upbringing, and did not have to split family resources with siblings. They were also raised among a macroeconomic backdrop of rapid GDP growth and wage increase. As a result, compared to China’s older generations, the Post-90s children tend to feel more optimistic about their futures and less inclined to save. In fact, they have often been described as “happy and confident spenders.”

The Post-90s generation also grew up with the Internet. While this is not unique to China, what is different is that as Chinese consumers they simultaneously witnessed an explosion of new brands. This younger set embraced the opportunity to gather information online and thus, has also become a more sophisticated group of consumers; often, they can look beyond a brand to make a more holistic decision, using online resources and reviews, to inform their purchases, considering features, quality and prices.

Express individuality

Most interestingly, the Post-90s group seizes opportunity to express their individuality. They view each product as an extension of their personal identity and a chance for self-expression. They are interested in the personality of a brand and the story behind a product—and consider it even better if they can engage in a dialogue with the brand or collaborate in the development of the product.

Some brands are ahead of the curve in understanding and appealing to this generation. For example, the Coca-Cola Company went as far as implementing a successful campaign to replace its iconic brand logos on bottles with online nicknames popular among the Post-90s generation, status updates used in social media, or lyrics from popular songs.

In another notable example, private smartphone manufacturer, Xiaomi, chose a collaborative approach to product development, making a concerted effort to consider and implement user feedback. This philosophy has resonated well with the Post-90s generation of those becoming more engaged and loyal customers, and who feel a connection with a brand and product that is tailored for their needs.

Most firms, however, are still grappling to discover what will resonate with this new generation of consumers. As the Post-90 generation grows to become China’s main consumer base, it will be important for brands to innovate and evolve along the way in order to prosper over the long term.

Opinion column by Hayley Chan, financial Analyst at Matthews Asia.

The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.

India FY 2016 Budget: It’s Not a Sprint, It’s A Marathon

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El presupuesto de la India para 2016 no es un sprint, es un maratón — Photo: Rubén Alexander. India FY 2016 Budget: It’s Not a Sprint, It’s A Marathon

The Union Budget for the fiscal year to March 2016 (FY16) has successfully managed to balance maintaining fiscal discipline and promoting growth by focusing on infrastructure investment and improving the ease of doing business. It confirms our view that policy actions will be incremental and tactical rather than tectonic, aiming to gradually put India’s economy back on track towards a sustainably higher growth rate.

Maintaining fiscal discipline, with some leeway to promote growth

First of all, the government maintained its fiscal deficit target of 4.1% of GDP for FY15, showing its commitment to enforcing fiscal targets. For FY16, the target was cut to 3.9% with an objective of 3% of GDP by FY18, one year later than previously planned.

By doing so, the government aims to balance the need to continue fiscal consolidation and to create leeway to promote growth. It is worth noting that these budget assumptions look better grounded than past assumptions, which makes us more confident that the government can avoid slippage on the targets.

Achieving a higher growth rate is critical for India to ensure its ‘demographic dividend’ – a young population and a low and falling dependency ratio – does not turn into a burden because of insufficient job creation.

A focus on infrastructure investment

To promote growth, the government is focusing on infrastructure investment, financed by the less stringent fiscal deficit target as well as the fall in crude oil prices which should help trim the subsidy burden by 50% to INR 300 billion (USD 4.9 billion).

In total, the government aims to allocate an additional INR 700 billion (USD 11.3 billion) to infrastructure investment in FY16 compared to FY15. It plans to set up a National Investment and Infrastructure Fund (NIIF) with an annual investment of INR 200 billion (USD 3.2 billion). Lastly, it wants to create tax-free infrastructure bonds to fund road, railways and irrigation projects.

Improving ease of doing business, empowering state governments

Also critical to reviving capital expenditure, the government is introducing a ‘plug-and-play’ model, which sets out clear rules for large projects, listing all applicable norms and laws ahead of the bidding process. Companies will not need to continuously ask for permits or clearance as long as they follow the guidance, which should speed up execution and increase the number of projects that get off the ground (and contribute to improving India’s infrastructure). In addition, companies should benefit from a cut in the corporate tax rate from 30% to 25% over the next four years.

Another important step was the decision to transfer more responsibilities to states by increasing their share in tax collections by 9%, in line with the recommendations of the Finance Commission. This marks a paradigm shift in the relationship between the central government and the states, which should promote efficient policy execution at the local level.

Towards a gradual growth recovery

This balanced budget confirms our view that policy actions will be incremental and tactical rather than tectonic. Most importantly, it provides a clear roadmap to build the foundations for a sustainable 7-8% growth in the coming years, which we believe is a positive for long-term investors.

Companies Will be Central to Global Growth

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Las compañías serán la clave para el crecimiento mundial — Foto: José María Silveira Neto. Companies Will be Central to Global Growth

Global financial markets have yet to take the consequences of numerous events in 2014 fully on board. Geopolitical risk featured prominently, the rate increase everyone expected in 2014 failed to materialise; instead, rates remained at historic lows while commodity prices collapsed.

Currency movements were behind half of financial market performance in 2014 but there were in fact numerous disparities, notably valuation divergences between cyclicals and non-cyclicals due to investor risk aversion. Against this backdrop, international equities, and value strategies in particular, offer numerous opportunities. But it is vital to adopt a diversified, long term approach.

Accommodating monetary policies (which has ended in the US but is just starting in the Eurozone), are factors benefiting companies which should see marked improvements incompetitiveness. In the Eurozone, where valuations are also very reasonable, the euro depreciation also plays an accelerator effect. US companies should benefit from a recovery of investments, as their levels are still under historical average. Finally the recovery in loan demand suggests that growth isimproving while corporate restructuring efforts should translate into higher margins and cash flow generation.

In this context of a small but sustainable growth recovery, some investment themes should stand out. For example, the global car cycle offers some opportunities. European brands benefit from improved margins and a high creation dynamic while sales of American brands, already at high levels, are supported by an old average age of vehicles. The resumption of credit should greatly benefit banks which are, on the other hand, heavily discounted.

Among other, we currently find value in names like Faurecia, Corning or TUI AG. Faurecia is a French car parts company which is the global leader in seats and interiors. Corning is a US company that makes electronic components. It is the leader in glass substrates used in touch screens (50% market share). The company is also active in environmental materials. TUI AG is a German tour operator created from the merger of two branches that were spun off a few years ago.

Non-cyclical stocks have so far benefited from two positive effects between risk aversion and the investorsearch for returns. The resulting cyclicals stocks discount offer many opportunities to benefit from the growth return in both the United States and Europe.

Christophe Foliot, Lead Portfolio Manager, Head of International Equities and Adeline Salat-Baroux, Portfolio manager International Equity Manager in Edmond de Rothschild AM (France).

One Easy Way to Preserve Your Wealth – and Enjoy It, Too

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If you are reading this blog, you are most likely blessed to be wealthy, or advise someone who is. There’s plenty of money to live life to the fullest. For now. But how do you preserve that wealth?

One answer is real estate. It is said that 90% of the Forbes 400 index of the world’s wealthiest people either made or retain their wealth in real estate. But not just any real estate. These people own high-quality, income-producing real estate, like apartment communities and office buildings. The ultra wealthy hold real estate long term, because they know that is how to preserve their wealth.

Your luxury home, your Alpine ski chalet, and “investment” condos in New York and Miami may (if you are lucky) provide some asset appreciation when you sell them, but in the meantime, they are costing you more than you will recoup. My advice: Enjoy them, but do not count on them to preserve your wealth. Do not expect them to be long-term wealth enhancers.

I just read an ad for an exotic car rental company called “Lou La Vida.” (Rent Life.) What a great philosophy! Rent the things that add to your enjoyment of life. Whether it’s cars or boats or condos, you can rent them when you want them, and that’s a lot cheaper than owning. So Rent Life! But buy future security.

And now is the perfect time. I’ve been in the real estate business for almost 40 years and I’ve never seen a better opportunity to invest in multifamily (apartment communities) real estate in the US. Home ownership is at its lowest rate in years, and apartment living is soaring, both for renters by choice and renters by need. And US demographics point to continuing demand for rental housing.

Why? Just look at the traditional American first-time home buyers. They are not buying homes:

They are burdened with large student loans and other debt. Unable to find jobs after college, they go back to school.
They don’t have the money for a down payment on a home.
They are delaying marriage and starting a family, which is a major driving factor in home ownership.
They want flexibility for employment purposes to move to a new job.

So they are renting. And, interestingly, so are their parents and grandparents as they down size or retire.

There are many more reasons to choose multifamily real estate to supplement your investment portfolio: on-going income, asset appreciation, tax advantages. Plus, real estate has outperformed all other asset classes over the past 12 years, and its value does not rise and fall with the stock and bond markets.

And interest rates!!! Right now, with low interest rates, we can leverage funds to provide the greatest returns.

By the way, there are several ways to invest in real estate. At Lloyd Jones Capital, we offer direct investment (as opposed to a REIT which is like buying stock). We have funds that we co-invest with major institutional partners for maximum leverage; we have individual property investments, and we have funds that target specific categories such as workforce housing. Or we can help you acquire a property and become your asset manager to protect your investment.

Good asset management is one of the keys to successful multifamily investing. But the most important, after analyzing and choosing a property, is the day-to-day property management of the asset. Lloyd Jones Capital partners with its sister company, Finlay Management, Inc. to oversee the operations and maintenance. Finlay Management has been in the business since 1980 and is an Accredited Management Organization.

Let me leave you with this reminder: Rent lifestyle; but for wealth preservation, purchase a quality, US apartment complex.

One simple way to protect your wealth.

One easy way to preserve your wealth.

Best way to enjoy your wealth – and keep it.

Rent Lifestyle, but invest in real estate.

Opinion column by Christopher Finlay, Chairman and CEO of Lloyd Jones Capital

One Cheer for India: Hip, Hip but no Hooray?

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Un brindis por India, con ligera cautela — CC-BY-SA-2.0, FlickrPhoto: C.K.Tse . One Cheer for India: Hip, Hip but no Hooray?

It seems that America, and American investors, are embracing India like never before. President Barack Obama was the chief guest at India’s recent republic day celebrations. The trip was the first such visit by a U.S. president, and an honor that India has typically bestowed on traditional allies. There was a sense of optimism over India’s place in the world, with Indian media headlines optimistic about the seemingly good chemistry between President Obama and Prime Minister Narendra Modi.

Obama’s visit to India capped several good months for India’s new government. The Modi government came to power on a platform of development economics, reflecting the desire of a poor nation to see rapid economic growth rather than a redistribution of wealth. Along the way there were some unanticipated good fortunes; weakening oil prices moderated inflation and provided some leeway to pursue reforms. And India’s stock market seems to have indicated its wholehearted approval.

Optimism regarding India is becoming the norm—look at the International Monetary Fund growth forecasts, for example. The IMF now expects India’s growth rates to begin to exceed those of China sometime between 2017 and 2018. And it is not as if India’s population is particularly old—on the contrary, 29% of its people are under 15 years of age, and a mere 5% is over 65. For China, the comparable percentages are 18% and 9%, respectively.

There is much that India can do to improve just by copying China’s growth, such as building infrastructure. And India can do so with a more entrenched sense of corporate governance and capital markets. China had to destroy a communist system and try to rebuild free markets. India’s task is presumably easier. So, one cheer for India!

But investors would do well just to cool their heels a bit here. Challenges remain. Structural reforms are difficult to push through given well-entrenched existing interests. These roadblocks get magnified in a democracy, particularly in such a large populous country. India’s parliamentary democracy has two bodies—Upper House and Lower House—any legislation needs to be passed by both these houses. In the Upper House, the ruling party is in a minority and hence has been unable to pass through any significant legislation.

And, moreover, it is not as if the market is trading at cheap valuations. The BSE 500 Index’s price-to-earnings ratio* (using the last 12 month’s earnings per share) is at 21x. While this might look only marginally higher than the long-term valuation of 17x, companies in sectors, such as property have underperformed. Several sectors are much more expensive than that reflected by the aggregate market valuation.

Using forecast earnings, the valuations appear much cheaper at 17x. But this is the point. At the moment, India is trading on expectations—expectations of accelerating earnings, expectations of better governance and expectations of faster economic growth. Given heightened expectations, even minor missteps can translate to pain in the stock market.

So, it is not that we don’t see the value of Modi’s proposed reforms or the promise of a young India, freed from the encumbrances of bureaucracy; it is just that these goals have yet to be achieved. One should invest in India only after a sober look at the long term. Beware of chasing price momentum.

Sudarshan Murthy, is research analyst at Matthews Asia.