Lower interest rates are key for re-rating of the equity market in India, said Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch. In an interview with Sanam Mirchandani, Hartnett said he believes India and China are the most attractive equity markets from a long-term perspective because they have the largest number of good companies.

Edited excerpts:

What is your reading of the US-China trade tensions?

The main drivers of equity markets are always two things – interest rates and corporate earnings. Trade war is secondary in terms of equity markets and is not the driving force. The S&P 500 has effectively risen from 600 to 3,000 in the last 10 years and the trade war has had no impact. If the trade war affects interest rates and earnings, only then it becomes important. To date, the trade war certainly has helped to put downward pressure on interest rates and has helped create a situation where central banks are more dovish in 2019 than they would otherwise be, and actually, this is a good thing. The impact of the trade conflict on corporate earnings is a problem, because it has affected the Asian export cycle and the manufacturing cycle in the US, Europe and Asia. While the impact has been negative, but certainly, it’s not catastrophic. Investors are right to be worried about trade but our advice has been – do not change your portfolio dramatically simply because of trade conflicts.

Where are the US interest rates headed?

The next move by the Federal Reserve is more likely to be a cut than a hike. The question is when. At Bank of America Merrill Lynch, we believe, the cut is more likely to be next year than this year. If there is any deterioration in either the American corporate earnings or the unemployment rate, the Fed may cut (rate) in 2019. The critical factor to be seen in the US is corporate bond yield because that’s what allows the corporations to finance business. Unless corporate bond yields go up from the current low levels, it is very difficult for equity prices to go down.

Your May fund managers’ survey detailed how record number of fund managers are positioning for a market fall. What are the reasons behind it?

People are hedged because the markets, certainly in the first four months of the year, rose very dramatically. While global commodity prices were up 15-20%, equities were up 10-15%. These are very big gains in four months. No one really wants to go short on equity market, because at the end of the day, people believe that if the market goes down, the Fed will cut and the US will eventually cut a trade deal with China. Everyone is nervous and everyone wants to hold on to their profits, and as a consequence, it pushes people to hedge dramatically.

In India, the Narendra Modi-led Bharatiya Janata Party has won the polls with a decisive majority, which the market seems to be liking. Does it call for a re-rating of India?

The critical thing for me continues to be interest rates. The combination of economic growth, inflation and the Budget — all of these things together with the fact that Indian interest rates at 7% are much higher than US interest rate of 2%. If all of these things make people buy Indian debt and if you start to see Indian interest rates move lower, then yes, it is possible that the Indian stock market will re-rate. The stock market in India was at an all-time high in January 2008. It was at an all-time high in January of 2018 in dollar terms and even today, it is at similar levels. If the Sensex in dollar terms can break out to a new high, there is no doubt that international money will be looking to increase weight on India.

Where do Indian equities stand in the list of emerging markets?

From a longer term perspective, India and China are the most attractive equity markets because they have the largest number of good companies. And then we have Vietnam, Nigeria and Brazil. But I think, if you were looking for a combination of investor trust in monetary and fiscal policies, government policy and the corporate sector, then India is always going to be up there in terms of choice for the emerging market investors.

Manufacturing activity in the US, Eurozone, mainly Germany, and Japan have been slowing. Is this a blip or a start of global economic slowdown?

In July this year, the economic expansion in the US will become the longest expansion of all time. It is 10 years or more into an economic expansion. That said, this expansion has been very different. It has been very slow and it has been one that has gone hand in hand with lower interest rates. Coming back to manufacturing, it means a lot for Japan, Germany, China and it means less for America. And that’s why the American economy is doing better than others because it is much more reliant on consumption. There is a risk of recession, without doubt, in the next 18 months. But I am not sure if that would be led by the manufacturing sector. You have got to see the nonmanufacturing sector in the US – unless that gets worse, I don’t think the manufacturing situation would matter much.

Emerging market equities have broadly underperformed developed markets in recent years. Do you see this trend reversing anytime soon?

Yes, the trend will reverse. The reason the emerging market equities have underperformed global equities is because EM equities have underperformed the US market, particularly the US tech. You have a situation today where if you look at the market-cap of let’s say the Indian stock exchange in dollar terms and if you look at that on an MSCI free float basis, the market cap of India is roughly about a little less than $500 billion while Facebook’s market cap is over $500 billion. Therefore, effectively, Facebook is larger than MSCI India, which is crazy. The story is not necessarily true for 2019 because this year, probably, the tech stocks will outperform. But from 2021-22 onwards, emerging markets will simply be better because the US market and tech stocks would be off their peaks. The other factor that is key for emerging markets is that you need to continue to see people buy emerging market bonds. For example, the Indian 10-year yield is about 7%. If that can fall to around 6% or below, that is going to be very critical to get people into emerging market equities. So lower Indian and emerging market interest rates coupled with lower US tech valuations would help emerging markets outperform over the medium term. Emerging markets is really a stock-pickers’ environment.

What is your outlook for oil?

One of the external factors that can be very harmful to both China and India is unanticipated rise in oil prices. Clearly, the situation in Iran is tensed. Going forward, a lot will depend on what the Iranians do rather than what the Americans do. The Americans are not looking for a significant rise in the oil prices and we have seen President Trump, a number of times in the past six months, intervening in the oil market. As of now, I am not convinced that oil prices are going to rise to a level which is really negative so far as India and China are concerned.

What is your view on gold?

Gold looks pretty good over the next six to 12 months for the simple reason that the dollar, over the next six to 12 months is probably going to head lower. In the short term, I don’t think you need to rush to buy gold. But generally, I think that gold price will do well over the medium term. I wouldn’t be surprised if it moves above $1,400 in the next 6-12 months. With a costly dollar, there is already a renewed enthusiasm for Bitcoins. It is partly because investors are looking for an alternative to the major currency. Once the dollar turns lower, that will also sort of bleed into gold prices.


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