Long bonds and equities attractive in current environment

Written by Saikat Neogi | Updated: Nov 30 2011, 06:33am hrs
There are parts of the market that are trading at high multiples and others that are trading in mid-to-high-single digits. And this dispersion presents a good stock-picking opportunity for investors, according to Ridham Desai, managing director and head of equity research at Morgan Stanley. In an interview to FEs Saikat Neogi, Desai says that in the current turmoil, long bonds and equities look attractive and one should not look to park money in shorter-term instruments because there is a likelihood that interest rates will come down in 12-15 months.

With Sensex down over 20% in 2011 and equity investments by Indian households plunging to a quarter-century low, how do you think retail participation can be boosted to broad-base the Indian markets

Retail investments have usually been a function of trailing returns. Hence, during 2003-2007, we witnessed a strong pick-up in equity investments. Returns have been volatile since then and that unnerves retail investors. There is another point to be noted here, that the appetite for financial assets in general has been weak. Essentially, households are investing their savings in gold and property rather than financial paper. This behaviour may be due to the fall in real rates; arguably, real rates were negative in 2010 and the first half of 2011. Rising inflation expectations curbed the appetite for financial paper. As inflation expectations recede, and real rates turn positive, a gradual return to financial assets is likely.

What are the domestic and global factors that you foresee that could further dent investor confidence in Indian markets

There are two domestic factors we are focused on: Inflation and government policies. If either or both of these improve, investor confidence should improve. Animal spirits take a sequence of positive developments to trigger. This is not an environment where it is likely. And global factors could play a role.

If the western world attacks their problems with excessive monetary easing, it could lead to higher commodity prices, which may then feed into India's inflation rate with negative consequences on India's growth, given how high rates are. On the other hand, if the problems in Europe morph into a capital markets freeze, India may find that capital flows into the country dry up. In the context of India's current account deficit, this may hurt growth like we had seen in 2008-09. So, global developments could be of critical importance to investor confidence.

Since one-year forward valuations have come back closer to the average levels, how are you looking at stock selection and what kind of sectoral advise will you give to investors

Equity valuations look attractive at around 12 times earnings for the broad market (lesser if you take forward multiples). However, valuation dispersion is very high compared to history. What this means is that there are parts of the market which are trading at high multiples and then other parts which are trading in mid-to-high single digits. This dispersion presents a good stock-picking opportunity for investors. In fact, we see this dispersion in earnings and stock performance as well. So, we believe this is a great market for stock-pickers. From a sectoral perspective, it is all about the time-frame. If the investment horizon is 12 months, consumption and technology should do well.

If someone can invest with a longer time horizon (certainly something we recommend, given the volatility in equities and the long-duration nature of the asset class), infrastructure, financials and consumer goods look good. In the short run, however, some of these sectors may struggle to perform.

How do you see the long-term fundamentals of the equity markets in India and how are foreign institutional investors looking at our market in the current context

The long-term fundamentals look good to us. The valuations are implying a long-term return of 15%. Corporate balance sheets are in excellent shape and India is likely to deliver high growth rates. FIIs (foreign institutional investors) with long-term horizons are constructive on India, but others who have near-term performance pressures are a bit reticent.

They are looking at inflation (hence RBI action) and government policy as triggers. Indeed, the current global environment is also an issue for these investors, given what impact it may have on India. In recent months, there has been greater debate on India's long-term story too and some people have come to believe that India's long-term growth outlook is not a given. We would agree with that prognosis. India will have to do its bit in terms of reforms to ensure that it delivers 8-10% growth. But on a relative basis, India does look more attractive than most markets.

In the medium-to-long term, what would investors preference be: bond or equity Which asset class do you think would do better

In the current turmoil, with a medium-term investment horizon (3-5 years), we are inclined to buy duration. Hence long bonds and equities look attractive. This is not the time to park money in shorter-term instruments because the likelihood is that interest rates will be lower in 12-15 months. Between long bonds and equities, we are more biased towards equities.

During high inflation, how do you think diversification of assets works for investors and what kind of asset allocation should a retail investor look at

Diversification of assets is important through economic cycles. So whether inflation is high or not, investors must have adequate diversification but also not over-diversify. A combination of equities, fixed income and some real assets is a desirable mix from a long-term perspective.