We are entering a period of turbulence, but you can profit off that volatility, notes Akash Prakash.
More than four years of underperformance has turned everyone into an emerging markets bear.
First it was the "taper tantrum" of 2013, which battered the currencies of the "fragile five" economies (including India) that were running large current account and fiscal deficits.
Subsequently, we have had the collapse in commodity prices; they have more than halved in the last 12 months (the Bloomberg commodity index is at its lowest level since 1999).
The collapse in commodity prices has damaged the fundamentals of those EM economies heavily reliant on resource exports.
Now, liquidity seems to be scampering out the door of the more healthy EM economies, as the risk reward equation of carry positions has changed post the new-found flexibility in China's currency. At the moment, in the EM world, there seems to be no place to hide.
However despite all this bearishness, we have yet to see capitulation and the underperformance of EM assets is likely to continue. The asset class is not yet cheap enough.
While the MSCI Emerging Markets equity index has just hit its lowest point in dollars since the third quarter of 2011, in local currency terms it is still 20 per cent above those lows.
In debt markets, the aggregate EM spread is only about 200 basis points above its historical mean. So, neither in debt nor in equity is there distress in valuations or market dislocations.
The EM sell-off has also been by and large differentiated, with country correlations not at the levels seen in previous panics.
In most EM asset classes, the price action this month, while brutal, has not been confirmed by strong volumes.
This price/volume divergence is more pronounced in debt and currency markets than in equities. There have been strong outflows from equity funds but much less from their debt counterparts.
This is important because over the last five years emerging markets have been more a debt trade than equities. Debt flows in all markets barring India/China have been far bigger then equity.
If and when there is capitulation in the EM asset class, we will see large outflows from the EM debt funds, putting pressure on yields and currencies. There will also be knock-on effects on equity. This shoe has yet to drop.
We seem to be midway through a fundamental reassessment of the growth prospects of EMs and the sustainability of these countries' growth models.
The slowdown in China, the fall in commodity prices, the delinking of global trade from GDP growth and the dollarisation of EM corporate debt are all secular headwinds to EM growth.
The volatility and underperformance in the EM asset class seems likely to continue for some time.
Sentiment, positioning, valuation - none of these indicators yet shows capitulation, nor enough damage to throw up a contrarian buy signal.
So where does that leave India? A decent spot in a bad neighbourhood?
We have very good macro fundamentals, limited exposure to China and enough low-hanging reform fruit to allow us to accelerate growth, despite global headwinds.
Our growth model is simple. We need to increase investment. We are a supply-constrained economy, in a world with no demand. We worry about inflation, in a world obsessed with deflation.
In a world of negative real rates, we have real rates of 250 to 1,100 basis points (depending on whether you use CPI or WPI). However, we will not be spared the EM pain.
India is a consensus overweight among global equity managers, and as continued EM underperformance causes more and more money to leave the asset class, we will have our share of outflows.
The days of FIIs being only buyers are over. We have largely remained unscathed from the EM turmoil till very recently, but the overweight and outperformance no longer allow us to remain immune to the travails of the asset class.
The strength of domestic equity flows has been a structural positive and will hopefully continue and cushion the foreign pressure.
We need to hope these inflows are structural and are the beginning of a domestic asset allocation shift. If these flows turn out to be pro-cyclical as well, then we will have no buffer to offset the foreign selling.
I remain a buyer of equities at every fall. We will have more days of high volatility, and steep price falls. There is no need to chase prices, buy only on the dips, as you will get enough of them.
But do use the price falls to buy your favoured stocks. The markets can easily fall another five or 10 per cent. This means individual stocks can gap down 20-25 per cent. We have our own spots of froth and overvaluation in mid-caps and "quality companies"; these stocks will surely come down significantly.
I still believe that over the next three years, India will accelerate growth to somewhere between seven and eight per cent.
Inflation and interest rates will be structurally lower, corporate profits will be somewhere near the long-term mean of six per cent of GDP and not four per cent like today.
I also believe that corruption and crony capitalism will go down, resource allocation and productivity of capital will improve and we will use digital technologies and new-age business models to leapfrog.
Yes, things are still slow on the ground. The lack of reform momentum, bench strength in government and political maturity across parties is disappointing.
Many of the reforms like direct benefits transfers, auctions of resources, etc, will cause short-term pain and slow growth. However is there any doubt that India will be in a structurally better place two to three years from now?
With the changes underway, will the economy and our companies not be more competitive?
While markets are not yet cheap, the sell-off will reset expectations and valuations. Stock-specific opportunities will open up.
If you do not believe the above, then obviously you should not buy on the dips - and you must question why you are in equities at all.
We are entering a period of turbulence, but use that volatility to your benefit.
This is not the time to lose heart. We are caught up in a global reassessment of EM assets; this is not an India-specific problem.
While it will get scary, and there is some risk of a systemic crisis, I do not believe that this is 1997 or 2008, as some of the more vocal bears would like us to believe.
If this does spiral into a systemic crisis, then obviously all bets are off, for then the pain and downside are not forecastable.
However, that is still not the base case. That remains this being a period of high volatility and steep corrections, a pause that refreshes and not a change of course.
The writer is at Amansa Capital. These views are his own.
