Dont see repeat of 2008 but beware of the Terminator effect of technical correction in US markets, Christopher Wood, Global Equity Strategist, CLSA tells Nikunj Dalmia of ET Now in an exclusive interview. Big risks in India next year are primarily external and outside govt control, says Wood.
Edited excerpts:
What is going on in the world? Why are there so many asset classes just going helter skelter?
This is the consequence of the US starting the monetary tightening cycle. Most high beta asset classes — cryptocurrencies — were hit first; then it rolled into emerging markets, Asia and then of course the US equity market at the end of last quarter. Last man standing is as I described it and obviously the minute the correction moved into US equities, there was significant technical damage done to the US bull market the FAANG stocks.
My base case is as monetary tightening continues, we run the risk of more corrections. But there is a significant possibility that we have a counter trend rally interlude. If my base case is correct, we will get some type of China-US trade deal before the next wave of tariffs are due for implementation in January.
How would you map the risk-reward ratio for equity as an asset class? There is a looming fear of trade war. Are we in for tough days, better days or flat days for equity markets?
In the short term, it depends on whether you believe there is going to be a trade deal at the G-20 summit or not. If there is a trade deal, then we can get a decent counter-trend year-end rally which will be led by Asian equities outperforming.
Asia is the market that has been hit most by the so called US-China trade war. If, however, I am wrong and there is no trade deal between US and China, then it is just bearish. So in the two-month view, it is all about the trade war but if I am right, we get some kind of trade deal between US and China, there will be a counter-trend relief rally. However, we are not out of the woods completely because we still have US monetary tightening going on.
But my base case is at some point next year, the US monetary tightening will end and the dollar will peak out. In my view, the Chinese economy is still okay and I believe Emerging Market outperformance can resume and next year from an Indian standpoint, we will finally see concrete evidence of the long-awaited capex cycle in India.
What is your view on the way bond yields currently are in India because we are no longer closed to 8% plus, the bond yields today have come to a seven or eight week low. So do you think the interest rates in the system per se currently are settled?
I have been telling investors, especially foreign investors, that if you buy the Indian 10-year bond yields at 8% or higher, that long term is a very good value and you should buy it. Amidst all this noise we see right now in terms of the seeming controversy between the central bank and the government, the practical point is that the central bank has been running a very tight monetary policy.
My understanding is that central bank is targeting headline inflation and based on that, you have had very high real interest rates in India which in a long run is positive for bonds because that is basically deflationary.
There is a very legitimate argument that the central bank has been too tight in terms of high level of real interest rates. Clearly core inflation is higher than headline but the RBIs former target is headline and the fall inflation seems to be partly driven by significant decline in food inflation which reflects long-term positive improvement in agricultural productivity.
In my view, the bottom line is 8% in Indian government bond yield is good value and obviously it is a bit lower than that right now. In my view, the big risks in India next year are primarily external and that basically outside this governments control. One big risk is the oil price. India has been lucky because Donald Trump did a U-turn on the policy on Iranian sanctions and that is the only reason oil has corrected in the recent weeks. I still think there is a real risk that oil trends higher in the next few quarters because of the lack of supply and second issue is the dollar.
I am hoping that dollar peaks out next year when the Fed tightening stops but for now so long as we are looking in America the current combination of fiscal easing and monetary tightening, we have a risk of further dollar strength. So those to me are the two key risk for India and they are both external.
In your model portfolio one very interesting addition is Reliance Industries. You are classifying it as Indian internet. Are you trying to say that Reliance has potential to be the Alibaba of India?
I am just basically saying if you are looking for a big cap play on rising digital e-commerce, rising transactions over smart phones, that is the best big cap play.
You also were quite constructive on commodities at the beginning of the year. What is your view on commodities at this point in time when the fear of trade war could have impact on global growth?
I am hoping China and US do a deal. I think Donald Trump wants to do a deal but on commodities, on oil, the risk goes higher because of supply constraints and strong emerging market demand for oil. To me, the risk for oil is demand destruction but that risk has just been reduced because oil prices have gone down and on industrial commodities I am not super bullish.
The capacity shutdowns in China from 2016 has led to a reduction in excess capacity in industrial commodities which in my view makes industrial commodities more resilient. My base case is that we do not get a recession in the US next year. We get a recession in the G-7 world only if we get big asset price declines. The economy will be driven by the asset prices, not the other way around.
Some would argue the joker in the pack could be the dollar index as it is now nearing 100. It has gone way below 100 in the past also. Is that the big elephant in the room that could change the global set up?
Yes we had a major spike, further highs in the dollar would definitely make for more deflationary dynamics. So far, the dollar has rallied this year but the last time we had this unusual combination in America of monetary tightening and fiscal easing was in the early years of Ronald Reagan in the early 80s. At that point, the dollar went way higher than it is today. Given we have got the most hawkish central bank in the G-7 world, what is surprising is that the dollar has not rallied more.
The sense we got from worlds biggest hedge fund manager Ray Dalio and classic investors like Howard Marks is that American markets are due for a correction. Is it time to diversify and be cognisant of risk?
That has been common sense since the start of the year simply because the longer monetary tightening goes on, the bigger is the risk to equities. We got a double whammy of monetary tightening in America. We got Fed rate hikes and Fed balance sheet contraction. The only surprise to me is that the correction took so long to happen in America.
At the end of the third quarter, I described the US stock market as the last man standing. So, that is just common sense. But we need to understand why the US market was so resilient and that is the dramatic impact of tax reforms. Donald Trumps tax reform was extremely bullish for US equities. It has driven a significant pickup in earnings growth because there was significant cuts in taxes and it also led to statistical proven evidence of a big repatriation of money held offshore by American corporates in the form of dividend payments back home.
It is quite clear that the big inflow of corporate money has triggered a whole new surge in share buybacks. In the first and second quarters of this year, there were record high share buybacks and that is the key reason for the US market outperformance. American corporates have been the biggest net buyers of US equities since 2009.
There has been a selloff in Chinese internet stocks as well as mainland stocks. Do you think India now becomes the only game in town where large allocations could kick in and that Indian markets will not correct substantially?
No, I think foreign investors should be looking to buy both China and India. In ,fact I would buy China before India right now because China is much cheaper and Chinese market has had a lot of domestically driven forced selling because of the Chinese governments deleveraging campaign. So, China is more interesting in the short term than India.
The Americans think that the weakness of Chinese stock market this year is driven by the Trump administrations trade agenda and that is completely wrong. The weakness of Chinese stocks this year is driven first and foremost by collateral damage from the Chinese governments campaign to squeeze out the excesses in shadow banking. This is long term very positive policy in China but it is definitely creating collateral damage.
A lot of shares had been pledged in by private sector companies owned by chairman of Chinese private sector companies and there had been a lot of forced selling. Any time you have forced selling of equities, it creates a long-term buying opportunity that is what you have today in the Chinese market. So, I would buy China today before India. I buy India more aggressively as I said in first quarter but I would be overweight both.
Every time when we see a large correction in global financial markets, parallels have been drawn with 2008. Are we likely to see a repeat of 2008 anytime soon?
No I do not think it is a repeat of 2008. But I do believe there is a major risk of a correction in the US which is triggered by technical factors which could lead to a much bigger selloff than warranted by the fundamentals. This is because of what I call the terminator effect in American market and that is the reality that up to 80% of trading in America is now done by machines and these machines are running on these algo driven trading models.
My guess is that most of these trading models are all based on the same simple methodology which is some version of what is known as risk parity and the underlying assumption of all these trading models is that when equities selloff happens, government bonds rally. What you need to trigger massive technical unwind and what will blow up the machines is bond and equities going down together, i.e., positive correlation on the downside. If you had two months of that happening, you will get a massive technical unwind on Wall Street which will look very horrible but it would be primarily technical.
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