MFA View on the Fundamentals and Markets

Goldman Sachs’ recent announcement that it is upgrading the Indian equity market from underweight to market weight has created a palpable sense of excitement. In a market where good news is hard to come by, many market participants have seized upon this piece of news just as a drowning man clutches at straws. Our view is one of guarded optimism. At the end of the first quarter of 2012, the domestic and international problems that led to the Indian markets nose-diving by almost 25 per cent in 2011 are not quite over.

But first let us examine Goldman Sachs’ reasons for the upgrade. Its analysts argue that the European problems that had weighed heavily on the Indian markets have abated. The month of March has gone by without inflicting much damage: while the Congress Party’s performance in the state elections was disappointing, at least the budget was neutral vis-à-vis the markets. Moreover, Goldman’s analysts derive optimism from the fact that core inflation is softening. They also expect domestic growth to revive in the second half of the calendar year. They have also suggested that as the year progresses earnings estimates for 2013 could get revised upward. And finally, they argue that current valuations are attractive compared to the 10-year average of the MSCI India index.

Many a slip…

No doubt the magnitude of the headwinds that affected the Indian economy and markets in 2011 has abated. But currently the glass is half full at best.

Rate cuts. After thebudget, the market is now hinging its hopes on interest rate cuts by the central bank. Rate cuts could well begin in April, but owing to inflation (which has abated but is not yet in RBI’s comfort zone), and inadequate reining in of the deficit and government spending in the budget, the quantum of rate cuts is likely to be limited. Economists at Citi, for instance, expect rate cuts of at best 50-75 basis points (bps) in 2012. After that, whether the RBI is able to undertake more cuts will depend on where oil prices are headed, and whether the government has undertaken credible measures to rein in the fiscal deficit (read, raised fuel prices).

Iran oil crisis. The price of crude oil remains elevated owing to the stand-off between Israel and the West on one side and Iran on the other over the latter’s pursuit of a nuclear programme. If the crisis escalates and the average price of oil rises to $125 per barrel in FY13, as many economists think could happen, that would spell disaster for India which imports 80 per cent of its oil needs. Oil comprises 30 per cent of India’s total import bill and a one dollar per barrel increase in its price raises its trade deficit by $800 million. Even at current price levels, the government has under-budgeted for oil subsidy. If prices rise, both the current account deficit and the fiscal deficit would balloon. Inflation would soar again, rendering rate cuts by the central bank difficult.

Rupee under pressure. Indiarequires massive portfolio inflows to fund its current account deficit (which stood at 4.3 per cent of GDP in Q3FY12). When these flows flag even a little, the rupee comes under pressure. This has happened again in March. In January and February portfolio inflows were of the magnitude of $6 billion each. But with portfolio flows slowing down in March, the rupee has depreciated to around 51 to the dollar.

A depreciating rupee affects foreign investors’ dollar returns and makes them negatively disposed towards the Indian markets.

Insufficient cut in fiscal deficit and high borrowings. In the budget, the Finance Minister projected a fiscal deficit target of 5.1 per cent for FY13. Though this target is more realistic than last year’s 4.6 per cent, it may not be achieved. Besides having budgeted too little for fuel subsidies, the government may also have over-estimated the revenue it is likely to earn from re-auctioning of telecom spectrum and from disinvestment. If the government overshoots the fiscal deficit limit, it could invite a cut in its sovereign rating, which would again affect foreign investments. Furthermore, since a high government deficit is inflationary, it will make rate cuts by the RBI more difficult.

The government’s borrowings, as indicated in the budget, will also not come down in FY13. This will prevent long-term rates from softening and will crowd out private borrowing. This could further postpone the much-needed revival in private investment.

Major reforms unlikely. Many of the UPA’s own allies, such as the Trinamool Congress, oppose key reforms. The UPA’s lack of majority in the Rajya Sabha is another impediment. Furthermore, the Congress Party’s recent losses in state elections may make it more cautious, and prevent it from attempting contentious reforms.

European problems may flare up again. In the fourthquarter of 2012, theIndian market was most closely correlated with the movement of Italian sovereign bond yields: the market fell as yields soared. It underperformed because several Indian firms have borrowed from European banks (which were in difficulties and could well have called in their loans).

Currentlythe euro zone’ssovereign debt problemhasabated after the European Central Bank (ECB) injected more than 1 trillion euros. But the problem could flare up again, especially in Portugal and Spain. Austerity programmes being implemented in the euro zone are bound to affect growth, and hence the revenue earnings of governments. This will make it more difficult for these governments to find their way out of the debt crisis.

A resurgence of the problems in the euro zone could once again create a risk-off environment and lead to outflows from emerging markets, including India.

Recovery in the US. If theUS clocks robust growth (2.5 per cent expected in 2012 vis-à-vis 1.7 per cent in 2011), it could lead to outflows from EMs (especially India which is mired in domestic problems) and into the US market.

A few positives

China slowdown. China’s growth rateis expected to slow down from 9-10 per cent in the recent past to 7.5-8 per cent in 2012. If the world’s biggest consumer of commodities slows down, commodity prices could soften. This would be a big positive for a commodity importer like India.

Policymaking initiatives. ThoughtheFinance Minister did not announce any big reforms in the budget, he did try to support investment in infrastructure, energy and the power sector by taking steps that would make more funds available to them and by offering tax concessions.

Another positive is the recent steps taken by the Committee of Secretaries, headed by the principal secretary to the Prime Minister, to remove bottlenecks that are affecting investments in core sectors. The Committee has proposed fast-track clearances for power and coal projects and expansion of production by existing mines without requiring fresh clearances. It has also instructed Coal India to sign fuel supply agreements with power plants that have entered into power purchase agreements. With the PMO now spearheading this initiative, the impediments affecting investments in core infrastructure sectors might well get removed.

More monetary easing by ECB. Given the scale of problems in the EU, the ECB’s 1 trillion euro LTRO programme may have to be supplemented with further doses of liquidity injection (possibly by mid-2012). This would whet risk appetite and support equity markets in emerging markets including India.

Notwithstanding Goldman Sachs’ positive prognosis, we would advise patience and caution. However, this should not be interpreted to mean that you should stay away from the equity markets. In fact, times such as these are good for ploughing money that you will not need for the next five years into equity markets.