Global and Local Uncertainty – Lets keep the faith

In this blog post I would like to share the views of one of the investment banks on the present market scenario. After almost three years of bull run in Indian markets we have entered a pocket of introspection. Key stock indices now trade along with most global markets, at levels that last prevailed in September ’07, before the US Fed commenced its rate easing cycle. Overall market capitalization is down by 27%, in calendar ’08 and stands at levels last seen in September ’07.
Key factors affecting Indian markets can be classified as

Global environment – uncertainty continues to unfold
The unfolding economic malaise in the US has been well articulated in various fora with the principal concerns surrounding the likelihood and the depth of an economic recession, the stagflationary environment seeming to emerge there and the ability of policy makers to engineer a smooth and swift recovery in such an environment. The sharp fall in the USD over the last few days against most major currencies – the EUR trades at its life-time high, while the JPY is at a 12-year high - seems to betray the market’s nervousness on the US economy’s health over the near term.

Commodities rally as hedge against the USD
The weakness in the USD has likely led to large-scale unwinding of JPY carry-trades, even as financial investors seem to be reallocating portfolios in favour of commodities, partially as a hedge against the greenback’s weakness. Thus, crude oil prices have risen sharply to all-time highs in the recent past despite projections of easing demand in the US, the largest consumer. The shift away from USD is seen by the fact that although commodities have rallied in USD terms, their price movements have been vastly subdued in EUR terms, ever since the US Fed cut rates in an emergency move in late January.

US recession
Increasingly, the debate has shifted from speculation over the possibility of a recession (in the US) to, predicting the extent of such an imminent eventuality. A spate of adverse incoming economic data pertaining to employment, consumer confidence and production have led various analysts to project two successive quarters of degrowth, which may likely be followed by a recovery in the second half of the calendar year, aided primarily by the spate of rate cuts expected from the US Fed and the tax rebate package already extended by the US Government. The IMF projects global growth as a result to slow from an estimated 4.9% in ’07 to 4.1% in ’08.

So how sensitive is India to the current global turmoil?
The confidence in emerging market economies’ ability to forge ahead in the backdrop of a US recession emerges from the insular nature of many such countries and the domestic strengths they enjoy. India figures prominently with its strong domestically driven growth pattern.

1. Despite integrating substantially with the world in recent years, India’s trade/GDP ratio remains at c32-33%, with exports to the US constituting a miniscule 2% of our GDP.
2. Various research agencies and the IMF have estimated that, every 1% change in US GDP, would impact India’s GDP by c0.2%.
3. A near doubling in investment/ infrastructure spends over the next few years to c8-9% of GDP would provide strong growth drivers for the economy that would percolate across a whole host of industries.
4. Aided by among the strongest income growth globally, lower taxes (both indirect and direct taxes were cut in the recent Budget) and potentially conducive monetary environment later in the year, domestic consumption demand is expected to pick up substantially over the next few years.
5. On the back of the above domestically led growth, corporate India is widely expected to grow its profits by c18-20% over the next two-years. This growth comes off strong balance sheets with debt levels lower than those seen at the beginning of the decade.
   
   However, while the medium/ long-term picture remains unchanged, over the short-term, the principle sources of permeation seem to be through the financial markets, where rising credit spreads and unexpected currency movements may create short-term turbulence for corporate India. Higher risk aversion in the near-term could also dampen companies’ ability to raise finance to fund their growth plans in the short-term.
   Most of the above may well be transitory in nature, given the longer-term robust outlook for India. Besides, domestic savings that stand at c34% of GDP and rising, would likely be able to support the investment requirements of the economy.

What is the near-term economic situation?
The Indian economy is undergoing an engineered moderation over the last four quarters and could now be well placed to regain its higher growth trajectory aided by fiscal and potential monetary impetus. Key factors here and the debate surrounding them include:

1. The Union budget has cut excise duty and sales tax, even while raising the income tax slab and granting an unprecedented farm loan waiver with the objective of easing domestic inflation and providing impetus to consumption demand.
   » These measures would not only raise income levels across the economy, but also make goods more affordable – both positive for driving consumption.
2. Rapidly falling US interest rates, a recent divergent trend of a weakening INR and conducive deposit and credit growth could help the RBI consider a benign monetary environment in the coming quarters. System rates have slid since January with bank lending and borrowing rates easing by c25-75 bp supported by domestic liquidity.
   
   » The flipside to this is however from stubbornly high domestic inflation, that faces the further risk of rising crude and commodity prices.
   » A fundamentally weak USD and broadbased currency appreciation across similar nations, could however raise calls for renewed appreciation in the INR, that would reign in inflation.
   
   Despite mixed signals, markets seem to be betting on rate cuts by the RBI in the latter half of ’08, mostly in an effort to buoy growth.
   Given the confluence of domestic (inflation, growth moderation) and international factors (oil prices, US recession, capital flows), policy making may well see some tightrope walking, while providing critically needed direction to markets over the near term.

Outlook
The ensuing global uncertainty may well cause markets to remain fairly volatile and gyrate to evolving international developments, while investors would closely watch its impact on Indian companies in the forthcoming quarterly financial results season. Initial indications hint at some disappointments around forex losses, bond exposures and easing order flows from the US.
Consensus estimates put earnings growth for the Sensex companies in FY09 at c20%, implying a P/E multiple of c14x at current index levels. While a consideration of the growth scenario over the next two-years at current valuations, demand investor attention, near term sentiment on global markets have raised risk aversion sharply. Even as the debate rages on the outlook for the US and thus, its key trade partners, the growth outlook for India remains largely intact. It is this backdrop that long-term investors would necessarily need to focus upon, while viewing domestic equity markets amid volatile periods.
Thus, while near-term volatility is virtually a given factor, the opportunity to invest at compelling valuation levels over a 2-3 year investment horizon may help in contributing to overall portfolio performance. With the ensuing uncertain environment, we believe large-cap stocks/funds may provide sound opportunities over the near term, while a carefully tailored portfolio of mid-cap stocks/funds would benefit over a 3-year horizon. Investors should use a tranched approach to investing so as to derive the most of the volatility in markets.

So as I always say Lets Invest...