sandip sabharwal

AS HEADWINDS BECOME TAILWINDS

2012-01-20T12:35:00.002+05:30

The last year was a tough year for the Indian markets for more reasons than one. The impact of the US slowdown as well as Euro zone issues was generic to everyone globally, however the specific issues that were headwinds in the last calendar year are now providing tailwinds for the markets and it is possible that these tailwinds become stronger as the year progresses.

My last article was at a time of extreme pessimism, sentiments seem to be a bit better now after a 10% market up move, however the underlying pessimism and a disbelief in what is happening is all pervasive. I just completed a visit to Gujarat; traditionally a market of bulls and the kind of extreme pessimism I saw all around further reinforced my view that the year 2012 on an overall basis will be a good year. The three most important Headwinds of last year were

High inflation leading to high interest rates – The inflation cycle has clearly reversed. The reversal would have come a bit earlier were it not for the unprecedented fall in the value of the rupee in the last 4 months of 2011. Inflation has come off sharply in December and we are likely to see a further fall off over the next few months. The figure for January in all probability will go below 7%. RBI has refused to cut rates or CRR till now but has changed its monetary policy stance quite clearly by undertaking significant amount of OMO’s. The huge up move in the global commodity cycle has stalled with sharp correction in a large number of commodities. The impact was not felt on the manufacturing inflation in India due to the fall in the rupee. However we will start seeing the impact from February onwards. As such we will see interest rates and liquidity continue to improve from here till the end of the year 2012. This will provide impetus to both consumption and investment demand which got stalled last year due to various reasons which included continually increasing interest rates.

No policy initiative- A lot has already been written on this so I will not write more. However in reality last year decision making came to a standstill and impacted investments across sectors. Over the last few days we have seen initiatives on Retail FDI, Aviation FDI as well as on power sector woes. I believe that this process will further pick up post election in February. From its absolute bottom we should see significant improvement during this year and the expectations today are so low that small initiatives will be taken positively.

The Rupee movement – The movement of the Indian Rupee became the final nail in the coffin last year end. The unprecedented fall by over 20% shook the confidence of investors and also impacted companies with Forex liabilities adversely. However the INR has reversed direction in line with my expectations but at a pace faster than what I expected this year. We have already seen a 5% plus appreciation since the beginning of the year. Typically INR appreciation cycles and stock market movements are positively correlated and we are seeing signs of that in the current month. The stated policy of the central bank is that they will not provide a direction to the currency but will reduce volatility. However that does not seem to be happening on either side. Overall prospects for the rupee continue to be constructive, however the pace of appreciation should slow down and there is an increased likelihood of two way movements with reduced volatility going forward.

As such the three major headwinds are now tailwinds for the markets. Typically in bearish phases of the markets the markets will always surprise us on the downside and similarly on up moves there are likely to be upside surprises.

Some areas of concern still remain which include the high Fiscal Deficit and the measures taken to address the same. Increasing taxes will be a retrograde step, as in a slowing economy increasing taxes will cause inflation and hurt growth. Steps should be more on the expenditure side. Growth boosting measures will also be constructive for the Fiscal deficit as it will boost government revenues. Although lot of armchair economist will push for higher taxes that is clearly not the way to go. Tax increases will further curtail demand and as a result of that the expected revenues from higher taxes will not flow through as both top line and bottom-line growth gets compromised. The time to address the fiscal deficit in right earnest will be in a recovery cycle as that is the time harsh decisions get adapted in the momentum of growth. An extreme example of this is seen in the Euro zone where troubled countries are being forced to under take austerity measures, however due to its negative impact on growth the Fiscal Deficit targets are going way off mark. Maybe those countries have not option, however Emerging Economies like

India

do have that option as the nominal GDP growth even in the worst of times is expected to be 13-15%. How subsidies are addressed in the budget will be keenly watched.

Growing NPA’s in the banking system is also an area of concern. However a large amount of that can be addressed through policy measures. Most of the stress is coming from infrastructure sector investments where real assets exist. However they are in a situation where the expected returns are not flowing through and projects are stuck due to one reason or the other. These issues should be addressed to a great extent over the next 12 months. The consumer side & the unsecured side seem to be under control.

Results & Markets

Results till date have not played out to the doomsday scenario. The early birds in the IT sector have shown mixed results which are not bad in the current global macro scenario. Banks seem to be doing better than expectations and some Auto companies that have reported have seen a decent set of numbers. A large number of companies are yet to report.

Markets have rallied sharply in the midst of extreme gloom and doom. We have seen a 10% up move from the bottom. The pace of the up move is clearly unsustainable; however what this move has done, along with the buyback announcement by Reliance Industries is that it seems to have clearly put a bottom to the markets around last years closing levels. Directionally markets still look constructive, especially in the broader market sense. I still stick with my view of this being a 15-25% kind of return year in the absence of any fresh cues to indicate otherwise. This will be a good year for stock pickers as macro concerns recede and investors start looking at pockets of value.

The interesting thing is that some markets globally already seem to be in a new bull phase. India and

China

do not fit into that right now and we need to evaluate things over the next few weeks to take a bigger call on the same.

Will write more soon as we get fresh indicators of where things could go.

2012

2011-12-30T16:00:00.002+05:30

It is quite amazing but true that the year 2011 has been the second worst year in the history of Indian markets with a decline of 25% in the Nifty and 35% in the Mid cap indices(since the 1980s at least). No prizes for guessing which was the worst year i.e. 2008. In USD terms the performance was even more disastrous with losses of 44% given the 19% decline in the value of the INR. The year began with cautious optimism after the fall that the markets had seen post peaking off in November 2010. However a sequence of events, foreseeable and unforeseeable made this a disastrous year for equity investors. A lot will be written on the year ahead and I have touched on some subjects in my previous articles a few weeks back. However sentimentally one thing is very apparent from all the strategy reports that I read today, as well as the commentary in various media.

2012 will be a very tough year for equity investors and it is unlikely that there will be significant returns during this year.
India will continue to underperform given concerns on inflation, high interest rates and poor governance.

I have infact not read more pessimistic commentary on India for a very long time as we see today. The same brokerages/research houses that were predicting Sensex at 23-24000 by the end of 2011 a year back are now forecasting markets at 12000 (at the lower range) to 18000 (at the median of the upper range). There are some who, albeit apologetically are predicting a move above 20,000 levels this year. However this is being done with a lot of caveats. The funniest are those reports where there are bull case, base case and bear case views where the difference between the bear case and the bull case is over 50-60%.

My take on the markets in 2012 is that we will see the Nifty/Sensex return anywhere between 15-25% and the broader markets by 25-35%. I believe that sentimentally the markets have bottomed out and the bottoming out, value wise will happen over the next few days or weeks. This should lead to a durable bottom being formed for the markets. I have touched on the logic for the same to a large extent in my article on the 5^th of December, an updated version of which I will present in brief and then more on the domestic situation and the markets.

The Euro zone Crisis – The Euro zone crisis and the debt issues related to Greece, Italy and

Spain

have been the main contributory factors to the nervousness in the global equity markets over the last several months. The crisis has got accented by a lack of faith in the political system and its ability to resolve the issues. This issue has been discussed a lot so I will not go into the details of all of this, however I do have a contrarian view on the future direction of news flow from Euro zone. We now have new governments in Italy, Spain and Greece i.e. all the troubled countries. Two of them are lead by technocrats and one by the right wing party. As such, in my view the worst of the news flow from Europe is now in and we might not get incremental negative news flow over the next 4-5 weeks. This is likely to be similar to the negativity due to news out of the US around 3-4 months back, which suddenly died out as the economic data started to improve. The entry of the IMF in the entire discussion combined with greater urgency to resolve the issues is also encouraging. Overall I do not expect Europe to create any deep cuts in the markets going forward. This was the view that I had put out a few weeks back and seems to have played out well. It seems clear now that although Euro zone will go through a cycle of deleveraging, slow growth, intermittent issues related to fiscal issues of troubled countries etc, the probability of a Euro zone breakup seems remote at this stage. Intermittent occasions of bond issuance of Italy and Spain will create volatility on those days. Infact if investors were so concerned on the Euro it would not have fallen by just 2-3% against the USD in the year 2011. As I wrote a couple of weeks back “Europe has clearly avoided its Lehman Moment”

News flow – The news flow from the

has been mixed. Over the last few weeks there seemed to be clear indications of an improvement in economic activity. The Fiscal issues will keep on creating volatility periodically, however low borrowing costs and an improving economy could lead to a Fiscal surprise next year.Overall economic activity seems to be improving, albeit at a slow pace in the US and there does not seem to be the likelihood of a double dip recession at this stage. Most corporates in the US are cash rich and market valuations are at just around 11X P/E for next year. Earning expectations for the year 2012 are pretty low with earnings growth forecast in the range of 0-5%. As such US news flow will create volatility but it does not look that it can create a fresh down move at this stage.

Infact

has not only created conditions for a down move, but it has actually supported global markets due to continuously improving economic data, especially related to employment numbers. Technically too the movement of the key indices above 200DMA’s and the breakdown of the similarity of the move from 2008 indicates further gains for US equities. The breakdown of VIX below 23-24 levels also indicates reduced risk aversion and greater confidence. Typically such breakdowns are followed by multiweek up moves.

GOLD – As I have written in detail in my previous article I expect 2012 to be a difficult year for gold. I expect a 20-25% correction before prices come to a level where actual demand rather than pure investment demand can support prices. Since I have written in detail earlier I will not repeat, however the most fancied asset class will have a tough time holding on.

China

– China is one aspect about which I have not written earlier mainly due to the fact that it is difficult to analyze it. However pessimism on China seems to be at its peak with the Chinese markets trading at valuations that are at multiyear lows. The expectations of some, of a hard landing in China do not seem to be playing out. The move from investment to consumption led growth seems to be moving slowly. By letting the Yuan appreciate in light of pressure on exports seems to have played out well. Inflation has also been controlled well by demand & supply led measures as well as administrative dictates (which can only work in that country and not in countries like India). The moderation in economic growth has been happening at a steady pace. However the key challenge will be holding up growth in light of falling export demand, controlling excessive investments in unproductive areas and the biggest factor will be the asset quality of Chinese banks and how they will hold up in light of increasingly challenging environment and pressure on profitability of Chinese corporates. The corporate sector in

China

is likely to be hit on two fronts i.e. higher wage costs due to rapidly increasing salaries as well as the strong up move of the Yuan against most other competing currencies. Just as an example, over the last one year the Indian rupee is down 20% against the USD and the Yuan is up nearly 6%. The way things look to me it seems the base case will be a soft landing rather than a hard landing for China in the near term. The two big surpluses that China has i.e. Current Account & Fiscal are vastly undervalued by the markets in my view. Officially China seems to be aiming at an 8% growth next year which is extremely strong in the current environment. The challenge is health of the banking system and how much it needs to be capitalized in order to support this growth as well as the state of health of the Provincial Governments about which there is very less transparency.

India

domestic factors & outlook

The Indian markets had to make do with not only global issues but also several domestic issues in the year 2011 making it one of the most turbulent years in recent memory. Although 2008 was challenging for India, it was generally perceived at that stage that the factors are largely external and as such should not have a lasting impact on the performance of the economy. We had also started giving lesser importance to the government as the economy became more and more open. However 2011 was a year which showed the importance of governance in promoting and sustaining economic growth as well as macroeconomic stability. The year 2011 was a year of high inflation, high interest rates, lack of policy making as well as the most challenging year for the Indian rupee since 1992 (ex of 2008).

The Rupee - The fall in the rupee is being attributed to high current account and fiscal deficits, which is true to some extent. However it is more due to a lack of confidence in the economy in the near term as well as cash flow mismatches on exports and imports. This aspect is extremely important to understand. Given the way the rupee fell and the continuous statements by policy makers that we are helpless in managing the rupee all importers have run to hedge their positions and no exporter is hedging. This creates a very huge mismatch in the short run. Let me try to explain. India has exports of broadly USD 20 bn a year and imports of USD 30 bn. Now this is a gap of USD 10 bn which is bridged by invisible flows, capital receipts, foreign borrowings, FDI etc etc. Now in a situation where everyone believes that the rupee can only fall all importers want to hedge, however no exporter wants to do the same. This creates a huge mismatch in the short run till the export proceeds flow in after a period of 90-120 days. This also creates a tendency to delay export inflows in order to realize a better rupee value. This actually makes me believe that the first quarter of 2012 can be a good period for the INR as the panic fall period now seems to be over and export realizations will start to come in. Other measures like reduction in holding period of Government and Infrastructure bonds as well as higher interest rates on NRI deposits should boost inflows. My base case view will be for a 3-4 % rupee appreciation in the first quarter of 2012 unless and until there are huge capital outflows.

Policy making – Initially we had a period in late 2010 and early 2011 when a large number of projects got held up on environmental issues. Later on after the 2G issue we have seen a significant decline in project approvals, takeoffs etc. This has got exacerbated by the continuous increase in policy rates by the RBI which has made lot of projects unviable. Reform measures have also got stalled. I believe that we are now at the absolute nadir of the decision making cycle and things can only improve from here on. I expect this to happen post election in February after which things would be much better.

Inflation would have come off much more sharply had it not been for the decline in the rupee. However the absolute correction in commodities and food prices combines with the strong base effect will take inflation down to nearly 5% by March 2012. In case the rupee also appreciates as I expect it too the overall scenario could be much better in 2012. As such we should have improving liquidity and much lower interest rates as we go through 2012 and this will provide a tailwind for economic activity to pick up.

Markets

The markets are today trading at a Mcap/GDP of 50%; in the beginning of 2008 this had gone up to as high as 160%. The Profits to GDP ration of corporates goes through phases of compression and expansion. Right now both gross margins as well as net margins are suppressed due to the huge input cost pressure that we have seen over the last 18 months as well as high interest costs. This is likely to reverse over the next two years. Eventually the Market capitalization will move towards the 100% level to GDP, if not more. This will provide strong returns over the next 3-4 years.

Markets seem to have taken most negatives in their stride as of now. The risk reward is strongly in favor of investing into equities at this stage. As inflation falls and interest rates come down there will be a revival in the economy and growth prospects will start improving. The timing of the bottom formation is difficult to predict, however it will happen in weeks not months.

Markets should be able to return 15-25% at the middle of the pessimistic/optimistic range over the next one year.

BEST WISHES TO EVERYONE AND HOPING FOR A GREAT 2012

GOLD – END OF CYCLE

2011-12-19T10:42:00.000+05:30

Over the last few days I have become more and more convinced that the up cycle for gold is now coming to an end and we will see a significant correction in this commodity before prices stabilize and move up again. My conviction has become greater after I talked to a vast variety of Investment Advisors/Fund Managers/Investors in general and took their view on Gold and other Asset Classes. Not to my surprise the only commodity that everyone had a buy on was GOLD. Gold today has become the most overowned and oversold ( in terms of it being sold as an investment idea) commodity. Infact the data coming out of Indian Mutual funds is also reflective of the sentiment where the inflows into gold funds have been higher than that of Equity Funds for a number of months over the last six months. This is despite the fact that the total assets under equity funds are more than 20-30 times that of gold funds.

I was frankly waiting for the technicals to become supportive of the fundamental view before putting out this piece. This now seems to be happening with Gold breaking down from a Symmetrical Triangle reversal pattern ( which is normally a continuation pattern and is rarely a reversal pattern which makes it stronger). As the chart reflects, there is now a breakdown which should see Gold moving down sharply over the next few weeks.

The biggest consumer of gold in the world has traditionally been India. It is likely that this will be the case going forward also, despite their being talk of China becoming the biggest consumer. The traditional jewellery demand in

India

is not a fad or fashion but something that is ingrained in the Indian system. This is very different from buying into an asset class that is fancied and where the prices are continuously going up. The significant increase in gold prices over the last few months have bought physical gold demand in India to a virtual standstill.

As per the data coming out of the World Gold Council Gold demand in the third quarter of 2011 reached 1,053.9 tonnes, an increase of 6% compared to the same period last year. This equates to US$57.7bn, an all-time high in value terms.

According to the World Gold Council’s Gold Demand Trends report for Q3 2011 this increase was driven by investment demand which rose by 33% year-on-year to 468.1 tonnes, The demand for physical demand for the traditional purposes fell by 15% in this quarter. Gold supply was 1,034.4 tonnes in the third quarter of 2011

Overall, Indian jewellery demand in Q3 saw a 26% decline in tonnage, when compared to the same quarter in 2010, to 125.3 tonnes.

The question then is, for how long can investment demand hold up the price of a commodity in light of falling end user demand. The most drastic example of this was the way in which oil prices fell in the year 2008 from levels of USD 150 to USD 30 in a period of just six months. That is not to say that such a thing is possible and likely in the case of gold However the truth of the matter also is that lot of investment demand is trend following demand and also exists because of the fear phycohsis that prevails globally today. Investment Advisors and asset allocators find it easy to sell Gold ETF’s to investors who are running scared of investing elsewhere. In a number of European countries investors are running scared to putting deposits in the banks of their own countries. Similarly, given the way global equity markets have performed and the kind of volatility that we have seen investors are unwilling to allocate much to equities at this stage. As a result deposits of banks perceived to be safe, bonds or Germany, UK and the US have become save haven investment plays. Besides this gold is perceived to be the reservoir of value (and not without reason). However investors investing into gold need to be clear of their expectations from this asset class. The probability that gold will yield much below what investors can earn via fixed deposits of banks in a country like

India

where 5 year deposits of the safest of banks yield near 10% is extremely high at this stage.

As gold prices start to first stagnate and then fall, there will not only be low incremental flows into gold linked investment products but there will also be outflows. A large number of Hedge funds that have built up significant long positions in gold might also go short as the trend reverses. Given the fact that the supply of gold continues to be strong this will ultimately lead to a period where there could be a sharp sell off in gold. The only saviours for gold at this stage are the Central Banks that continue to buy with the trend. As price correct even they will move out and further accelerate the correction.

Contrary to views of gold prices moving to USD 2500 etc. my view at this stage would be for a correction in prices by atleast 20-25% over the next one year.

Europe seems to have avoided its Lehman moment, focus shifts to growth

2011-12-12T11:08:00.001+05:30

The EU summit started with extremely low expectations and that was also reflected in the movement of the markets prior to the summit where most markets sold off going into the summit. This by itself was a good sign that post event; at least we will not have a severe market selloff.

The key takeaway as far as I am concerned s that the so called “Lehman Moment” has been avoided by the decisions taken at the summit and with the moves of the ECB. Although most people have taken the resolve of the ECB not to print money negatively I think that it is a positive move as money printing at a time when the overnight deposits with the ECB are at all time highs and the discount rate is 1% will only accelerate inflationary expectations without contributing significantly to growth. This was the very reason why the US FED decided not to go in for another QE at the end of the last one and opted for Operation Twist. At that time also I had pointed out that it was a good move, however in the short run markets had taken it negatively, however its positive impact showed up after a few days.

The main concern in the Euro zone is not the availability of money but the lack of faith. In order to restore faith the new deal that has been proposed which will put strict limits as well as monitoring of Fiscal Deficits is a good move for the long run. Over the short run my view has been that with there now being Technocrat led governments in Greece and Italy and a new government in Spain there is unlikely to be any significant negative news flow from this part of the world over the next few months. The commentary that I read seems to suggest that the lack of offer from the ECB to buy large amounts of bonds is being taken negatively. However the key is that there needs to be a return of faith in the Euro’s future existence and once investors are convinced on that they the negativity will start reducing gradually. If the entire market is on one side and the ECB is on the other side, irrespective of how much they buy the markets will not turn. I believe that the key from here on is on implementation.

Directionally I believe that volatility in the markets should reduce as most key events are behind us now. From there on economic data will become more important.

In the Indian context this week is full of data with the Industrial Production data that came out today was in line with the number that came out in the Times of India a few days back at -5.1%. The consensus was for a half percent decline. Capital goods data has turned extremely negative with no new projects taking off. Inflation data on Wednesday and Thursday & the RBI policy on Friday. No major economic decisions are likely from the governments’ side till the 21^st when the winter session of parliament comes to an end. Post that we could see the government becoming more serious on the economy. It is likely that economic activity would have bottomed out in India now, the key will be to see the pace of revival. The revival will be slow given the way the economy has come to a standstill due to extremely tight liquidity conditions and high interest rates. Inflation out on Wednesday should be in the region of 8.6% vis a vis Reuters consensus of 9.04%.

With global commodity prices ex of crude cooling off and food inflation coming off sharply we are likely to see a sharp decline in inflation in India over the next three months. This will set the tone for significant easing from the RBI. Interest rates a year from now should be at least 150-200 basis points lower from the current levels. This will be supportive of both consumption and investment demand. However lack of policy response to boost capital formation might lead to India continuing to underperform other Emerging Markets. Sentiments for investment into Indian equities is at its nadir today and the key is to see when the sentiments turnaround. Since early October when the markets bottomed out after their last selloff, key large EM's like Brazil, Korea, Hong Kong etc are up nearly 15% and India is almost flat, thus reflecting domestic growth concerns.

It was interesting to read the panel discussion of ET NOW in the economic times today where most investors seemed to be on the pessimistic side. I remember attending a similar discussion in February 2009 where the sentiments were similar and the markets turned around within a few weeks of that. Let’s hope it is the same this time too.

Current State of the markets, more near the bottom than the top

2011-12-05T10:47:00.001+05:30

I would like to begin this piece by an interesting observation. Exactly around a year back a survey was done of around 50 India focused Fund Managers as to the direction of the markets in the year 2011, the survey revealed that more than 45 Fund Managers were of the view that the year 2011 will be one of strong gains and the median forecast for the Sensex and Nifty were 23000 & 6500. (Regardless to say the writer was also in the bullish camp with a target of 24000 & 6700). A similar survey was done a couple of weeks back in which more than 75% of FM’s were bearish and predicted a decline in the year 2012. This is very similar to the scenario I saw in early 2009 when most market participants were bearish and that year was one of the best years for the markets. My guess is that 2012 will be a good year for the markets as most concerns reduce in intensity and will set the tone for much bigger moves in the following years.

Indian markets have been in a free fall over several weeks where we saw the Sensex decline from a level around 18000 at the end of October to current levels of 15500 for the Sensex before bouncing back by around 1000 points. There have been several contributory factors for this the prominent among them and their future directions are as follows

The Euro zone Crisis – The Euro zone crisis and the debt issues related to Greece, Italy and Spain have been the main contributory factors to the nervousness in the global equity markets over the last several months. The crisis has got accented by a lack of faith in the political system and its ability to resolve the issues. This issue has been discussed a lot so I will not go into the details of all of this, however I do have a contrarian view on the future direction of news flow from Euro zone. We now have new governments in Italy, Spain and Greece i.e. all the troubled countries. Two of them are lead by technocrats and one by the right wing party. As such, in my view the worst of the news flow from Europe is now in and we might not get incremental negative news flow over the next 4-5 weeks. This is likely to be similar to the negativity due to news out of the US around 3-4 months back, which suddenly died out as the economic data started to improve. The entry of the IMF in the entire discussion combined with greater urgency to resolve the issues is also encouraging. Overall I do not expect Europe to create any deep cuts in the markets going forward.

News flow – The news flow from the US has been mixed. Over the last few weeks there seemed to be clear indications of an improvement in economic activity. However political issues related to budgetary cuts and the lack of cohesion between the two political parties in that country will keep on creating volatility periodically. However overall economic activity seems to be improving, albeit at a slow pace in the US and there does not seem to be the likelihood of a double dip recession at this stage. Most corporates in the US are cash rich and market valuations are at just around 10X P/E for next year. Earning expectations for the year 2012 are pretty low with earnings growth forecast in the range of 0-5%. As such US news flow will create volatility but it does not look that it can create a fresh down move at this stage.

Domestic Factors – I believe that the major reason for

India

’s underperformance vis a vis most other Emerging Markets has more to do with domestic factors rather than global ones. Some Emerging markets like Korea, Brazil etc have made significant positive formations technically. Markets like Australia are also similarly positioned.

A lack of policy making – Policy response from the government in light of the global factors as well as a drastic slowdown in investment demand in the country has been tepid to say the least. Governance has come to a standstill and no decisions seem to be taken. This has lead to a further slowdown in the economy on the top of global factors. There are some signs that the government is now seized of the crisis and is planning to restart some reforms and push some decisions. If this happens it will reduce the negativity to a great extent. However on an overall basis this aspect seems to have bottomed out at this stage and can only improve. Lack of policy making has also led to acceleration of the economic slowdown and reduced government revenues. This has had an impact of the government having to borrow more from the markets. As a result government bond yields moved up sharply before correcting over the last few days.

Constant monetary tightening in the midst of signs of clear slowdown – RBI has stood out as the only central bank that has continued to hike rates despite clear signs of a drastic growth slowdown and a very uncertain global environment. This has further accelerated the slowdown in the economy as the cost of funds has become prohibitive. For example the 3000 plus companies that reported results have seen interest costs move up by nearly 50%. The central bank has totally misread the impending economic slowdown as well as the fact that the drivers of inflation in India ex of food are mainly global in nature and as the global economy slows the inflation will come down sharply of its own. We will see this happening over the next six months where inflation will come down from 9.7% to 6% over the next 6 months.

Most central banks across EM’s have reversed their tightening policies and have begun interest rate cuts 3-4 months back. China has also cut Reserve ratios last week. Interest rates have become restrictive for growth and the liquidity shortfall in the system has also lead to a slowdown in credit flow. High interest rates are making projects unviable and have lead to working capital costs go up sharply for corporates. The RBI has made the first move towards easing via their Open Market Operations. The next step should be a CRR cut. I believe that now this cycle is clearly likely to reverse and we will see interest rates cuts from the RBI much sooner than the general consensus. As rates start coming down markets will improve.

Sharp decline in the value of the Rupee – Most emerging market currencies fell sharply in the period July to September and the Rupee was one of the worst performing of the lot. However as the recovery set in over the last few weeks the Indian Rupee has continued to slide. The main reason for this is cited as the Current Account Deficit. However I really do not subscribe to that view as the Current Account deficit has not increased meaningfully for this to be the reason. The actual reason is the last of faith in the Indian Growth story in the short run. Just around a year back policy makers in India were talking of a huge deluge of Dollars and they were not sure how it will be handled. Today we are in a totally reverse position where they have put up their hands and are saying that we cannot do anything to control the depreciation of the Rupee. Conceptually I am not in favor of intervention. However when a trade becomes a no brainer then policy makers need to take measures. FDI reforms are the need of the day and the flow of capital into the country needs to be eased significantly. However all said, at the current levels the probability of a major decline is low. As the rupee stabilizes we should see foreign investors becoming more confident about investing into India.

Taking most things into account and also taking into account the market psychology as well as valuations I am of the view that the current situation of the markets is akin to early 2009 where one could see only negativity and that was the time that markets bottomed. Valuations, especially of the broader markets are today nearing historic lows and the overall market is also trading at 12X 2013E earnings which is very attractive. My view of the markets over the next one year is that of a worst case of 14800-15000 for the Sensex (at 12X P/E) and 26000 as the best case (on a 20x P/E. Markets are seem to have taken most negatives in their stride as of now. The risk reward is strongly in favor of investing into equities at this stage. As inflation falls and interest rates come down there will be a revival in the economy and growth prospects will start improving.

Markets should be able to return 20-30% at the middle of the pessimistic/optimistic range over the next one year.

A time for contrarian investing

2011-11-18T21:17:00.001+05:30

As the markets flirted with their low levels during the course of this year the one thing that was missing was a feeling of complete capitulation and total apathy and panic setting into the markets. Although I had expected the lows of around 15500 for the Sensex and 4700 for the Nifty to hold and they have held till date none of these events earlier during the year saw a sharp unrestrained fall in mid cap stocks and also in a large number of infrastructure stocks which most investors had been holding on with the hope of a bounce back. This phenomenon has happened during the last few days and I have got a feeling in the market which is similar to the period of January/February 2009 before the markets formed a durable bottom and set the tone for the next up move.

I believe that the markets are now ripe for contrarians investing as a vast majority of stocks are underperforming and it is only the high priced defensives that are outperforming. An analysis of the BSE 500 since the beginning of the year shows that out of 500 stocks only 90 are up and the rest of them are down for the year. —

So what is the basic tenet of Contra investing-?

Uncertainties emerge in global events, economic growth, government policy etc. All such events converging today, creating huge opportunity for generating future returns. Thus current environment is apt for contrarian investment

The reasons why a Contra strategy is apt at the current point of time are

Most funds/investors are betting on the safest stocks. Top holdings of mutual funds are all among the top 10 market capitalized companies in India and constitute over 30% of total equity holdings .When these stock don’t move, several MFs don’t perform in the short run and this kind of Risk Aversion prevents more creative stock selection.

Majority of stocks have not performed in the last 12 months, although market is 20% down from the peak, several stocks are languishing much below their historic high

Economic growth is bottoming out and fundamentals can only improve

Significant fear clouds judgment and impedes value unlocking and Lot of high potential stocks cheaply available and a large number of well Several well established stocks have seen sharp P/E reduction showing loss of investors belief

Long term fundamentals of most of the stocks remain robust while there are short term challenges

All this has led to high under ownership in a vast majority of stocks. As a contrarian investor sudden drop in investor interest poses an entry opportunity.

As fundamentals change, the extent of under-ownership determines the speed of appreciation

A rightly timed investment into a under-owned stock can result in quick gains

Exit is easier when the herd comes in

The contrarian strategy is also applicable in investing over market capitalizations where mid caps/large cap premium and discount varies over periods of time depending on market sentiments. This switch between market capitalizations is also a contra strategy which is largely favoring mid caps at his stage.

The key is that contra investing is not value investing. The key is that when growth investing is contra one has to be a growth investor, when value is contra one has to go growth.

The contrarian investment theme is often confused with the fundamental or value investing. But it is a fallacy….It involves far more complex thought process. It is a way of thinking which is difficult to emulate.

• Contra investing also requires incubating stocks for some time before they find favor with the rest of the market. Proactively identify new investment themes and build up strong positions before a majority of investors

• It is also important to Monitor stock/sector ownership and relate it to the fundamentals of the sector. Get out of over owned stocks and get into under owned ones. Avoids momentum stocks and over owned sectors, thus improves risk profile

At this stage my key contra bets will be well established mid sized corporates which strong brand franchises or business franchise which might have some short term concerns that are leading to a severe mispricing of the long term potential. If one takes stocks with a market capitalization of at least Rs 1000 crores where stocks are down at least 60% from their peak values or the valuation discount from the peak valuations are at least 50% a portfolio of at least 20 high quality stocks can be easily built which on a buy and hold strategy can yield at least 100% over a two year holding period.

However while evaluating such companies it is also important to evaluate companies in a manner where there should not be a value trap as some companies specially in the infrastructure sector have destroyed their balance sheets via aggressive bidding and high Debt: Equity levels to such an extent that there is very little tangible equity value left in these companies, although the stocks might be cheap on a Price to Book basis. Again to reiterate the value trap is the biggest folly in contrarian investing.

However on the flip side it is also true that post evaluation if one comes to the conclusion that as interest rates ease off and cash flows improve the debt burden can be reduced then one of the biggest equity value creations do happen via the shift of the total enterprise value from debt to equity while the overall enterprise value might not change. For example, let’s say there is a company with Debt+Equity of Rs 10000 Crores out of which, on today’s day Debt is Rs 8000 Cr and Equity is Rs 2000 Cr. Over the next couple of years it can happen that the overall company value does not change but Debt comes down to Rs 6000 Cr and Equity value goes upto Rs 4000 Crores. As such equity returns can be 100%.

In January 2008 India's market capitalization peaked at Rs 75 Lakh Crores and Market cap to GDP was at 160% & in March 2009 the Market Capitalization bottomed out at Rs 30 Lakh Crores.

Current Market capitalization stands at Rs 70 Lakh Crores and Market cap to GDP is at 77% on 2011-12 GDP & 65% on 2012-13.

Eventually as the bull market matures over the next 3-4 years, the Market cap to GDP should approach the earlier peaks.

India

’s GDP in the year 2014-15 should be at Rs 135 Lakh crores.

Assuming a mature and peaking bull market at that stage the market capitalization could be at around Rs 200-220 Lakh crores.

This implies a tripling of Market Capitalization from the current levels over the next 4 years.

Per annum returns could be at an average of 25% plus.

The current bearishness and apathy towards equity could be one of the best entry points for the Indian markets

Since it’s already become a big note on Contrarian Investing I will write more on this subject later. However the value in the market is tremendous today and selective buys at these levels will generate huge returns over the next bull cycle.

A New Beginning?

2011-11-05T16:58:00.002+05:30

I have just come back from a Diwali break and had a good vacation. I did not miss much during my trip and most of the markets and stocks seem to be placed similarly as they were a couple of weeks back. The results season has progressed and in general has been quite decent given the low expectations that had got built up due to high inflationary pressures and poor economic data over the last three months.

One of the key facets of the results which have come out strongly is that consumers are still spending strongly even in an environment where inflation is near double digits. Consumer good companies have held or improved margins and reported strong nominal growth, although the volume growth has cooled down. Consumer Durables, especially that tend to get financed have seen some pressure and could see a further slowdown if interest rates remain high.

The complete inefficacy of RBI’s monetary tightening seems to have now been realized by the central bank and by making a statement towards no further tightening in the latest policy when reported inflation is still high and food inflation is at 9 month highs is a clear admission that the scope of inflation control does not lie in higher interest rates. Global commodities have cooled off over the last 3 months and a large number of commodities are now trading at or below levels of the same time last year. However the impact of this fall has got nullified in India to some extent due to the depreciation of the rupee. The INR is down by around 9.8% over the last one year and as per some studies a one percent appreciation/depreciation affects India’s WPI by around 0.3%. As such a 10% depreciation itself would contribute to a 3% increase in inflation. In other words if the INR had not depreciated the inflation would have been more near 7% than the current 9.7%.

The good part of the depreciation of the rupee has been that it has provided breathing space for the industry which has been reeling under high input and interest costs. The Chinese Yuan has appreciated by around 6% over the last one year and the INR has fallen by 10% thus providing an incremental competitive advantage of 16%, which is quite huge. Although skeptics have doubted the strong show by Indian exports over the last couple of years, one reason for the same is the improving competitiveness of Indian exporters in the global market place. With the Yuan set to appreciate further and with wage pressures being much greater in China than in India over the next 3-5 years Indian manufacturers across the board have a great opportunity to take away some market share from Chinese exporters. However policy support from the government in terms of ease of operations, better infrastructure and reduction in red tapisim will be required over the long run if India has to leverage its demographic dividend.

The twin deficits of Current account and Fiscal deficit have raised concerns with regards to India over the last few months. On the fiscal side things are unlikely to improve in the near term as government spending is largely inflexible and revenues are coming down due to a slowing economy. The inability of the government to go ahead with the disinvestment programme has also created a revenue gap that needs to be covered with greater market borrowings. This has had an impact on government bond yields which have gone up by nearly 0.5% since the announcement of additional borrowings last month. In order to avoid crowding out there have been relaxations on foreign borrowings as well as norms of FII’s investing into both government debt and corporate bonds over the last two months. The relaxations should help bring in an additional USD 10 billion of funds into the country till March and reduce crowding out to some extent. On the current account side things seem to be much better with the trade deficit being at levels of USD 9 billion for the last two months. If the current run rate persists then the trade deficit can be controlled at 6% of GDP and the Current account deficit at 2.5%.

The global situation

The global situation has seen pulls on both sides over the last one month. Whereas the news flow from Europe has been mixed i.e. sometimes positive and at other times negative the news flow as far as the US economy goes seems to be continuously improving albeit slowly. The data coming out of the US clearly indicates a low probability of double dip and a slow economic growth in the near term. Data on housing and on the jobs front has also showing incremental improvement.

Euro zone seems to be going through a phase of crisis of confidence where not only large money market and debt funds globally have sold out Euro zone sovereign debt, but even large Euro zone banks have cut down holdings in countries where there seems to be even a whiff of trouble. Recent results of European banks clearly show that most banks have been continuously writing off Greek debt and selling out Italian and Spanish debt. It is clear that ECB cannot absorb such huge amounts of selling. A leveraged EPSF with huge firepower is required to bring back some semblance of confidence. Given the fact that the Euro has held on pretty well it does not seem as if there is a huge outflow out of Euro zone as a whole. It is just a move towards safety. On an overall basis the negative news flow out of Europe seems to have peaked out now.

Markets

There are two aspects to the markets at this stage. The first is the downside risk, where it is clear to me that we seem to have made a very strong bottom at levels of 4700 for the Nifty which is unlikely to be breached anytime soon. Currently we are around 10% higher than those levels. There has been a significant time wise correction along with value correction in the markets. As investors have got frustrated most have got out of small & mid caps and most investors (who are left in the equity markets) are just concentrating on large caps. For confidence to come back it is necessary for markets to sustain at higher levels and as that happens we will again see money flow into the broader markets which seems to be very cheap relative to the large cap indices on an overall basis.

The second aspect is about the upside. My initial view was that we will see the markets retrace, at least 50% of its entire fall from last November levels. This leads to levels of around 5500 & 18300 for the Nifty and Sensex respectively. The pace of the subsequent up move will be dependant on the trajectory of inflation/interest rates as well policy initiatives from the government. Expectations for growth have come down substantially. When we started off this year the estimates were for an earnings growth of 20% for the current year and 25% for next year. Current estimates for next years growth have now come down to 16%, which seems to be fair in the context of lower input cost pressures going forward as well as our being at the peak of the interest rate cycle.

As such on an overall basis, it seems at this stage that most of the concerns are in the price. However any upside from an improving macro environment in 2012 is not being factored in at this stage. This gives me the confidence that 2012 will be a good year for he markets.

Astrologically speaking – I just could not resist writing this so here it goes. There is an extremely significant astrological phenomenon that takes place in the middle of November where the most powerful of planets i.e. Saturn moves into his strongest position as it moves into the sign of Libra. Libra is the sign where Saturn gets exalted and acts extremely positively. The discomfort that it felt during its last two transits in Leo and Virgo now will give way to a feeling of extreme comfort. The last time this phenomenon happened was in the period 1982-85 where it unleashed an extremely strong bull market which eventually ended with the crash of October 1987. A similar phenomenon is likely to recur over the next three years. However as Saturn is a slow moving planet it might take some time to give its fruits. Normally Saturn requires Jupiter to either conjoin or aspect it to trigger it off and given that both planets will face each other from November 2011 till May 2012 we should see the trigger sometime during this period. More on financial astrology later.

Purely fundamentally speaking we are more near the bottom of the market than near the top and the next year should be good for the markets. How good is a question that will be determined more by the pace at which data improves.

Results season starts well

2011-10-19T11:52:00.001+05:30

The low expectations result season has started off reasonably well with most of the companies reporting till date either beating or meeting expectations. Although it is early days yet, given the fact that we have gone into the results season with low expectations it augurs well for the markets.

The general observation from the results till date is that the IT sector companies have held up well on the face of increasing uncertainties in the macro environment and have reported results in line. The outlook for the profitability of these companies in the near term has improved significantly due to the sharp depreciation of the Indian Rupee. This should help earnings growth even for the next year. Demand will certainly see some impact in the year 2012, especially from the BFSI segment. However overall the current results season and commentary till date does provide downside protection to the stock prices of these companies.

The other key standout factor has been from the few results of the banks that have come out. The best part of the result of these companies has been that the Non Performing Assets seem to still be well under control. As such the apprehensions of a significant fall in asset quality does not seem to be playing out as of now. However given the fact that the actual impact of credit tightening is yet to fully play through and also the fact that the tightening has been severe over the last three months there is likely to be deterioration in asset quality going forward. The second thing has been that Public Sector Banks have not yet reported earnings and a greater stress is expected on that side of the banking universe. However overall given the fact that the interest rate cycle has peaked out and also the fact that the sector on an overall basis has underperformed the markets since November 2010 the downside for this sector also seems to be protected. However the preference will be for private sector banks with adequate capital adequacy and a lack of requirement for immediate fund raising.

A few results from Oil & Gas as well as Automobile companies also have come in line or better than expectations. However we are likely to see more results coming out over the next two weeks and it will be important to see if the current trend holds up or we see a deterioration going forward.

Overall my view from the result season is that given the fact that expectation are running low, an outperformance will be rewarded strongly however an underperformance might not be punished too much.

The Macro Scenario

The Macro scenario on the domestic side continues to be one of slowing growth. The Industrial Production figures released last week clearly indicate a broad based slowing down of growth. RBI in its statements of the last two meetings has been trying to justify their actions by a surgical examination of the data. On one instance they quoted strong durable and auto sales and in the other meeting they quoted strong growth ex of capital goods. However unfortunately for them they have run out of all these explanations this time as the slowdown is evenly spread out. As I pointed out in my last article the downside risks to inflation have increased with the sharp correction in global commodity prices. However the rupee weakness and the lag in increase of Fuel, Electricity and Fertilizer prices is keeping Year on Year reported inflation higher than what it would have been in a free pricing environment.

The other key macro development domestically has been the sudden announcement by the government about additional market borrowings which led the bond yields to shoot up by nearly 40 basis points. RBI and Government actions have now set up a vicious cycle. On one hand there is hardly any policy action to boost growth and investments. On the other hand continuous RBI tightening has led to slower growth which in turn has affected government revenue collections. Given the fact that most of the government expenditure is inflexible, falling revenues and increased borrowing costs will lead to a further deterioration in the Fiscal Deficit situation.

The only way out is to boost growth by greater reforms and policy actions. Although global slowdown and falling commodities will aid inflation in the short run, the long run solution lies in boosting supplies and inducing greater investment confidence. Although there is no risk to India’s long term growth prospects poor Macroeconomic Management is affecting prospects in the short run.

Globally the markets seem to have adjusted to the Euro zone situation and the news flow out of the US has actually been positive in terms of growth outlook. Results from US companies have either beaten or met expectations in a majority of cases. Macro data in terms of the unemployment, housing, manufacturing etc. also seems to be improving albeit slowly. This gives confidence to my view that the

will recover better than what most people expect and thus improve investor confidence in general.

Incremental downgrades in the Euro zone as well as policy flip flops have not been met with significant negative reactions. There is also some news flow on the possibility of the EPSF being used as a bank which can leverage itself by 3-5 times. Any such move could improve risk appetite significantly. These things should become clearer over the next two weeks.

Markets

The markets started the last quarter of the year in a state of pessimism and extreme risk aversion. There has been a huge flow out of equities into gold,cash, commodities and hedge funds. Moreover most hedge funds entered the quarter with very low net long positions and in a capital protection mode. If markets stabilize and the view of a durable bottom for the year gets established we could see strong flows coming back into risky assets this quarter. Given the fact that expectations are low and valuations are reasonable, the probability of a strong last quarter is very high.

The bottom seems to be well in place. The question is on the extent and pace of the up move. I would still go with the view of a 25% one year upside potential with an 8-10% downside possibility in the near term in case there is some unforeseen event risk.

Calling RBI’s bogey on inflation PART II & Market Outlook

2011-10-03T11:21:00.004+05:30

As a follow up to my article written a few weeks back I am now writing this article which will further prove that Indian WPI inflation is largely driven by global commodity prices with a lag. Although the earlier article did prove that RBI policies are totally ineffective in controlling inflation while restricting investment demand and growth. The current analysis also shows the same effect.

For the purpose of the analysis I have attempted to see the impact of the movement of Reuters CRB index and have tried to correlate it with Indian WPI inflation.

- In my first iteration I just took the WPI figures as they are over the last 12 years and did a correlation with the Reuters CRB Index on a like to like basis. This correlation did work well however there was a lag impact that was apparent.

-Secondly I did an analysis of the WPI with the Reuters CRB Index taking a 3 month lag i.e. the impact of the movement of global commodity prices is felt in India with a lag of 3 months. This correlation came out to be pretty strong with a correlation of 72%.

Thirdly in order to further refine the study I broke up India’s WPI inflation into two parts where I removed food price inflation out of the WPI as that is largely driven by domestic production and policies. As such I did a correlation of WPI (Manufacturing+Primary ex of food+Fuel) with the Reuters CRB Index on a 3 month lag basis. This analysis shows a more or less perfect correlation as is reflected in the chart given above. The correlation for these series is 81%. The impact is stronger if the Rupee appreciates during the process and has a greater lag if the Rupee depreciates.

As such given the fact that the Reuters CRB Index has crashed by over 15% in the month of September 2011 the impact of this on the WPI inflation will be seen clearly by December. Inflation will fall much faster than being currently estimated and given the way global commodities have corrected we could be at a 5.5% figure by March 2012.

Without reiterating the points that I made in my previous article this analysis further proves the ineffectiveness of RBI policies on inflation in an globalized world with low customs duties and free trade. It is time to focus on growth in the domestic economy as the global growth falters

Markets

The month of September was another tough one for global markets with the sell off that started in a big way in August continuing during the start of the month before the markets started to stabilize by the second week of the month. Most Western markets ended up with losses of around 4-5% and the Indian markets were down by around 1.5%. The key feature of the month however was not the movement in the stock markets but in the forex, commodity and bond markets. The Euro crisis along with the extreme scare in global markets created an artificial global shortage of Dollars with most banks refusing to take counter party risks and a significant pull back of money by US Banks, Funds, and Investors etc in the

out of Euro Zone banks. As a result we saw a sell off in most currencies and the USD index moved up by over 6% during the course of the month. The fall in the Indian Rupee was in line with the rise in the overall USD Index where we saw the INR fall by 7% vis a vis the USD. Except for very few currencies like the Japanese Yen and the Chinese Yuan most currencies fell sharply vis the USD. We also saw the unprecedented move by the Swiss in which they have effectively pegged the value of the Swiss Franc to the Euro and this caused a massive upheaval in currency markets. A similar intervention from the Japanese is also being talked of at this point of time. Technically the USD index seems to be poised to move to levels of 82-83 over the next few months.

Most global commodities corrected sharply during the month with copper seeing one of the most massive falls of around 25%, Crude fell by over 12% and most other Industrial and agricultural commodities corrected similarly and the Reuters CRB Index ended with losses of 13% for the month. Commodity speculators were holding on to their speculative position in the hope of QE3 and as that got dashed with the commentary that came along with “Operation Twist” of the US FED there was a massive outflow out of commodity long positions in the last 10 days of the month. Although we have seen a cut in long position, there is yet to be a sharp outflow out of commodity funds which should happen over the next couple of months and further pressurize commodity prices. With the duration of Operation Twist being till May 2012 and hopes of QE3 will be only after that.

The Euro zone crisis continued during the month and despite all the reassuring words most people believe that Greece might not be bailed out under the current conditions. As such this issue will create volatility on periodic basis. However the worst impact of this in the near term seems to be over with the next tranche of bailout money likely to be released by October mid.

The bond markets also saw huge movements with the bonds of troubled Euro countries again getting sold off and the rally in US and German bonds continued for the month. Yields on US 10 year bonds fell from 2.23% at the end of August to as low as 1.67% before ending the month at 1.92%.

Gold prices saw a massive sell off during the month as there was no QE3 and investors decided to book some profits in one of the only performing assets. The correction seems to have some more legs to go and we could see the correction continue to $ 1450 levels at the first instance and maybe to $ 1300 over the next few months.

On an overall basis taking into account the panic in the markets as reflected in volatility indices, overbought positions of Bunds and the US Govt Bonds, massive outflows out of Equity Funds globally etc. it looks like we are more near the bottom of the markets than there being any possibility of a massive selloff in equities. The key in my view is whether we have a “Lehman Moment” or not. If we do not then we should have made a low for 2011 for the equity markets globally and will see a recovery in this quarter.

As far as the domestic scenario goes the industrial production data surprised on the downside and inflation was in line with expectations. There was some movement from the government on the policy front but there is a lot that needs to be done on that front. Whether India will be able to outperform the emerging market basket will depend a lot on this in the near term. Growth prospects have diminished but not significantly and the current year should see a growth of 7.5% plus. The growth for the next year will be dependant a lot on the revival of the investment cycle which has come to a standstill. There is significant momentum that has built on the Highways construction front but the other areas are lacking. One of the issues that NHAI needs to keep in mind is that granting projects just on a lowest bid could be counterproductive a lot of the companies winning bids are excessively leveraged and might find funding difficult.

Overall l am looking towards the last quarter of the year constructively as one of the major concerns for

India

i.e. High Inflation will get addressed significantly as discussed in the first part of the article. Global developments will create volatility but equities look cheap. Crude oil prices look set to correct more driven by falling demand and a faster revival in Libyan production, this will be extremely beneficial in the Indian context. In the absolute near term there do not seem to be triggers for a sharp move on either side however as the time correction is playing out markets are looking more and more interesting.

In a nutshell my guess is that we have a worst case downside of 8-10% with an upside potential of 25-30% over the next one year.

FED Acts Rightly

2011-09-23T11:01:00.003+05:30

The US Federal Reserve launched its new initiative “Operation Twist” yesterday and the main aim of the same is to reduce long term rates and promote greater lending and try to stimulate the economy. The key statements that came out were

“There are significant downside risks to the economic outlook, including strains in global financial markets,” the Fed statement, this statement is different from the one given out last month which just talked about downside risks. It looks like the FED has taken the Euro zone developments into account while formulating this statement.

The Federal Reserve will replace $400 billion of short-term debt in its portfolio with longer- term Treasuries in an effort to reduce borrowing costs further and counter rising risks of a recession. The central bank will buy securities with maturities of six to 30 years through June while selling an equal amount of debt maturing in three years or less. The program will extend the average maturity of the Fed’s Treasury holdings to 100 months, or 8 1/3 years, by the end of 2012, from 75 months.
The Fed’s System Open Market Account held $2.64 trillion in securities as of Sept. 14, which included $1.65 trillion in Treasury notes, bills and inflation-protected bonds and $995 billion of mortgage debt.
The main aim of this move seems to be to take the long term interest rates down and flatten the government bonds yield curve. Due to virtually zero short term rates a large number of banks have been just playing the yield curve and not lending in the markets. As the yield curve becomes flatter over the longer time frame the FED seems to be betting that the banks will be forced to lend. The availability of money in terms of narrow money supply does not seem to be an issue in the US economy, however the broader money supply is not growing and consumer credit continues to shrink.

The central bank said today it will also reinvest maturing housing debt into mortgage-backed securities instead of Treasuries “to help support conditions in mortgage markets.” Previously, the Fed had been reducing its holdings of mortgage securities to reinvest that money in Treasuries instead. Yields on Fannie Mae and Freddie Mac mortgage securities that guide U.S. home-loan rates tumbled the most in more than two years relative to Treasuries after this announcement. This move could have a greater impact on the overall market sentiments and 30 year mortgage rates have fallen to multi decade lows of 4.1%. The bet here seems to be that this will promote refinancing and give greater money in the hands of households which can be used for consumption. Since 70% of the US economy is consumption dependant this move seems to be targeted towards reviving the housing market and also consumer sentiment.
However the FOMC vote was 7-3. Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Charles Plosser of the Philadelphia Fed voted against the FOMC decision for a second consecutive meeting. They “did not support additional policy accommodation at this time,” the Fed statement said today. This essentially means that the hopes that many people are harboring of a QE 3 goes out of the window. Since this programme will run till the end of June 2012 we should expect any move on QE 3 only after that.

The avoidance of QE3 is the best thing to have happened in my view. The additional money that was being printed was only going into speculating in commodities and currencies. This had led to inflation spiking up and as a result had impacted consumer sentiments. The lack of QE3 combined with the issues in the Euro zone is likely to be positive for the US Dollar. The US Dollar index is looking extremely bullish technically and is pointing towards an eventual move towards 82-83 levels from the current levels of 78. This should lead to a significant correction in commodities going forward. Despite economic slowdown commodities were holding on just because of widespread speculation and will see some easing going forward.
The sentiments in the near term were also impacted due to the downgrade of three US Banks by Moody’s. Moody's Investors Services announced the downgrade of Citigroup, Wells Fargo, and Bank of America -- three of the United States' top banks. Among the primary reasons: the U.S. government is less likely to step in to save a troubled financial institution. This further added to the negative sentiments in the markets.

MARKETS
The initial reactions of the markets have been negative. However, the reaction cannot be just attributed to the US FED action as it is also a combination of the developments in the Euro Zone and data releases from China which indicated slowing growth.
On an overall basis market valuations look cheap at this point of time and slowing global growth combined with a lack of incremental money printing should lead to a significant commodity correction over the next six months. This will bring inflation down and will be incrementally positive for the Indian markets which have largely underperformed due to inflation concerns.

On the other side an up move in the US Dollar, combined with a USD shortage in the global economy has lead to a sharp downward move in most EM currencies except China. This will have two impacts: On one side it will somewhat reduce the impact of the falling commodity prices on inflation as the fall in prices is countered by the weaker currency. On the other side it will make exports of countries like India much more competitive to that of China and help in addressing global imbalances of trade.

There are several indicators of panic in the market today which include
-Record pull-out from equity funds
-Record buying in gold which has taken gold prices to a premium to platinum. As per today’s newspaper reports there is
a shortage of storing space for gold due to the amount of investment buying that is happening.
-The yields of US Govt bonds & German Bunds have gone to all time lows thus indicating a desire for safety over returns.
-Traditional long only funds have been losing money and leveraged hedge funds have seen record flows with theindustry growing rapidly this year

The sentiment play out is likely to happen over the next few weeks, however fundamentally the case for decoupling of Emerging Markets from the developed world has become much stronger. I expect that as fear subsides we will see a significant outperformance of high growth, non commodity focused Emerging Markets. India is likely to be at the forefront of such a move unless and until the impact of government inaction on crucial economic decisions continues for a prolonged time period.

A majority of Indian companies benefit due to a rupee depreciation as it provides an artificial import duty barrier while making exports more competitive. Except for companies that have got significant forex borrowings the current move of the INR is also an earnings accretive for corporate India.

Like overvalued stocks stocks do not start moving down immediately after they are sold, an investor should not expect that undervalued stocks will start rising immediately after they are bought. Patience is required on both sides of the market.

As the market correction continues along with the time correction the downside for the markets is reducing and the upside potential is increasing. The level of 4700 for the Nifty and 15700 for the Sensex should hold for the markets. Valuations at 12X 2013 earnings and a peaking interest rate cycle also provide downside protection. Financial market linkages could create some downside in the near term but it will be a time to BUY.

Panic at its peak and markets looking to climb the wall of worry

2011-09-20T14:36:00.001+05:30

The last couple of months have been amazing in terms of the amount of negative news they have generated right from the slowdown of the US economy and the volatility due to delay in passage of the Debt limit to the actual US downgrade. This was followed by increased pressure on troubled Euro zone countries where the contagion effect has been difficult to control due to two factors; one being the magnitude of the problem and secondly being the nature of the beast that is EU which is heterogeneous, slow moving, electorate focused etc. On top of these two the domestic factors have been the turmoil in the government during and after the Anna Hazare movement and the refusal of inflation to come down despite continued and incessant RBI tightening.

This has led to a situation of extreme panic in the mind of investors which has manifested itself in the form of record outflows out of Equity Funds. As per an article that I read today the total withdrawals from US Equity funds since April 2011 have been nearly USD 72 billion and are almost equal in magnitude to the withdrawals in the months leading from Lehman to February 2009 after which the markets bottomed. Debt and Money market funds have also turned wary with a number of US based funds withdrawing from Europe and going into specific country bonds which has led to absurdly low yields in countries like the US, Germany, Britain, Switzerland etc. while the rates have gone up for most other countries. The extreme fear has also created a situation of dollar shortage in the markets which has led to most currencies (ex of the Yuan off course) falling sharply in value against the USD. The Indian rupee has depreciated by nearly 8% over the last 6 weeks.

GOLD

In the meantime there is a huge movement into investing in gold and other precious metals which has pushed the price of gold up to levels that are difficult to justify by any logic. Infact the movement in gold prices is very similar to that of the move in the Mid 1970s when gold prices moved up from USD 100 to USD 800 to the ounce. The current move of gold started at levels of around USD 250 and at levels of USD 2000 gold would be up by 8 times from the time of the start of the move. Given the extreme bullishness in gold I am tempted to call a top in this commodity, however I will resist from doing that at this stage. However gold should ultimately top out at levels of USD 2000-2200 on the upper side.

If we look at the Q2 2011 figures on gold consumption as released by the WGC gold demand fell 17% during this quarter to 919.8 Tonnes. Jewellery demand was up 6% to 442.5 T and Demand from exchange traded funds fell by 82% to 51.7 T. Central bankers were major buyers at 69.4 T. Central bankers bought more gold in the first half than in the entire year of 2010. Although ETF demand fell the demand for coins and bars went up sharply and these are also used for investment. China and India comprise over 50% of gold demand. Gold supply during this quarter was 1058.7 T. Gold imports into India went up by 60% to 267 T. Investment demand was up 78% to 108.5 T and jewellery 17% at 139.8T.

The kind of buying being seen in gold and the huge amounts that are going into investment demand have two parts to it. The first is a structural shift where investors would hold some gold as that has been the asset which has moved up for the last 11 years and the trend tends to be followed. The second is the buying due to fear, lack of faith in paper currencies, inflation etc. which are cyclical by their very nature and will reverse at some stage. Given that there isn’t any actual shortage of gold availability and that it is an asset class that is the most fancied at this point of time indicates that eventually over the next year or so as things stabilize we should see gold peaking out .

The US dollar also seems to be shaping up for a longer term up move against most global currencies and over the next one year we are likely to see levels of 81-83 for the US Dollar Index. This move should be accompanied by moderating global commodity prices and will incrementally be positive for the Indian markets as it will reduce inflationary pressures.

MARKETS

At the time of the US downgrade my view was that this event will not have a long term impact on the markets. However the combination of this with several other events and the risk of a Greek default, European bank concerns and concerns on the downgrade of countries like Italy and

Spain

has spooked the markets. Macroeconomic numbers also have been reflecting slowing growth all over. These factors have led to the severe sell off in the markets over the last 6 weeks.

The key is to see thing going forward. Most negatives now seem to have got discounted into the markets and as such it is likely that we have made a base for the year 2011. Given the fact that this has been accompanied by great fear and cash movement out of risky assets we should see a significant pull back rally fructifying over the next few days. However the key will be to see whether this pullback can get converted into a sustainable rally.

Technically also most global markets have made significant positive divergences which point towards a strong pull back rally.

As things stand now the markets do look cheap in terms of valuations, however it lacks triggers to take the markets up beyond 10-12% above current levels. The triggers for the same could be in the form of

- A reduction in negative news flow from Europe and a perception in the minds of investors that some sort of short term solution has been found.

- An improvement in macroeconomic numbers coming out of the US

- Fall in domestic inflation and a perception of sustainability of the decline, which would in turn bring an end to the RBIs tightening cycle

- A clear change in perception of government decision making which can lead to the investment cycle being revived

However as time correction plays out the markets are becoming more and more attractive for longer term investors as a large number of stocks are available at dirt cheap valuations. The key now is to buy into these stocks and hold on without bothering about short term volatility.

Come September after the August Mayhem

2011-09-08T10:23:00.000+05:30

The month of August started off with the downgrade in the Sovereign rating of the USA which led to a severe sell off in most of the global markets. There was a flight to safety and as a result of which we saw US Government Bonds, German Bunds and precious metals rally significantly. Gold prices touched all time highs during this month and ended the month up by over 12% for the month. Along with other world markets the Indian markets also fell sharply before showing a small bounce back at the end of the month. The large cap indices ended down by 9% during the month. The markets made a panic bottom in the 4th week of August and were down by 14% for the month at one point of time.
Looking forward I believe that the markets seem to have made a bottom for the current year at levels of 4700 for the Nifty and 15700 for the Sensex and this is what we had anticipated during our last review. However the pace of the bounce back in the markets will depend on several factors that include.

RBI’s policy stance – RBI has been the most hawkish central bank over the last several months and has continuously surprised markets by hiking rates more than anticipated. Twice over the last six months this move of the RBI has led to a strong build up in the markets getting stalled. The current policy rates are restrictive and have led to a slowdown in both investment and consumption demand, especially in interest rate sensitive industries. We have seen that over the last few weeks several central bankers like those of South Korea and Australia have held rates citing global concerns. There have been others like those of Brazil and Turkey that have actually cut rates citing global concerns, despite the fact that short term inflationary pressures exist in those countries. The key will be to see the stance that RBI takes. The previous policy actions of RBI have not yet fully had their impact and most contributors to inflation except for food have seen a downward pressure building up. Under the circumstances RBI now needs to be concerned about growth and hold rates. However, given the policy stance of the RBI, investors will be wary till 16th September and we are unlikely to see any sharp upmove in the markets till that point of time.
Government policy actions – Prior to the anti corruption protests starting off on 16th of August, we have seen some signs of positive policy actions being restarted by the government. However this process again went into the cold storage during the entire protest period. The key will be to see whether we see some proactive policy steps to aid economic growth coming from the government over the next few weeks. India’s premium to emerging markets has steadily come down due to a series of scams as well as the perceived lack of governance. Any positive moves on this front will be extremely important to bring stability into the markets.
Developments in the Western economies – The data flow out of the US economy has been mixed over the last few days. Although, there have been signs of stabilization of the economy, the news flow on the employment front has not been good. The key thing going forward will be to see how policy makers in the US respond to these challenges as there are two important events that will be watched this month. President Obama will lay down his initiatives to improve the employment situation and the US Fed has a two day meeting at the end of September where they are likely to respond afresh to evolving developments. With the marginal benefit of QE3 being more towards disruption and feeding inflationary pressures it will be interesting to see how they respond.
Europe also has been slow to respond to the crisis in the Euro Zone. The agreement reached to set up the stability fund and its norms of operations are still to be put into operation. This is creating further fears in the minds of investors and has led to volatility in the markets. More than the US, it is the diversity in Europe and the inability to have a cohesive response that is hurting the markets. This month will again be crucial to see the European response as fears of a credit market freeze up, like that of 2008 has been building up in the minds of investors over the last few weeks.

However, even after taking all the above concerns into account there are several indicators that are pointing towards an extremely oversold market. This includes –

-Technically the markets during this month became as oversold as they were during late 2008 and early 2009. There are large short positions and most market participants are bearish on the markets. Reuter’s polls of 57 leading investment houses in the United States, Europe ex-UK, Japan and Britain showed the average stock holding in a balanced or model portfolio falling to 49.2 percent. It is lowest since at least February 2009

Outflows from Equity funds have continued at a rapid pace with Emerging Market Funds losing nearly USD 8 billion in August, reflecting panic in the minds of investors.
Gold prices zoomed up by nearly 12% in August and gold is looking extremely overbought. Gold has now risen continuously for the last 11 years.
Specific to India trading volumes and speculative activity has come down substantially and leveraged positions on stock futures continue to be extremely low. Money has been flowing from equities to gold and bonds.
These factors combined with market valuations that are at around 12X 2013 E earnings clearly point towards a low downside risk in the markets. However an upmove is likely to take time to develop and we expect that to start from October/November as the current news flow and global events get discounted. Given global slowdown concerns, ultimately all higher growth economies will get strong inflows, however for that fear needs to reduce.

The month of September has started off constructively and we have seen an initial sign of decoupling of Indian markets from the turmoil in Europe. However it will be wrong to conclude this as a foregiven conclusion as the markets do face event risks in the near term. The good thing about the current move has been that the Nifty Futures have continued to be at a discount to the spot despite a 10% move from the bottom. This indicates that the bears are holding on while the bulls are attempting to regain charge. It will be an interesting battle over the next few weeks.With the current upmove the markets have more or less shrugged off the fall post the US Downgrade, which in my view in any case should not have had such a drastic impact.

The key event for India is the RBI policy where, hopefully the RBI will not use the current bump up in food inflation to hike rates. The sharp increase in onion and some other vegetable prices is primarily responsible for this. We have seen most central bankers (even of countries facing inflation) either hold or cut over the last one month. If RBI decides to hold we could see the rally continue, a hike could lead to another sell off as the current interest rate environment in India has become increasingly restrictive for growth.

Overall looking for 4700 for the Nifty to hold for this year and a steady upmove till the end of the year. A clearer direction will be visible after September which is a month full of events.

DECIPHERING RBI’s INFLATION BOGEY

2011-08-22T13:08:00.000+05:30

I have wanted to carry out this analysis for a long time now and the criticism of a lot of people that I do not understand economics and I need to go back to school to learn the subject has prompted me to write this article.

As I went about analyzing the data I became more and more convinced about the inability of RBI in controlling inflation as measured in India today via the Wholesale Price Index. I have argued many times in the past also that RBI’s policies are good for controlling asset bubbles. However given the fact that India is very small part of the global economy and the inflation as we see today is largely driven by high food and global commodity prices there is very little the RBI can do in an atmosphere where there is an extremely loose monetary policy in most major economies. Despite the growth outlook globally being weak we have seen that commodity prices have held on (till now at least) due to widespread speculative activity. However not taking that point forward I will now analyze the composition of Indian WPI inflation and the contribution of various segments in the 9.2% inflation of July and show that RBI’s inflation bogey is not going to be controlled by monetary policy. Only a supply response or a correction in global commodities will bring inflation down and the huge monetary tightening that the RBI has done will only slowdown growth, destroy corporate balance sheets and could create a period of at least two years of slow growth.

Now I will proceed step by step. (pardon me for a slightly long article)

The overall inflation for the period ended July 2011 was 9.2%. The first category to be analyzed is the Primary Articles that constitute 20.11% of the WPI and had an inflation of 11.3% for the said period and contributed 2.65% to the overall WPI Inflation. Now primary articles include Food and Non Food products.

Food articles – This category carries a weight age of 14.33% in the Indian WPI basket. Food inflation for the 12 month period ended July 2011 was 8.2%. Now the basket of food products comprises Food grains (4.1% weight age), Fruits & Vegetables (3.84%), Egg Meat and Fish (2.41%) as the major categories. Now no one can argue that monetary policy will have any impact on the prices of these products that are largely driven by a steady growth in domestic demand, both due to an increasing population and improving prosperity that is improving the food basket. The only way Food inflation can be brought down is by increasing supplies (that infact have been good for the last two years) and reducing wastage. Although incrementally there have been improvements in storage and transportation there is still a long way to go. Moreover with Minimum Support Prices moving up every year and input prices also moving up it is highly unlikely that we will see food inflation move down structurally in India in the near term. Cyclical improvements will be there which policy makers will propound as structural improvements. Food inflation contributed 1.17% to the overall inflation for the period ended July 2011.

Non Food articles – This category carries a weightage of just 4.25%, however the inflation in this category for the period ended July 2011 was 15.5%. This category includes products like Natural and Man made Fibres, Oil seeds, Tannery products, Sugarcane, Rubber, Tobacco, Flowers, and Minerals both metallic and non metallic and Crude Petroleum. Now any person who looks at these products will immediately see that these products are either agri products or global commodities whose prices will not be determined by monetary policy. The non Food article category contributed 0.65% to the overall inflation despite a very low weightage.

The Fuel and Power category has a weightage of 14.91% in the overall WPI inflation basket. This category had an inflation of 12.04% for the period ended July and contributed 1.8% to the overall inflation. This category is divided into

Mineral Oils – This has a weightage of 9.36% and constitutes products like LPG, Petrol, Diesel, Aircraft Turbine Fuel etc. The inflation in this category was 15.36% and contributed a whopping 1.43% to the overall inflation of 9.2%. RBI’s monetary policy has absolutely no role in any way in controlling the inflation of this category driven by global prices and government decisions on fuel price increases.

Coal and Electricity – These two constitute the majority of the remaining part of the Fuel and Power category with a combined weightage of 5.47%. Coal prices moved up from March as the government took a decision to increase prices in March of the current year and as such coal price inflation at this point of time stands at around 15%. Electricity prices have been stable vis a vis last year and have not contributed to the inflation. As such these two combined have not contributed much to the overall inflation.

As such on an overall basis the above categories have contributed around 3.6% to the overall inflation of 9.2%. As such around 5.6% is contributed by manufactured products that have a weightage of 64.97% in the WPI. Now the inflation of this category is given as the primary reason by the RBI in increasing policy rates and tightening policy. This is a big bogey which will become evident as you go through the following paragraphs.

The overall manufacturing products inflation for the period ended July 2011 was 7.49%. Now let us break it up into various categories.

Food Products – Food products have a weightage of 9.97% and include Diary products like Milk, Ghee, Butter, Ice-cream etc, canned food, Maida, Atta, Sooji, Bakery products, sugar, gur, edible oils, oil cakes, tea, coffee, salt, spices, pickles, papad, Readymade food products etc. as the major products. Now howsoever much I might think I find it very difficult to believe that monetary policy can impact the prices of these products in any major manner. Most of these products are priced depending on input prices which are largely commodity. Now one might argue that if people are squeezed very hard and the RBI forces the economy to hard land then some of the primary inflation might not be passed on by the manufacturers of these products. However the reality is that even in that case the impact will be minor. The consumption of these products only has to grow as India becomes prosperous. However if supply of milk, food grains, tea, coffee etc increase then prices will come down of their own. The price of milk as an example was subdued right through the last high growth phase of the economy. However given that every year consumption is rising and supply has not kept up the prices have increased substantially. However in products like sugar, atta, maida etc where supply has gone up prices have come down despite increasing consumption. Food product inflation was inline with the overall manufacturing inflation at 7.55% and contributed 0.75% to the overall WPI inflation.

Beverages, Tobacco and Tobacco products – Weightage 1.76%, inflation 11.25%, no impact of RBI monetary policy. Prices of these products have largely moved up due to increased taxes at both the central and stage levels.

Textiles – Weightage 7.32%. Textiles includes both natural and man made fibres and includes products like Cotton Yarn, Cotton Fabric (various cloth, bed sheets, hosiery products etc.), Polyester Yarn, Viscose Staple Fibre, Nylon Yarn, Mixed products, Woolen products like carpets & shawls, blankets, sweaters, jute products, shirts, mats, undergarments etc. The main reason for the increase in prices of these products was the runaway rise in cotton prices to the magnitude of nearly 150% from March 2010 to March 2011. Subsequently cotton prices have nearly halved. As cotton yarn prices move up normally VSF and other man made product price also move up as there is a degree of replacability. Now if we analyze deeply the increase in yarn and fabric prices has been directly as a result of higher cotton prices. As these prices have corrected we will see the impact on yarn and fabrics also flow through over the next few months. Whereas the overall inflation in textiles has been 12.87% the inflation for cotton textiles has been 22% and that of manmade has been around 8%. How will monetary policy bring these prices down. Prices went up as cotton shot up and will similarly come down. One can argue that if demand is suppressed then the ability to pass it on via the garments and ready product route to end customers will come down. That is possible to some extent, however given that most of the composition of this category has global pricing linkages there is little role of Indian monetary policy. Textiles contributed 0.94% to the overall inflation of 9.2%. Given that there is likely to be a record cotton crop globally and man made fibre capacities have gone up it is unlikely that we will have very high textile inflation next year.

Paper and paper products, Weightage 2.03%, inflation 7.29%. Again largely global commodity price linked. Products include various kind of paper, cartons, cardboard, books and journals, newspaper etc.

Rubber and plastic products, Weightage 2.98%, inflation 7.68%. Products include tyres and tubes whose prices are linked to input prices of rubber and carbon black that have shot up sharply, Plastic products include plastic pipes, components, plastic films, tooth brush, plastic bottles, syringe, polyester films, polymer sacks and other rubber products. This category does have some products where demand will get impacted as the economy slows and as such primary cost pass through might become difficult. This is true of products like tyres and tubes, consumer plastic products etc. However some products like polyester films, PVC pipes etc have a direct linkage to input prices without huge value addition. For this category we can still argue that monetary policy has an impact.

Chemical and chemical products – Weightage 12.01% Inflation 7.94%. This category includes basis inorganic chemicals like acids, caustic soda, soda ash, lime, alumina, titanium dioxide, hydrogen peroxide, ammonia, chlorine, hydrogen, fatty acids, aromatic chemicals, other organic chemicals etc. If we look at all these products the one thing that is clear is that most of these are global commodity products where Indian prices largely follow global trends. The other thing is that most of them are related to crude oil prices in one way or the other. As such monetary policy can do little to impact their prices. The other major component of this category are Fertilizer and Pesticides. Now fertilizer prices in India did not move up at all for nearly two years. After pricing deregulation prices have moved up and we have seen that Fertilizers that have a weightage of 2.66% are now seeing an inflation of nearly 10%. However these prices are moving up as a result of change in policy and totally delinked to demand compression due to monetary policy. Pesticide prices have been stable.

Other products in this category include paints and varnishes, dyes, drugs and medicines, perfumes, cosmetics, toiletries. Also it includes, products like thermocol, polymers, petrochemical intermediaries, rubber chemicals, explosives, agarbattis, additives etc among others. Now in this category there is a mix of industrial and consumer products. However here again on the industrial side most products are globally priced commodity products. Among the consumer products also most except maybe products like paints, varnishes etc will not get impacted in terms of demand by monetary policy action. Interest rates hikes will neither reduce consumption or prices. However reduction in rubber, palm oil, crude oil prices etc will have a moderating impact on the prices of these products. Chemical and chemical products contributed 0.95% to overall inflation.

Basic Metals, alloys and metal products – Weightage 10.75%, Inflation 10.05%. This category includes products like iron and steel, castings and forgings, ferro alloys, aluminum, copper, zinc, gold, silver, nuts and bolts, steel structures, cylinders, furniture’s and fixtures, metal containers, pressure cookers, chains and locks etc. The maximum weightage is to ferrous metals that have an 8.06% weightage. All ferrous metal products are globally linked and follow global prices with a lead or lag. Other metals like aluminum, copper, silver, gold etc also follow global prices. Except for a very few consumer products like pressure cookers, locks etc most of these are globally linked commodity products. Under the circumstances there can be no impact of monetary policy on the inflation of this category that has contributed 1.08% to the overall WPI inflation.

Machinery and machine tools – Weightage 8.93%, Inflation 2.7%. Now we finally come to a category where monetary policy has an impact of compressing demand and as such controlling the price increases of these products. Here we already see an impact with inflation at just 2.7%. This category includes agricultural machinery, industrial machinery, cranes, lifts, fasteners, plastic machinery, loaders, machine tools, airconditoners, refrigerators, chillers, engines, earth moving equipment, pumps, batteries, switches, and transformers. Watches, sewing machines, generators, wires, cables, lamps, fans, washing machines, TV, CD Players, computers, dish antenna etc. In this category of products monetary policy has slowed growth and has also impacted price pass throughs.

Transport Equipment and parts – Weightage 5.21%, Inflation 2.8%. Another category where monetary policy works and has compressed demand and pricing power of producers. Companies have also become efficient and held margins to a great extent. Products include various automobiles and their parts, railway equipment etc.

CONCLUSION

In conclusion I would like to say that my analysis clearly points out that not more than 25% of the overall WPI basket is impacted by RBI’s monetary policy. The increase in rates by the RBI has only managed to slow down growth and led to balance sheet issues with more leveraged corporates. The same policy mistakes are being made that were made in the year 2008 where despite signs of a global crisis RBI kept on tightening and removing liquidity before having to do a volte face in a matter of months. Most other central banks like those of Korea, Turkey, and Australia to name a few have held rates over the last few weeks citing global concerns. The last hike by China was a few months back. Under the circumstances no one should be under the illusion that it will be monetary policy that will bring inflation down. It will in fact be the impending global slowdown and the base affect. For example, on the 1^st of January 2011 the Food price index was at 196.5, as per the latest data of 6^th August 2011 it is at 191.9. As such there has been no food price inflation since the beginning of the year. Similarly the primary articles index on 1^st of January was 197.5 and on 6^th August it was exactly the same at 197.5.

Now taking the argument to the other side, I do not in any way want to say that monetary policy does not have an effect on inflation. However in a globalized economy where countries comprising the top 50% of World GDP are actually printing money or pursuing extremely loose monetary policies there is no way we can control global inflationary pressures due to Indian rate hikes. The second point is that the whole concept of targeting WPI is flawed and the inflation targeting should be on CPI that should comprise the current consumption basket and include things like rents, transportation costs and other services that form a big part of the current consumption basket. Moreover policy makers also need to realize that as per established economic theory there is a lag in monetary transmission and even if they actually believe that they can bring down inflation, they need to give the previous actions enough time to have an effect.

Given good monsoons and the global slowdown that is underway the probability is high that these indices might soften further over the next couple of months. As such there is a reasonable chance that we might have food and primary articles inflation at zero to 2% by the end of the year. The question we have to ask is, whether it is due to the tight monetary policy.

I don’t buy RBI’s bogey on its ability to control WPI inflation and neither should you.

P.S As I was just about to finish writing this article the minutes of the last RBI rate setting meeting were released where a majority seemed to be in favor of holding rates.

MID MONTH MARKET REVIEW

2011-08-18T14:20:00.000+05:30

As the month of August started off, my view was that the level of the Nifty at around the 5200 levels should hold unless and until some catastrophic event takes place. Unfortunately for all of us such an event took place right at the start of the month with the downgrade of the credit ratings of USA from AAA to AA+. This resulted in a sharp selloff in most equity markets globally and did not spare the emerging markets too. The sell off initially started off from the crisis in the Euro Zone countries with the bond yields of Italy and Spain shooting up with fears of the crisis spreading to these countries. With both these countries coming out with significant Austerity measures and with the ECB coming in to buy the bonds of these countries (albeit reluctantly) the bond yields fell down sharply and now the yields have come down to the levels that prevailed around a year back when markets were much higher and stable.
The downgrade of USA's credit rating was unlikely to have a long term impact on equity markets in any case and resulted in a panic bottom formation in global markets. Given the fact that the US FED has committed to keep short term rates at virtually zero for the next two years and the 10 year bond yields have come down to nearly 2.2% levels the equity markets are looking abnormally cheap relative to bonds in that country with the Equity Yield (defined as the EPS of the S&P index divided by the value of the index) at around 8% today. In this scenario either equities are very cheap or the markets think that growth is going to fall off sharply and there is a strong chance of a deep recession. I believe that the probability is now high that we will start seeing some revival in the US economy. The biggest drag has been high food, garments and fuel prices and all of these are now showing signs of softening.
With the severe sell off in the global markets we have now seen most global factors being factored into the markets. As such the focus has shifted back to the domestic factors. The domestic factors were essentially two
High inflation and RBI tightening - The high and stubborn inflation rate has been one of the biggest factors that has resulted in India underperforming the global as well as emerging markets. I have talked of this topic a lot earlier so I will not go in much detail except for reiterating the fact that most of the inflation is food and global commodity driven which is totally out of the hand of RBI. With the government not taking much of steps to augment the supply side high inflation at periodic intervals will continue to plague the Indian economy. The good part is that the slowdown in the global economy has resulted in lot of commodity prices coming down sharply and good monsoons and better productivity will result in food inflation coming off over the next few weeks. A large number of central banks globally have avoided hiking rates in the recent past citing global concerns. However, the RBI believes that India is a country that is totally immune to global concerns and has continued to tighten aggressively. This is a significant policy misstep which the RBI might regret at a later date. Twice over the last 6 months the markets have started to make a base and move up but have been stymied by 50 basis point hikes by the RBI. Any further tightening might lead to a significant slowdown and it is time for the central bank to look around and see the global scenario before taking any action. Domestic interest rates now seem to have peaked out, however we have to see when they start declining. However as things stand now my view is that a year from now we should have rates that are atleast 200 basis points lower. However market could be concerned about the next RBI action till the next policy announcement in September Mid.
Lack of Policy making - This has been the second biggest concerns for the markets. Over the last couple of weeks we have seen positive news bites from the government on this front. However the anti corruption protests have the potential of delaying these things further. There was an expectation of things moving forward during the current Parliament session which seems less likely now. This has resulted in India underperforming most global and Emerging Markets over the last 3-4 days. This could continue in the near term as these concerns are unlikely to go away in the near term. This could create further underperformance in the near term and in case the global markets weaken further we could see a further selloff.
In terms of fundamentals based of the now downgraded earning of around a 1200 EPS for the current financial year and a 1400 EPS for the next year for the SENSEX, the markets are now trading at valuation of 12X next year earnings. This creates a very strong base for the markets as far as valuations are concerned at a time when the interest rate cycle seems to be peaking out. In terms of pure fundamentals the markets are looking very cheap; mid and small cap stocks that were already cheap have become cheaper with the complete capitulation seen across the board over the last few days.

However technically there seems to be a further downside of 5-6%. Under the changed circumstances I now believe that markets should now bottom out at around 4800 levels for the NIFTY and 15700 levels for the Sensex. Markets are cheap but could get cheaper as absolute panic sets in. However this does not change the longer term outlook in any way and subsequent to the current phase getting over a strong rally should unfold. The movement of the markets over the last few days reflects a complete capitulation on the mid cap side of the market which should typically result in a durable bottom being formed. Global and Emerging Market Equity funds have also seen the most outflows since the end of 2008 which is also typical of a capitulation from the side of investors. In terms of timing the next upmove should start over next 6 to 8 weeks as the shock of the current fall gets absorbed and the base for the new move gets formed.

DECOUPLING STAGE II

2011-08-11T14:40:00.000+05:30

At various stages of the markets when the global financial markets tend to be linked to each other on a day to day basis most investors lose focus on the fact that over the long run higher growth economies with better growth prospects and earnings growth will outperform on a sustainable basis. However the key is that the decoupling always happens over a period of time and in times of panic and euphoria most markets tend to be linked to each other.

At this point of time the investor focus largely is around the crisis in the US which is more related to its economic growth prospects rather than the actual risk of a default by the US. It is actually quite perverse that the risk aversion trade has run so much that the US 10 year bond yields have actually declined from around 2.55% to 2.1% after the downgrade by S&P. However the reality in actual terms seems to be that there is now a realization that the US Government has run out of fiscal tools and the US FED has run out of monetary tools to revive the economy in the short run and the lower bond yields are actually a reflection of the fact that now investors believe that growth will be subdued for a longer period of time and the risks of deflation are greater than the risks of inflation.

In the Euro zone the issues related to the troubled countries have been well talked about however the rumors around the downgrade of France from AAA have continued to go around despite multiple statements by S&P that the rating is AAA with stable outlook. Similarly the credibility that ECB has built over time has come in use after their pledge to buy Italian and Spanish bonds where the yields on the bonds of these countries have fallen by over 1% each despite not much of actual buying taking place. This also goes to show that there was a heavy contribution of short positions in the increase of these bond yields. Now Italian/Spanish bond yields have come back near the range in which they traded in the first half of the year. However the pressure of rating agencies and the markets have now forced the hands of the governments of these countries to have a credible fiscal plan. This essentially means a cut in expenditure and increase in taxes that should drag economic growth. As such although the crisis in the Euro zone could have stabilized for now but growth prospects have also diminished. Among the other large developed economies Japan continued to remain in a state of virtually no growth and the sharp run up in the value of the Yen due to the risk aversion trade will further pressure growth prospects in that country.

In this over all scenario the focus will again shift to BRICS plus other high growth emerging economies that constitute around 20% of the world economy at this stage. These markets underperformed the developed markets since November 2010 till July 2011 mainly due to inflation concerns. The play for this short period of time essentially that the Western economies are now reviving fast and with low inflation and the developing countries will need to reduce growth in order to control inflation. This strategy did work for a short period of time, however this was largely a result of QE2 from the US Fed which unleashed a wave of liquidity into the global market place and instead of going into improving credit and economic growth in the US was used by Hedge Funds and commodity speculators to push up commodity prices. This in turn resulted into inflationary pressures into high growth Emerging economies. Now given the fact that liquidity is ample and US bond yields are at all time lows, and also the fact that the failure of QE2 was one of the reasons for the US downgrade we are unlikely to see a QE3 anytime soon. However I do believe that given the extremely low interest rates prevailing now an economic revival should take place, albeit slowly.

That brings us to the question of decoupling. In the previous market phase of the beginning of the rally of the markets in early 2003 till the bottom in March 2009 is as follows - Whereas the world index moved down by 17% in this period the Indian markets were up 240% and the MSCI EM Index was up 166%. (For some reason I am not able to upload the graph, which could have been more illustrative. The outperformance really took off after the fall of May 2004. At the beginning of the BRICS rally in 2003 EMs constituted just around 2-3% of world market capitalization. As of now they are around 16-18%. Over the next two decades this will move towards atleast 50% if not more.

In the second phase that started in March 2009 the MSCI World is up just 46% as against 102% for MSCI EM and 109% for the Sensex. This has been despite a severe underperformance of Indian markets over the period November 2010 till July 2011. I believe a strong decoupling phase similar to what started in May/June 2004 and got accelerated in July/August 2006 is likely to start now as poor economic prospects in the West and lack of reckless money printing will keep commodity prices subdued. The reasons for the same will be as follows

Given the state of the global economy, specifically the USA, Europe and Japan nearly 50% of the world economy is unlikely to participate in the next big up move

A shattered financial system, low savings rate and high fiscal deficits will take years to repair

Given the fact that a large part of these economies is driven by consumption, rising unemployment and pressure on wages will subdue economic growth

In the short run these economies can be pump primed through fiscal measures

However over the next 5-10 years economic growth in these countries is likely to be between 0-2%

High fiscal deficits will lead to a reduction in spending and increase in taxes which will further drag economic growth

However in this period, India and some other EMs will stand out and show strong economic growth

As a huge deluge of dollar looks for better returns, most developing economies with potential for reasonable returns will get huge inflows

This will be a period of growth with low inflation as 50% of the world will not grow and demand pressures will be low

External borrowings will remain cheap

Fiscal deficit will not be a concern for fast growing economies like India as growth will lead to higher tax revenues and there are disinvestment possibilities

Consumption will revive strongly as the situation stabilizes. Credit availability will be strong as NPA levels have been well controlled

As such the current phase of panic in the markets could be one of the best buying phases of the markets for any investor with a medium term perspective. This is not the time to be scared out of the markets but to be scared in.

“The actual risk tends to be the lowest when the perceived risk is the highest”

Evaluating the US Downgrade

2011-08-06T20:03:00.000+05:30

The much awaited downgrade of USA’s credit rating took place today morning. The event was imminent the question off course was when and in line with the way market shaking news has a habit of happening in quick successions it has happened today. With the US Government debt moving up to levels of 100% of GDP and the lack of response of the US economy to the huge money printing by the US Fed along with the kind of political brinkmanship that we saw leading up to the Debt ceiling debate have led to this downgrade in simple lay man terms. Evaluating the impact and its repercussions could be a long topic so I propose to give my views in the form to questions. (Also I am attempting to be brief)

Will it lead to a risk aversion trade – The fact of the matter is that the risk aversion trade has been going on for several months now and is clearly reflected in the way the US Treasuries and German Bunds have rallied. UK Gilts went to all time highs a few days back. The US 10 year yields have fallen to levels of 2.35% yesterday. So what kind of risk aversion trade are we talking about, will money flow into the debt instruments or the currency of the country which has been just downgraded. I guess it will be perverse in a sense. The other trade could be move into the Swiss Franc or the Japanese Yen, which are already trading at all, time highs against the USD. Or would it mean a flow into gold that again is trading at all time highs. Can the downgrade of a country lead to a rally in its Treasuries? I guess not. As such as the initial panic (which ideally should not be there as AA+ is not really a bad rating and the next downgrade should not happen till after the US Presidential elections next year) the flow should actually be towards high growth Emerging Market assets. Why should anyone buy a US 10 year bond at 2.35% where the probability of a capital loss is extremely high. Moreover the US Dollar has got no yield support and as such given the interest rate differentials the USD should only depreciate against most currencies. In such a scenario, money flowing into US Treasuries seems highly unlikely to me.

What do the low yields of US Bonds reflect – More than the risk aversion trade I guess it reflects a failure of QE1 and QE2 whose purpose was to generate growth and inflation in the US economy. However a 10% fiscal deficit, weak currency as well at money printing equivalent to nearly 15% of US GDP has not been able to generate the inflation in the US that the Fed was targeting in order to fight the way out of low nominal GDP growth. All the money printing has not been able to create economic growth and employment in the US and has only been used by hedge funds for speculating in commodities. Infact QE2 and its failure is one of the key reasons of the US downgrade in my view. As such the low yields in the US reflect the view of market participants that the economy is unlikely to see any significant recovery for a prolonged period of time.

Will there be a QE3 – I believe that the downgrade totally rules out QE3 now as that could create conditions for a further downgrade in credit rating of the USA. There is no shortage of money in the system with overnight rates being almost zero. Infact banks have so much money that they are charging customers to keep their money as the credit growth is not happening. Although the inflation is not reflected in the numbers that are coming out of the US, however the reality is that the huge speculative move that QE 2 created in commodities especially crude and food prices has hit consumption in the US directly. Given that the US consumes nearly 22 million barrels of crude per day, the USD 40 per barrel that QE2 created hit the US consumers by USD 320 billion per annum. This is nearly 2.5% of the US GDP and given that incomes have not grown at that rate just the increase in oil prices has had the impact of taking away all the increase in incomes over the last one year. On top of that we have seen food prices across the board move up sharply and there was also a very sharp rally in fibre and fabric prices which when combined with higher wages in China has led to higher apparel prices in general. As such although official inflation figures show that prices are under control in reality the households are under severe stress. The high unemployment rate is also contributing towards poor consumption growth. As such QE3 is now totally ruled out in my view.

What happens to commodity prices – Commodities that have rallied sharply since the start of QE 2 will now absorb the new reality of slower global growth as well as the fact that growth is unlikely to be strong for some time to come. This will pressurize commodity prices. Hedge funds that have moved into commodities in a big way will need to reevaluate the new scenario and reduce their bets on commodities. We could see the correction of the commodity universe continue over the next few months before they stabilize given the fact the Emerging Economies will continue to grow strongly. (My prognosis in my article ‘Commodities and the demise of QE2’ seems to be now falling in place)

What happens to money flows – The reality of the situation is that there is huge money sloshing around in the global economy and given the slow recovery in the US and UK along with the stress in Japan we will see cheap money being easily available. Given the yield differentials as well as higher growth prospects of EM’s the money will seek out these countries for higher returns. The economies among the EM universe that can create enough absorptive capacity will see a deluge of capital once the initial uncertainty subsides. As such I would give around couple of months for people to absorb the new reality and subsequently money flow to EM’s should be very strong. I would think that this will be from October/November 2011. Given the fact that we had a trade out of inflation facing economies since November of last year this trade should reverse in a big way over the next one year.

What happens to Indian markets – In the short run the short term traders could dominate and we can see a sell of in equities. However I personally do not see any major reason why it should sustain. It is very clear now, looking at the way the equity markets have behaved over the last couple of weeks that this move was anticipated if not seen coming. Most European markets have corrected by 20% in a very short period of time, US markets by nearly 12-13% and most EM’s by over 10%. Normally the markets play the sell on rumor buy on news very well. As such we will need to see how it plays out this time. Equities are very cheap relative to growth prospects at this point of time and could become cheaper if the markets sell off due to this news. The two big concerns in India were inflation and the lack of policy making leading to low investment demand. Both these issues are likely to get resolved going forward.

Inflation is likely to fall much more sharply than what most people anticipate as the commodities crack and there are clear signs of improvement in government decision making in the very near past. As such the high interest rate environment that was impacting demand as well as investments should see an improvement going forward. Nifty closed at 5200 on Friday and Sensex at 17300. Markets are at 12X 2013E earnings, which is cheap in the historical context (it can get cheaper for short periods of time) however will not sustain long term. India could have done much better had we not seen a panic rate increase by the RBI last month. I believe we are in a mid 2006 kind of situation where the concerns of Emerging Markets of that time is now there with developed markets. After making panic bottoms in the third quarter of 2006 most EM’s rallied sharply to new highs over the next one year. The probability of this happening this time around exists even today. India will definitely regain its favored investment destination tag over the next few months. The only issue seems to be technical at this stage with a number of charts having broken down from their key levels which could create a short term correction.

Investors should not be reactive on whatever happens next week as returns after panic sell offs tend to be quite robust. There seems to be no change in the long term prospects whatsoever due to the US Downgrade and frankly I cannot really see why there should be a sell off at all.

RBI – Wrong prescription & diagnosis, results & markets

2011-07-27T17:41:00.000+05:30

For the second time in three months RBI’s monetary policy announcement has led to a breakdown in the build up of a positive trend in the markets. A 25 basis points increase would have led to the continuation of the rally and we should have seen markets at around 6000/6100 for the Nifty by August end and this was my view for the last few weeks. However the negative sentiments generated by the RBI policy is likely to shift the target by around a month further as the markets readjust to the new reality and take into account a further squeeze in profits due to higher interest costs.

RBI with the recent hike has increased interest rates by 125 basis points in just three months. (Incidentally this is the overall tightening that China has done over the last one year). In the few days prior to the policy announcement by the RBI we saw several central banks like those of Korea, Israel, Indonesia etc hold rates citing European and US debt concerns and slowing global growth. However RBI obviously believes that India is a country that is insulated from the rest of the world and operates in isolation and as such global factors need to be ignored. This is the same stance that the previous RBI governor had taken in the second half of 2008 which led to a severe disruption in economic activity over a period of nearly 6-9 months. I think the central bank has operated similar to that of a frustrated investor who after waiting for months finally decides to throw in the towel at the absolute bottom of the cycle.

The fact of the matter is that it is the global commodity cycle up move which has caused inflation in India to spiral. One of the logic given to increase rates is increasing core inflation. However as I have argued before the pass through of an abnormal increase in input costs is but natural. However even then a 7% core inflation in a scenario where lots of commodities have rallied nearly 50-100% over the last one year is quite reasonable. How can manufacturing inflation be taken in isolation to the input price increases. In any case we are today at the mercy of arm chair economists and it is becoming difficult to predict their future moves.

One of the surprising things that came out in the policy was the frustration of RBI with government inaction on improving the supply situation as well as bottlenecks in the same. In a way they have stated that we are alone in this fight now and under the circumstances we have no option but to try to curtail demand severely and hope that it will control inflation. However the reality remains that RBI can do little to control inflation that is driven by global commodities and rising food prices.

If the target for inflation by March end is still 7% then that is something that will be achieved just by the base effect. As such they seem to have actually given up hope of their policies having any effect.

The fact is that higher rates at a time of policy paralysis will have two effects. One will be that further capacity additions across segments will come down as money becomes more expensive and this will further feed inflation into the system. Secondly the cost of borrowing of the government will go up and along with it the indirect tax collections will come down (due to slower demand growth) and corporate tax collections will come down (due to lower profitability). Moreover the denominator for the calculation of Fiscal deficit will come down as GDP growth will be lower. As such this could create an upward bias on the direction of the Fiscal Deficit.

The last few days we have seen several developments on the global scene where we have seen that the Euro zone has acted with speed in order to contain the contagion effect of Greece and seem to have been successful in the short to medium term. However the US Debt ceiling and Fiscal Deficit issues continue and have been affecting the global markets negatively over the last few sessions. Ultimately there will certainly be an increase in the US Debt ceiling; however the key is the future fiscal deficit of that country and the deficit reduction. For this fiscal year the US will have a deficit of around 10% of GDP and the US Fed has injected liquidity of around 5% of GDP through QE2. Despite such a huge stimulus we have not seen any appreciable improvement in the economic activity as most of the excess money has gone into commodity speculation. Under the circumstances, given the fact that the US Banking system is now reasonably healthy and corporates in the US are doing well it will be important to now act on cutting the fiscal deficit. A downgrade in rating can set up a spiral of increasing borrowing costs for the US that it will be able to ill afford in the long run. The fact of the matter is that they need to cut spending and increase taxes.

MARKETS

Overall the results season has been mixed with divergent results. The good part about the results has been that in the financial sector the NPAs seem to be under control and this is absolutely essential in a phase of increasing interest rates. The key will be to see how they behave over the next 3-6 months. The IT sector has given good results and the outlook seems to be positive. Telecom as a sector seems to be bottoming out and the financials should bottom out sometime during the current quarter as inflation tops out. On an overall basis after doing a company by company analysis it seems to be clear that the level of 5200 for the Nifty seems to be a clear bottom which will not be breached unless and until we have a catastrophic event or an unprecedented sell off in global equities. As such the downside to the markets seems to be limited.

However given the tight liquidity scenario and the slowing investment cycle the upside also seems to be limited near term as the markets adjust to the new interest rat environment. Decision making on the policy front and clearance of projects, lesser delays and reform measures as such become important to take the markets out of its range bound trading. Ultimately we should break on the upside, however when is the question now. It could now be only later in the year. Inflation should start easing over the next two months and that could be the trigger for the up move. In the meantime we could again see defensives outperform despite them trading at extremely high valuations.

On the other hand August could actually be a month of hardly any negative news flow and inflation data for July could also surprise on the downside as there was a spike up last July. It’s a time of glorious uncertainties and it will be a good time to pick up the stocks one likes and has belief in and hold on for the rally which will eventually unfold.

All roads lead to Rome

2011-07-19T10:40:00.001+05:30

As the ancient saying goes, that is what has been happening in the financial markets since the beginning of the current month. After Greece, Portugal and Ireland got downgraded to Junk the speculators have now trained their guns on Italy and Spain, as a result of which we have seen extreme volatility in the financial markets over the last few days. Along with this we have also seen a drama being played out in the US in relation to the Debt ceiling where despite both sides of the political spectrum knowing that this is something that has to be done a political game is being played out.

In midst of all of this we have also seen the start of the results season and the first few results have been in line with expectations. Most companies are still seeing a robust topline growth with some pressure on margins. The outlook of the technology majors is robust, thus providing a downside protection to the stock prices. The initial results from the banking space have also been good with the main monitor able i.e. NPA’s still in control for a vast majority of banks. The health of banks is important to sustain economic growth given the tight liquidity and high policy rates.

The Industrial production data that was released was way below expectations and for the first time in so may months the Inflation data also surprised on the downside. Inflation remains elevated but the bias for the remaining part of the year remains for a downward movement of inflation. As a result of the extremely tight monetary policy as well as a policy paralysis we have seen credit growth slowly starting to taper off as demand of funds for new capacity creation is drying on. The economy at this point of time is positioned in a manner where on one side the consumption story continues to be strong due to a strong employment situation as well as rural prosperity. The increase in realization on farm products, especially for cash crops combined with the dole outs under Bharat Nirman have led to strong accretion in rural incomes. The services side of the economy also continues to grow strongly. The problem today lies on the investment side where a slowdown in clearly visible. The only bright spot seems to be in the roads sector where NHAI has finally got its act together and order placements are progressing at a fast pace. The process of building new highways should now gain momentum which should continue at least for the next three years.

At this point of time it seems as if most of the domestic factors that have contributed to a downward movement of the markets seem to have been factored into the markets. However the risk today lies more from the global factors with policy makers in the Euro zone grappling with the response to the new crisis that has unfolded over the last few weeks which has sent yields on bonds of various countries perceived to be risky soaring. Although a lot has been written about this already, from whatever data is available I do not think that the kind of pessimism that is being displayed for the two larger economies of Italy and Spain is justified. It is accepted that Italy has a Debt to GDP of 120%; however the fiscal deficit for this year is projected at 3.9% and moving to a balance over the next three years. This is not such a dire scenario for the kind of battering of Italian bonds that we are seeing. There is too much cheap money floating around that is being used by speculators to short bonds and equities while pushing up commodities.

The other global factor has been the US Debt ceiling and a possible downgrade of rating of that country. I believe that the debt ceiling will be raised with the usual drama as that happened during the deliberations for the financial sector bailout talks; however the impact of a downgrade of USA’s sovereign rating could impact financial markets negatively. However this is something that we need to watch out for over the next few months. I had actually started turning negative on gold prices till this announcement came out. However a US downgrade could be a game changer for gold. Physical demand has fallen drastically after the recent uptick in prices and for gold prices to sustain we need a continued bout of uncertainty.

Market Outlook

I have been bullish on the markets for some time as my view has been that factors contributing to a downward market movement are largely in the prices. Most investors are underweight on India and domestically investors are on the sidelines and cash positions are high. Speculative positions are also extremely low. We have seen foreign investors pump in around USD 2 billion into the markets over the last few weeks. This has picked up a lot of slack from the markets.

Monsoons after being volatile have picked up well over the last week and this will be positive for agricultural output, prices as well as rural incomes.

The markets clearly seem to have made a bottom around the 5200 levels and it will now take a catastrophic event to take prices below that level. The markets are looking for a trigger to move up and that could be in the form of a short term resolution of Euro zone issues, US moving forward on the debt ceiling or/and RBI taking into account global uncertainties and not hiking rates in the 26^th July policy meeting. We could see markets being ranged till that date before making an attempt to push higher.

I still maintain my view that we should see a level of 6000-6100 for the markets, however a push beyond that will require some clarity on government policy making as well as the inflation outlook.

Looking Bullish

2011-07-04T20:10:00.002+05:30

The month of June turned out to be a very interesting one for the markets where the markets sold off in the early part of the month due to negative news flow on global markets as well as the biggest concern over the last few months i.e. inflation. In the middle of the month there was also news flow on the review of the Double Taxation Avoidance Treaty with Mauritius which resulted in a selloff in the markets that took the markets to the February/March lows. This fulfilled one of the criteria that I had in mind and had anticipated for a final market bottoming, which was a re-test of the lows made earlier during the year as it was a necessary condition to make the bears confident and create negative sentiments in the markets. Infact, on the 28th of June, we saw cash market volumes touch 28 month lows which also confirmed another necessary criteria for a market to bottom and which is to have a phase of total apathy towards equity which we have seen for some time now and which finally seems to have reached its crescendo.

As a result of this in the third week of June we saw a poll of market participants and Fund managers predicting a fall in the markets to levels of 15,000 for the Sensex by the end of the year. That was the exact day on which the markets actually bottomed out. A similar poll in early January had seen consensus forecasts of markets being at 22,000 to 24,000 for the Sensex by the end of 2011.

Overall the markets ended the month up by around 2% and the mid cap indices ended the month down by around 1%.

The markets at this point of time seem to have discounted most of the negative news flow and most of it seems to have been discounted in the markets. The factors contributing to the downward risks for the Indian economy have now bottomed out. Factors related to the Telecom scam as well as slowdown in policy making from the side of the government seem to have been well discounted into the markets. Inflation seems to have peaked out now and the figures that will be released for June should be the peak for the current economic cycle. Global factors that have affected the Indian markets negatively have largely surrounded developments in the MENA region as well as issues related to the troubled countries in the Euro zone. With Greece passing the austerity package on the last day of the month we seem to have seen the bottoming of these concerns in the short run i.e. for the next three months. However long term concerns are alive and will rear their head sometime in the future.

As investors look at the markets today, they should look at what the year 2012-13 will be rather than what the immediate prospects will be. The commodity cycle seems to have clearly topped out for now and factors such as a slowdown in the global economy as well as seriousness by China in controlling inflation in its economy and also in preventing overheating concerns will prevent any big upsurge in commodity prices any time soon. With the US Federal Reserve also through with its money printing binge (again for now at least) the upside risks to commodity prices due to increasing liquidity has also reduced. Policy makers in the most prominent economies are also recognizing the adverse role of commodity speculation in creating commodity bubbles and its impact on threatening the fledgling recovery in the global economy. We could see restrictions coming on commodity trading or on bank funding of commodity hedge funds at some stage if prices starts shooting up again as leaders of many prominent countries have spoken about it in the recent past.

Typically markets start doing well in anticipation of improving margins and growth prospects. Next year will see companies improve margins as input prices start to come down and previous price pressures get passed on. The impact of higher interest costs will also wear off next year; both due to the base affect as well interest rates that should be lower by at least 150 to 200 basis points at the same time next year.

In the near term I expect markets to rally by another 10% over the next 6-8 weeks as the excess cash on the sidelines gets deployed and a bout of short covering starts in the markets. The next few days could see the large caps move sideways while mid cap stocks do a catching up. As such July could be much better for mid cap stocks. Movement of the markets beyond 6100-6200 levels looks difficult at this stage as every market up move is accompanied by an up move in commodities that again raises inflationary fears. A stable to less steep commodity price up move will be necessary for markets to move to new highs and will be something to monitor.

Gold seems to be topping out as of now, I will write on this more in detail shortly. The key will be to see if it is a medium or long term top.

The markets are setting up for a very strong upmove in the second half of 2011 and there is likely to be a reversal of the Buy Developed markets and sell Emerging Markets trade in this time period.

Most events over for this month, now what ?

2011-06-16T17:27:00.001+05:30

REUTERS CRB INDEX

Most of the major events scheduled for this month are now behind us with the IIP data (downside surprise), inflation (upside surprise) and the RBI policy (no surprise) getting over today. Under the circumstances the movement of the markets till the end of the month again goes back to that of following global cues. The advance tax numbers did not show any negative or positive surprise either. As such it is more important to analyze and get a hang of what’s happening globally and its impact on the Indian markets.

Globally the main theme seems to be of slowing growth with economic numbers deteriorating for the US and a number of Western countries. China reported growth numbers in line; however the impact of monetary tightening and high inflation is likely to slow down growth in China going forward. The Peoples Bank now finally seems to be acting seriously to control the genie of inflation and this has created liquidity tightness in the Chinese system. However the fixed investment binge still continues in that country and unless addressed and soft landed should lead to a hard landing at some stage.

My key call for the last two months has been for a commodity correction, which seems to be half way through at this stage. The US Dollar is looking increasingly bullish technically and could see levels of 77.5-78 in terms of the USD Index going forward. A combination of strengthening USD and slowing global growth is likely to weigh heavy on commodity prices. We have already seen crude oil prices come down to levels that are below those at the time of the start of the Libyan crisis. This is despite no resolution to Libya, simmering discontent still on in lot of Middle East countries and a failure of the OPEC talks on increasing production. This just shows the extent to which the oil market is overbought by speculators and hedge funds. A 10%, if not more correction in prices of crude is imminent. At some stage as the Libyan crisis comes to an end we could see a further sell off. Under the circumstances the projections of crude at USD 120-130 per barrel look absurd to me at this stage. Other commodities have also corrected along with crude but some of the industrial metals have not corrected in any major way and we should see that correction also unfold going forward. The Reuters CRB index looks to be completing a very negative head and shoulder pattern and technically this implies a further sharp fall of around 8-10%.

The key is that in a scenario where commodities are correcting sharply due to growth concerns, can the stock markets rally? The biggest problem that India has faced over the last 8 months has been related to inflation and its impact on growth. A fall in commodity prices will address most of the inflation concerns in India given that the monetary policy in India is formulated on the commodity focused Wholesale Price Index. However it is also observed that normally when commodities drop off sharply markets do not move up. However as the correction in commodities plays out completely over the next few weeks it will create a huge foundation for a big up move in the markets subsequently. Although it is difficult to time the duration of this corrective move in commodities, my guess is that it should be over sometime in July.

Events in Greece will also we watched closely as most people now believe that country has to default now. The impact on the markets of such an event should be limited given that it is now widely speculated. However if it happens it should impact the Eurozone more. Given the large stakes involved, my guess is that the adjustment will be done as smoothly as possible and any big write offs will not happen at this stage and will be pushed into the future.

July is also the results season and it will also provide an opportunity for investors to take a more informed call on the outperformers of the next rally. As things stand today in the markets we see the markets demarcated into two different pockets. The first is that of defensive stocks that have become institutional favorites. In case of these stocks the valuation are at a P/E of 25 to 50. On the other side is rest of the market where valuations are at 10 to 15 times for large caps and 5-10 P/E for mid caps. My guess is that as interest rate and inflation concerns peak out we will see a large number of cyclicals and growth stocks start to outperform as valuations are cheap and earning visibility will come back.

In terms of an overall view it still looks like the February/ March lows should be a good durable bottom for the markets for a strong rally into the second half of the year.

Two months of drift - Could June be better

2011-06-01T15:25:00.003+05:30

The month of May again turned out to be a boring one for the stock markets. The markets drifted down right from the beginning of the month and we saw a slow and steady decline in both the front line and broader indices in the first three weeks of the month. The drift in the markets started with the RBI’s monetary policy at the beginning of the month where the hike in policy rates as well as the undertone of the policy was extremely hawkish. This has now created growth concerns for the economy in the near term without changing the long term outlook for the markets. The Nifty & the Sensex ended with losses of 3.3% for the month.

The other key developments during the month were the much anticipated election results, which were on an overall basis pretty good for the Government and as a follow through for the markets. The Industrial Production numbers as well as inflation surprised on the upside and the GDP growth figures released at the end of the month were slightly below expectations.

One positive figure that came out at the end of the month was the actual Fiscal Deficit figure for the last year which came at 4.7% as against 5.1% projected at the time of the presentation of the Union Budget. In one of my articles at the beginning of February I had pointed out that Fiscal deficit should not be more that 4.1%. However despite accounting for huge amounts of additional fuel and fertilizer subsidies in the month of March 2011 the Fiscal Deficit still remained well below the governments projected figures.

We believe that the markets are now bracing up for a strong up move in the second half of the year. As we had anticipated there was a severe sell off in commodity prices in the first half of the month. The key to observe now is whether we have seen the worst of the commodity correction or there is one more leg to go. I would think that we could see one more round of commodity price sell off before things stabilize for the commodity universe. Although a correction in commodity prices is extremely positive as far as India is concerned the only issue for the near term is that typically when commodities see a severe sell off markets do not rally at the same time and typically do that with a lag.

Typically strong markets up moves are followed by a correction and a phase of consolidation. However the market sell off in the year 2008 saw a rapid bounce back without a multimonth consolidation phase that followed the rallies in the early 1990s as well as in 1999-2000. As such it is our view that the consolidation of the markets in the range of 5000-5500 Nifty for a greater part of the last two years has actually a sideways correction which will give way to a strong up move, starting the second half of this year. A lot of trading interest in the markets has shifted to commodities; especially over the last 9-12 months as typically trading interest is more in asset classes that have done well in the immediate preceding period. This has created a scenario where the broader markets in terms of small and mid cap companies in India have become extremely cheap relative to the growth prospects. We expect this undervaluation to get corrected over the next 2 years where this segment of the market should provide very strong returns to investors.

The markets in India are now trading at a value of around 80% of current years projected GDP. At the peak of the last bull market in January 2008 this value had gone upto as high at 160%. Over longer periods of time the market capitalization in a country will be a proportion of the value of the Gross Domestic Product. In phases of high earning growth and margin expansion this ratio will also expand and in phases of margin squeeze and lower earnings growth this ratio will move down. We expect that as the bull market moves to its next phase and reaches a peak 3-4 years from now the Market Capitalization/GDP ratio will again go back to its euphoric levels of 150% plus. This would mean a tripling of India’s market capitalization over the next 4-5 years. As such the current phase of apathy towards equity investing could be one of the best times to actually invest into the markets.

Most of the concerns as far as domestic factors are concerned i.e. those related to inflation, lack of policy making, tight liquidity, lower earning growth etc. seem to have been factored into the markets at this stage. However an unprecedented global event like that of a default by one of the troubled Euro zone countries can lead to a short term sell off in the markets. However given the fact that it is an event that is not unanticipated, its impact should be short-lived.

Overall we are quite constructive and bullish on the markets at this stage and we believe that the markets are looking good for investors with a 1 to 3 year perspective. Whereas large cap stocks could return 20% in this time frame the returns form mid caps could be double of this. A recent phenomenon over the last few days has been a pick up in Merger and Acquisitions activity, specially related to small & mid cap companies where these are typically happening at valuation that are at a premium of 50-100% over the current market value of these stocks. The M&A in privately held companies is also at a significant premium to the valuation for similar companies that are listed in the markets. This clearly shows that the SME segment is trading at a very high undervaluation at this stage.

Directionally we believe that the markets should move to a level of 22-24000 for the Sensex and 6800-7000 for the Nifty before any major correction happens now.

"In the short run the market is a popularity contest, but in the long run it is the strength of your convictions that matters"

Commodities - more to go & QE2's demise

2011-05-12T12:32:00.000+05:30

Over the last 10 days we have seen a sharp sell off in commodity prices after an unprecedented run up since last May/June which saw the prices of most commodities rally anywhere between 40-100% plus. The rise in prices initially obviously was fuelled by a greater confidence on economic growth prospects as well as reducing fears on the US economy as well as the Eurozone crisis. However after the initial move the entire upmove in commodities got fuelled by the easy money availability due to QE2 and huge speculative buying by leveraged commodity hedge funds as well as speculation on commodity exchanges. The two commodities that to my mind signify the height of speculation were cotton and silver where prices moved up by nearly 150% in less that a year. As I pointed out in my article on the 23rd of April, where I quote - "There is today extreme speculation in precious metals, specifically silver where the largest Silver ETF has been adding nearly 60-70 tonnes per day. Now we have to see this in the context of actual silver consumption per year which is around 25000 tonnnes globally i.e. around 70 tonnes per day. As such financial speculation is adding as much demand if not more per day as actual financial consumption, which in my view is the height of speculation."

The broad based fall in commodity prices has been accompanied by a bounce in the US Dollar where the USD index has rallied by nearly 5% from its bottom. After the first week of correction most analysts started giving out buy reports on these commodities despite the fact that there is a real demand destruction happening in a large number of commodities due to increased prices. Given the state of the global economy where real income growth continues to remain very low on an aggregate basis, this kind of price up move is difficult to absorb. We are today not in the hay days of 2005-2007 where issues of unemployment, low growth, and Fiscal deficit issues did not exist. The money printing by the US Fed has played the biggest part in the commodity rally given the fact that the actual credit growth by banks in the US for the first quarter has been negative. As such most of the money being printed is going into buying some asset or the other. Under the circumstances the impending end of QE2 will definitely impact speculative commodity demand.

The other important factor to note is that when corrections start after a blowout rally they never end in one week. As such irrespective of the price damage in the first week there will be further corrections over the next few weeks as the speculative fervor turns from buy on dips to sell on rise and the large scale long positions start converting into shorts. Although it is difficult to give the extent of correction to follow, intuitively I would believe that the follow through correction will be similar in magnitude to what we have already seen over the last 10 days. Crude prices are back to levels where they were when the Libyan crisis had started to unfold. This just shows how much speculation was contributing to the oil price upsurge as the Libyan crisis is nowhere near to resolution at this stage. A resolution in Libya at some point of time has the potential of creating a USD 10 per barrel further downside in crude oil price in my view. Overall there should be another 2-4 weeks of commodity price correction before prices stabilize.

Various economies have started to slow down and the growth figures coming out of various high growth emerging economies like India & China are also indicating slower growth in the near term. The Eurozone crisis is rearing its head again and growth seems to be stalling in most Western economies too. This should also help in keeping commodity prices in check. The big commodity up move seems to be over for now. The strength of the US Dollar is also negative for commodities and the bounce back in the USD's value seems to still have some way to go given the kind of oversold state it was in. Another 4-5% bounce back from the current levels cannot really be ruled out.

Markets

Subsequent to the RBI's monetary policy the Indian markets have underperformed due to concerns of slower growth and impact on profits and investments due to higher interest rates. The biggest concern for the Indian markets since November last year has been that of inflation. It first started with food inflation, went on to primary products inflation and then finally to manufacturing inflation. As per figures released today food inflation on a Year on Year basis is now down to 7.7% from levels of 20% in January 2011. These are figures pertaining to end of April when the global commodity price correction had not yet started. The index of Food Articles in the WPI was at a level of 196.5 as on 1st of January 2011 and has come down to 184.7 as on 30th of April. As such on an overall YoY comparison inflation is still high but sequentially over the last 4 months it is down by nearly 6%. Similar is the case with primary articles where on a YoY basis inflation is at around 12% but from 1st of January it is a negative 2.5%.

As such in my view inflation will fall much faster than what RBI has projected in its recent monetary policy. This will reduce one of the biggest roadblocks to India's outperformance and the second half of the current year should see India outperform significantly.

The other fear in the minds of investors is the impact of the end of QE2 on the Indian markets. The answer to this is not simple. Once the overall money printing from the US Fed stops and all other major economies remain in a tightening mode the stock of money available will get constrained. This will have a more profound impact on commodities rather than stock markets in my view. The Indian markets have infact fallen in the tenure of QE2 as such its withdrawal, mainly due to its impact on curtailing inflationary pressures would be positive for India. The important thing to realize is that even though QE2 will end the overall monetary situation still remains very accommodative. As per the latest survey the US Fed is unlikely to hike before 2012.

As such the second half of this year should see a reversal of the inflation trade and a strong bounce back in performance of high growth Emerging markets including India.

The results season is past the half way stage and it has been a mixed one which has largely led to downgrades and earning expectations for the current year i.e. 2011-12 have on an aggregate basis seen downgrades of 4-5%. This has also been reflected in the way the markets have moved. Analysts are today building in high cost pressures due to input costs, slower growth and a much tighter monetary policy into their projects. All of these might not necessarily fructify.

I continue to maintain my view that the February/March low is now a good base for the markets and if we get to those levels sometime during this month that should be the bottom for the current year from where we should see a 25% kind of rally by the end of the year.

RBI spoils the party

2011-05-03T21:45:00.003+05:30

The much anticipated monetary policy by the RBI took place today where the Reserve Bank finally gave way to arm chair economists and hiked rates by 50 basis points as against an expected 25 basis points. The apparent reason for the same is to anchor inflationary expectations. However the reality is that this has been done a bit too late in the day. When inflationary expectations were actually building up at that time the RBI was in the process of balancing inflation and growth and in last years 4th quarter policy infact projected a pause in the rate hike cycle. Its projection of inflation in March 2011 was 6% just six months back and it is the same for March 2012 today. This was in November 2010 when most primary commodity prices had already shot up by nearly 50%. Any economist of merit will know that as input prices move up the down the line industries first wait for some time to see if it is a temporary move. Once they realize that the prices are not going to come down in a hurry the second level of pass through happens and then after a lag the third level.

The strangest part of the policy statement has been that inflation will remain at March levels till September before easing off. The question therefore is that if inflation has not come down even after 9 interest rate hikes and several CRR hikes what is actually going to bring it down now?

The fact of the matter is that RBI's monetary policies are more effective in controlling asset bubbles rather than inflation and this is something that I have pointed out several times in the past too. Given the fact that the prices of a large number of commodities like crude oil, copper, palm oil, other minerals and food products etc shot up sharply from May/June 2010 till November/December 2010 and the magnitude of the rise was 40-70%, a pass through of this kind of price pressure is all but natural. At this stage making a comment that inflation is now passing off to manufactured products is stating the obvious. As an example take the tyre industry. Natural rubber that forms the majority of the cost of raw materials for the industry shot up by an average of 37% last year. Now if tyre manufacturers would not pass on the cost price increase they will make huge losses. As such tyre prices went up by an average of 18% last year and as a result of this the companies were able to cut down the losses; however tyre companies still made losses in the last quarter. However the reality is that the pass through of costs has happened only partially and a part of this cost absorption has happened because of increased volumes and better efficiencies. Now rubber, carbon black & nylon tyre cord that are the three major raw materials for tyre manufacturing are all global commodities. As such how is tight monetary policy of the RBI going to bring down the prices of these commodities? At best a very tight policy will cut down demand of tyres in India and make these companies make more losses.

A second example is that of the textile industry where cotton prices shot up by a whopping 150% from July 2010 to February 2011 before correcting around 15%. In this scenario where cotton forms a huge chunk of the price of yarn and fabric and margins in these products are in single digits what option do manufacturers have but to increase yarn and fabric prices. As such yarn prices have also doubled in this time period. As yarn prices do up so do prices of fabric and finally garments where there has been a hike of around 20-25%. Now all these are manufactured products. So what does RBI want this industry to do, shut down or absorb all costs and start making losses?

A third example of manufactured products lets say is the Auto industry. Key inputs here include steel, various other forged parts, wires, electronics, tyres etc. The input cost of each one of these products has gone up by a minimum of 20%, if not more over the last one year. However the increase in car/truck/motorcycle prices has been in single digits. As such due to higher volumes and better production economics companies have been able to absorb input costs as well as increased wage costs of 10-12%.

A fourth example will be the follow through impact of a rise in crude oil prices. This leads to an increase not only in fuel costs but also of various chemicals, polymers, fibers etc. Now since these are global commodities the prices in India are just a follow through of global prices. Moreover India consumes just around 3% of global crude oil consumption and as such Indian monetary policy is unlikely to impact global crude prices in any significant way.

The point that I am trying to make is that when there is such a huge input cost pressure there has to be a spill over to manufacturing. As such the spill over has to be seen in the perspective of the cost pressures. I would rather argue that with such a primary cost pressure if the manufacturing sector inflation is below 10% it is infact a great achievement.

Ex of the global commodities on which RBI has no control, the only way to reduce price pressures is to improve supply or improve efficiencies. Due to the various inefficiencies and bureaucracy of governance new projects have found it difficult to start up and we have seen a number of industries working at peak capacity at this stage. The way to control inflation as such has to be by boosting production. We have already seen that in an industry like cement where capacity has been added the inflation over the last three years has been much below inflation despite the steep increase in a large number of input costs for the industry. Higher capacity and larger number of players have kept the prices in control in a large number of consumer durable products.

However the same is not true of food products where a lack of farm sector investment in production/storage/transport still has kept Indian production yields much below global averages and post harvest wastage continues to be huge. Despite recognizing these issues there really is no major effort to boost efficiencies in this sector. A false sense of complacency is there due to the normal monsoons of last year and projections of a normal monsoon this year. However I dread to think what will happen to food inflation in a year of below par monsoons. As such huge investments are required in various aspects of this sector.

In my analysis there are two ways that inflation will come down. The first is a crack in the global commodity bull market as a result of slowing global growth and tighter monetary policy, especially by China. There is clear evidence of demand destruction in the consumption of crude oil. This should ultimately manifest itself in lower prices. The statement by the Chinese Central Bank today that the primary objective of monetary policy now is to achieve price stability is also a clear indication that China is likely to tighten faster and this is likely to be a major factor for commodity price correction.

The other major factor here will have to be the stoppage of money printing by the US Federal Reserve. The commodity rally has been supported to a great extent by the USD carry trade. The USD also looks to be heavily oversold at this point of time and QE2 comes to an end next month. This should create a short term pull back for the USD and lead to a fall in commodity prices.

A large part of the Indian Wholesale Price Index that is used by the RBI for setting monetary policy is driven by commodity prices both primary and manufactured. As such the above factors by themselves are likely to lower inflation going forward and the credit for the same will be taken by them. RBI today risks getting downgraded from the best ranked central bank to one of the worse ones due to its poor reading of macroeconomic trends over the last six months and its inaccurate forecast for the next six months.

Anyways enough of Central bank bashing. Now coming to the markets. Clearly this policy has taken away the sting from the banking sector that forms the largest part of the Nifty, at least for the near term. Other interest rate sensitives might also be pressured in the near term. Under the circumstances after the severe sell off seen over the last few sessions the markets at this point of time lack a big trigger to move either ways. And as such I would believe that we are in for range bound trading over the next 3-4 weeks by which time there will be a clearer idea of the direction of inflation and if things turn out the way I think they should then we could see some easing off of concerns. Overall I still believe that we will see a new high and much higher levels this year, however it is likely to be delayed by a quarter beyond my earlier target of it happening over the next 3-4 months.

Results ETC. ETC.

2011-04-23T21:14:00.000+05:30

With the results season now beginning to start in all earnest it is important to see how results have panned out till now and the key takeaways from the same. The most prominent results out till date have been from the Technology and the Banking segment. Technology sector results have been positive in general and the most important thing is the guidance that the companies have given on hiring as well as top line growth for next year. With growth likely to be in the region of 25% for the top tier companies for next year the things are looking good for this sector. However cost pressures are also high, currency movements are a concern and valuations at a 50% premium to market multiples. The other set of results that have come out have been from banking where the banks have reported in line with expectations and the outlook again seems to be positive. The key risks for the future will be increase in NPA’s as interest rates move up and also a likely squeeze in margins with the cost of funds moving up.

The bigger positive from IT sector results that I see is the very strong hiring picture in the sector which is extremely positive for the economy. The addition of nearly half a million people in this sector over the next 12-18 months is likely to boost consumption across the board. It should also be positive for housing demand over the medium term. The other positive that I see from this picture is that the strong growth in IT exports will boost the Forex income of the country and will have a positive impact on the current account deficit going forward. IT sector exports for this year were in the region of USD 60 billion and a 25% growth in USD terms implies a growth of USD 15 billion over the next 12 months which when combined with the general buoyancy in exports seen over the last 12 months should see the Current Account Deficit remain well under control despite the spike in crude oil prices.

The mid cap companies have just started to report and results in general have been pretty strong given the cost pressures and higher interest rates. Given the extreme pessimism surrounding this sector positive results have seen stock prices respond positively. I believe that this is likely to be a key feature of the current results season where in sectors where expectations are running very low any positive surprise will lead to a sharp up move in stock prices. Also where mid cap companies surprise positively we can see a sharp up tick again.

Crude price impact

The biggest talked about issue (specifically in the Indian context) has been the up move in crude prices and its impact on the economy and consumer demand. It is important to see who is impacted by inflation the most and how the inflation of crude prices will impact various economies.

At a price of USD 100 per barrel the total consumption of crude oil in India at a consumption rate of 3 million barrels per day is USD 110 billion per annum. In the current year i.e. April -March 2012 India’s nominal GDP is expected to be around Rs 90 lakh crores i.e. USD 2 trillion. As such oil consumption would be around 5.5% of GDP. Given the fact that nominal GDP growth in India is likely to average 15% and population growth is around 1.5% per annum the per capita income growth would be 13.5% pa. Similarly China consumes around 8.3 million barrels per day of oil and as such total consumption will be USD 300 billion pa on a GDP of USD 5.87 billion.

The consumption of oil in the USA is 22 million barrels per day and this implies a total value of USD 800 billion per annum.

Now the key is to see that given the economic growth and growth in per capita income which economy will be impacted more due to the spike in crude oil prices. Now if India growth at a nominal rate of 15% it implies an addition of GDP of USD 300 billion for the next year. Assuming a demand growth of 7-8% and a further price up tick of 15-18% next year the incremental increase in value of oil consumption will be USD 110*25% (APPROX)= USD 137.5. As such out of the incremental addition of GDP of 300 billion the crude oil consumption increase is USD 27.5 billion i.e. around 10% of incremental GDP. Now assuming no growth in oil consumption in the US and a nominal GDP growth of 4% the consumption of oil will be USD 800*1.18= USD 944 billion. Now addition to GDP of the US on a base of USD 14 trillion odd will be USD 560 billion. As such nearly 25% plus of the incremental GDP growth is going towards funding oil consumption. As such the entire logic of fast growing emerging markets being impacted more due to the oil price spike is founded on poor logic. Given the high unemployment picture in the developed world combined with poor income growth this will reduce consumption growth and given that consumption forms a big part of these economies it will provide headwinds to an already fragile economic growth picture in these economies. The Europeans are relatively better positioned given that the Euro has appreciated by nearly 20% since June last year and as such in Euro terms oil is not up as much as is USD terms where crude has surged nearly 50% in the same time frame.

However all said the excessive speculation in commodities is not presenting a very positive picture for inflation in general. The key is to see when the US Fed will realize that they need to wind down the excessive money printing. They are the last ones left now, off course with the follower BOE, however with China now tightening aggressively and the ECB joining in the one way commodity rally runs the risk of a severe sell off some time over the next 2-3 months. RBI needs to carry on with its measured hikes without giving in to the hawks in the system, as in a scenario where a large number of primary input commodities have risen by 40-50% since last may a WPI of 8.5% is not really bad if not seen in isolation. We have already started to see demand destruction now in oil consumption, also in the case of edible oils we have seen exports of palm oil out of Malaysia falling and stocks rising over the last few weeks, there is a glut of steel in the global system. There is today extreme speculation in precious metals, specifically silver where the largest Silver ETF has been adding nearly 60-70 tonnes per day. Now we have to see this in the context of actual silver consumption per year which is around 25000 tonnnes globally i.e. around 70 tonnes per day. As such financial speculation is adding as much demand if not more per day as actual financial consumption, which in my view is the height of speculation.

OVERALL MARKET VIEW

The overall market view continuous to be bullish and markets should continue to climb the wall of worry. As per my technical analysis (purely, nothing fundamental) we should see the next major correction in the markets only after a new high and much higher levels over the next few months. With a large number of Asian and other emerging markets already crossing their November/all time highs we should see the Indian markets follow with a lag. There continues to be pessimism in the markets and a lot of money on the sidelines, which I think will come in only after the earlier high gets taken out. As such my base case view at this stage will be that the markets are set for a further rally before any significant correction sets in (defined as more than 5-6%). As I wrote earlier the outlook is better for sectors and stocks where expectations are low and chances of outperforming earnings are higher.

You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right-and that’s the only thing that makes you right.” -Warren Buffett

WHAT NOW

2011-04-09T20:53:00.002+05:30

The stock markets have bounced back quite smartly from the depths that they saw in the months of January and February. At the end of February when all hell had broken loose with most people expecting the markets to correct further and the Nifty and Sensex to reach 4800 and 16000 respectively, my view was that we are likely to see a rally of at least 10% over the months of March and April. Although I have taken a somewhat conscious decision not to predict very short term market movements as they are like “Crystal Ball Grazing” the psychology of the markets combined with the fundamental factors made me confident that the markets seemed to be undervalued at that stage. I had also anticipated that mid caps should start doing well from April onwards and we have seen some buoyancy come back to this part of the market with most of the small and mid cap stocks rallying 20-40% from their bottoms over the last couple of weeks. However most mid caps are trading well below the levels seen in November 2010. This is at a time where the Russel Small Cap Index for global small caps is trading at all time highs. Small and mid caps in India are still trading way below not only their all time highs seen in Early 2008 but also well below the levels seen in October/November 2009 after the first burst subsequent to the market bottom led to a large number of these stocks shooting up by 4-5 times in just around 6 months. I still continue to believe that the valuations on a large number of small and mid cap stocks that we see today are similar to those seen after the Emerging Markets crash in May 2006. A large number of these companies have grown multifold in this period and still trade at market valuations that are 20-30% of those seen in 2008. Even if we were to argue that the January 2008 levels were those of gross overvaluation, still the values seen today seem to be of significant undervaluation.

As we enter the results season what we need to see is the factors that are likely to impact the markets and individual stocks in this period. On top of this we have the macro environment and the need to evaluate the impact of various events that are happening globally on the markets.

The key factors domestically seem to be

Inflation – Food inflation seems to be cooling off sharply and this was one of the major factors that influenced markets in the month of January. Food inflation that had shot up to as high as 20% in early January is likely to fall to levels of 5-6% over the next 2-3 weeks. This will be due to a combination of high base effect and also falling prices. The good thing for India is that the current crop season has been extremely good with record production of wheat, sugar, pulses and other food grains. A large number of other global commodities also seem to have stabilized with the exception of crude, gold, silver and other precious metals. However we seem to have seen the peak of inflation in India and although the pace of decline will be slower than earlier expected (mainly due to high crude prices) the overall trend seems to be for it to go lower. In terms of tightening RBI has been one of the most aggressive central bankers and as the Chinese and Europeans drop in we should see some softening of commodity prices going forward.

The counter impact is due to the continued money printing by the US Fed and the recent liquidity pumping by the Japanese. However inflation in is likely to hit the shores of the US earlier than later and will force the US Fed to act. The continued looseness of the US policy has led to a sharp drop in the US Dollar and further boosted the USD carry trade. However I believe that the bigger carry trade over the next couple of years will be the Yen carry trade with the Yen expected to depreciate due to poor economic fundamentals. However on an overall basis the entire trade of selling inflation facing emerging markets like India, China and Brazil in favor of Western markets seems to have to come to an end and we should see an unwinding of this trade going forward. Given higher growth prospects EM's should come back into fancy now.

Liquidity – The liquidity tightness kept by the RBI took borrowing costs up sharply in India over the last 3-4 months with rates for some deposits and loans shooting by nearly 200 basis points or more. However liquidity seems to be easing now and this should be positive for economic growth. Global liquidity is extremely strong and this has also led to a sharp increase in oversees borrowings by Indian corporates as the all inclusive cost of USD borrowings gives a benefit of at least 2 percent over domestic rates at this stage.

Policy Making and order flow improvements – After the series of scams and slowdown in government policy making things seem to be coming back on track now and this year should see record orders being places in the Roads & highways segment. Corporate Capex also seems to be chugging along at a good pace. With the softening of the Environment Ministry’s position on awarding projects we should see higher activity in the mining segment and also in large Greenfield projects in the metals and infrastructure segments. Order flows from large Public Sector Enterprises had also come to a standstill due to the various corruption scams that came out. This should also improve going forward. Also with the government looking at higher FDI flows some relaxations for such flows and opening up of some industry segments should be seen this year.

Other factors -

PIGS – PIG gone S left – Its amazing that the bankruptcy of Ireland, Portugal and Greece has hardly impacted global markets and has infact been accompanied by a sharp rally in the value of the Euro. The Euro which was believed to be a currency in peril has come through the crisis very well. With the USD and JPY in doldrums, the Euro has seen a sharp revival. Spain as per what the bond spreads indicate seems to be in a much better position than it was at the beginning of the year with credit spreads for Spain contracting by 150 basis points over this period. This removes one big overhang on the global markets given the size of that country and its economy. However it might be too premature to give it an all clear.

MENA – The crisis in the Middle East and North African countries has an impact on the global economy not due to the size of those economies but obviously their oil supply disruption potential. The key for us to evaluate today is that whether a USD 125 price for Brent and USD 112 for US Crude (when inventories are at all time highs) has built in most of these concerns. In my view the worst except for a big revolution in Saudi Arabia seems to be in the price of crude today. The probability is very high that we will see a significant sell off in crude and precious metals if the situation in this region stabilizes over the next couple of months. However on an overall basis this is something that seems to be unpredictable at this stage. US crude that was trading in the mid 80s at the beginning of the Libyan crisis is now at 112 levels per barrel thus reflecting a political risk premium of over 30% and this seems to have factored in the worst of oil supply disruptions at this stage. Speculative flows can sustain the prices for some time but not for a prolonged period of time.

Flows – The continued outflow from Emerging Market equity funds in favor of developed market equities was one of the prime reasons for EM underperformance from November 2010 to February 2011. However the last two weeks have seen a sharp reversal in flows to EM funds with flows of USD 2.3 billion followed by USD 5.6 billion in the last week. This has happened at a time when short positions in the markets seem to be quite high and most investors are still very skeptical about the rally. If one watches the electronic media business channels (which I avoid) most investors still are of the view that the current rally is a pull back rally. This infact makes me more confident that this is a more sustainable rally. The good part for the Indian markets specifically is also that domestic mutual funds have started to see strong net inflows. The net market flow position from domestic insurance companies also seems to have bottomed out. Domestic insurers pumped in just around Rs 4000 Cr in to the markets in the 12 month ended March 2011 which is nearly an 80% plus fall from Rs 30000 Cr plus last year. I guess the next year should be better for insurers also. Domestic MF's that pulled out Rs 20,000 Cr plus should be pumping in at least this number over the next one year. In conclusion the overall flow picture seems to have improved sharply for the remainder of the year.

Rupee – The fact that the INR did not depreciate despite the sharp sell off that we saw in the equity markets and rising fears of increasing current account deficit due to higher crude prices was a clear indicator that the correction in the stock markets was likely to be a short one. Technically the rupee seems to be well positioned for a sharp up move over the next few months. The continued improvement in the growth of Indian exports over the last six months has surprised lot of people. This has kept the Current Account deficit at levels of 2-2.5% for the current year and it should be lower than 2% next year as the position of invisibles flow also has improved, especially that of IT exports and remittances from the Gulf countries given the high prices of crude oil. Typically INR movements and the markets have been highly correlated.

OVERALL OUTLOOK

My overall outlook is constructive on the markets at this stage. We could see some consolidation of the markets after the sharp up move; however the trend seems to be for the markets to see much higher levels this year. The results season is unlikely to impact the markets significantly and the impact will be positive for mid cap stocks that surprise positively given the extremely depressed levels at which they trade. Bull moves are build on skepticism and fear and there are indications of both at this point of time. Oil prices are a headwind but not an insurmountable one. It is clearly a buy on dips market at this stage. My base case view at this point of time is for the markets to rally 10% above their highs seen in January 2008 at some point during this year. That would imply a 20% rally over the current levels. Mid cap outlook seems to be much better.

“ We have two classes of forecasters: Those who don’t know and those who don’t know they don’t know.”-Jhon Kenneth Galbraith.