Financial markets are opportunistic in nature. Markets will turn around on a dime if it feels that there is money to be made. Indian equities, bonds and currency are seen as place where there is money to be made. The reason why India is seen as place where there is money to be made in the short term is that the Sensex and Nifty price earnings ratio are still well below highs seen in late 2007 and early 2008, the economy is looking to have bottomed out, the government has suddenly turned reformist, RBI is likely to ease monetary policy in 2013 and the Indian Rupee (INR) is trading just off 5.5% from all time lows. FII’s investing in India believe that risk return trade off is positive in India given that the Sensex, Nifty, ten year government bond and the INR offer value at current levels of 19300, 5880, 8.20% Rs 54.80 respectively. Markets are calling for upsides of 10% each on the Sensex and Nifty and INR and a fall of at least 50bps on the ten year government bond yield.
Why equities, bonds and currency will do well in the short term
The Sensex and Nifty price earnings ratio at around 17x 2012-13 earnings are below the 25x levels seen in 2007. Earnings growth of Sensex and Nifty companies are seen to have bottomed out in 2012-13 at around levels of 10% to 12% and with prospects of uptick in earnings growth, markets are pulling the indices higher given reasonable price earnings ratio.
The bottoming out of earnings growth of Indian equities coincides with the bottoming out of India’s economic growth. India’s GDP growth for the second quarter of 2012-13 came in at 5.3%, a three year low. GDP growth is expected to tick up from lows in the second half of 2012-13 on the back of factors such as lower interest rates, reform push and low base effect.
RBI had signaled in its October 2012 monetary policy review that it is open to lowering interest rates starting January 2013. RBI will have the low GDP data to work with as it goes into its January policy review. There are expectations that RBI could lower benchmark policy rates in its December 2012 policy review but that is a separate debate by itself. Financial markets are expecting interest rates to be lower than current levels in 2013 and that is adding on to positive sentiments for bonds and equities.
Table 1. Market Movements
The government is pushing through FDI in retail in the current parliament session and indications are that it will succeed in its efforts. The government has also opened by aviation, insurance and pension sectors for FDI. The FDI in retail will give the UPA government a much needed political victory and it sends out signals of a reformist government to investors.
The INR at Rs 54.80 to the USD is trading around 5% off from its all time lows. The INR has room for gain given that the government is opening up the country for capital flows. The government has increased limits of FII investments in debt by USD 10 billion to take the total limit to USD 75billion. The government is encouraging capital flows to negate the effects of a CAD (Current Account Deficit), which is expected at around 3.5% of GDP in 2012-13. FII’s have invested close to USD 22.5 billion in Indian equities and debt calendar 2012 to date and more FII investments are expected given the positive outlook for Indian markets. FII flows help improve sentiment on the INR and this will take up the INR going forward.
Long term risks are high
In the short term Indian markets will do well on the back of the reasons given above, however in the longer term, markets are in danger of falling off from cliffs. The reason is that the government is progressively increasing India’s macro economic risk. India at present requires structural reforms in the form of fiscal consolidation, fuel price decontrol, improving infrastructure, and state level reforms.
The government is yet to show seriousness in long term fiscal consolidation measures such as improving the tax to GDP ratio (stagnant at 10% levels for the last decade) and lowering subsidy to GDP ratio (sticky at around 2%). Fuel prices are yet to be decontrolled and if oil spikes up from levels of USD 110/bbl on brent crude, the government will have fresh worry in its hands.
India’s infrastructure is a mess with vital sectors such as railways and airlines making losses. The government does not have money to spend for infrastructure and corruption us keeping out serious private sector players.
States are a law unto themselves and there is no accountability for their finances. Chief ministers use public funds as their own personal treasury and give out freebies for votes. States level reforms are a must for the country’s finances to improve.
India is trying to plug the current account gap through encouraging capital flows. Higher exposure to external capital flows that are short term in nature increases India’s vulnerability to external shocks. India does not seem to have a long terms solution to reduce its current account deficit and that will keep the INR volatile.
Buy India now but sell at the right time .