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Comment: India is ahead of the curve, nearing end of rate rises

Mon, 22/08/2011 - 17:38

On 25 July, India raised its repo and reverse repo rates by 50bp and is likely only one or two rate rise away from the top of the cycle. This is important because this means that while the rest of Asia faces one to two years of rate hikes, India stands alone in being close to the end of their rate rise cycle, according to Dylan Tinker of Venus Capital Management…

As a result, we believe India will look like a relatively attractive equity market in Asia by the end of the 3Q, 2011. By this time, India will no longer be the market that is raising rates the fastest, which has depressed equities. In fact the reverse will be true. Previously Asian “hot” markets like Indonesia should be facing higher rates, and India should be done with their rate rise – which should be broadly positive for the equity market.

We, at Venus Capital argue that inflation has actually been relatively stable over the last two years – in which time India has posted strong GDP and corporate growth. It is true that the Reserve Bank of India (RBI) did mistakenly expect a drop in drop in inflation, however this optimism was not shared in the private sector. We believe that with solid growth numbers expected, the market depressed, and policy tightening coming to an end, the medium-term outlook for equities has never been better.

As rates in India plateau, the impact on equities should be positive, and could be very positive. Historically, the last time that (reverse repo ) rates plateaued in India, the Indian NIFTY jumped 78% over the following 18 months. This strong move in equities was linked to international issues, but also aided by the fact that in India investors knew rates were only going to go lower over the following years, lowering the cost of capital, and that overall macro risks would be reduced.

The positive domestic environment that aided the rally in 2006 & 2007 should be present in the 3Q of 2011 when the RBI starts to signal that they are nearing the end of the rate rise cycle. It is clear that the equity market is currently thinking of the end of the rate rise cycle. In late March and April, the Indian market (NIFTY) jumped 9% as investors hoped that lower food inflation numbers would mean that there would only be 50bp more of rate rises. However, when food inflation did not continue to trend down, it was clear that there was more rate rises left. As a result, the market gave up its gains.

The implication of the March spike in the NIFTY is important. Although the Indian market ended in May at a similar level to where it started four months before, it showed that equity investors are on the lookout for lower rates, and that they will re-rate the market higher when India is perceived to be nearing the end of the rate rise cycle. This is positive as India is going to definitely end the rate rises in the next few months. Thus, we believe an equity rally is coming in India soon – most likely at the end of the 3Q.

The strong swinging effect that foreign investors have on the Indian market is well documented. Foreign investors (FIIs) tend to invest over prolonged periods in India and this drives the market higher. Every single significant equity rally in India is largely due to sharp foreign inflows. Domestic investors know this and watch for the start of foreign buying.

To generalise, we believe that foreign investors are much more sensitive to macro economic variables than local investors – who are focused more at the company level. However, since local investors follow international investors, the result is that both groups are focused on macroeconomic variables, and this means that the effect of interest rates on the Indian equity market is extreme – probably higher than it should be – and this induces a “boom and bust” equity market cycle linked to changing interest rates, and inflation.

Given that there has been significant concern about inflation and raw material prices since the beginning of the year, we would expect that Indian corporate earnings estimates would have suffered in this period. This would seem logical as the market is down 12% since the beginning of the year. However, forward earnings estimates have actually remained stable or have increased over the last year. The one year forward EPS growth of the Indian NIFTY Index is about 18% - the same growth rate it has been since the beginning of the year. Hardly anything has changed. We are currently at the end of results season and there have been a few downgrades linked to input price escalation, but this is clearly not a watershed event.

The fact that Indian corporate earnings have not been downgraded in the last year, reinforces our earlier point: that the current malaise in the market is mainly due to the low relative appeal of India to FII investors. With inflation still at elevated levels and rates rising, FII’s are not putting money into the market, and local investors are waiting on the sideline until foreigners come in. However, the underlying Indian corporate growth story does remain in-tact, even though inflation is elevated.

For the last few years, India has experienced high inflation due to cost-push (e.g. raw materials and food) and demand-pull (rising middle class) factors. However, inflation has been stable in India since April 2009. As seen in the chart below, inflation in India has really gone through two long periods in India: First, from ’03 to ’07 – where it averaged 6%, and then from ’09 to the current day, where it averaged 9% (2008 was really an anomaly – when the world was awash with liquidity and the world was trying to effectively factor in new surging demand from India and China).

So, although there is a popular notion that inflation in India has recently increased – this is actually incorrect. In fact, not only has the trajectory of inflation remained constant since 2009, The latest reading of the annual growth of inflation is 9.2% - the slightly lower than the two year average.

Although the headline inflation in India is at a low ebb, the markets still did not like the April inflation report in India. As seen in the next chart, the March readings were very encouraging – with 3 of the six inflation components sharply down MoM, and two being flat. This lead to some speculation that India may have “turned the corner” on inflation. And indeed, it was evident that the government’s program to reduce food speculation and mark-ups were working. However, the April data was ugly – the six key components of WPI inflation were all up more than 1%. This data dashed the optimism many investors had, and it resulted in the Index giving up the 7% rally it enjoyed from the previous month. Our view, however, is that government made such a large public push in March to reduce inflation, that a lot of the March price increases were pushed forward from March to April. Thus, the same trend remains intact – it is just that the March number was artificially low, and the April readings were artificially high. In May, the inflation numbers were back to regular monthly growth levels.

We are convinced that inflation in India will continue on roughly the same trajectory that it has been on for last two years – roughly 9% per annum growth. This is simply an unfortunate mainly borne from the fact as India’s middle class is becoming an economic powerhouse, which is causing demand to grow faster than supply and affecting all of the sub-categories of inflation.

Although inflation should remain elevated, we are remain upbeat on the potential for corporate earnings growth. Corporate growth is already growing well in an inflationary market: last year the NIFTY posted a 26% rise in EPS, and this coming year it is projected to be 18%. FY13 growth is currently pegged at 18% as well by analysts, which we believe is reasonable. The same storyline can be told of GDP. Since 2008 GDP (in constant 2004 prices) has grown: 6.1%, then 7.3%, and 8.2% last year. Next year consensus expectations are 7.5%. Since India has battled consistent inflation since 2009, we believe that the track record is clear: that country and corporate growth can persist despite inflationary pressures.

Authorities in India closely watch food inflation. This is probably the most important sub-category because the effects of food inflation are regressive and if food inflation was to get out of hand, the response could be overwhelming. There are many encouraging aspects of food inflation. First, the government has taken many steps to address structural issues related to food inflation: breaking up cartels, discouraging hoarding, funding a storage network, and ensuring retail providers to not mark-up food items exorbitantly. Second, it is encouraging to see that food inflation is at its lowest level in almost two years and it is now below 9%. This not only reduces overall inflationary pressures, but also reduces the risk of the government bringing up food affordability in the rates discussion.

Although food inflation has a small weight in the WPI inflation Index (15%), the potential for food inflation to surge and induce a policy response is still present. The key issue with food inflation is that there is low farm productivity, no increase in farmable lands, increasing dietary patterns, poor storage, and higher global food price. Moreover, India still has very restrictive laws on combining farm plots and increasing yields through scale.

As a result of these issues, per capita agricultural production in India has remained abysmally. As seen in the chart below, although GDP per capita has surged, per capita production of foodgrains, oilseeds and sugarcane have remained stagnant. It is clear that more structural reforms are needed, and it is a good sign that this process has started.

With high consumption and rising commodities, salaries and input costs, the general impression is that inflation in manufacturing is strong. However, inflation here is manageable. As seen in the previous chart, this sub-category has experienced 5-6% YoY growth in inflation over the last two years with little volatility.

It is important to note that inflation in India is largely the byproduct of a much larger fundamental issue: that 400m people in India are moving into the middle class, which dramatically increases consumption. This tectonic event is going to continue to be the base driver of the Indian economy, which should provide stable growth for years ahead.

In India, consumption contributes 2/3rd to the GDP. Over the last decade it has been very resilient and has grown consistently by 6.5%. Private consumption is almost 50% of the economy and has been rising due to the increasing income levels of industrial and rural workers, increasing jobs, penetration of the consumer goods, and the higher leverage of the consumer. These factor do not look to change anytime soon.

Many investors believe that inflationary expectations have sharply jumped in India this year. This is not exactly true. Consensus estimates for inflation have always been 8%-9%. However, at the beginning of the financial year, the Reserve Bank of India (RBI) projected an average inflation 5.5% for FY11 - and has since adjusted this to 9.1%. It is clear that the RBI expected India to return to the pre-2008 levels of inflation. However, the private sector never shared the RBI’s optimism. We are honestly not sure what gave the RBI such confidence, given that input costs and wages all remain high.

Inflation during the first half of the 2011 was dominated by food price rise and during second half it became more generalized with both sticky food prices and manufactured non-food inflation kept the headline numbers elevated. More recently, inflation has been led by non-food manufacturing prices and rising fuel prices. This consistent stickiness of the inflation has really perturbed the central bank. Even though during early 2010 RBI policy stance was to keep the monetary policy in an accommodative mode but during second half it started calibrated exit from the policy accommodation. However, the stubbornly elevated level of inflation has forced RBI to change the monetary policy stance in 2011 towards inflation fighting.

This dramatic miscalculation on inflation has raised question marks on RBI’s credibility. Further, given this miscalculation, many foreign investors are under the impression that either inflation is dramatically worsening. However, as we have mentioned earlier, inflation over the last 2 years has remained very stable, although elevated.

We think with recent 50bps Repo rate hike (Repo rate: RBI’s key policy rate or lending rate) and thus raising rates by 300bps from the level of 5.25% in early 2010 to the current level of 8.5%,shows that RBI is taking adequate steps but is not done with the monetary tightening. We believe that the RBI will be raising rates by a further 25bp in the next 3-4 months before letting rates plateau.

Throughout Asia, India stands alone in being close to the end of their rate rise cycle. This fact is important as consensus estimates has India raising rates one or two more times over the next three months, before ending the rate rise cycle. As a result, India will look like a relatively attractive equity market in Asia by the end of the 3Q as India should be done with their rate rise – which should be broadly positive for the equity market.

We argues that inflation has actually been relatively stable over the last two years – in which time India has posted strong GDP and corporate growth. With solid growth numbers expected, the market depressed, and policy tightening coming to an end, the outlook for equities has never been better.

We continue to favour small cap companies in order to gain exposure to the growth potential in the Indian market. Over the last ten years, we have found that small cap companies (between USD100m and USD1.5bn) have outperformed the NIFTY (large cap) Index by over 30% per annum. With interest in India increasing as rate tightening comes to an end, we expect that small cap companies will continue their historical outperformance.

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