Mumbai: Some foreign institutional investors, or FIIs, the largest investor class in the Indian market, could start reallocating capital here as they bet on further meltdown in crude oil prices, even as several equity strategists at large global brokerages appear to be reaching a consensus on the merits of such bets.
The logic: strong inverse correlation between Indian equities and global crude oil price is making India a good bet against falling crude oil and other commodity prices, say some of these analysts.
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India is largely seen as an “oil put” and “it will go up if the oil goes down”, said Merrill Lynch’s Asia equity strategist Mark Mathews in his regional investment strategy report on Thursday. There is a general belief among global institutional investor community “that the commodity cycle is rolling over”, wrote Mathews.
Indeed, between mid-February and mid-July, when the price of crude oil shot up at least 50%, from $96 a barrel to a record $147, India was among the worst performers across the emerging markets, slumping 30%.
Since mid-July, India’s bellwether equity index, the Sensex, has gained at least 20% from the 12,500 levels, as the price of crude oil and the entire commodity complex witnessed a more than 20% correction. This inverse correlation was witnessed once again in mid-August, as crude oil prices started rising. The Sensex lost at least 8%, losing in six of the eight trading sessions between 12 August and 21 August, as the price of crude oil, which had dropped to a low of $112 mid-August, rose above $120 a barrel.
On Friday’s trading on the Bombay Stock Exchange, the Sensex gained at least 1% to 14,401.49, while crude oil prices softened to around $114 on the New York Mercantile Exchange, or Nymex.
CONTRARY POSITION (Graphic)
CLSA Asia Pacific’s equity strategist Christopher Wood is advising clients to raise India’s weightage in the Asian portfolio by 3%, with money taken out from China, Korea and Taiwan.
In a Friday report, dubbed Greed and Fear, Wood wrote that the meltdown in global commodity complex is “a major positive for India”.
Oil and commodities are correcting because of slowing global growth.
According to Wood, the Indian economy, much less driven by external factors than most emerging market economies, “remains the best long term story in Asian equities, both from a top-down and bottom-up perspective”.
The new, slightly more bullish outlook on India is emerging even as many FIIs perceive Indian stocks as being relatively expensive, especially in a high interest rate environment. “The increased bet on India is not dramatic because the Indian equity story is not yet completely straightforward in a bullish sense. The risk of further monetary tightening cannot be ruled out,” noted Wood. Still, he said he is convinced that inflationary pressure will collapse in India in the coming months.
The wholesale price-based inflation in India is now at 12.63% and economists are expecting this to cross 13% in coming weeks. Since the beginning of this fiscal year, the Reserve Bank of India, or RBI, has raised its policy rate by 125 basis points and banks’ cash reserve ratio (CRR), or the money that commercial banks are required to keep with the central bank, by 150 basis points to make money dearer. One basis point is one-hundredth of a percentage point.
It may be too early to cheer, as the correction in the commodity prices will take time to reflect in inflation, said some analysts.
“The follow-through of the decline in commodity prices may take some time to manifest itself in lower inflation as domestic steel prices are 20% below international prices and unregulated petroleum products have just 1.55% weight in wholesale price index, while regulated petroleum products have 5.43%,” said analysts Nemkumar, who goes by one name, and Ashutosh Datar of India Infoline Ltd, a large institutional equities brokerage in India in terms of volume.
A Lehman Brothers’ Asia economic report on 22 August noted that peak pressure on inflation has passed in India but slowing global demand and policy tightening are set to weaken growth this year. “Despite these challenges, we are structurally bullish on India’s long-run growth,” the report said.
Stuart Smythe, head of equity at Macquarie Securities (India) Pvt. Ltd, too, said Indian economic growth could be around 7%, well below the estimates of the Indian central bank, but according to him, India’s internal consumption-led growth will remain strong even as fears of demand destruction and drastic global economic slowdown persist.
India’s long-term growth picture and the economy’s relatively high resilience are again being cited by some analysts amid mounting bets on declines in commodity prices.
High inflation, fuelled by the commodity price boom, was perceived to be the highest risk on India’s economy and growth of local companies. However, after a steep correction in commodity prices, most analysts now see the case of oil prices shooting to $200, predicted by at least one large US investment bank, as unreal.
“The crude oil saga of $10 to $145 has been nothing but a giant attempt by the intelligentsia to put logic…any logic…in order to justify this 15-fold rise in the price of crude oil,” noted a mid-August report by Devina Mehra, chief strategist of First Global Securities Ltd, which runs brokerage services in Indian, US and UK markets. First Global estimates oil prices at around $50 a barrel in the next 12-18 months.
Indian equities have emerged as an interesting hedge against the price movements in crude oil because of their inverse correlation with the commodity complex, according to analysts. This, in turn, has forced a change in hedge funds’ perception on Indian equities, going from an expensive market to a strong bet against oil prices.
Until mid-July 2008, the popular strategy of hedge funds playing emerging markets was to go long on Brazil and Russia and to short India and China, to play the sharp rise in the price of crude oil, the indisputable leader in the commodity complex.
The fortunes on equity investments in Brazil and Russia. have strong linkages to the global commodity cycle, as many of their publicly-traded companies do business on commodities.
Both India and China underperformed Russia and Brazil by 39% between October 2007 and June 2008.
However, with the steep fall in crude oil prices since mid-July, the popular strategy of hedge funds changed to long China and short India. This was mainly because of the difference in current account balances in these two countries and the high inflation worries in India.
This bet went wrong because of the oil price equation. Indian markets gained sharply since mid-July, while Chinese stocks continued to fall.
As a result, “the past months have been very difficult for many Asian hedge funds,” according to the Merrill report.
Institutional brokers in India now believe that the market could attract a good amount of hedge fund money in the short term as these multi asset class investors reallocate capital purely to bet against the commodity complex.
Also, brokers feel that some of the capital flowing out of Russia, in the wake of the Georgia conflict, could find its way to India, especially that of Bric-focused funds.
Hedge funds mostly take exposure to Indian markets through index futures traded in overseas markets as well as exchange traded notes, or ETNs, with returns linked to Indian index. While few hedge funds are registered as FIIs, some others are clients on the participatory note or offshore derivative accounts of foreign brokerages operating in India.
The Barclays Bank Plc. iPath ETNs, linked to the MSCI India Total Return Index, popular among foreign investors, have gained some 18.9% in the past one month even though they are down 37.6% year-to-date.
Brokerage Enam Securities Pvt. Ltd points out that FIIs net sold some $4 billion worth of Indian stocks in the April-June quarter when crude prices went up sharply. Since January, FIIs have taken out some $7 billion from the Indian equity market after bringing in $17.36 billion in 2007. If oil prices continue to fall, one can expect the trend to reverse.