Last Friday, a day before the election results were announced, Bloomberg reported that the hedge fund managed by HSBC Holdings Plc. asset manager Sanjiv Duggal had reduced its net India exposure to zero because of “uncertainty over election results”. Now that the elections have not only removed that uncertainty, but have also replaced it with a hugely positive surprise, investors who had withdrawn from India are likely to scramble to get back in. That’s why everybody expects the markets to open with a big upward gap on Monday.
This initial tidal wave will lift all boats. But the question is: Will it lead to a re-rating of the Indian market? There’s every reason why it should. That’s because investment into the Indian market has been hobbled by the government’s lack of headroom on the fiscal front. Equity strategists and economists have for long compared India unfavourably with China in this respect. As HSBC economist Robert Prior-Wandesforde writes in his recent research note with the telling title of “New Government, Old Problems”, “An expansionary budget in June would prove counter productive by preventing the RBI (Reserve Bank of India) from cutting and risking a sovereign credit downgrade. The challenge for the government will be to cut the structural deficit, without reducing the capital/infrastructure spending share in GDP (gross domestic product).” But with the absence of the Left, that constraint may ease a bit, since disinvestment of public sector units and incentives for investment can now be back on the agenda, while the auction of 3G (third generation) spectrum will also bring in money. The stability of the government will allow it to concentrate on structural reforms. In short, the risk-reward outcome for the Indian market has improved considerably.
Also See Rapid Rise (Graphics)
But hasn’t the market already gone up too fast? The Sensex’s trailing price-earnings (P-E) multiple is back to 16.5, up from less than 12 times in November. It’s almost back to the P-E levels prevailing last September, before Lehman Brothers Holdings Inc.’s collapse roiled global markets. Contrary to popular perception, the Indian market has already been outperforming most others. The MSCI Index for India has done better than the MSCI Emerging Markets Asia Index both in the last three months and year to date. What’s more, it has also done better than the MSCI China Index. In fact, investors had become strongly overweight on India last month, as the Merrill Lynch and Co. survey of global fund managers indicated. Among global emerging market investors, China was the most overweight in April, followed by Turkey and India. The survey said that “rotation towards markets sensitive to currency, rates and risk such as India, Turkey was observed in April, following news of G-7 (Group of Seven) quantitative easing and IMF (International Monetary Fund) funding”. Normally, these factors would point to tepid performance in the future, but it’s very likely that the election results will extend the rally. Also, according to Citigroup Inc.’s estimates, as on 8 May, the 2009 forward P-E multiple of the Indian market was 14.1, against an Asian emerging market prospective P-E of 16.4, which means that India is relatively not very expensive.
True, many questions still remain, such as whether the Congress party will indeed implement structural reforms or prefer to concentrate on measures such as the rural employment guarantee scheme, whether a new dose of stimulus will be applied as the effect of the earlier one wanes, and whether the improvement in the Indian and the global economy is the result of re-stocking inventory levels. Some of the answers will be provided in the Union budget, but until then hope, riding on a surge of liquidity, is likely to push the markets higher.
How should the rally be played? Tim Rocks and Daniel McCormack of Macquarie Securities, writing of the Asian region as a whole, believe the rally is being “driven by an inventory restocking phase that will be positive for a broad range of cyclical sectors in Asia”. CLSA’s Christopher Wood has written that Asian real estate is likely to do well out of the current asset reflation. A study by Enam Securities Ltd recommends a host of “buys” in the event of a stable government, in sectors ranging from banks to real estate to power, metals and consumer goods. Their sells: the top information technology (IT) firms, a few pharma companies and some highly indebted firms. Anagram Research recommends public sector units, infrastructure, power firms and banks. The markets will probably continue to rally in the cyclicals, with defensives such as pharmaceuticals and home and personal care products, and sectors linked to external demand such as IT taking a back seat.
Will this attempt at decoupling, too, end in tears, such as the earlier one in 2007? The current spurt of liquidity that’s spilling over into risky assets is the result of money supply growth by central banks at a time when the need for credit in the real economy is lower. Will the expansion in money supply be enough to offset the contraction in global leverage as a result of the crisis, and will the current green shoots in the economy grow? It’s also not very comforting that markets such as Russia have done so well and some have said the rally has led to a “dash for trash”. But those are questions for the future. In the short run, as CLSA’s Wood points out, “The practical point is that caution drains away the more stocks rise and the more attention focuses on cash burning a hole in the pocket given the lack of return on that cash. Indeed, the new carry trade for speculators is to borrow cheap dollars and buy emerging market bonds and equities.”
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Graphics by Sandeep Bhatnagar / Mint