2011 was India’s ‘annus horribilis’, topping the charts of the world’s worst performers, losing over a third in dollar terms and delivering the country’s second worst equity market performance in history. I think most of us recognize the reasons why, though too many government officials still blame ‘Europe’, when most of India’s current problems are in fact self-inflicted (you don’t get the prize for the worst performing major market and currency simply due to ‘external factors’).

That means they are technically within India’s control to resolve: indeed, the steps taken to resolve the multitude of issues will be the key to the outcome for markets in 2012. Come January and the truck load of year ahead predictions lands on your desk. Rather ironically, however bearish the tone, they all seem to plump for a year end Sensex target of around 18,000. Tempting though it is at this time of year to make bold predictions for the year ahead, we think it is too early.

Forecasting is inherently difficult as it is, but with ‘ceteris paribus’ seemingly a dead concept it is particularly futile right now. The fact is that the outlook remains extremely foggy and the biggest single factor will be political decisions that have not yet been taken, and are hard to predict. 2011 was an extraordinary year in many ways, but particularly in the influence of politics on financial markets – whether the Euroquake, Arab Spring, divisive US party politics impairing its credit rating, or indeed India’s political cacophony. Systemic concerns, politics and policy announcements drove financial markets more than corporate fundamentals last year. In large part this explains why the majority of active funds across the world underperformed in 2011: it is easier and we are better at predicting corporate earnings than political outcomes.

Unfortunately it looks unlikely that early 2012 will be a return to normal, with any shift back to focus on economic and corporate fundamentals. Certainly that looks unlikely in India ahead of important state elections and the budget in March. Until there is greater clarity on the political environment and policy initiatives in the Union budget, we think investors are better off taking a wait and see stance, and remaining relatively cautious and defensively positioned.

But what about the new rate cycle?

The big plus this year is likely to be the turn in the monetary policy cycle, with the RBI’s policy priority gradually shifting from controlling inflation to ensuring a stabilization and then recovery in growth. There has been growing certainty over the last fortnight on where we are in the monetary policy cycle. Inflation is starting to fall, given the high base effect and falls in food inflation. Recent rhetoric from the RBI reflects that rate hikes are over and assigns almost a 100% probability on its next move being an interest rate cut.

We think that the uncertainty on ‘core’ inflation in the face of worsening deficit indicators and INR depreciation, as well as the RBI’s desire to be very careful about inflationary expectations, means uncertainty in the exact timing of a rate cut, though we expect the first Repo rate cut in Q1 FY13, with the April meeting being our best guess. We expect a CRR cut in January 2012 as increased government borrowing, election related spending and RBI intervention (USD selling) negatively impact domestic INR liquidity.

We also expect the RBI to lower its GDP growth target for FY12 from 7.6% YoY currently to about 7.2% YoY in the third quarter review meeting in January 2012. Its inflation projection of 7% YoY in March 2012 is likely to remain unchanged. The rate cut cycle this time is unlikely to be as aggressive as in 2008. Back then, the entire rate cut cycle was short in duration – merely six months – and heavy on quantum - with an initial 100 bps cut in the Repo rate and cumulative cuts of 425 bps. That was in response to a sudden and highly uncertain global crisis. The backdrop this time is serious, but very different; a structurally challenged though better understood developed world scenario, but combined with a more difficult domestic scenario.

In the absence of a systemic crisis caused by a tail event in Europe, we think a better parallel for assessing the impact might be the rate cut cycle of 2001-2004, which was far more gradual –extended over three years - and less aggressive – with cumulative cuts of 400 bps in the Repo rate. In that cycle, from an average of 7% in the one year before the rate cuts began, WPI inflation slipped to an average of 3.7% in the two years following the first rate cut, with manufacturing inflation slipping from 3% YoY to 2.2% in the corresponding periods. To the extent that it is driven by structural factors in the current highinflation scenario, it is unlikely that inflation will moderate in a hurry in FY13 as it did in the 2001-2004 rate cut cycle.

We expect WPI inflation to average 7.2% in FY13. So with this combination of persistent domestic structural inflationary factors, a stubbornly high oil price and twin deficit concerns meaning a weak Rupee, it is hard to see the RBI doing a sudden volte face and aggressively easing. In terms of the impact on investment, our analysis suggests that real investment growth started picking up only after the rate cut cycle was over i.e. around March 2004, and moved above trend only in 2004-05. The investment growth slowdown is expected to be prolonged this time as well. Though the trends in fixed investment growth so far are not necessarily more worrisome than in 2001-2004, it’ll likely be more difficult for corporates to finance investment both externally and domestically, even after the RBI embarks on the rate cut cycle, given:

 1) high government market borrowings (up by INR 930bn over and above the budget for FY12), which will likely crowd out already shallow bank credit growth;

2) risk version limiting availability of global liquidity and

3) policy and political uncertainty negatively impacting foreign investment into India. Also, the critical investment led growth can only recover when domestic and foreign investors not only see reforms and investment-friendly policies and initiatives, but also regain confidence in the government’s ability to implement them. That won’t happen overnight.

Lastly, in terms of the impact of rate cuts on the markets, there’s no historical evidence, from the 2001-2004 or 2008-2009 rate cut cycles, to suggest that the markets will be in a hurry to recover ahead of, or early in the rate cut cycle. In the 2001-2004 cycle, the Nifty remained rangebound for most of the period of rate cuts, recovered marginally in the last phase, to then recover significantly only once the rate cuts were over and the RBI went into a pause mode. The RBI paused after March 2004 and the Nifty returned 15% in the year that followed and 92% by March 2006.

Things were entirely different in the 2008-2009 cut cycle, when the equity market continued to collapse for the entire duration of aggressive rate cuts and recovered only after the RBI had paused.

The huge rebound of 65% over the following year was to a great extent about a recovery in confidence following a period of unprecedented global uncertainty.

What implications does this have for market behaviour this time? History doesn’t give any real precedent to assume that the market will be in any hurry to lift itself with a turnaround in the rate cycle. History is only ever a guide and clearly the backdrop of rate cuts is different this time, but we suspect the turn in the rate cycle alone is not in itself enough of an inflection point, and it is still too early to switch to an aggressive recovery stance. There are three things to look for clarity on first:

1) a bottoming out of the earnings downgrade cycle;

 2) the Eurozone crisis and, most importantly,

3) India’s state elections, budget and ensuing policy initiatives.

1) The earnings cycle: when will it bottom out?

Macro predictions for India are now mostly fairly pessimistic and this has gradually filtered down to bottom-up earnings estimates, though we don’t think it has gone far enough and the divergence in consensus expectations is now very wide.

The consensus expectation for FY13 earnings growth is ~15%, but this masks a range from 0% to high teens. We expect the Q3 FY12 results season, which kicks off this week, to be a difficult one, resulting in FY13 earnings being pared back several percentage points. The driver of downgrades over the past two quarters has been raw material input and interest cost inflation both squeezing margins, and whilst these have peaked, there is now weakness in previously robust revenue growth. So we expect the earnings downgrade cycle to continue throughout calendar Q1.

2) Eurozone: no silver bullet, but at least a wave of liquidity

A Eurozone recession in 2012 seems a near certainty given the fiscal drag, collapse in business and consumer confidence and lending slowdown in the face of banking system de-leveraging. No doubt we’re in for a few surprises, but at least some progress has been made, notably in the ECB’s extraordinary liquidity measures (€490bn), easing pressure on Europe’s banking system and buying time for politicians to deliver longer-term solutions. But Q1 is likely to remain a dicey period in Europe, given €14.4bn of Greek debt matures on 20th March, a busy schedule of sovereign debt auctions, the need for Eurozone governments to ratify the December agreements on greater fiscal unity and, critically, visibility on progress towards European banks meeting the European Banking Association’s core tier 1 capital requirement of 9% by June 2012. Europe won’t be the primary driver for India, but given its potential impact on sentiment, and the importance of the European banks to Indian corporate borrowing, all these events in Q1 strengthen our belief that caution is the right approach for now.

3) India’s state elections, budget and ensuing policy initiatives

But the biggest driver of our caution in calendar Q1 is the uncertainty caused by a busy state election calendar, especially in Uttar Pradesh (UP), and then the announcement of the budget just after the election results in March.

Policy paralysis is likely to persist in the run up to elections, and there is also risk of populist election friendly measures, whilst the ensuing budget will be a critical one in terms of signaling a return to a reform agenda, but also steps towards fiscal consolidation, some of which could be negative for corporate earnings, such as a hike in corporate tax rates to raise revenues.

2012 begins elections in five states in Q1, then there is a gap before ending with Gujarat’s polls in Nov-Dec 2012. The UP election is the key one and may materially impact the composition of central government and therefore ensuing policy trends and reforms over the remaining two years of UPA rule. Given volatile and unreliable allies like DMK and TMC, a more stable partner like SP with its 23 MPs could boost confidence and help pave the way for reforms. We see three possible scenarios:

a) SP + Congress:

This is the best result for the central government as SP can support and form part of the government, potentially helping it get rid of TMC.

b) BSP + Congress or BSP alone:

Not too bad for the central government since they have been supporting the  government in the past. They also helped the government in the Lok Sabha during current winter session.

c) BJP:

This would be the most destabilizing result and could also lead to complete policy paralysis or even early general elections.

But what about valuations, don’t they discount all our caution?

After a c.26% fall in 2011 India has at least moved from the most overvalued club at the start of the year, to being ‘sensibly’ valued now. A headline valuation of ~13x forward earnings it is below historic averages, yet still at a premium to the emerging market average. And frankly most markets are now trading below historic averages, and given the foggy outlook and trauma that investors have suffered over the past three years, such a situation may well persist. India is not at the c.10x levels seen in previous troughs, and given the uncertainties we’ve raised above, ‘sensible’ valuations aren’t compelling enough.

The valuation argument does become more compelling when one looks beyond market level multiples to different sectors, as well as mid/small cap vs. large cap. One of the features of 2011 was a flight to

1) defensives, particularly Consumer Staples;

2) to ‘quality’ and away from any governance risk and

3) a big move up the liquidity curve away from mid and small caps. This caused a massive divergence of performance between sectors, and between large vs. mid/small caps. So whilst Consumer Staples is trading at a 14% premium to its historic average, Industrials and Financials are at an >40% discount. This suggests that in the months ahead there may well be compelling opportunities to become more aggressive in some of the mid caps and in beaten down sectors, such as Industrials and Capital Goods, so investors should keep a close eye on project approvals.


(Nick Paulson Ellis is the country head, India, Espirito Santo Securities.)

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