Caught between a rock and a hard place

Here’s a piece of information that will leave you scratching your head. Foreign institutional investors have pumped in a record ₹1.4 lakh crore into Indian equities in FY13 — the highest-ever net inflow in a fiscal year since their entry in 1992. That’s enough to make any rational investor on the Street wonder, “What are these guys seeing that we aren’t?” Except for political banter, the lame-duck UPA 2 government hasn’t engaged in any meaningful reforms to warrant such confidence. The FY14 Union Budget was a non-event; the first year of the 12th Five-Year Plan is already history without the economy making any headway; and, despite the records flows, the market dished out an insipid 8% return in FY13 as domestic investors continued to rush to the nearest exit.

Against such a backdrop and with domestic sentiment at its nadir, it wasn’t exactly a full house at the FY14 forecast event of the Indian Association of Investment Professionals (IAIP), a member society of the CFA, held at the Bombay Stock Exchange on April 2. This time the panelists for the annual ritual, which is in its fifth year, featured Neelkanth Mishra, director, India equity strategy, Credit Suisse; Nilesh Shah, president, Axis Capital; Prasun Gajri, chief investment officer, HDFC Standard Life Insurance; and Sajjid Chinoy, India economist, JP Morgan.

The opening remarks by Sunil Singhania, president of IAIP and head of equity at the country’s second-largest mutual fund house, Reliance MF, set the tone for the evening — sombre and pessimistic. “Last year was a challenging period for the Indian economy, which deterred domestic investors from equities. The poor performance of real estate and gold has now raised the question — what’s next?”  

It’s the economy, stupid

Putting into context last year’s market performance on the back of foreign institutional flows, Mishra of Credit Suisse expressed concern that, for all the optimism, the real economy had slowed down significantly with very little investment happening. Unlike between 2003 and 2007, when investment spending grew as much as 15%, since the 2008 crisis, it is consumption spending that has kept the economy ticking. In fact, industrial output in the fiscal gone by was practically zilch. But the bigger worry, according to Shah of Axis Bank, is that small and medium enterprises, which act as the economy’s backbone in providing employment and probably even encouraging exports, haven’t been reinvesting in their businesses.

He reasons, “It is not because they lack funds but they don’t have sufficient incentive to do so,” and any initiative to boost this industry will be a step towards recovery and encouraging more investment into businesses. Even in many other sectors, it has become increasingly difficult to set up projects with rising costs and policy delays and so, instead of investing in India, the big players of Indian markets are investing abroad. Lest you forget, it was Kumar Mangalam Birla who recently criticised the government by stating that the risk for India was pretty elevated and chances were that for deployment of capital one would look at asset overseas rather than in India.

However, Chinoy of JP Morgan feels that austerity and GDP expansion cannot happen at the same time. The government was running a high fiscal deficit even during the crisis period, when ideally it should have tightened its belt in preparation for tough times ahead. “The price of these past excesses is being paid today as the government has been forced to embark on major austerity measures such as deep cuts in planned expenditures to contain the fiscal deficit,” he adds.

Highlighting the risk of a recovery in demand, Chinoy felt any demand pick-up without enough supply in the market could fuel an increase in inflation. Though the Reserve Bank of India (RBI) has cut the policy rate twice in the recent past, it has warned of limited scope for further easing, given that headline and food inflation are
already high. 

Unless the central bank obliges the powers that be, since this will be the final year before we head for general elections in May 2014 (if not earlier), the repo rate will be pretty much around 7.5% right through the year.

On the whole, the panelists seemed to be pinning their hopes on government action to kick in. While Mishra felt policy clarity at the central level could be beneficial for boosting investments, Shah was of the view that the over-₹97,000 crore government spending in the coming fiscal would have a positive impact on the overall economy.

Echoing his co-panelist’s view, Chinoy felt that even if the central bank did cut rates by another 50 basis points, it wouldn’t make as much difference as the passing of important bills and reform measures would end up doing. But the very fact that he expected GDP growth to be around 5.75-5.8% and current account deficit at 4.5% of GDP was ample indication that the economist wasn’t exactly expecting miracles to happen. 

What it means for equities

Interestingly, though, the panelists struck a cautious note on the outlook for FY14. Just before the panel discussion, Jayesh Gandhi, director, IAIP, and fund manager at Morgan Stanley, had highlighted findings of the recently-concluded Annual Forecast Survey for FY14. Surprisingly, more than 43% of the respondents expected equities to give the best returns in FY14, followed by fixed income at 23%, whereas only 7% believed that gold would be the best asset class. With the markets already down 14% year-till-date and with the results for Q4FY13 not expected to look pretty, no one wanted to hazard a guess on where the market was headed. The lone positive voice was that of Mishra, who believed the Sensex would end next year at a level of 21,500.

Among sectors that were expected to do well, Shah of Axis felt that in the run-up to the elections the government will, as usual, focus on the power industry. So, aligning with power-related companies will be beneficial as, “Super returns can be expected in some stocks”. How many investors would actually buy into Shah’s views is anybody’s guess, given the drubbing that power stocks have taken in the recent past.

It seemed that Mishra wasn’t on the same page as Shah. The India strategist felt that infrastructure stocks, including that of power, were still ripe for more correction as the ground reality was far from rosy. “Over the next five years, I don’t expect order books to start growing. Against such a backdrop, I believe consensus estimates of only 5% decline in earnings over the next fiscal is ridiculously optimistic,” he pointed out.

In FY13, it was quality large cap stocks that were in focus. But Shah chose to question the rationale. “Quality stocks are still in the bull market while the so-called ‘non-quality’ stocks are still at the bottom of the bear market.” For instance, over the past five years, TCS has gone by almost three times, while some others in the markets have gone down by about 80%. “Even if these quality stocks do not witness an inherent price correction, they are likely to go through value and time corrections and thus would underperform the markets,” he felt. 

Gajri of HDFC Standard Life, however, was of the opinion that the trend of investing in quality stocks will continue in the near future as, “It is up to the investor whether he is investing for a period of six months or over three to five years. Other than that, quality versus non-quality is not a major issue.” Also, the fact that many quality stocks with sound cashflows and well-structured balance sheets are available at reasonable valuations will keep the momentum going.

While the investment cycle has clearly slowed down, Mishra firmly believes that the future looks bright. Having travelled the hinterland of India, he was of the view that on the ground, rural India has changed for the better. Thus, he felt stocks focused on servicing the bottom of the pyramid could turn out to be quality, multi-year bets. 

The verdict

With apologies to Karl Marx, hope (rather than religion) is the opium of the masses, and such was the case with the panelists as well. The consensus was that the economy would recover but it would be a long drawn-out process. “We need to separate bottoming out and the beginning of acceleration,” pointed out Chinoy, adding that, “We have to go through this painful readjustment for some more quarters.” According to Gajri, more than domestic, global macros could play an important role in deciding what happens next. “What if inflows suddenly stop? How will that affect the currency or the markets? That whipsaw can be very troubling.” Concurring with him was Chinoy, who expressed concern that the current account deficit (CAD) was being funded through hot money [portfolio investments (FII), ECBs, and NRI deposits], which will put pressure on the rupee again when the repatriation of this money along with the profits/interest begins. “This is not India-dedicated flows, it is pre-allocated,” pointed out Chinoy. In other words, investors could pull out money in the blink of an eye. 

However, Mishra felt that the easy money policy adopted by global central banks will continue to push flows into developing markets such as India. And given that many active India-dedicated fund managers are still underweight on India, the opportunity on the upside was still higher. “We can do a lot of grave digging — whether 15x or 14x valuation is good enough. But expect 5-7%, perhaps 10%, increase in multiples because globally, asset allocators are going to move into equities over the next several years. Also, given that bonds back in the US are offering less than 2% yield-to-maturity, the shift to equities will happen sooner than later,” opined Mishra. 

While the view is that extreme pessimism is already priced in the markets and, hence, macros and earnings could surprise on the positive side, Shah felt that one could still end up seeing high yielding debt investments outperforming equities on a risk-adjusted basis. “And with already low expectations, this is as good as it can get,” he summed up.