MARKET COMMENTARY

Cautious Movement

Equity markets worldwide continued their upward trend in February driven by buoyant economic data from U.S. and renewed hopes of a workable solution to Euro Zone Crisis. Indian Markets too kept up their pace with the global rally for most part of the month but gave up some gains during the last week on concerns over soaring crude price and its effect on the domestic economy. On the whole, the benchmark Sensex moved up by 3.25% during the month and closed at 17753 points. MSCI India recorded a gain of 4.78% as against MSCI EM’s rise of 5.89%. The mid and small cap indices continued their outperformance over the large caps by moving up 8.8% and 6.1% respectively. FIIs emphatically displayed their current risk appetite and liquidity by buying equities worth USD 5.12bn in February, their fourth highest monthly net-inflow since their entry into India. Meanwhile, domestic mutual funds continued to be aggressive net sellers in the equity segment taking out about USD 421 mn.

ECONOMY

LTRO 2 - Harbinger of hope and liquidity
Global markets have seen a resounding rally since ECB’s first liquidity injection of EUR489bn during Dec 2011, somewhat similar to QE1 driven emerging markets rally in late 2010. However, market performance during QE2 phase was subdued. It remains to be seen how the second phase of ECB’s Long-Term Refinancing Option (LTRO) program involving 530 billion euros (higher than expectations) announced during end of February impacts the global risk assets going forward this year besides the real economy of EU in the mid-term. The Greek package – Voluntary Private Sector Initiative (PSI), second bailout package and extended fiscal austerity – that has been agreed recently has cut down the risks of immediate default and disorderly exit from European Union. However, the upcoming elections in Greece and France besides a range of important countries like USA, China, Russia and Egypt could magnify policy uncertainties in respective regions with corresponding global effects. In the Indian context, FII inflows would be a key derivative of global risk appetite and liquidity funnel. Meanwhile, Oil prices have been creeping up, partly on recovery hopes but also reflecting political tensions in Iran and Middle East. The Brent prices have so far not broken out of the USD 95- USD 125 per barrel range seen since early 2011. But, if Iran nuclear issue escalates and triggers a spike up to USD 150 per barrel then economies worldwide may again shift back to a mood of caution.

Q3FY12 Domestic GDP growth – Bottoming out

India’s Real GDP growth fell to a 3-year low of 6.1% yoy in Q3FY12 (against 6.9% in Q2FY12), slightly lower than consensus expectation of about 6.3%. The data clearly shows that economy is undergoing an industry led slowdown. Industrial growth remains weak at 2.6% yoy, primarily due to contraction in mining (3.2% yoy) and puny manufacturing activity (0.4% yoy). However, on the positive side, construction activity (including construction of roads, bridges, ports and housing) has shown healthy pickup (7.2% yoy), auguring well for investment activity. Despite healthy construction growth, investments – as seen from expenditure side of GDP – posted quiet weak growth (1.2% yoy) which possibly reflects dull capex activity in the economy. In recent years, the economic growth has been driven more by consumption than by investment. Continuous slow-down in investment activity will affect the consumption with lag, which is a worry.

Fig 1- GDP at a 3-year low                                                   

  Fig 2- Industrial activity to see improvement ahead 

Meanwhile, services sector continued to post healthy growth (8.9% yoy vs 9.3% last quarter), providing the much needed support to the economy. Continued resilience of the services sector could be due to the fact that majority of its sub-sectors such as trade, transport, government spending etc are largely immune to the adverse business cycle conditions, a phenomenon observed during 2008-09 downturn as well. Going into Q4FY12, industrial growth should improve, as suggested by pick up in manufacturing momentum in Nov-Dec period (refer fig-2), improvement in mining activity and jump in forward looking PMI data. Besides, base effect will also be supportive in Q4. Overall, we believe Q3 marks the bottom of the ongoing economic downturn, although pick up is likely to be very gradual. We expect GDP growth for FY12 to be about 6.9-7.0%.


Inflation and IIP review
January inflation came in at 6.55% as against 7.5% a month ago, marginally surprising on the down side. The decline was mainly on account of base effect in the primary articles side rather than any meaningful drop in prices. Core inflation (non-food manufactured products) dropped sharply to 6.68% from 7.7% in December. Considering the seasonality in the food prices segment (mainly vegetables) that is currently pulling down the inflation and hardening of crude oil prices, RBI may not cut rates in its review meeting on March 15. The central bank has also signaled that it will be difficult to contain inflation without a proper support from fiscal side. Hence, we expect that it would wait and review the fiscal proposals in the union budget to be presented on March 16 before starting to ease policy interest rates.

The Index of Industrial Production (IIP) grew 1.8% yoy during Dec 2011, considerably lower than the consensus estimate of 3.4%. While the monthly numbers seem weak, it could partly be due to the de-stocking effect post the stronger than expected growth in Nov 2011 (5.9% yoy vs 2.1%). Capital goods production continues to remain weak, confirming the slow-down in investment activity. Though the PMI in manufacturing indicates that the worst is over for IIP, it will take time to recover significantly considering the global and domestic headwinds.


MARKETS
Pausing for Breath

At the beginning of the year, it was widely expected that the Indian Markets would turn around gradually in 2012 with major upside expected towards the latter half. However, the remarkable change in global investor risk and liquidity climate combined with change in RBI policy stance has fast tracked the market rally much to the surprise of the domestic investors. While the large caps have risen about 15%, the mid and small caps have moved up about 24% with certain beaten down sectors and stocks even seeing a 100% increase. Considering the sharp rally in such a short span, we expect the markets to switch into review mode in the near-term with important domestic economic and political events like state election results, RBI policy review and FY2013 Union budget lined up in March. Also, the oil price movement and development in EU (Elections in Greece & France and the impact on bail-out package) would keep the markets cautious.

With the ruling party facing an election debacle in the key state of Uttar Pradesh, the penultimate budget to be presented by the current government in mid-March will be one of its last opportunities to do something constructive that will create a positive impact pan India. The finance minister has his task cut out in pruning the fiscal deficit by raising some indirect taxes, broaden the service tax net and simultaneously reduce the subsidy bill. This process is going to be extremely painful considering the current status of economy. High fiscal deficit leads to increased state borrowings for unproductive purposes thereby crowding out private sector fund needs for capex investments. Also, several key bills like the Lokpal Bill, the Food Securities Bill, the Companies Act Bill, GST (Amendment) Bill, Direct Tax Code and Mines and Minerals Regulation Bill that have been tabled a while ago have still not been able to obtain the parliamentary approval. With the state election results behind (and also unfavourable), markets would keep a close tab on how the congress government moves ahead with its long over-due reform process.

With GDP growth touching a 10 quarter low of 6.1% for the quarter ended December ’11, it is now widely acknowledged as a missed opportunity among the investment community largely reconciled to 6.5 to 7% growth. While investment trends remain lackluster, we hope that the recent announcement regarding ‘fast-tracking’ power and coal issues is not another false start. Despite good FII flows and consequent rally, it is difficult to confidently claim that this is a new bull market as it seems to have already factored in lot of expectations on improved governance and fiscal consolidation. Though capital flows can take markets higher in the immediate term, it is hard to imagine that the flows will off-set the problems on the current account side. Even if we assume that the worst phase of slower GDP growth is behind us, the earnings upgrade cycle is sometime away.

We believe in the secular long term growth potential of India’s consumption led economy, and reflect it in the way we build our portfolio. But we accept that we will be subjected time and again to the self-fulfilling inflation led interest rate cycle, and must bear its consequences upon Growth and Valuations. Our longing for better policy led measures to address the supply-side issues that lend inevitability to the inflation cycle, remains a hope today. Consequently, we accept the sub-optimal performance of India’s economy as the norm and focus upon the opportunities that arise from the volatility.

While the reversion to mean of mid and small cap valuations has commenced, there is still plenty of scope in this trade, and we expect small and midcaps to continue their out-performance over large caps. Sectorally, we continue to prefer financials and rate sensitive sectors in the expectation that RBI will cut rates soon. We expect Oil prices and currency risk to be led, in the near term, by the Iran situation. At this point, we are factoring in a prolonged negotiation between the world powers and Iran; not an all out war.

Extracts from Unifi's Monthly Newsletter

MARKET COMMENTARY

Springing Up

Global markets witnessed a remarkable bounce-back in January led by improved risk appetite and hopes of policy action driven growth momentum. Upbeat economic data from U.S and China lifted the sentiments worldwide and abetted equities to rally through the month. Copious FII inflows, shift in monetary policy stance and largely in-line domestic corporate results boosted the Indian markets performance further. The benchmark Sensex rose sharply by 11.2% during the month and closed at 17193 points. With about a 7% rise in rupee against the USD, MSCI India was among the best performers in Emerging Markets with a 20.8% rise. The mid and small cap indices outpaced the large caps by increasing 14.4% and 16.5% respectively. FIIs were aggressive net-buyers of about USD 2.03bn worth of stocks whereas domestic funds were on the selling side taking out USD 371.62 mn.

ECONOMY

Liquidity revives Sentiments; Can they ensure growth?

European Central Bank’s gargantuan refinancing effort (nearly half trillion Euros credit line to European Banks against their illiquid securities) is far greater than all forecasts and could turn out to be a game changer for the regional crisis if the banks utilize the funds to re-build their capital and core lending business instead of buying bonds. Further, the U.S Fed’s comments about maintaining interest rates at near zero levels until 2014 (earlier it was 2013) has minimized the possibility of liquidity crunch induced global slow-down. Meanwhile, IMF has reduced 2012 global growth forecasts to 3.3% from 4% citing increased downside risks – advanced economies to grow by 1.2% instead of 1.9% and emerging economies to grow by 5.4%. Given the revival in liquidity and sentiments, it will be interesting to wait and watch if the actual growth turns out to be better or not.

Domestic Macros – Upturn possibilities increase

The industrial production growth of November 2011 jumped to 5.9%, as against the street expectations of 2.1%, reversing the steep decline of 4.7% reported in October.  The sharp rebound was led by consumer goods that grew by 13.1%. Both the credit as well as deposit growth for December have accelerated to 17% levels. Headline WPI inflation for December eased sharply to 7.47% (a 2-year low) from 9.11% in November, reflecting both seasonal drop in food prices and favorable base effect. However manufactured inflation continued to remain sticky at elevated level of 7.41%, slightly lower than 7.7% recorded in November. We expect the headline inflation to trend below 7% in the coming months.

Figure 1-Industrial Production growth since Nov 2010         

                            

Figure 2 – Wholesale Price Inflation movement from March 2010 

Although the government is likely to overshoot its FY12 fiscal deficit targets, FY13 position could be a lot better with the emergence of two lifelines – 

1. The restitution of global risk appetite and liquidity would energize the proposed divestment of stakes in public sector companies, and 

2. The recent Supreme Court verdict cancelling the 2G licenses awarded in 2008 has thrown open the possibility of auctioning the restored spectrum at market driven ates (2010 3G auctions fetched USD 15 bn). 

Further, the steep 7% appreciation of Rupee against the dollar in January (highest monthly gain since 1980) and the continuing trend in early February would ease some pressure off the government’s crude oil imports amidst its forex reserves dropping to a 17-month low. Both IMF as well as RBI are of the opinion that FY13 GDP growth would be better than FY12 growth. In fact, IMF has pegged the FY13 growth at 7.3% while bringing down the FY12 number to 7%.

Q3FY12 Monetary Policy Review – Signaling a change

The central bank, in its recent review, surprised the markets with a CRR cut of 50bps while leaving the repo rate unchanged at 8.5%.  The Cash Reserve Ratio cut will inject primary liquidity of Rs.320bn into the system and would help in addressing the structural liquidity deficit seen in recent months (LAF deficit had gone up to Rs.150bn). However, RBI considers that rate cuts are not warranted at this juncture as upside risks to inflation persist. The policy document indicates that a reduction in the policy rate will depend upon ‘signs of sustainable moderation in inflation’.  In our opinion, RBI will wait for the FY 2013 Union Budget to be presented in parliament, (during mid-march) before making any decisive move on rate cuts. The RBI has reiterated its concerns about the rising fiscal deficit besides revising its FY12E GDP growth target downwards from 7.6% to 7%. RBI retained its inflation estimates for year-end March ’12 at 7%, considering the lagged impact of the rupee depreciation.  On the whole, it is clear that the growth-inflation balancing stance of the monetary policy stance has now decisively shifted towards supporting growth.  

MARKETS

Confident beginning - Downside risks muted but remain

After ending 2011 as the 2nd worst performing emerging market, Indian markets have rebounded sharply in the first month of 2012 aided by a host of positive global as well as domestic cues. The activity in bourses has also gained momentum with average cash volumes touching a 13-month high. Besides the CRR cut and EU developments, the Q3FY12 (Oct to Dec 2012) results of corporate India have also been supportive of market rally. At little more than the half way mark, the consolidated performance of BSE 200 companies that have declared their results so far have been marginally ahead of consensus expectations. Topline growth has been fairly robust at 25.6% yoy punctuated by shrinking EBIDTA margins (17.4% in Q3FY12 vs. 21.2% in Q3FY11) and earnings growth of 5.6% year-on-year. Most importantly, the overall downgrade cycle has been relatively benign with a 1% cut in FY13 Sensex EPS so far.

The upcoming central budget is going to be a very important event in the near term and would provide indicators as to how the government proposes to move ahead with policy reforms and fix problems in infrastructure, power and mining. Considering the fiscal deficit, the budget per se may not be corporate friendly as there is a possibility of increase in all taxes ranging from excise duty, service tax to surcharge on corporate tax. Nevertheless, a bullish view on India could emerge from better governance and policy reforms which would determine the sustainable long-term growth trajectory. The quick rebound from the 2008 crisis lulled the policymakers into believing that 9% growth was routine and double digit increases were round the corner. However, 2011 has provided a clear warning that poor governance would significantly jeopardize the India growth story. Going by the recent posture of the government in terms of fast tracking project approvals and resumption of concerted efforts to clear pending bills, it appears that introspection is on and amends would be made going forward.

Direct access for foreigners to the Indian stock market - Is the excitement for real??

Glenn Roger Carr, Vice President, Unifi Capital

The Indian Government has made a strong bid to strengthen the domestic markets by proposing to allow Qualified Foreign Investors (“QFIs”) to invest directly into the Indian equity market vide press release dated January 1, 2012 issued by the Ministry of Finance. The proposed new investment route is aimed at providing the much needed stimulus and to improve the sentiment of our markets

Currently, investing through the FII route directly or by going through a sub account of an FII are the only means for foreign individuals or institutions to invest into India.  In August 2011, the Securities and Exchange Board of India (SEBI) had permitted QFIs to invest into mutual fund schemes, thereby providing an indirect way of making foreign investments into Indian equity markets, and that was the starting point of the current policy which we shall carefully analyse

Key Highlights of the Proposed New Regime as provided under the Press Release

1.    RBI to grant general permission (i.e. under the automatic route) to QFIs for investment under PIS route similar to FIIs.

2.    The investment by QFIs would be subject to an individual investment limit of 5% of the paid up capital of the Indian company and an aggregate investment limit of 10% of the paid up capital of the company. These limits are over and above the limits applicable in case of investment by FIIs or NRIs under PIS route.

3.    QFIs would be allowed to invest only through a SEBI registered qualified depository participant (“DP”) and all the transactions would have to be made through this DP only.

4.    DPs would be the ones who would be required to ensure that the QFIs comply with the KYC norms and the stipulated regulatory requirements.

Pros and Cons of the policy

1.      Under the current SEBI (Foreign Institutional Investors) Regulations, 1995 there are stringent conditions imposed on the registration of FIIs and sub-accounts such as if an asset management company or an investment advisor has to be registered as an FII, it has to indicate that it is proposing to make investments on behalf of broad based funds. Further, funds can be registered as sub-accounts only if they fulfill the broad based criteria. Similarly, if an individual wants to register as a sub-account, then inter alia he has to fulfill minimum net worth criteria of USD 50 million. With these conditions not being imposed on a QFI it makes it easy and gives the investor the incentive to register and invest directly as a QFI.

This would allow a large group of foreign investor’s direct access to the Indian equity market instead of investing through FIIs/sub-accounts and at the same time will provide wider opportunity to the Indian companies to raise funds.

2.    If we look carefully at the regulations, it states that the individual limit of 5% and the combined QFI limit of 10% of paid up capital per stock is over and above the FII and the NRI limits that are already in force. This could mean that QFI’s could now buy into stocks that were earlier blocked due to the FII or NRI limit being breached. I would actually think that some of these stocks would see substantial fresh investment into them thus pushing their prices up.

3.   There are questions about whether NRI would be classified as QFI’s? Even though there is no direct mention to the contrary, it is quite clear that the QFI   limits are over and above NRI limits, which could lead us to conclude that NRI’s do not qualify under the new QFI regulations.

4.  The tax treatment for the QFI investment will ultimately decide the success or otherwise of this regulation. While it is quite clear that these investors will not benefit from a zero tax regime( which the bigger players who invested through the FII sub-account route benefitted for many years and continue to do so)it remains to be seen what kind of  tax structure and the method of taxation that would apply to the QFI’s. I do believe that the larger investors would any day prefer their tax benefit to the ease of investing option.

It would only be the smaller foreign investor who invested through the non discretionary route of a sub-account (which is a complicated and costly route to take) who would probably consider this trade off worth taking. In that sense one may not see a rush of fresh investments coming in through the scheme but it could definitely bring in a new breed of investors and widen the base of the current investor profile.

5.    When a guru of the stock market was asked about this new regulation he said that opening just one market does not excite him too much, he went on to say that if one opens the stock market they should open up the commodity and currency market also then only will the big boys be interested to invest large amounts into India. This then clearly is another affirmation that the BIG investments may not line up under the QFI route.

6.    The pessimist may ask why an individual foreign investor should choose India, wont he put his money where his mouth is? And even if we assume that he is a diehard Indian market optimist one would think that he would prefer the easy route of an India ETF which is now available in choice especially in the American markets.  This argument I must confess does hold a lot of weight.

7.   SEBI has stated that one of the objectives of this regulation is to broad base investor bases, improve inflows and make the market less volatile. While the first two objectives are definitely achievable to some degree it is difficult to understand as to how QFI investments will reduce volatility. QFI’s are not lateral thinkers they will think and act like all investors who are driven by greed and fear and in market swings these investors will act like any other thus probably adding to the volatility and not reducing the same. Statistics from the American and British markets also tell us that 90% of the investors are day traders and if they now choose to invest into India there is no reason for these individuals to suddenly turn into long term players.

8.  It would be appropriate to conclude the analysis by looking at one big benefit that the QFI will finally have and that is true beneficial ownership. As a client who invested through the FII or through a sub account the client were merely holders of buy positions in a company and never enjoyed  voting rights and other benefits which they will now be able to exercise as “real shareholders”

It would also be very interesting to study the operative guidelines that SEBI is going to put in place. The qualified DP’s/ brokers  who believe that the QFI segment is a one worth servicing would have to ensure new systems and process( the kyc part of it would be a big challenge-unless simplified), beef up research by a huge margin and also gear up to build their brand, and after doing all this there is no assurance of success.

The QFI has thrown up a lot of debate and discussion and the proof of the pudding will be in its eating, so as we wait and watch for the happenings in the next few weeks like all investors I hope that more than anything this would improve the market sentiment more than anything else.

The author is Vice President at Unifi Capital. Views expressed are personal.

glenn@unificap.com