Column: Indias changing palette

Written by Neelkanth | Neelkanth Mishra | Updated: Jan 2 2014, 02:56am hrs
In an earlier column in this paper, we pointed out that expectations of a sharp revival in large-scale investments post elections in 2014 are misplaced (Elections won't trigger revival, December 12, 2013,

Middle-income consumption growth is also likely to stay subdued. Stagnant wages due to a weak formal economy are being exacerbated by sustained high inflation and a delayed supply response in white-collar workforce (courtesy of the boom until 2010). A useful indicator of these trends in the private sector is the real wage of an entry-level engineer entering an IT company. After keeping pace with inflation until 2008, real wages have almost halved in the past five years, so much so that an entry-level engineer now takes less cash home than a taxi driver in Mumbai. This is unlikely to change until the formal economy recovers. For the one-third of the middle class paid by the government (state, central and municipal governments as well as government owned companies), the government's pay commission cycle (every ten years: next one due in 2016) drives consumption cycles, and the 7th Pay Commission won't affect salaries until 2017-18.

There will be volatility around the elections, certainly, but the market should revert to trend soon afterhistory suggests elections do not really change the direction of the market.

So, what really is the trend Does the continued weakness in large-scale investments and middle-income consumption mean the economy and the markets will continue to drive negative headlines In my view, the big story will be the continuing divergence in fortunes of large-scale investments and middle-income consumption on the one hand, and low-income consumption on the other. Growth in the informal economy will continue to drive wage growth for the poor.

Continuing expansion in rural roads and electrification and the spread of mobile phones is driving unprecedented change and job creation away from the big cities. Analysts ignore the growth in rural wages at their own peril, as this affects the bulk of Indias workforce. Ninety percent of employment in India is informal, and rural wages are the best proxy for the strength of this economy, as wages for low-end urban jobs are closely linked to rural wages. Although growth in rural wages dipped to 14% in July, it was back to 16.4% in September, and is broad-based enough to suggest July was an aberration. We expect growth in real terms to stay at 4-5% over the next one to two years, driving strong bottom-of-the-pyramid consumption. Not surprisingly, in recent meetings, we heard several companies say that despite the broader weakness, the rural part of their operations had not seen any slowdown. For Maruti, the share of rural sales rose from 3% to 30% in the last six to seven years, and they expect 15% plus growth to continue for several years. For GSK Consumer as well as Hero Motocorp, rural growth is 1.5 to 2 times the growth in urban consumption. Companies with a predominantly low-income focused basket continue to report strong volume growth.

Investors are understandably cautious, as this trend is already in its third year. But some of these cycles last several years, and the opportunities created by last-mile infrastructure improvements (spread in mobile telephony, household electrification, rural roads) are likely to fuel a self-sustaining cycle for a long time. More importantly, contrary to popular perception, consumption-related sectors are least liked by analyststhe percentage of ratings that are "Buy" on consumer stocks is at six-year lows, and the worst among all sectors other than government-owned banks. This suggests the likely surprise to the market will be upward.

Further, the muted if not lack of reaction in the equity and currency markets so far to the start of the feared "taper" by the US Federal Reserve confirms our view that India will be much less impacted than earlier feared. The CAD has shrunk substantially and we believe sustainably, reducing dependence on volatile external capital flows. Further, the Indian economys interest rate linkage with that in the US is feeble at best, with very little of FII debt holdings remainingfrom around $39 billion in May, FII holdings in debt are under $20 billion. Also, keep in mind that India has already recorded five straight months of low trade deficitsindeed, India stands out among peers in terms of the improvement in trade balance in recent months. With the economy slowing, imports are slowing while the currency depreciation and a recovering world economy has boosted exports.

For the broader stock market indices this means continued strength, as stocks of companies exposed to consumption and exports have already gained weight from those of industrials, materials and banks. This sector rotation has implications for both earnings changes as well as P/E multiples for the broader indices. While MSCI India P/E is 7% lower than its average, once adjusted for the change in sector weights over time, it is 15% below its adjusted average. Changing indices also explain why the sharp economic slowdown has not driven earnings declines for market indices. We expect earnings downgrades to resume as December quarter results are announced in January and February, bringing to an end the upgrades to consensus EPS since September that were largely due to a mark-to-market of rupee-to-a-dollar exchange rate for exporters.

However, we stay constructive on the broader market, and maintain our defensive portfolio positioning. The current beta rally in our view is a sign that investors are turning neutral weight to avoid being whip-lashed on the day of the election results. We believe this rally is an opportunity to cut beta exposure, and not a sign that large-scale investment is likely to recover.

The unknowns

Each year sees some new surprise that few had foreseen at the beginning of the year: trying to forecast these is impossible almost by definition. These are possible but low-probability events that if known in advance can help outperform significantly. A few that come to mind are: (1) a sharp fall in oil prices; (2) the rupee appreciating to 55-56 against the dollar; (3) strong legislative action under a new government that shows potential GDP acceleration in a few years; and (4) banking system reform driven by RBI that shakes the industry out of its zombie state.

The author is India Equity Strategist for Credit Suisse