In our view, politics in India and Fed tapering will be the focus of the markets in 1H14 and will overshadow the economy and earnings that drive long-term market performance. For 2014, we have an index target of 23,500 based on 15x 1-year forward earnings.
#1: Taper to drive correction in early 2014
In our view, three factors will likely drive a correction in markets in early 2014 to 19,000-19,500 levels:
a) Tapering by the US Fed.
b) Supply of paper the government needs to raise $6 bn in equity by March 2014 to meet its disinvestment targets.
c) Rate hikes and sluggish December quarter earnings.
Fed may taper early 2014
For the past few years, global markets have been characterised by a high-liquidity, low-growth regime. This will probably change to a higher growth and lower liquidity environment, in our view. The market impact of this change was seen in June 2013, when fears of the US Fed reducing its monthly purchases of Treasuries and Mortgage Backed Securities (MBS) led to a sell-off, especially in the emerging markets (EMs). The markets rebounded sharply when the Fed decided to defer tapering.
Our US economist, Ethan Harris, believes the decision on tapering will be data-dependent. His base case is of a March tapering, but he now believes that there is a 15% chance of a Dec 2013 tapering, 30% chance of a Jan, 2014 tapering, 35% chance of a March tapering and a 20% probability that it is after March.
So what will be the impact of tapering on India
We make three points:
a) Longer term, we believe tapering will have limited impact on markets and the economy. In fact, if the US economy improves (which is why the Fed is tapering), it may help the Indian economy and markets.
b) However, near-term the markets will likely correct given concerns of reducing liquidity while the benefit of a stronger US economy will be felt only with a lag. Given the strong rally (near 20%) in the market over the past 15 weeks, the fears of tapering will provide an excuse for the correction the market could drop to the 19,500 levels, in our view.
c) We do think India is now better prepared for tapering than it was six months ago. Hence, the correction in the rupee may be only 5-7% this time and the markets may correct 7-10%, lower than it did six months ago.
a) Trade and current account deficit lower now: The trade and current account deficits are substantially lower now than they were six months ago. From a trade deficit of $20 bn in May 2013, the trade deficit has now come down to $11 bn. Similarly, the current account deficit (CAD) has reduced substantially from $21.8 bn in Q1FY14 to $5.2 bn in 2QFY14.
b) FII investment in debt has reduced substantially: The shock India had six months ago was led by a sharp sell-off by FII investors in Indian debt. Given that the outstanding amount of FIIs in the debt market has reduced substantially, there is limited room for them to hurt the currency.
c) Forex reserves almost similar: The one area where there is no improvement has been forex reserves, which are at a level similar to six months ago despite the FCNR swaps that raised almost $32 bn. The low forex reserves, and import cover of 7.5x do make the market vulnerable to a currency attack.
#2: Better political environment to help markets
The reform climate over the past year has improved with faster clearance of projects and reduction in oil subsidy. However, the proximity of elections has made consensus building difficult. Post the elections in May 2014, the reform environment will likely improve and hence, the new government will be able to take necessary steps to revive the economy. Currently opinion polls indicate that the front-runner is the Narendra Modi-led BJP. However, they also indicate that the BJP would fall short of a majority and need the support of regional parties to form a government. The market expects the new government to take steps to revive the investment climate in the country.
We make four relevant points here
(a) History has it that over longer periods of time, there is no discernible trend of market performance or GDP performance during any particular government.
(b) However, in election years, markets do move strongly based on the political scenario. Indeed, the past two elections have seen strong double-digit swings on the election result day. This return has been significant to the performance of the markets in that year. However, in the past two elections at least we have also seen the strong moves not borne out over the term of the government. Thus in 2004 when UPA-1 came to power, we saw a sharp sell-off. But the five-year term of UPA-1 produced one of the best returns during any governments tenure. Similarly, there was a near 20% rally in 2009 when UPA-2 came to power. But four-and-half years since then have proved a big disappointment.
(c) The historical tendency of the market is to have a pre-election rally given hopes for acceleration of reforms post-elections. The markets have seen a pre-election rally in five of the past six elections, yielding an average return of 15%.
(d) Opinion polls have had a mixed track record as fortunes swing during the last stretch.
#3 Economy to recover, but slowly
While we expect the market to recover led by a better reform environment post elections, the economy and earnings may be slow to follow. Hence, the 2014 move up in markets will be mostly led by hope of a better economy, in our view.
#We expect GDP growth in FY15 to be 5.4%, against 4.7% in FY14. IIP growth will, however, be moderate at 2.8% vs 1.4% in FY14, by our estimate. A better global growth environment and interest rate cuts in late 2014 may drive a recovery in GDP growth.
#The fiscal deficit may continue to be a concern. We expect FY15 fiscal deficit to be 5.3% of GDP (vs our expected 4.8% in FY14) as the spillover of subsidy of the current year is accounted for. Similarly, the current account deficit may rise marginally to 3.1% of GDP as gold imports are normalized.
# Earnings growth may recover from our top-down expectation of 8% for FY14 to close to 10% in FY15. Bottom-up FY15 expectations of 18% are likely to see downgrades again.
How fast can capex cycle recover post-elections
The recovery of the capex cycle will be a slow and gradual process, in our view. There are four reasons why the capex cycle has been weak. We examine these to see how fast they can be reversed:
# Low business confidence
Weak business confidence has been responsible for risk aversion among corporates. A strong government post-elections would help reverse this. But it will need an improvement in the economy, both globally as well as domestically, before we can see a reversal in business confidence.
# Stress in the economy is still high
Investment climate is strong when profitability levels are high. Currently, stress in the economy is high with projects not able to meet their forecast profit projections, leading to high level of restructuring in the economy.
The formation of the Cabinet Committee on Investments has already started the process of easing regulatory bottlenecks. The new government post-elections will accelerate project clearances, in our view.
#High gearing will likely be a constraint
Gearing in corporate India is very diverse there is one set of companies that is sitting on negative debt levels. But firms that are leading on investment spends are sitting on high levels of debt. We think a meaningful capex cycle is unlikely till we see these companies repair their balance sheets.
This will likely be led by sale of assets.
In case of a sharp rally in equity markets, we may see the repair of balance sheets accelerate if these companies are able to raise equity.
Positioning is negative
The overweight on India amongst GEM funds is at a 5-year high. This could lead to a sharp downside in markets if any negative event causes a sell-off by FIIs in India.
Sector strategy: Changing gears
We present three themes (a) Rupee-sensitive names (pharmaceuticals, software) to hedge near-term taper fears. (b) Economy, reforms related (autos, private banks, oil) on hopes of better reform environment and an economic improvement, and (c) Small exposure to deep cyclicals, which include beaten down infra names and government banks .
Top Buys: ICICI Bank, Lupin, Maruti, TCS, ONGC
Top Underperforms: Powergrid, Tata Steel, HUL Top Mid-Cap Buys: Bharat Forge, Motherson Sumi, Aurobindo Pharma, Eicher Motors, LIC Housing