US & US

The market situation in the US has become like a lethargic giant too big to feed himself and too small to be kept famished. In fact, one school of thought reveals that most home-grown US companies have notched up ordinary quarterly performance, while the arms of these companies in the emerging markets (BRIC nations) have excelled their parent companies back home.

From the evil spell of subprime mortgage loan-induced problems (that led to huge write-offs in the books), which has been discussed ad infinitum, to increasing unemployment, continuously increasing trade deficit, and announcement of aid package and Fed rate cut, the US economy is yet to free itself from the grips of recession. In fact, the quarter-on-quarter growth shows growth will fall to 0.8% this year, compared to 2.6% in 2007

Hence, to make good their losses, exacerbated due to recession, big financial institutions that have invested their money in emerging and Asian markets are offloading their stake and book profits. This has led to immediate downward trend in all the Asian and emerging markets.

India was not left behind and saw a mammoth decline of more than 3,500 points from its peak high. So, an immediate question that crops up is how well-equipped and sturdy are Indian markets to fight the recession impact of the US. In fact, in answering this question one can dispel myths and bring to surface truths not facts, which would judge the foundation of Indian markets.

Is the home insulated?

Emphasises Vinayak Purshottam, research head with a foreign brokerage, ?Over the last week, Indian markets have not been a lucrative destination. However, it has still outperformed Asia over the last 12 months, even more so in $ terms. Though one has seen a ballpark estimate of $3 billion of outflows over the last five trading days, this is being offset by strong domestic institutional buying of around $1 billion in the last two days, with insurance funds of almost $4-5 billion still to be deployed by March-08.?

Also substantiates Vishwanath Yadav, an independent scholar, ?Even if the US markets continue to languish, there is no cause of great concern. It must be noted that around 35% of the Sensex that consists of global influence (IT/pharma) could see earnings downgrades. However, the exposure of these sectors to the domestic situation has a domestic element (e.g. lower oil prices will reduce subsidies), and the remaining 65% of the index should benefit from the strong domestic capex cycle, with upside to growth from cuts in local interest rates and taxes.?

This makes sense considering that India-growth-consumption-untapped-potential-story remains encouraging and prospering (earnings continue to grow at 20%).

Sturdy domestic turf

A consequence of the US recession will be withdrawal of investments. In seven days, including January 21, the Indian stock market lost 8% of its value. This translates to about $400 billion wiped out. Also, textile exports may find it difficult to achieve its target. However, a boom in the information technology and business processing outsourcing sector will continue. US companies looking for cheaper alternatives may outsource additional work.

One feature worth mentioning of India?s economic performance in the last six years is that it is driven by domestic consumption and not on exports. This is completely opposite for China, where exports drive the economy and domestic life may be ruined if orders dry up. In fact, India?s exports to the US constitute 16.83% of its total exports. The sector which would be hit hard is the diamond market as its total exports contribute 60% to the US market alone.

Total impact

However, on the whole, there wouldn?t be a drastic impact on the Indian markets. Says a foreign institutional brokerage in its report ?India Strategy?, ?Our visits in India this week indicate that companies remain optimistic about growth prospects. Foreign investors remain structurally underweight. We stay overweight and target the Sensex to reach 23,000 by the year-end (up 29% from the current level). With the lowest export/GDP ratio in the region, India should be resilient even in the face of a sharp US slowdown.?

But there is a worry about rapid interest rate cuts by the Federal Reserve. This would widen the gap between Indian and US interest rates, resulting in a capital outflow from the US to India where interest rates are still high. The arrival of excessive cash in India would create a huge inflow. Combine this with a weakening dollar and this would erode any export advantage. Hence, additional rapid interest rate cuts by the Fed would require an appropriate response from India .

An advantage

One of the best aspects of Indian markets has been its domestic demand. This maintained the tempo of growth momentum. In an article on emerging markets potentials, Jeff Chowdhry, head of emerging market equities at F&C, says it is a myth that if the US slows it will be disastrous for emerging markets. In fact, he opines that those markets where domestic demand is a bigger driver than export demand, greater stability would sustain. India being at this stage, it is not as susceptible as other emerging markets. Not to mention about the weak dollar and the accumulation of huge foreign exchange reserves.

The strategy

Despite the uncertainty of further downside, long-term investors should now increase their exposure. It is lucrative to buy large caps, infrastructure stocks, and IT, which have no positive catalysts and are underperforming. Large caps like L&T, BHEL, which have strong order books (more than two times their sales), are considered good options. Advises Muthuraman Mudliar, a technical analyst, ?Even though it is tempting to look at some beaten down small- or mid-caps or momentum-large caps, it is better to continue to focus on large cap domestic players – especially the rate sensitive laggards and the strong free cash flow-generating growth stocks.?

Sectors like autos, private banks, capital goods, cement, and media would be investment options considering that these sectors have no correlation with the US slowdown. However, it is seen that the US slowdown brings about a sharp fall in commodity prices. Hence, cutting an exposure to metals, oil & gas/petrochemical and IT could be a sensible move.

You must take into account the fact that the recent dip in Indian markets is not associated to the US slowdown. FIIs had remained net buyers of India until mid-January, while they sold out of other markets in the region. After being sold out in other markets, they have got rid of $3.9 billion of Indian shares too. However, this sell-off coincided with a time when some large IPOs (notably that of Reliance Power, which received applications totalling $90 billion for the $3 billion of shares on offer) have sucked retail money out of the secondary market

More so, the continued run-up seen in the markets meant that valuations of the markets had got very over-stretched, while those in the rest of the region had fallen back to more sensible levels. MSCI India reached a peak multiple of 24(x) in early January at a time when MSCI China had already fallen back to 18(x) from its peak of 25(x) last October (it is now only 15x). As a result, foreign investors took profits:

In fact, the International Monetary Fund forecasts that emerging market growth will slow to 6.9% in 2008 from 7.8% last year. It also says that the development of Asia will slow by 1% to a still-rapid 8.6%. Hence, the concern here is not the US recession and its upshots (which though cannot be pronounced irrelevant), but the domestic trading pattern. This is entirely dependent on educated buying of fundamentally good companies, which would stand the test of time, instead of following the flock in panic and reap losses.