Low Inflation to Mild Deflation in Western Economies is good for high growth economies like India

Sandip Sabharwal - Uncategorized - Low Inflation to Mild Deflation in Western Economies is good for high growth economies like India

Over the last several months the fear of deflation has again picked up and has resulted in the yields on German Bunds falling to all time lows and yield just around 2% for a 10 year paper. Similarly despite the Fiscal deficits in the US and the huge borrowings by the US Government the 10 year yields are down to 2.7%. The reason for this has been a steady decline in the momentum of recovery in the US where leading indicators of economic growth, real estate prices and job creation are all pointing towards a slower than expected recovery. This is turning out to be a blessing in disguise for these countries as they are able to fund their deficits at abnormally low cost of funds. The short term LIBOR rates as well as T Bill rates are hovering near 0.2%.

Although globally this is creating a fear about asset prices I believe that for capital constrained economies like India where there also exist significant supply constraints this is not necessarily negative. Although in the short run all financial markets tend to be linked to each other in the long run the decoupling play will become a reality due to the easily availability of low cost capital globally.

I recently met a senior banker who told me that for AAA corporates who are looking to benchmark their borrowings to the one month LIBOR the effective cost comes to around 2.1-2.2% on an unhedged basis. On a fully hedged basis it would go up by around 200 basis points. As such overseas borrowings at such low interest rates can be a boon for the investment cycle in India which is just starting to pick up. Given the fact that most infrastructure investments in India would yield at ROCE of above 14% there is likely to be a huge inflow of capital into this segment as globally investors look to invest into deflation beating assets.

The second most important positive for India in this scenario where everyone is looking at a slower global recovery will be that global commodity prices will either correct downwards or remain in a range for the foreseeable future. This will reduce the inflationary pressure that have built up in the economy and will lead to a slower tightening by the RBI and thus lead to sustained long term growth. The growth trend has already started to move up and we should see an 8-9% real growth coming through over the next 5 years.

Under the circumstances there is a great likelihood that we will see a significant flow of capital into high yielding assets like equities and real estate in high growth emerging economies. In conclusion I believe that low global inflation will only accelerate the growth prospects of domestic oriented economies like India.

Now to address some common questions I encounter –

Since our markets are FII dependant what will happen if they pull out – This is the most common question of lot of retail investors and advisors in India. My answer to this is that although we might like to think that FII’s or MFs or any other set of investors are a homogenous set, it is actually not true. At every point of time there are different fund mangers taking different views and inflows or outflow on a net basis depend on what the majority is doing. However predicting market movements on the likely flow of money is dangerous as we saw after the year 2007. As such the focus has to be on economic and earnings growth which is likely to remain strong going forward.

Should we be in large caps or mid caps – As the economy recovers the first benefit goes to the large caps and then it flows down to the mid caps. Given the fact that we are now 15 months into the recovery cycle we now see smaller companies doing better. As such there is huge amount of value that lies in mid cap stocks. However, as in any bull market a huge number of speculative stocks start moving up as the cycle plays our. It is important to focus on fundamentals and given that we have nearly 4000 small & mid caps to choose from one can always find a few good ones. I think mid caps should be part of the portfolio, but how much will vary from person to person depending on the time horizon of investing and the risk appetite.

What are the sectors to bet on I think that among large caps Technology, Financials, Capital Goods and Auto stocks look good and in the mid cap themes Airlines, Construction, Liquor & Mid cap IT look interesting. However on the mid cap side one need to be very stock specific in approach.

Overall the markets are finding it difficult to break out of the range in which it is trapped. Let’s see whether we get a 5 odd percent correction before the year end up move or a sideways move followed by a rally.

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