What ails the Indian Markets?

After rallying over the last quarter of the year 2012 on the back of improving global risk appetite and the restart of the stalled economic reform initiatives of the government we have seen that the Indian markets have started to stagnate and underperform global markets over the last few weeks. Although the benchmark indices are off by just around 3% from the peaks of early January the damage on the mid cap side of the market has been much more severe with stocks losing between 20-50% in value despite there being no significant news flow. This has been despite record funds flow from Foreign Investors since the beginning of January. Some of the reasons for the underperformance are as follows

Growing doubts on the pace of recovery – The initial set of reforms announced by the government created significant euphoria in the markets. However this has weared off over the last few weeks mainly due to doubts on the pace of recovery, especially after the CSO downgraded GDP growth estimates for the current year to 5%. Although the government has moved on fiscal consolidation and cut expenditure severely in the recent past, without any moves to actually kick start stalled infrastructure projects as well as Corporate Capex this move is actually growth negative in the near term. Bottlenecks on already awarded projects need to be cleared at a much faster pace. The expectations when the Cabinet Committee on Investment was set up was that this would move fast to clear various projects that are stuck due to the lack of one clearance or the other. However, the movement till date has been slow. It is anticipated that the pace will pick up going forward and the current week will see moves on granting environmental clearances to a number of coal projects. There have also been movement on clearances for some projects and news flow on the government wanting to clear the roadblocks on highway development projects. These issues will be closely watched by the markets going forward.

Changing goal posts of the RBI and lack of support for growth – The WPI for the month of January fell to a multiyear low of 6.62% although the CPI dominated by food prices has remained high. The RBI did cut policy rates in the last meeting; however it was accompanied by increased provisioning requirements on restructured assets going forward. This effectively removed the possibility of any significant reduction in lending rates. The latest reason being propounded for not cutting rates is the high CAD. The realty is that the CAD has been increasing despite Indiahaving one of the highest nominal rates in the large economies.

Abnormally high interest rates have damaged corporate and bank balance sheets. The one percentage point higher interest rate that RBI is trying to give to the savers is not really working as low demand is leading to lower incomes and growing unemployment. Can the saving rate be boosted while incomes are under stress and the cost of living is high? The element that is contributing to high inflation is largely food & fuel at this stage. Both are out of control of the RBI. Given that CPI gives 50% weight age to food, I guess it’s the RBI’s belief that households are spending 50% of their income on food. If that is the case and food inflation is so high, then isn’t it obvious that savings will fall. The way to boost savings is to boost growth and not control growth.

High CAD is the new punching bag – Keeping interest rates high to control the CAD is textbook theory. It is not working very well in the Indian context due to lack of alternatives for key import products as well as lack of capacity addition in alternative products.

 Looking at the analysis of the trade data, the ways to reduce the CAD have to be the following –

Domestic investors are putting money in unproductive assets – Domestic investors have moved away from investing in financial products due to a variety of reasons. Lower disposable incomes are leading to a lower accretion of bank deposits. Insurance sector is getting lower money due to the money lost by investors in ULIP’s. Mutual Funds are suffering due to continued redemptions. Equities were always a push product in Indiagiven the lack of an equity cult. As such lower commissions for distributors combined with lower efforts from AMC’s given the pressure on profitability due to lack of growth in assets has lead to record redemption pressure from equity mutual funds. The way to reverse this is to provide incentives for long term savings and investments. Some moves on this are expected in the Union Budget; let’s see how it plays out.

Corporate results were mixed, good to start and poor to end – The results season started off with a bank and ended with a whimper. The results were mixed with some companies doing well, however there was clear evidence of slowdown playing on corporate results. Most PSU banks reported a growing stress on the balance sheets while the private sector was quite resilient. Similarly high interest costs and slow project movement hit most of the infrastructure companies. Most of the infrastructure companies still have decent orders and if bottlenecks on execution are removed we should see improved results as well as pick up in economic activity going forward. The slowdown has now percolated down to the consumer sector also where growth has shown signs of slowing down.

It seems to be very clear at this stage that the government is very serious about the fiscal consolidation effort. However that by itself is not going to be enough given that the government has been in hibernation for years. Significant credible steps will be needed to boost private investments at a time when the government is containing its expenditure. Given the stance of RBI on not supporting growth, the onus is largely on the government at this stage. A scenario where the government is reducing fiscal deficit, monetary policy is tight and the private sector investments are also not picking up will be disastrous for the economy. Lower government borrowings next year should ideally lead to reducing interest rates in the economy, however it will be interesting to see the pace and extent of the decline. Globally most major stock markets have done well YTD due to reducing Euro zone concerns as well as an improving growth outlook. The big fixed income to equity shift that is on globally should last for the foreseeable future. The key is to see how well we can capture the same. I was expecting a pre budget rally which has not played out till date as investors have been wary. This is not necessarily bad as a good budget will then set the tone for a bigger up move in the later part of the year. The markets are now flat YTD; however the 15-18% growth thesis for this year still seems valid. The upside to this return range hinged on inflation falling faster than anticipated. That event is fructifying, however as the central bank is not responding to this move I will stick to the above range at this stage.