2011

The year 2010 passed off as a pretty eventful one with the stocks markets gyrating in a very narrow range for a large part of the year before taking off in September and ending the year with gains of around 17%. The beginning of the year saw a generally positive tone pervade and the various concerns as in Euro zone, US economy, recovery in emerging economies and the pressures of inflation and deflation dominated the global scene. Specific domestic events were the good monsoons, stubbornly high inflation and a strong economic recovery.

The uncanny part about the beginning of this year is that the issues and positives seem to be more or less the same as last year and the only positive besides all of those seems to be a recovery of sort in the US economy with most parameters being tracked out there coming out better than expectations over the last few weeks. I believe that the key events to watch out this year will be as follows (not necessarily in order)

Will any euro zone economy default – The pressures being faced by a number of euro zone countries seem to be such that any sort of reorganization or loan repayments, bailouts etc without a haircut to bond investors is eventually going to only prolong the problems. Given that devaluation of the currency is not an option available to these countries in order to kick start their economies a combination of very high refinancing costs as well as fiscal constraints will lead to a lost decade for most of these countries, unless they decide to default and restructure for a faster recovery. Given that the real cut in budget deficits for most countries in the Euro zone as well as UK will start only this year, its impact on constraining economic growth will need to be watched closely. The happenings in this part of the world will continue to create volatility on and off despite the extremely low news flow over the last 3-4 months.

How fast will China tighten – Specific to emerging economies the main issue is likely to be inflation rather than deflation being faced by the West? Under the circumstances the stance of China becomes critical as China has neither let its currency appreciate nor tighten enough to control asset bubbles and inflation. The Peoples banks seems to be way behind the curve. Although a lot of people blame the RBI for being behind the curve I think that they are not as most people do not understand that CRR hikes act with a lag and the multiplier of the CRR hikes at the beginning of the year have started to have their impact now and that has led to severe liquidity tightness in the system over the last three months. Beyond this factors like high food prices and high global commodity prices cannot be controlled by the RBI. As such the stance of the Chinese central bank becomes extremely important as China has contributed to a large extent to the incremental increase in consumption of lot of commodities like steel, copper, coal, crude oil etc. etc. Also China will need to let the currencies appreciate and also tighten more by increasing policy rates in 2011. This should eventually have an impact on slowing or reversing commodity price movements. Its impact on the growth of the Chinese economy will also need to be monitored which has been growing at 8% plus for the last two decades.

Quantitative easing – The huge incremental quantitative easing by the US Fed has led to huge amount of speculation in commodities’, equities as well as emerging market assets. Given that the US economy seems to be stabilizing the key will be to see whether this cycle now is controlled and whether there is any incremental easing by the Europeans in order to support their economies. This is important for emerging economies both for the funds flow cycle as well as to control inflation and asset bubbles. The huge balance sheets of these central bankers will also need to be unwound at some stage. The impact on long term bond yields in these economies at the stoppage of QE will also need to be monitored closely.

Inflation – This is one of the biggest issues facing India and I believe is one of the two biggest risks to the performance of the markets and the economy. Given that the RBI is traditional a conservative central banker it would generally prefer to control inflation over growth and this could lead to a mid cycle slowdown of the economy. The extreme monetary tightness has in any case started to have an impact on the performance of the corporate sector as well as their interest costs. Greater liquidity tightness and higher rates also lead to incrementally higher NPA’s for banks and thus impact their ability to reduce lending costs.

Freeze on governance due to a variety of scams – The number of issues that have come up in the recent past like the Commonwealth issue, 2G spectrum issues, Money matters, midcap stock manipulation issues etc. have created a sense of wariness in the minds of investors. Its real impact will be felt due to a lack of decision making as well as progress on policy issues. Investors will be wary of buying into mid cap names due to concerns on governance in the near term. (However without any long term impact).

Besides this a large number of projects are getting held up due to lack of coordination among ministries, specifically on the highways side as well as due to environmental issues. A number of mining, steel, power etc projects are held up due to these issues and since these are long gestation projects with large capital outlays it can have a long term impact on the performance of the economy as domestic supplies do not keep up with demand.

Global and domestic fund flows – Global fund flow into Indian equity markets set a record in 2010. Domestically investors redeemed from mutual funds and reduced investments into insurance companies. The key will be to see the progress on both fronts this year. My guess is that we will see lower overseas flows but positive domestic flows this year. Overseas flows could come down from USD 28-29 bn to maybe USD 20 bn, however incremental domestic flows could see a swing of over USD 6-7 bn due to negative flows of around USD 4-5 bn turning positive.

Performance of the corporate sector – The markets are building in a 20% earnings growth for next year. Meeting or exceeding of these expectations will be incrementally positive for the markets and an underperformance will be negative.

Markets

As I look at the markets we see that there is wariness and skepticism among domestic investors with regards to the equity markets. However markets in the US and Europe seem to be ignoring the risks inherent in their long term growth and VIX the fear index has declined sharply. As such the risks to the
Indian markets lie more in a reversal of external flows in the short run due to some event risk or risk aversion rather than something inherently wrong that could happen domestically.

With India getting nearly 30% of all the money that went into emerging market funds in 2010 the allocations for the current year will become very important. Overall this year should be a positive year with a 18-20% kind of gain, however given the fact that we did not have any deep correction in 2010 we will have at least one sell off of the 20% kinds sometime during the year and in all probability in the first half of the year.

In terms of sectors the underperformer of the last two year i.e. infrastructure sector in general should be an outperformer given the huge under ownership and the fact that most investor now believe that the sector should continue not to do well even this year. Mid caps that were doing well till August and subsequently underperformed badly should see a bounce back this year. Technology should do well and banking overall should underperform. The Auto sector will face pulls of good consumer demand and rising interest rates but should overall do well. Commodities should do well in the near term before selling off later.

The dark horse for the year could be Telecom where all negatives seem have been factored in, however positives are not seen in the near term horizon.

The near term looks positive with markets likely to scale new highs in January 2011. Overall I expect the year to end at Nifty levels of around 7300 and Sensex at 24500.

HAPPY INVESTING.