2012

It is quite amazing but true that the year 2011 has been the second worst year in the history of Indian markets with a decline of 25% in the Nifty and 35% in the Mid cap indices(since the 1980s at least). No prizes for guessing which was the worst year i.e. 2008. In USD terms the performance was even more disastrous with losses of 44% given the 19% decline in the value of the INR. The year began with cautious optimism after the fall that the markets had seen post peaking off in November 2010. However a sequence of events, foreseeable and unforeseeable made this a disastrous year for equity investors. A lot will be written on the year ahead and I have touched on some subjects in my previous articles a few weeks back. However sentimentally one thing is very apparent from all the strategy reports that I read today, as well as the commentary in various media.

I have infact not read more pessimistic commentary on Indiafor a very long time as we see today. The same brokerages/research houses that were predicting Sensex at 23-24000 by the end of 2011 a year back are now forecasting markets at 12000 (at the lower range) to 18000 (at the median of the upper range). There are some who, albeit apologetically are predicting a move above 20,000 levels this year. However this is being done with a lot of caveats. The funniest are those reports where there are bull case, base case and bear case views where the difference between the bear case and the bull case is over 50-60%.

My take on the markets in 2012 is that we will see the Nifty/Sensex return anywhere between 15-25% and the broader markets by 25-35%. I believe that sentimentally the markets have bottomed out and the bottoming out, value wise will happen over the next few days or weeks. This should lead to a durable bottom being formed for the markets. I have touched on the logic for the same to a large extent in my article on the 5^th of December, an updated version of which I will present in brief and then more on the domestic situation and the markets.

The Euro zone Crisis – The Euro zone crisis and the debt issues related to Greece, Italy and Spain have been the main contributory factors to the nervousness in the global equity markets over the last several months. The crisis has got accented by a lack of faith in the political system and its ability to resolve the issues. This issue has been discussed a lot so I will not go into the details of all of this, however I do have a contrarian view on the future direction of news flow from Euro zone. We now have new governments in Italy, Spain and Greece i.e. all the troubled countries. Two of them are lead by technocrats and one by the right wing party. As such, in my view the worst of the news flow from Europe is now in and we might not get incremental negative news flow over the next 4-5 weeks. This is likely to be similar to the negativity due to news out of the US around 3-4 months back, which suddenly died out as the economic data started to improve. The entry of the IMF in the entire discussion combined with greater urgency to resolve the issues is also encouraging.  Overall I do not expect Europe to create any deep cuts in the markets going forward.  This was the view that I had put out a few weeks back and seems to have played out well. It seems clear now that although Euro zone will go through a cycle of deleveraging, slow growth, intermittent issues related to fiscal issues of troubled countries etc, the probability of a Euro zone breakup seems remote at this stage. Intermittent occasions of bond issuance of Italy and Spain will create volatility on those days. Infact if investors were so concerned on the Euro it would not have fallen by just 2-3% against the USD in the year 2011. As I wrote a couple of weeks back “Europe has clearly avoided its Lehman Moment”

US News flow – The news flow from the US has been mixed. Over the last few weeks there seemed to be clear indications of an improvement in economic activity. The Fiscal issues will keep on creating volatility periodically, however low borrowing costs and an improving economy could lead to a Fiscal surprise next year.Overall economic activity seems to be improving, albeit at a slow pace in the US and there does not seem to be the likelihood of a double dip recession at this stage. Most corporates in the US are cash rich and market valuations are at just around 11X P/E for next year. Earning expectations for the year 2012 are pretty low with earnings growth forecast in the range of 0-5%. As such US news flow will create volatility but it does not look that it can create a fresh down move at this stage.

Infact US has not only created conditions for a down move, but it has actually supported global markets due to continuously improving economic data, especially related to employment numbers. Technically too the movement of the key indices above 200DMA’s and the breakdown of the similarity of the move from 2008 indicates further gains for US equities. The breakdown of VIX below 23-24 levels also indicates reduced risk aversion and greater confidence. Typically such breakdowns are followed by multiweek up moves.

GOLD – As I have written in detail in my previous article I expect 2012 to be a difficult year for gold. I expect a 20-25% correction before prices come to a level where actual demand rather than pure investment demand can support prices. Since I have written in detail earlier I will not repeat, however the most fancied asset class will have a tough time holding on.

China – China is one aspect about which I have not written earlier mainly due to the fact that it is difficult to analyze it. However pessimism on Chinaseems to be at its peak with the Chinese markets trading at valuations that are at multiyear lows. The expectations of some, of a hard landing in China do not seem to be playing out. The move from investment to consumption led growth seems to be moving slowly. By letting the Yuan appreciate in light of pressure on exports seems to have played out well. Inflation has also been controlled well by demand & supply led measures as well as administrative dictates (which can only work in that country and not in countries like India). The moderation in economic growth has been happening at a steady pace. However the key challenge will be holding up growth in light of falling export demand, controlling excessive investments in unproductive areas and the biggest factor will be the asset quality of Chinese banks and how they will hold up in light of increasingly challenging environment and pressure on profitability of Chinese corporates. The corporate sector in China is likely to be hit on two fronts i.e. higher wage costs due to rapidly increasing salaries as well as the strong up move of the Yuan against most other competing currencies. Just as an example, over the last one year the Indian rupee is down 20% against the USD and the Yuan is up nearly 6%. The way things look to me it seems the base case will be a soft landing rather than a hard landing for China in the near term. The two big surpluses that China has i.e. Current Account & Fiscal are vastly undervalued by the markets in my view. Officially Chinaseems to be aiming at an 8% growth next year which is extremely strong in the current environment. The challenge is health of the banking system and how much it needs to be capitalized in order to support this growth as well as the state of health of the Provincial Governments about which there is very less transparency.

The Indian markets had to make do with not only global issues but also several domestic issues in the year 2011 making it one of the most turbulent years in recent memory. Although 2008 was challenging for India, it was generally perceived at that stage that the factors are largely external and as such should not have a lasting impact on the performance of the economy. We had also started giving lesser importance to the government as the economy became more and more open. However 2011 was a year which showed the importance of governance in promoting and sustaining economic growth as well as macroeconomic stability. The year 2011 was a year of high inflation, high interest rates, lack of policy making as well as the most challenging year for the Indian rupee since 1992 (ex of 2008).

The Rupee – The fall in the rupee is being attributed to high current account and fiscal deficits, which is true to some extent. However it is more due to a lack of confidence in the economy in the near term as well as cash flow mismatches on exports and imports. This aspect is extremely important to understand. Given the way the rupee fell and the continuous statements by policy makers that we are helpless in managing the rupee all importers have run to hedge their positions and no exporter is hedging. This creates a very huge mismatch in the short run. Let me try to explain. India has exports of broadly USD 20 bn a year and imports of USD 30 bn. Now this is a gap of USD 10 bn which is bridged by invisible flows, capital receipts, foreign borrowings, FDI etc etc. Now in a situation where everyone believes that the rupee can only fall all importers want to hedge, however no exporter wants to do the same. This creates a huge mismatch in the short run till the export proceeds flow in after a period of 90-120 days. This also creates a tendency to delay export inflows in order to realize a better rupee value. This actually makes me believe that the first quarter of 2012 can be a good period for the INR as the panic fall period now seems to be over and export realizations will start to come in. Other measures like reduction in holding period of Government and Infrastructure bonds as well as higher interest rates on NRI deposits should boost inflows. My base case view will be for a 3-4 % rupee appreciation in the first quarter of 2012 unless and until there are huge capital outflows.

Policy making – Initially we had a period in late 2010 and early 2011 when a large number of projects got held up on environmental issues. Later on after the 2G issue we have seen a significant decline in project approvals, takeoffs etc. This has got exacerbated by the continuous increase in policy rates by the RBI which has made lot of projects unviable. Reform measures have also got stalled. I believe that we are now at the absolute nadir of the decision making cycle and things can only improve from here on. I expect this to happen post election in February after which things would be much better.

Inflation would have come off much more sharply had it not been for the decline in the rupee. However the absolute correction in commodities and food prices combines with the strong base effect will take inflation down to nearly 5% by March 2012. In case the rupee also appreciates as I expect it too the overall scenario could be much better in 2012. As such we should have improving liquidity and much lower interest rates as we go through 2012 and this will provide a tailwind for economic activity to pick up.

Taking most things into account and also taking into account the market psychology as well as valuations I am of the view that the current situation of the markets is akin to early 2009 where one could see only negativity and that was the time that markets bottomed. Valuations, especially of the broader markets are today nearing historic lows and the overall market is also trading at 12X 2013E earnings which is very attractive. My view of the markets over the next one year is that of a worst case of 14500-14800 for the Sensex (at 12X P/E) and 26000 as the best case (on a 20x P/E.) 

The markets are today trading at a Mcap/GDP of 50%; in the beginning of 2008 this had gone up to as high as 160%. The Profits to GDP ration of corporates goes through phases of compression and expansion. Right now both gross margins as well as net margins are suppressed due to the huge input cost pressure that we have seen over the last 18 months as well as high interest costs. This is likely to reverse over the next two years. Eventually the Market capitalization will move towards the 100% level to GDP, if not more. This will provide strong returns over the next 3-4 years.

Markets seem to have taken most negatives in their stride as of now. The risk reward is strongly in favor of investing into equities at this stage. As inflation falls and interest rates come down there will be a revival in the economy and growth prospects will start improving. The timing of the bottom formation is difficult to predict, however it will happen in weeks not months.