Please Share:: 
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
POST MARKET CRASH REPORT DATED Jan 21, 2011
2011 year end Sensex target - 21,000
We are setting our year end (Dec-11) Sensex target at 21,000, implying a 10%
return from current levels. At our target, the Sensex would trade at a fwd PE
multiple of 16.4x – which is a premium of about ~7% to the average multiple at
which market has traded over past five years.
Long term story intact, headwinds in short term
While we remain convinced about the long term India investment story, the Indian
market is set to face a gale of headwinds in the short term. For long term
investors, a downdraft in the short term will be an excellent opportunity to pick
value. Over 1H2011 we are concerned about the persistence and nature of already
elevated inflation, particularly in a year which is likely to see resurgence in global
commodity prices. We believe that permitting FDI in multi brand retail and
implementing agricultural reforms may assuage investor concerns. Markets may
also react positively if global commodity prices show a decelerating trend.
Improving global macro, resilient domestic consumption - key positives
We are enthused by the resilience of the Indian consumer and the improving
global macro environment both of which should bode well for equity markets.
2011 should also witness a rotation from global fixed income markets to equity
markets and in such a scenario the Indian equity market will not remain insulated.
Domestic consumption fuelled by rising prosperity – across rural and urban India-,
high aspiration levels and the lifestyle induced propensity to consume, continues
to remain resilient against the backdrop of elevated food inflation and rising prices.
An intriguing paradox: rising global commodity prices negative for India Inc
but positive for BSE Sensex
While rising international commodity prices will stress the Indian macro
environment, the impact of higher commodity prices and improving global macro
has a positive impact on BSE Sensex earnings with sectors geared to global
recovery i.e. oil, metals, software and international automobiles (Tata-Jaguar Land
Rover) constituting 45% - 50% of Sensex earnings. With inflation worries reigning
supreme – at least in 1QCY11, we would like to stay cautious on rate-sensitives
and our sector preferences would be biased towards global cyclicals and global
recovery plays like IT Services. We are also particularly excited on global
commodities and telecom. We also remain excited over continuing rural prosperity
and the likely favorable bias given by the government to the agriculture sector in
the forthcoming budget. Our top buys are premised on abovementioned themes.
Our top Buys are Cairn India, Sterlite, SAIL, Infosys, TCS, Tata Motors, ITC, Asian
Paints, Bharti and Mahindra and Mahindra.
Risks to our base case:
Upside risks: (i) resolution of the current political inertia, (ii) earnings upgrades and
(iii) re-emergence of confidence in capex cycle. Inflation remaining persistently
elevated in 2HCY11 is the key downside risk.
Investment Summary
Long term story intact, headwinds in near term
Since the nadir seen during the global financial crisis (9th March 2009), the BSE Sensex has
delivered a +133% return. In CY10 the Indian equity market (BSE Sensex) outperformed
many of its emerging market peers. The out performance was led by a quicker than
anticipated, domestic consumption driven economic recovery and the country emerging as a
key beneficiary of the global deflation trade, blessed by benign global commodity prices and
a stable, fiscal and political environment. While we remain convinced about the long term
India investment story, the Indian market, in our view is set to face a gale of headwinds in the
short term. For long term investors, a downdraft in the short term will be an excellent
opportunity to pick value. Over 1H2011 we are concerned about the persistence and nature
of already elevated inflation, particularly in a year which is likely to see resurgence in global
commodity prices. The Indian market may remain range bound until the government has
been able to convincingly tame inflation or is able to communicate strategic shifts in policy
which could temper inflation expectations. We believe that permitting FDI in multi brand
retail, articulating a conscious policy on raising agricultural productivity and attracting
investments in the food supply chain may be suitable policy responses which may assuage
investor concerns. Markets may also react positively if global commodity prices show a
decelerating trend, which may perhaps occur in the second half of the year, when interest
rates begin to rise in the developed world.
Tug of War between inflation and growth; effort to tame inflation
now taking precedence over inherent growth bias
We believe that 1QCY11 will see the market being swayed by a continuing tug of war
between inflation expectations and growth. We confess that the government of India’s
growth bias so far is now being overwhelmed by the pressure to tame persistent and
elevated inflation and to shield the economy from rising global commodity prices. In such an
environment the market will remain concerned about the risk of a knee jerk policy error. The
government’s response to tame inflation may also bring back the overhang of an inflationwary
government, akin to that seen during periods of high inflation in CY07.
Improving global macro, resilient domestic consumption - key
positives
While we are worried about inflation being the key headwind for India, we are positively
enthused by the resilience of the Indian consumer and the improving global macro
environment, which should bode well for equity markets. 2011 should also witness a rotation
from global fixed income markets to equity markets and in such a scenario the Indian equity
market will not remain insulated. The intriguing aspect of the Indian economy – and one that
underscores our conviction on India’s long term fundamentals- remains the resilient domestic
consumer. Domestic consumption fuelled by rising prosperity – across rural and urban India-,
high aspiration levels and the lifestyle induced propensity to consume, continues to remain
resilient against the backdrop of elevated food inflation and rising prices. We are positively
surprised that despite rising petroleum prices, higher financing costs and price hikes by auto
manufacturers, demand appears to be resilient (our auto analyst Srini Rao expects four
wheeler demand growth to rise by 26% in FY12 after a historic 30% growth in FY11). Airline
passenger traffic has also remained significantly above trend growth rates despite sharp
airfare hikes. Similarly in mortgages, we have not seen any appreciable drop in HDFC’s
disbursement growth, even as the company has raised effective mortgage rates three times
in FY11 by a cumulative 125bps. We believe that consumption will remain the mainstay of
Indian economic growth in FY12 unless the Reserve Bank of India is compelled to move into
a policy overdrive to tame elevated inflation or manage inflation expectations in an
environment of rising global commodity prices.
An intriguing paradox: rising global commodity prices negative
for India Inc but positive for BSE Sensex
While rising international commodity prices will stress the Indian macro environment, the
impact of higher commodity prices and improving global macro has a positive impact on BSE
Sensex earnings with sectors geared to global recovery i.e. oil, metals, software and
international automobiles (Tata-Jaguar Land Rover) constituting 45% - 50% of Sensex
earnings.
With inflation worries reigning supreme – at least in 1QCY11, we would like to stay cautious
on rate-sensitives and our sector preferences would be biased towards global cyclicals and
global recovery plays like IT Services. We are also particularly excited on global commodities.
We also remain excited over continuing rural prosperity and the likely favorable bias given by
the government to the agriculture sector in the forthcoming budget. We have a selective
preference for consumption names where our analyst Harrish Zaveri prefers stocks in sub
sectors that possess pricing power. We are constructive on the outlook for the telecom
sector with our analyst Srini Rao convinced about abating competitive intensity and the
positive impact of 3G services on incumbents.
Our top buys are premised on abovementioned themes. Our top Buys are Cairn India (direct
proxy on global crude prices, although Vedanta deal may be an intermittent overhang),
Sterlite, SAIL (although the return of an inflation wary govt may emerge as an overhang),
Infosys, TCS, Tata Motors (geared to global plutonomy), ITC, Asian Paints, Bharti and
Mahindra and Mahindra.
2011 year end Sensex target of 21,000, implying a return of 10%
from current levels
We are setting our year end (Dec-11) Sensex target at 21,000, implying a 10% return from
current levels. At our target, the Sensex would trade at a fwd PE multiple of 16.4x – which is
a premium of about 6-8% to the average multiple at which market has traded over past five
years. We believe that this multiple is justified given India’s attractive long term potential and
resilient domestic consumption. We believe that this premium can widen substantially if
structural issues on infrastructure and oil subsidies are resolved and the government can take
up pending second generation reforms (FDI in multi brand retail, raising foreign limit in
insurance, implementation of direct tax code and goods and services tax). We would also
believe that in case there is a reversal in the upward trajectory of global commodity prices,
India’s valuation premium will expand as the country remains susceptible to high oil prices.
Risks to our base case
Our base case is that the Indian equity market will remain choppy over the near term and
then grind upwards, to end the year 10% up. However we highlight following risks both
upside/downside to our base case:
Upside risks: (i) resolution of the current political inertia, (ii) earnings upgrades, (iii) reemergence
of confidence in capex cycle, (iv) strong structural reforms from the government
and (v) Sudden and sharp rebound in global risk appetite
Downside risks: Key downside risks are: (i) Worsening of European Sovereign debt crisis
leading to a Lehman kind of event (albeit we assign low probability to it) could evoke strong
safe-haven seeking behavior from investors, (ii) inflation remaining persistently elevated in
2HCY11.
Sector summary
Figure 1: Brief Sector views
Sector Classification Sector Summary
Consumer Discretionary
Autos
We expect volume growth to normalize in FY2012, except for the 4W segment. We expect structural factors such as demographics &
rising disposable incomes coupled with low penetration & new model launches, to help maintain momentum in 4W. Our volume
growth estimates are: 2W - 14% (FY12E) vs. 25% (FY11E), Commercial vehicles -12% (FY12E) vs 25% (FY11E), 4W - 26% (FY12E) vs.
30% (FY11E). We forecast tractor growth at 11%, in line with its long-term trend rate. We expect margins to trend down by 50-80bps
for most companies on account of rising input costs and competitive intensity
Consumer Staples
Food, Beverage &
Tobacco
Cigarettes, paints, watches, jewelry, remain the best categories to invest in within the Indian context. Headwinds however, relate to
rising input costs. The key winners would be the ones which have pricing power.
House & Personal
Products
The big home, personal care and foods category face headwinds from higher commodity prices going forward despite the good long
term demographics, higher income and consequently purchasing power of the Indian middle class.
Energy
DB’s oil team believes that 2011 will see oil demand-supply fundamentals tightening keeping oil prices above US$95/bbl. We expect
upstream companies, particularly Cairn India, to focus on growth in reserves and production volumes. The rebound in petro-products
demand is expected to push regional refinery utilization rates higher with Singapore Complex GRMs expected to average US$6/bbl in
CY11, 30% above last year. We expect petrochemical margins to improve in the second half of 2011. RIL will be the key beneficiary of
higher refining and petchem margins. However, the Indian oil marketing companies will continue to see challenging times as losses on
sales of subsidized fuels keep mounting.
Financials
Banks
We expect loan growth to be 20-22% in 2011 similar to the growth rate in 2010 driven largely by infrastructure and retail and some
corporate capex demand. Given the prevailing tight liquidity and recent increase in funding costs we expect margins to remain under
pressure for a couple of quarters and rebound thereafter. However, FY12E NIM decline over FY11E NIM may not be more than 15-
20bps. The probability of central bank continuing to tighten because of inflation has largely been factored into the rates through the
recent spike. The big positive for banks this year would be fall in credit costs due to lower slippages from corporate loan portfolio; retail
NPL accretion has already slowed down.
Real Estate
While we are positive on the Medium to L-T prospects of the sector (driven by demographics and demand potential as also local
nature of players), we are worried on the immediate prospects (increasing interest rates and fall in affordability). We expect developers
would be forced to cut prices and focus on execution to drive demand and cash flows. Most of near term concerns are well factored in
the 90%+ underperformance of sector since Jan'09. We are more positive on the Mumbai and Bangalore based developers.
Health Care
Pharmaceutical & Bio
Significant stock out performance (20%) in CY10 despite limited positive news flow results in limited margin of safety now. Companies
will have to deliver on promises (approvals, launches, and market-share) in 2011. Intensifying competition across markets and INR
appreciation are other significant threats.
Industrials
Capital Goods
Order inflows could continue to show slowdown with macro headwinds, delay in government spending and higher interest rates. At
the same time, the rising EPC capacity with the country and competition from foreign players in some sectors (such as power
generation & transmission equipment, oil & gas equipment) could put severe pressures on realisations; which along with the rising
commodity cycle could hurt margins of the industry.
Information Technology
Software
For FY12E we expect continued strength in demand for offshore sourcing of services, with India solidifying its position as a key
destination. The baton will now pass from 'operating leverage' led earnings growth to 'broad based demand' across all key verticals
and services. Growth will be driven by improvement in demand for higher value-added services like consulting and package
implementation, engineering and R&D and system integration. the possible impact of wage inflation on margins will be mitigated
Materials
Building Materials
Cement producers may have to go for another round of production discipline as margin pressures could be quite high given (a) FY12E
utilization is estimated to be c82% (much lower than the levels where they get natural pricing power) and (b) seaborne thermal coal
prices are on the rise. Our estimates factor in some of benefits of pricing discipline of 6-7 months over FY12E.
Metals & Mining
We believe commodities will enjoy a fresh wave of investment flows during 2011. We expect another strong year for the industrial
metals complex. We anticipate aluminum could be a favored metal for investors as cost inflation and tight energy markets in China
create the potential for China to emerge a net importer in 2011. In steel, prefer integrated producers with captive access to raw
materials.
Telecoms
We are optimistic on the Indian telecom sector on account of abatement in competitive intensity and expected positive impact of 3G
services on the financials of Indian wireless incumbents. Incumbents have successfully defended revenue-share and the impact of
tariff falls on margins has been lower than expectation. We believe tariffs would consolidate at current level as new entrants with
leveraged balance sheets and weak cashflows are unable to engage in price competition for an extended timeframe. We also note that
the addressable market for 3G services is larger for India due to the pervasive lack of wirelines – this bodes well for incumbents
Utilities
Power developers may be able to support a demand growth of c6% - implying that spot tariffs could be at INR 4/kwh; despite
commissioning of new capacities and seasonable weakness in demand. With the cut-down in production targets of Coal India on
account of environmental issues, coal availability within the country is growing at much lower pace than the requirement levels;
constraining the utilization levels of plants. Prefer vertically integrated models.
Source: Deutsche Bank,
Valuations suggest
headwinds maybe in the price
Sensex seems to be fairly valued and factoring in most of the
near term negatives
After a sharp correction in January, the BSE Sensex is currently trading at 14.7x - largely in
line with Long Term average of ~14x but at a discount to the past five year average multiple
of 15.7x. Over the past one year the Sensex has traded in a very tight band of 14.5x-17x. .
The recent YTD market correction (8%) has again pushed Sensex valuations close to the LT
average which offers reasonable support, in our view.
What will take the index up from here?
We expect the market to remain range-bound in immediate term particularly until there is
some clarity on taming inflation. The trigger for a positive move is likely to come from the
following factors: (i) earnings upgrades, (ii) resolution of current political inertia, (iii) reemergence
of confidence in capex cycle, (iv) systemic liquidity turning benign and (v) strong
structural reforms from the government. While most of the above factors seem to be in place
for the long term, we expect near term to remain uncertain.
However, investment environment should improve later in the year by when we expect to
witness (i) normalization of political environment, (ii) abating of inflationary pressures, (iii)
some visibility on corporate and infrastructure capex, (iv) improvement in relative valuation for
Indian equities and (v) structural reforms like FDI in multi brand retail.
India’s premium to Asia ex-Japan and US has shrunk sharply
after a significant YTD underperformance
Indian markets have underperformed Asia-ex Japan and US by 9% and 11% respectively.
While MSCI India is down 8% YTD, Asia and US are up moderately by 1% and 3%. This has
led to a substantial shrinkage in India’s premium to MSCI Asia ex-Jap and US. After a near 14
month gap MSCI India premium to MSCI Asia ex-Jap (currently 219bps) has moved below
the LT average of 285 bps. Besides, with the emergence of the Developed Market trade,
India’s premium to US has more than halved from 343 bps in end Dec to 161bps currently.
Inflation should remain a key
concern
Multiple inflationary pressures emerging
Food inflation is the biggest worry for the government currently
India has been experiencing persistently high inflation (>7% yoy) for close to a year now.
Ironically, the government’s quest for inclusive growth and social cohesion have engendered
the resilience of rural India’s consumption and ironically are the factors contributing to
inflationary pressures as food supply trails rising rural prosperity.
Is high food inflation becoming structural in nature?
We are worried that food inflation may become structural because:
�� Higher household income (both rural and urban) is exerting upward pressure on food
prices with rising affordability and the move up the food value chain
�� India is also witnessing a shift in food consumption pattern towards high protein- diet
(which are naturally pricier than the earlier food basket) - driving food expenses per
capita upwards
�� Third and perhaps most worrisome is the deficient and inadequate supply side. Interplay
of (i) underinvestment in food supply chain, (ii) presence of middlemen, hoarders and (iii)
state’s involvement in public distribution, have all led to several inefficiencies and
avoidable wastage.
While the government may not be able to address the demand side of the food equation, it
needs to urgently address the supply side by reforming the food supply chain ensuring
adequate investment in procurement, cold storage, distribution and retail. For this the
government may look at permitting FDI in multi brand retail (particularly food).
Global commodity prices not providing any comfort either
Apart from food inflation (which accounts for ~26% of the WPI index), the rise in global
commodities (especially crude oil, coal and metals – which together account for 17% of the
WPI index) has resulted in WPI inflation staying above 7%. Global commodities have been on
an uptrend due to the confluence of several factors - : (i) unprecedented infusion of liquidity
by developed market Central Banks (notably US$600bn worth of QE-2 of Fed, US$1trn worth
of backstop by ECB/IMF for troubled EU peripherals, near zero rates of Fed, ECB and Japan),
(ii) strong demand from EM, (iii) weakening US$ and (iv) economic rebound in US.
Rising crude prices pose challenge to the macro economic
environment
Global crude prices have risen by as much as 25% over the past four months on the back of
(a) expectation of stronger global oil demand driven by Chinese demand, (b) drawdown of
OECD oil inventories (c) reduction in OPEC spare capacity in CY12 and (d) a QE2 induced
boost to risk appetite which has generically benefited most of the commodities. In response,
DB’s commodities team has also raised their forecasts for CY11 crude prices by 11% to
US$97/bbl vs. US$87.5/bbl earlier.
Oil has been a bete noire for Indian policymakers. since India imports ~75% of its oil demand
and oil imports account for ~33% of total merchandise imports. Higher oil prices aggravate
the twin deficits (i.e CA and fiscal), financial health of PSU oil marketing companies and
inflation outlook for India.
Our economists highlight the following sensitivities of crude prices to key economic
parameters:
On Inflation: Fuel products make up about 15% of the WPI; within this segment, petrol and
diesel prices have already seen substantial increases (+24.5%yoy and +15%yoy respectively)
in the past year. Still, both products would likely see further upward adjustment in prices as
the global crude oil price heads toward USD100. Another 10% or so rise in petrol price and 4-
5% increase in diesel price is likely, in our view. First and second round effect of the fuel
price increase could add another 80bps to WPI inflation, as per our calculations.
Consequently the 2011 average WPI inflation could well exceed 8.0%.
On current account deficit: We estimate the elasticity of the current account with respect
to oil price to be about 0.15, .i.e. a 10% rise oil prices worsens current account by about
0.15% of GDP. Hence the current account deficit could exceed 3% of GDP in 2011, but not
much more than that if oil prices stay around USD100 through the course of the year
On fiscal deficit: We estimate that higher oil price in 2011 could pose a ½% of GDP worth
of risk to the FY11/12 budget. However the authorities are unlikely to absorb the entire
additional cost, preferring to push some of the spending to the next fiscal year and some offbudget.
The government will also force substantial losses on state-owned oil companies as
yet another way to defray the explicit cost of living with 100 dollar oil. But the direct and
indirect cost to the Indian taxpayer will likely be substantial, nonetheless.
The curious paradox: rising global commodity prices benefit
Sensex even as economy is impacted negatively
While rising international commodity prices will stress the Indian macro environment, the
impact of higher commodity prices and improving global macro has a positive impact on BSE
Sensex earnings with oil, metals, software and international automobiles (Tata-Jaguar land
Rover) constituting 45% - 50% of Sensex earnings.
The biggest among these is Reliance Industries (~12% of Sensex PAT), followed by ONGC
(9%), Sterlite (4%), and Hindalco (2%). In addition, if we take the total exposure of Sensex
earnings to global factors, the corresponding figure would rise to ~48%% with inclusion of IT
services, Pharma and JLR’s earnings.
Earnings cuts likely, albeit
moderated by strong demand
Inflationary pressures behind the prospects of earnings cut….
As elaborated earlier, Indian companies face multiple headwinds from sharply rising cost
base and hence we believe there exists the risk of downward revisions to our earnings
forecasts.
We believe that analyst estimates have not yet factored unanticipated and across-the-board
rise in costs or the need to hold prices of commodities like steel and cement, where the
government may frown on rising prices.. While the earnings season is still in its early stage,
few big names have already seen earnings cuts as noted below:
Some of the key downgrades in the Dec-qtr earnings season have been:
Infosys: We have cut our FY12 and FY13 earnings estimates for Infosys by 7% and 4%,
respectively. Volume growth of 3.1% qoq (vs. our estimate of 7%) and a 2.7% rise in
reported pricing contributed to 5.9% qoq growth in USD revenues (vs. our estimate of 8.5%).
EBIT margins were flat qoq at 30.2%. This was 115bps lower than our forecast, mainly due
to a 170bps qoq volume-induced drop in utilization (including trainees).
Larsen & Toubro: We have cut estimates by 16% in FY12 and 19% in FY13. The slowdown in
the investment cycle finally hit Larsen & Toubro, whose order inflows fell 25% yoy—with the
company stating in the post-results conference call that it could miss its order inflow target of
+25% yoy for FY11. We have cut our consolidated EPS estimates for FY12 and FY13 by 20%
as a result of a slowdown in new order wins, coupled with the strong rise in commodity
prices.
…but we do not think that Sensex earnings growth will fall
below 16-18% for FY12, in a bear case scenario
While there do exist distinct possibilities of downward earnings revision, the degree of
revision should not be too sharp and we believe that FY12 should still end up showing
earnings growth in the range of ~16% - 18% (down from the current estimate of ~21%). Our
confidence on this stems from a reasonably strong correlation between earnings growth and
nominal GDP growth over the past decade (>50% over FY00-10) and the multiplier between
the two has ranged between1-2x in high growth years- while during the crisis years the
correlation has broken out (on certain instances earnings growth has even dipped into
negative territory). Since our base case scenario envisages a non-crisis year (despite several
headwinds) we believe that Sensex should at least be able to show earnings growth
multiplier of 1-1.2x nominal GDP growth, which our economics team estimates to be 15.7%
for FY12.
Also, it seems that many companies have been able to pass on some part of raw material
price hike to the end consumer. The undercurrent of strong aggregate demand in the
economy implies that the end consumer has the ability to absorb the rise in final product
prices (for details please refer to the section titled “The resilient Indian consumer”). A strong
and better than expected GDP growth in 1HFY11 has been chiefly driven by resurgence in
private final consumption expenditure, which has rebounded from the lows of 2.65% in Mar-
10 quarter. The latest reading of PFCE growth at ~9% reflect that the demand from private
sector has come back to the pre-crisis level.
In conclusion, while we believe that there will be downward revision to earnings estimates,
but the degree of downgrades will not be sharp since companies have demonstrated ability
to pass on the prices to end consumer and contain margin compression within acceptable
limits.
Will the government launch
bold reforms?
Inflation, scams and state elections to keep political machinery
occupied for the first half; reforms to take backseat
With the emergence of several scams in past few months (banking and 2G) and with
persistent inflation a major part of government’s efforts will be diverted towards addressing
these issues with policymaking and reforms taking low priority. In addition, several assembly
elections (including key states of West Bengal, Tamil Nadu and Kerala) are due in 1HCY11
and hence the political machinery will remain occupied
… but there exists a strong case to urgently allow FDI in multi
brand retail
Despite the likely inertia over reforms, we see high probability of government permitting FDI
in multi brand retail, as it will send out a clear signal about the government’s serious intent to
put in place an architecture which will help to mitigate the structural nature of inflation. India’s
food supply chain is highly inefficient and characterized by avoidable losses due to an
interplay of (i) underinvestment in food supply chain, (ii) presence of middlemen, hoarders
and (iii) state’s involvement in public distribution
While the government may not be able to address the demand side of the food equation, it
needs to urgently muster political will and support to reforming the food supply chain
ensuring adequate investment in procurement, cold storage, distribution and retail. Given the
urgency of the situation, it is very likely that the government may put this issue on a fast-track
and send out a strong signal of its intent to control structural aspect of food inflation.
Momentum in disinvestments should continue
FY11 is on track to be a watershed year for disinvestment. The government appears to be on
course to achieve its ambitious Disinvestment targets. While we do not see a likelihood of
strategic divestment (i.e. govt. holding falling below 51%), we do expect the government to
bring down its stake in several companies to 75%. Besides, we also foresee government
pulling down its stake to below 75% in few large cap companies, so as to conveniently meet
its disinvestment target. Already, the government is deliberating to reduce stake in ONGC to
below 75% and we remain convinced that more such instances will follow.
The resilient Indian consumer
Resilient consumers counterbalance rising prices with greater
purchasing power
Consumption accounts for close to 60% of India’s GDP and the recent positive surprise in
GDP growth data is attributable to a sharp rebound in growth in private final consumption
expenditure – indicating that the Indian consumer is willing and also able to consume - even
at high price points. The latest reading of PFCE growth at ~9% reflect that the demand from
private sector has come back to the pre-crisis level. Rising prices (specially food inflation at
~20%) have not yet led to serious social tensions or public protest - indicating that
consumers across various strata of society are able to absorb the price hikes.
A rising tide of liquidity is lifting all boats
While unprecedented backstop of liquidity from DM central banks is bidding up the prices of
commodities, Indian consumers also seem to have benefited from a combination of higher
income levels and wealth effect from rising gold prices (Indians are generally big holders of
gold), higher land prices, and rising equities. This has put higher purchasing power into the
hands of Indian consumer, who does not seem averse to spend the new found wealth on
conspicuous and other consumption items.
Despite price hikes volume growth has remained robust in
several categories
Despite a series of price hikes in various products/services, demand has continued to remain
robust – an indication of pricing power of companies in some cases and purchasing power of
consumers in most. 2010 witnessed the strongest volume growth – in many years - in both
4 wheelers and 2 wheelers despite several players hiking product price by 4-5% in latter half
of 2010 and oil prices also moving up ~10%.
Despite hikes in 4W-2W and petrol prices, auto sales continue to exhibit robust growth
Sales growth of sector leaders Maruti and Hero Honda has remained impressive, even after
the price hikes. Importantly our Auto team expects a continuation of robust growth of 26% in
4 wheelers in 2011, despite a significantly high base.
Dec-10 quarter witnesses largest air traffic in 2010, despite hike in ATF and airfare
We witness similar trend in other items of consumption both discretionary and staple.
Growth in airline traffic has bounced back to ~25% in Nov despite the hike in fares and is
amply reflected in sharp jump in airline load factor to 82%. Latest data from DGCA exhibits
that Oct-Dec’10 quarter witnessed the recorded the largest air traffic at 14.7mn fliers
Mortgage rate hikes in 2010 do not seem to have any appreciable impact on sanctions
or disbursements either
Similarly in mortgages, we haven’t seen any appreciable drop in HDFC’s disbursement
growth, even as the company has effectively raised the mortgage rates three times in FY11
by a cumulative 125bps. Sanctions growth has in fact moved up in the Sep-10 quarter
despite hikes in the preceding quarters – hinting at the robust demand for fresh mortgages
even after rate tightening. However, it still needs to be seen if mortgage disbursals are
impacted post RBI’s tightening of prudential norms for real estate loans.
Job opportunities register robust 27% yoy growth in Dec-10;
sequential growth remains intact
The labor market is also increasingly getting tight, with higher job opportunities putting skilled
workers in a strong bargaining position to negotiate higher salaries. The latest report of
Monster India (a subsidiary of global leader in job placements) on online job opportunities,
reveals that job opportunities rose by a robust 27% yoy in Dec-2010, with the absolute
reading for Dec-2010 being the highest since start of the survey period. Rising job
opportunities are clearly a lead indicator of an increase in purchasing power of consumers -
even as wage inflation exerts pressure on corporate margins. Some other key findings of the
report were:
�� Online recruitment activity expanded in nineteen of the 27 industry sectors monitored by
the Index between November and December. Twenty two industry sectors registered
positive annual growth
�� Online demand escalated in 12 of the 13 occupational groups monitored by the Index.
The longer-term growth trends improved in 11 occupational groups.
�� Annual growth rate is positive and robust in all 13 cities;
Bull-run in global fixed
income is fading out
Bond funds were the recipient of strong inflows in 2010 as
perception over developed economy’s growth remained weak
The report from DB’s European Strategy team indicates that, Global bond funds were the
highest recipient of fund allocation in 2010 with bond funds in total witnessing a 17%
accretion in AuM. The corresponding number for global equities was rather muted at 2%.
Bond funds witnessed inflows worth US$223bn while equity funds saw inflows of ~93bn.
This behavior was in line with the excessive provisioning of liquidity by Central Banks globally
lowering policy rates to near zero, and fragile confidence over the global growth prospects.
With US economic data showing signs of improvement, asset
allocation should move up the risk curve; US equities should rise
We believe that the strong bull market in fixed income in 2010 may already be on its last legs
as there are several signs that growth in US economy is getting better by the day (with the
infusion of monetary stimulus and fiscal bounty in form of tax cuts), and European sovereign
risks are likely to be contained although there will be intermittent bouts of risk aversion (like
the Greece and Ireland bailouts that flared up in may and Nov 2010). On this premise it is
likely that inflows into bond funds may reverse and find home in more riskier asset classes
like equities, emerging markets and commodities.
Our US Equity Strategists also believes that there should be a reversal of 2010 flows with US
equities likely to witness greater flows and end the year positive. They observe that:
�� Flows will return to equities when they have in past cycles, which is once there is
confidence in the economic recovery and the Fed communicates it is done trying to
lower rates for the cycle.
�� The fixed income markets are under-pricing the strength of an economic recovery and
the likelihood of the Fed initiating a rate hiking cycle beginning (or even discussed),
which will begin to be priced into the market in 2011.
�� The asset allocation out of bonds as typical at this point in the cycle and as having much
further to go, eventually benefiting equities over the course of the year.
Positive US equity market not necessarily negative for Indian
equities
While the case for positive performance of US equities seem to be consensus now, several
skeptics have started to believe that this will likely lead to outflows from Emerging markets
like Indian equities and hence lead Sensex lower in 2011. We believe that:
�� It is a misperception that the inflows into US equities could be financed by outflows from
EM funds. Rather, bond funds are most likely to be used to fund the buying of equities
globally, in our view
�� Second, an outflow from bond fund is symptomatic of return of risk appetite
underpinned by confidence over DM economic recovery getting stronger. This should
benefit most of the risk asset classes (like equities, EM and commodities) and not just
US equities alone
�� Thirdly, the chart below suggests that a year of positive return for US equities is not
necessarily bad for Indian equities. On the contrary, in the past decade Indian equities
have outperformed S&P500 in all years when US equities have provided positive annual
performance. The underperformance has chiefly been in years when both the equity
markets ended the year negative – underscoring the high beta nature of the Indian
market. The risk to this hypothesis could probably be extreme developments either in
global economy (i.e. EU peripheral debt crisis blowing over) or idiosyncratic domestic
risk
Commodities to witness bull
market in 2011
DB is constructive on its outlook for commodities
As a corollary to the reversal of bond flows, our commodities team believes that 2011 will be
a positive year for all types of commodities. This expectation is underpinned by their belief
that: (a) emerging market growth will remain strong, (b) the Fed’s efforts to stimulate US
growth will be successful, (c) European sovereign risk will eventually be contained and (d)
physical fundamentals in many commodity markets remain tight. Our team believes that
2011 will be characterized by fresh investment inflows into the commodities complex. The
sector’s appeal reflects investor appetite to gain exposure to emerging markets, as a tool to
hedge against tail events and market anxiety towards higher inflation ahead.
China remains a bullish factor for commodity markets despite short term disruption risk from
monetary tightening. In 2010, the country had become an even greater source of demand for
commodities such as thermal coal, silver, soybeans and cotton. While industrial metals
demand has the highest correlation to credit growth and consequently would be the most
sensitive to monetary tightening measures, we believe the underlying growth outlook in
China remains positive.
Positive read through for Indian Metals: our key overweight
We are convinced that 2011 will see the word supercycle emerge once again in the lexicon
of commodity investors. Investors must position for all commodities ranging from oil and
metals to foodgrains going up and remaining at above trend levels throughout the year,
which may perhaps acclerate the return of the fed tightening cycle to 2011 from current
consensus expectations of early 2012. As highlighted in the inflation section above, a strong
global commodities price environment will be beneficial for those Indian companies which
have their revenues benchmarked to global commodities prices.
Flows and risk appetite
should improve
Despite a weak start to 2011, FII flows into Indian equities should
remain positive for full year 2011
After a record year of FII inflows (~US$29bn) in 2010, the start to 2011 has been rather
sedate (with FIIs withdrawing ~US$725mn YTD). Investors currently remain wary due to
�� Sharply rising food inflation, despite expectations to the contrary.
�� Concern over the policy environment. The winter session of Parliament closed without
any business being conducted.
�� Emergence of the DM vs. EM trade, where strength of US recovery, Irish bailout and
relative undervaluation of DM vs. EM has attracted investor flows into developed
markets.
Source: Deutsche Bank; Bloomberg Finance L.P.
While we expect a period of uncertainty over Indian equities in 1HFY11 (with interspersed
instances of strength), sentiment towards India should most likely improve once the current
environment normalizes as: (a) relative valuations are likely to become much more attractive,
(b) there should be some resolution to the prevailing political gridlock (c) India’s high growth
potential should start to reassert itself (d) with interest rate hikes by Fed and ECB expected in
2H2011, the massive flows into Debt funds in 2010 should witness some rotation back into
Equity oriented funds
Domestic funds have begun to witness net inflows – first time in
past seven months
Domestic mutual funds have been in regulatory crosshairs in 2010 with SEBI banning entry
load for Mutual Funds and the regulatory authority over the ULIPs devolving to Insurance
Regulatory & Development Authority (IRDA) instead of SEBI. This ensured that through a
better part of 2010 domestic mutual funds witnessed new outflows.
However, in past few months we have noticed a sharp turnaround in redemption pressure in
equity mutual funds while gross inflows have remained relatively stable. This has enabled
mutual funds to report a net inflow figure (albeit a moderate US$214mn) in Dec’10. This also
seems to have driven net buying by mutual funds in Jan 2011.
While it may be too early to extrapolate this trend of net inflows to the rest of 2011 (also
affected by recent hike in deposit rates which may lead to savings gravitating towards bank
deposits), we believe that the worst of the regulatory overhang for mutual funds is behind us
and hence should be incrementally positive for MF flows into Equity markets.
India Equity Research Reports, IPO and Stock News Visit http://indiaer.blogspot.com/ for complete details �� ��
POST MARKET CRASH REPORT DATED Jan 21, 2011
2011 year end Sensex target - 21,000
We are setting our year end (Dec-11) Sensex target at 21,000, implying a 10%
return from current levels. At our target, the Sensex would trade at a fwd PE
multiple of 16.4x – which is a premium of about ~7% to the average multiple at
which market has traded over past five years.
Long term story intact, headwinds in short term
While we remain convinced about the long term India investment story, the Indian
market is set to face a gale of headwinds in the short term. For long term
investors, a downdraft in the short term will be an excellent opportunity to pick
value. Over 1H2011 we are concerned about the persistence and nature of already
elevated inflation, particularly in a year which is likely to see resurgence in global
commodity prices. We believe that permitting FDI in multi brand retail and
implementing agricultural reforms may assuage investor concerns. Markets may
also react positively if global commodity prices show a decelerating trend.
Improving global macro, resilient domestic consumption - key positives
We are enthused by the resilience of the Indian consumer and the improving
global macro environment both of which should bode well for equity markets.
2011 should also witness a rotation from global fixed income markets to equity
markets and in such a scenario the Indian equity market will not remain insulated.
Domestic consumption fuelled by rising prosperity – across rural and urban India-,
high aspiration levels and the lifestyle induced propensity to consume, continues
to remain resilient against the backdrop of elevated food inflation and rising prices.
An intriguing paradox: rising global commodity prices negative for India Inc
but positive for BSE Sensex
While rising international commodity prices will stress the Indian macro
environment, the impact of higher commodity prices and improving global macro
has a positive impact on BSE Sensex earnings with sectors geared to global
recovery i.e. oil, metals, software and international automobiles (Tata-Jaguar Land
Rover) constituting 45% - 50% of Sensex earnings. With inflation worries reigning
supreme – at least in 1QCY11, we would like to stay cautious on rate-sensitives
and our sector preferences would be biased towards global cyclicals and global
recovery plays like IT Services. We are also particularly excited on global
commodities and telecom. We also remain excited over continuing rural prosperity
and the likely favorable bias given by the government to the agriculture sector in
the forthcoming budget. Our top buys are premised on abovementioned themes.
Our top Buys are Cairn India, Sterlite, SAIL, Infosys, TCS, Tata Motors, ITC, Asian
Paints, Bharti and Mahindra and Mahindra.
Risks to our base case:
Upside risks: (i) resolution of the current political inertia, (ii) earnings upgrades and
(iii) re-emergence of confidence in capex cycle. Inflation remaining persistently
elevated in 2HCY11 is the key downside risk.
Investment Summary
Long term story intact, headwinds in near term
Since the nadir seen during the global financial crisis (9th March 2009), the BSE Sensex has
delivered a +133% return. In CY10 the Indian equity market (BSE Sensex) outperformed
many of its emerging market peers. The out performance was led by a quicker than
anticipated, domestic consumption driven economic recovery and the country emerging as a
key beneficiary of the global deflation trade, blessed by benign global commodity prices and
a stable, fiscal and political environment. While we remain convinced about the long term
India investment story, the Indian market, in our view is set to face a gale of headwinds in the
short term. For long term investors, a downdraft in the short term will be an excellent
opportunity to pick value. Over 1H2011 we are concerned about the persistence and nature
of already elevated inflation, particularly in a year which is likely to see resurgence in global
commodity prices. The Indian market may remain range bound until the government has
been able to convincingly tame inflation or is able to communicate strategic shifts in policy
which could temper inflation expectations. We believe that permitting FDI in multi brand
retail, articulating a conscious policy on raising agricultural productivity and attracting
investments in the food supply chain may be suitable policy responses which may assuage
investor concerns. Markets may also react positively if global commodity prices show a
decelerating trend, which may perhaps occur in the second half of the year, when interest
rates begin to rise in the developed world.
Tug of War between inflation and growth; effort to tame inflation
now taking precedence over inherent growth bias
We believe that 1QCY11 will see the market being swayed by a continuing tug of war
between inflation expectations and growth. We confess that the government of India’s
growth bias so far is now being overwhelmed by the pressure to tame persistent and
elevated inflation and to shield the economy from rising global commodity prices. In such an
environment the market will remain concerned about the risk of a knee jerk policy error. The
government’s response to tame inflation may also bring back the overhang of an inflationwary
government, akin to that seen during periods of high inflation in CY07.
Improving global macro, resilient domestic consumption - key
positives
While we are worried about inflation being the key headwind for India, we are positively
enthused by the resilience of the Indian consumer and the improving global macro
environment, which should bode well for equity markets. 2011 should also witness a rotation
from global fixed income markets to equity markets and in such a scenario the Indian equity
market will not remain insulated. The intriguing aspect of the Indian economy – and one that
underscores our conviction on India’s long term fundamentals- remains the resilient domestic
consumer. Domestic consumption fuelled by rising prosperity – across rural and urban India-,
high aspiration levels and the lifestyle induced propensity to consume, continues to remain
resilient against the backdrop of elevated food inflation and rising prices. We are positively
surprised that despite rising petroleum prices, higher financing costs and price hikes by auto
manufacturers, demand appears to be resilient (our auto analyst Srini Rao expects four
wheeler demand growth to rise by 26% in FY12 after a historic 30% growth in FY11). Airline
passenger traffic has also remained significantly above trend growth rates despite sharp
airfare hikes. Similarly in mortgages, we have not seen any appreciable drop in HDFC’s
disbursement growth, even as the company has raised effective mortgage rates three times
in FY11 by a cumulative 125bps. We believe that consumption will remain the mainstay of
Indian economic growth in FY12 unless the Reserve Bank of India is compelled to move into
a policy overdrive to tame elevated inflation or manage inflation expectations in an
environment of rising global commodity prices.
An intriguing paradox: rising global commodity prices negative
for India Inc but positive for BSE Sensex
While rising international commodity prices will stress the Indian macro environment, the
impact of higher commodity prices and improving global macro has a positive impact on BSE
Sensex earnings with sectors geared to global recovery i.e. oil, metals, software and
international automobiles (Tata-Jaguar Land Rover) constituting 45% - 50% of Sensex
earnings.
With inflation worries reigning supreme – at least in 1QCY11, we would like to stay cautious
on rate-sensitives and our sector preferences would be biased towards global cyclicals and
global recovery plays like IT Services. We are also particularly excited on global commodities.
We also remain excited over continuing rural prosperity and the likely favorable bias given by
the government to the agriculture sector in the forthcoming budget. We have a selective
preference for consumption names where our analyst Harrish Zaveri prefers stocks in sub
sectors that possess pricing power. We are constructive on the outlook for the telecom
sector with our analyst Srini Rao convinced about abating competitive intensity and the
positive impact of 3G services on incumbents.
Our top buys are premised on abovementioned themes. Our top Buys are Cairn India (direct
proxy on global crude prices, although Vedanta deal may be an intermittent overhang),
Sterlite, SAIL (although the return of an inflation wary govt may emerge as an overhang),
Infosys, TCS, Tata Motors (geared to global plutonomy), ITC, Asian Paints, Bharti and
Mahindra and Mahindra.
2011 year end Sensex target of 21,000, implying a return of 10%
from current levels
We are setting our year end (Dec-11) Sensex target at 21,000, implying a 10% return from
current levels. At our target, the Sensex would trade at a fwd PE multiple of 16.4x – which is
a premium of about 6-8% to the average multiple at which market has traded over past five
years. We believe that this multiple is justified given India’s attractive long term potential and
resilient domestic consumption. We believe that this premium can widen substantially if
structural issues on infrastructure and oil subsidies are resolved and the government can take
up pending second generation reforms (FDI in multi brand retail, raising foreign limit in
insurance, implementation of direct tax code and goods and services tax). We would also
believe that in case there is a reversal in the upward trajectory of global commodity prices,
India’s valuation premium will expand as the country remains susceptible to high oil prices.
Risks to our base case
Our base case is that the Indian equity market will remain choppy over the near term and
then grind upwards, to end the year 10% up. However we highlight following risks both
upside/downside to our base case:
Upside risks: (i) resolution of the current political inertia, (ii) earnings upgrades, (iii) reemergence
of confidence in capex cycle, (iv) strong structural reforms from the government
and (v) Sudden and sharp rebound in global risk appetite
Downside risks: Key downside risks are: (i) Worsening of European Sovereign debt crisis
leading to a Lehman kind of event (albeit we assign low probability to it) could evoke strong
safe-haven seeking behavior from investors, (ii) inflation remaining persistently elevated in
2HCY11.
Sector summary
Figure 1: Brief Sector views
Sector Classification Sector Summary
Consumer Discretionary
Autos
We expect volume growth to normalize in FY2012, except for the 4W segment. We expect structural factors such as demographics &
rising disposable incomes coupled with low penetration & new model launches, to help maintain momentum in 4W. Our volume
growth estimates are: 2W - 14% (FY12E) vs. 25% (FY11E), Commercial vehicles -12% (FY12E) vs 25% (FY11E), 4W - 26% (FY12E) vs.
30% (FY11E). We forecast tractor growth at 11%, in line with its long-term trend rate. We expect margins to trend down by 50-80bps
for most companies on account of rising input costs and competitive intensity
Consumer Staples
Food, Beverage &
Tobacco
Cigarettes, paints, watches, jewelry, remain the best categories to invest in within the Indian context. Headwinds however, relate to
rising input costs. The key winners would be the ones which have pricing power.
House & Personal
Products
The big home, personal care and foods category face headwinds from higher commodity prices going forward despite the good long
term demographics, higher income and consequently purchasing power of the Indian middle class.
Energy
DB’s oil team believes that 2011 will see oil demand-supply fundamentals tightening keeping oil prices above US$95/bbl. We expect
upstream companies, particularly Cairn India, to focus on growth in reserves and production volumes. The rebound in petro-products
demand is expected to push regional refinery utilization rates higher with Singapore Complex GRMs expected to average US$6/bbl in
CY11, 30% above last year. We expect petrochemical margins to improve in the second half of 2011. RIL will be the key beneficiary of
higher refining and petchem margins. However, the Indian oil marketing companies will continue to see challenging times as losses on
sales of subsidized fuels keep mounting.
Financials
Banks
We expect loan growth to be 20-22% in 2011 similar to the growth rate in 2010 driven largely by infrastructure and retail and some
corporate capex demand. Given the prevailing tight liquidity and recent increase in funding costs we expect margins to remain under
pressure for a couple of quarters and rebound thereafter. However, FY12E NIM decline over FY11E NIM may not be more than 15-
20bps. The probability of central bank continuing to tighten because of inflation has largely been factored into the rates through the
recent spike. The big positive for banks this year would be fall in credit costs due to lower slippages from corporate loan portfolio; retail
NPL accretion has already slowed down.
Real Estate
While we are positive on the Medium to L-T prospects of the sector (driven by demographics and demand potential as also local
nature of players), we are worried on the immediate prospects (increasing interest rates and fall in affordability). We expect developers
would be forced to cut prices and focus on execution to drive demand and cash flows. Most of near term concerns are well factored in
the 90%+ underperformance of sector since Jan'09. We are more positive on the Mumbai and Bangalore based developers.
Health Care
Pharmaceutical & Bio
Significant stock out performance (20%) in CY10 despite limited positive news flow results in limited margin of safety now. Companies
will have to deliver on promises (approvals, launches, and market-share) in 2011. Intensifying competition across markets and INR
appreciation are other significant threats.
Industrials
Capital Goods
Order inflows could continue to show slowdown with macro headwinds, delay in government spending and higher interest rates. At
the same time, the rising EPC capacity with the country and competition from foreign players in some sectors (such as power
generation & transmission equipment, oil & gas equipment) could put severe pressures on realisations; which along with the rising
commodity cycle could hurt margins of the industry.
Information Technology
Software
For FY12E we expect continued strength in demand for offshore sourcing of services, with India solidifying its position as a key
destination. The baton will now pass from 'operating leverage' led earnings growth to 'broad based demand' across all key verticals
and services. Growth will be driven by improvement in demand for higher value-added services like consulting and package
implementation, engineering and R&D and system integration. the possible impact of wage inflation on margins will be mitigated
Materials
Building Materials
Cement producers may have to go for another round of production discipline as margin pressures could be quite high given (a) FY12E
utilization is estimated to be c82% (much lower than the levels where they get natural pricing power) and (b) seaborne thermal coal
prices are on the rise. Our estimates factor in some of benefits of pricing discipline of 6-7 months over FY12E.
Metals & Mining
We believe commodities will enjoy a fresh wave of investment flows during 2011. We expect another strong year for the industrial
metals complex. We anticipate aluminum could be a favored metal for investors as cost inflation and tight energy markets in China
create the potential for China to emerge a net importer in 2011. In steel, prefer integrated producers with captive access to raw
materials.
Telecoms
We are optimistic on the Indian telecom sector on account of abatement in competitive intensity and expected positive impact of 3G
services on the financials of Indian wireless incumbents. Incumbents have successfully defended revenue-share and the impact of
tariff falls on margins has been lower than expectation. We believe tariffs would consolidate at current level as new entrants with
leveraged balance sheets and weak cashflows are unable to engage in price competition for an extended timeframe. We also note that
the addressable market for 3G services is larger for India due to the pervasive lack of wirelines – this bodes well for incumbents
Utilities
Power developers may be able to support a demand growth of c6% - implying that spot tariffs could be at INR 4/kwh; despite
commissioning of new capacities and seasonable weakness in demand. With the cut-down in production targets of Coal India on
account of environmental issues, coal availability within the country is growing at much lower pace than the requirement levels;
constraining the utilization levels of plants. Prefer vertically integrated models.
Source: Deutsche Bank,
Valuations suggest
headwinds maybe in the price
Sensex seems to be fairly valued and factoring in most of the
near term negatives
After a sharp correction in January, the BSE Sensex is currently trading at 14.7x - largely in
line with Long Term average of ~14x but at a discount to the past five year average multiple
of 15.7x. Over the past one year the Sensex has traded in a very tight band of 14.5x-17x. .
The recent YTD market correction (8%) has again pushed Sensex valuations close to the LT
average which offers reasonable support, in our view.
What will take the index up from here?
We expect the market to remain range-bound in immediate term particularly until there is
some clarity on taming inflation. The trigger for a positive move is likely to come from the
following factors: (i) earnings upgrades, (ii) resolution of current political inertia, (iii) reemergence
of confidence in capex cycle, (iv) systemic liquidity turning benign and (v) strong
structural reforms from the government. While most of the above factors seem to be in place
for the long term, we expect near term to remain uncertain.
However, investment environment should improve later in the year by when we expect to
witness (i) normalization of political environment, (ii) abating of inflationary pressures, (iii)
some visibility on corporate and infrastructure capex, (iv) improvement in relative valuation for
Indian equities and (v) structural reforms like FDI in multi brand retail.
India’s premium to Asia ex-Japan and US has shrunk sharply
after a significant YTD underperformance
Indian markets have underperformed Asia-ex Japan and US by 9% and 11% respectively.
While MSCI India is down 8% YTD, Asia and US are up moderately by 1% and 3%. This has
led to a substantial shrinkage in India’s premium to MSCI Asia ex-Jap and US. After a near 14
month gap MSCI India premium to MSCI Asia ex-Jap (currently 219bps) has moved below
the LT average of 285 bps. Besides, with the emergence of the Developed Market trade,
India’s premium to US has more than halved from 343 bps in end Dec to 161bps currently.
Inflation should remain a key
concern
Multiple inflationary pressures emerging
Food inflation is the biggest worry for the government currently
India has been experiencing persistently high inflation (>7% yoy) for close to a year now.
Ironically, the government’s quest for inclusive growth and social cohesion have engendered
the resilience of rural India’s consumption and ironically are the factors contributing to
inflationary pressures as food supply trails rising rural prosperity.
Is high food inflation becoming structural in nature?
We are worried that food inflation may become structural because:
�� Higher household income (both rural and urban) is exerting upward pressure on food
prices with rising affordability and the move up the food value chain
�� India is also witnessing a shift in food consumption pattern towards high protein- diet
(which are naturally pricier than the earlier food basket) - driving food expenses per
capita upwards
�� Third and perhaps most worrisome is the deficient and inadequate supply side. Interplay
of (i) underinvestment in food supply chain, (ii) presence of middlemen, hoarders and (iii)
state’s involvement in public distribution, have all led to several inefficiencies and
avoidable wastage.
While the government may not be able to address the demand side of the food equation, it
needs to urgently address the supply side by reforming the food supply chain ensuring
adequate investment in procurement, cold storage, distribution and retail. For this the
government may look at permitting FDI in multi brand retail (particularly food).
Global commodity prices not providing any comfort either
Apart from food inflation (which accounts for ~26% of the WPI index), the rise in global
commodities (especially crude oil, coal and metals – which together account for 17% of the
WPI index) has resulted in WPI inflation staying above 7%. Global commodities have been on
an uptrend due to the confluence of several factors - : (i) unprecedented infusion of liquidity
by developed market Central Banks (notably US$600bn worth of QE-2 of Fed, US$1trn worth
of backstop by ECB/IMF for troubled EU peripherals, near zero rates of Fed, ECB and Japan),
(ii) strong demand from EM, (iii) weakening US$ and (iv) economic rebound in US.
Rising crude prices pose challenge to the macro economic
environment
Global crude prices have risen by as much as 25% over the past four months on the back of
(a) expectation of stronger global oil demand driven by Chinese demand, (b) drawdown of
OECD oil inventories (c) reduction in OPEC spare capacity in CY12 and (d) a QE2 induced
boost to risk appetite which has generically benefited most of the commodities. In response,
DB’s commodities team has also raised their forecasts for CY11 crude prices by 11% to
US$97/bbl vs. US$87.5/bbl earlier.
Oil has been a bete noire for Indian policymakers. since India imports ~75% of its oil demand
and oil imports account for ~33% of total merchandise imports. Higher oil prices aggravate
the twin deficits (i.e CA and fiscal), financial health of PSU oil marketing companies and
inflation outlook for India.
Our economists highlight the following sensitivities of crude prices to key economic
parameters:
On Inflation: Fuel products make up about 15% of the WPI; within this segment, petrol and
diesel prices have already seen substantial increases (+24.5%yoy and +15%yoy respectively)
in the past year. Still, both products would likely see further upward adjustment in prices as
the global crude oil price heads toward USD100. Another 10% or so rise in petrol price and 4-
5% increase in diesel price is likely, in our view. First and second round effect of the fuel
price increase could add another 80bps to WPI inflation, as per our calculations.
Consequently the 2011 average WPI inflation could well exceed 8.0%.
On current account deficit: We estimate the elasticity of the current account with respect
to oil price to be about 0.15, .i.e. a 10% rise oil prices worsens current account by about
0.15% of GDP. Hence the current account deficit could exceed 3% of GDP in 2011, but not
much more than that if oil prices stay around USD100 through the course of the year
On fiscal deficit: We estimate that higher oil price in 2011 could pose a ½% of GDP worth
of risk to the FY11/12 budget. However the authorities are unlikely to absorb the entire
additional cost, preferring to push some of the spending to the next fiscal year and some offbudget.
The government will also force substantial losses on state-owned oil companies as
yet another way to defray the explicit cost of living with 100 dollar oil. But the direct and
indirect cost to the Indian taxpayer will likely be substantial, nonetheless.
The curious paradox: rising global commodity prices benefit
Sensex even as economy is impacted negatively
While rising international commodity prices will stress the Indian macro environment, the
impact of higher commodity prices and improving global macro has a positive impact on BSE
Sensex earnings with oil, metals, software and international automobiles (Tata-Jaguar land
Rover) constituting 45% - 50% of Sensex earnings.
The biggest among these is Reliance Industries (~12% of Sensex PAT), followed by ONGC
(9%), Sterlite (4%), and Hindalco (2%). In addition, if we take the total exposure of Sensex
earnings to global factors, the corresponding figure would rise to ~48%% with inclusion of IT
services, Pharma and JLR’s earnings.
Earnings cuts likely, albeit
moderated by strong demand
Inflationary pressures behind the prospects of earnings cut….
As elaborated earlier, Indian companies face multiple headwinds from sharply rising cost
base and hence we believe there exists the risk of downward revisions to our earnings
forecasts.
We believe that analyst estimates have not yet factored unanticipated and across-the-board
rise in costs or the need to hold prices of commodities like steel and cement, where the
government may frown on rising prices.. While the earnings season is still in its early stage,
few big names have already seen earnings cuts as noted below:
Some of the key downgrades in the Dec-qtr earnings season have been:
Infosys: We have cut our FY12 and FY13 earnings estimates for Infosys by 7% and 4%,
respectively. Volume growth of 3.1% qoq (vs. our estimate of 7%) and a 2.7% rise in
reported pricing contributed to 5.9% qoq growth in USD revenues (vs. our estimate of 8.5%).
EBIT margins were flat qoq at 30.2%. This was 115bps lower than our forecast, mainly due
to a 170bps qoq volume-induced drop in utilization (including trainees).
Larsen & Toubro: We have cut estimates by 16% in FY12 and 19% in FY13. The slowdown in
the investment cycle finally hit Larsen & Toubro, whose order inflows fell 25% yoy—with the
company stating in the post-results conference call that it could miss its order inflow target of
+25% yoy for FY11. We have cut our consolidated EPS estimates for FY12 and FY13 by 20%
as a result of a slowdown in new order wins, coupled with the strong rise in commodity
prices.
…but we do not think that Sensex earnings growth will fall
below 16-18% for FY12, in a bear case scenario
While there do exist distinct possibilities of downward earnings revision, the degree of
revision should not be too sharp and we believe that FY12 should still end up showing
earnings growth in the range of ~16% - 18% (down from the current estimate of ~21%). Our
confidence on this stems from a reasonably strong correlation between earnings growth and
nominal GDP growth over the past decade (>50% over FY00-10) and the multiplier between
the two has ranged between1-2x in high growth years- while during the crisis years the
correlation has broken out (on certain instances earnings growth has even dipped into
negative territory). Since our base case scenario envisages a non-crisis year (despite several
headwinds) we believe that Sensex should at least be able to show earnings growth
multiplier of 1-1.2x nominal GDP growth, which our economics team estimates to be 15.7%
for FY12.
Also, it seems that many companies have been able to pass on some part of raw material
price hike to the end consumer. The undercurrent of strong aggregate demand in the
economy implies that the end consumer has the ability to absorb the rise in final product
prices (for details please refer to the section titled “The resilient Indian consumer”). A strong
and better than expected GDP growth in 1HFY11 has been chiefly driven by resurgence in
private final consumption expenditure, which has rebounded from the lows of 2.65% in Mar-
10 quarter. The latest reading of PFCE growth at ~9% reflect that the demand from private
sector has come back to the pre-crisis level.
In conclusion, while we believe that there will be downward revision to earnings estimates,
but the degree of downgrades will not be sharp since companies have demonstrated ability
to pass on the prices to end consumer and contain margin compression within acceptable
limits.
Will the government launch
bold reforms?
Inflation, scams and state elections to keep political machinery
occupied for the first half; reforms to take backseat
With the emergence of several scams in past few months (banking and 2G) and with
persistent inflation a major part of government’s efforts will be diverted towards addressing
these issues with policymaking and reforms taking low priority. In addition, several assembly
elections (including key states of West Bengal, Tamil Nadu and Kerala) are due in 1HCY11
and hence the political machinery will remain occupied
… but there exists a strong case to urgently allow FDI in multi
brand retail
Despite the likely inertia over reforms, we see high probability of government permitting FDI
in multi brand retail, as it will send out a clear signal about the government’s serious intent to
put in place an architecture which will help to mitigate the structural nature of inflation. India’s
food supply chain is highly inefficient and characterized by avoidable losses due to an
interplay of (i) underinvestment in food supply chain, (ii) presence of middlemen, hoarders
and (iii) state’s involvement in public distribution
While the government may not be able to address the demand side of the food equation, it
needs to urgently muster political will and support to reforming the food supply chain
ensuring adequate investment in procurement, cold storage, distribution and retail. Given the
urgency of the situation, it is very likely that the government may put this issue on a fast-track
and send out a strong signal of its intent to control structural aspect of food inflation.
Momentum in disinvestments should continue
FY11 is on track to be a watershed year for disinvestment. The government appears to be on
course to achieve its ambitious Disinvestment targets. While we do not see a likelihood of
strategic divestment (i.e. govt. holding falling below 51%), we do expect the government to
bring down its stake in several companies to 75%. Besides, we also foresee government
pulling down its stake to below 75% in few large cap companies, so as to conveniently meet
its disinvestment target. Already, the government is deliberating to reduce stake in ONGC to
below 75% and we remain convinced that more such instances will follow.
The resilient Indian consumer
Resilient consumers counterbalance rising prices with greater
purchasing power
Consumption accounts for close to 60% of India’s GDP and the recent positive surprise in
GDP growth data is attributable to a sharp rebound in growth in private final consumption
expenditure – indicating that the Indian consumer is willing and also able to consume - even
at high price points. The latest reading of PFCE growth at ~9% reflect that the demand from
private sector has come back to the pre-crisis level. Rising prices (specially food inflation at
~20%) have not yet led to serious social tensions or public protest - indicating that
consumers across various strata of society are able to absorb the price hikes.
A rising tide of liquidity is lifting all boats
While unprecedented backstop of liquidity from DM central banks is bidding up the prices of
commodities, Indian consumers also seem to have benefited from a combination of higher
income levels and wealth effect from rising gold prices (Indians are generally big holders of
gold), higher land prices, and rising equities. This has put higher purchasing power into the
hands of Indian consumer, who does not seem averse to spend the new found wealth on
conspicuous and other consumption items.
Despite price hikes volume growth has remained robust in
several categories
Despite a series of price hikes in various products/services, demand has continued to remain
robust – an indication of pricing power of companies in some cases and purchasing power of
consumers in most. 2010 witnessed the strongest volume growth – in many years - in both
4 wheelers and 2 wheelers despite several players hiking product price by 4-5% in latter half
of 2010 and oil prices also moving up ~10%.
Despite hikes in 4W-2W and petrol prices, auto sales continue to exhibit robust growth
Sales growth of sector leaders Maruti and Hero Honda has remained impressive, even after
the price hikes. Importantly our Auto team expects a continuation of robust growth of 26% in
4 wheelers in 2011, despite a significantly high base.
Dec-10 quarter witnesses largest air traffic in 2010, despite hike in ATF and airfare
We witness similar trend in other items of consumption both discretionary and staple.
Growth in airline traffic has bounced back to ~25% in Nov despite the hike in fares and is
amply reflected in sharp jump in airline load factor to 82%. Latest data from DGCA exhibits
that Oct-Dec’10 quarter witnessed the recorded the largest air traffic at 14.7mn fliers
Mortgage rate hikes in 2010 do not seem to have any appreciable impact on sanctions
or disbursements either
Similarly in mortgages, we haven’t seen any appreciable drop in HDFC’s disbursement
growth, even as the company has effectively raised the mortgage rates three times in FY11
by a cumulative 125bps. Sanctions growth has in fact moved up in the Sep-10 quarter
despite hikes in the preceding quarters – hinting at the robust demand for fresh mortgages
even after rate tightening. However, it still needs to be seen if mortgage disbursals are
impacted post RBI’s tightening of prudential norms for real estate loans.
Job opportunities register robust 27% yoy growth in Dec-10;
sequential growth remains intact
The labor market is also increasingly getting tight, with higher job opportunities putting skilled
workers in a strong bargaining position to negotiate higher salaries. The latest report of
Monster India (a subsidiary of global leader in job placements) on online job opportunities,
reveals that job opportunities rose by a robust 27% yoy in Dec-2010, with the absolute
reading for Dec-2010 being the highest since start of the survey period. Rising job
opportunities are clearly a lead indicator of an increase in purchasing power of consumers -
even as wage inflation exerts pressure on corporate margins. Some other key findings of the
report were:
�� Online recruitment activity expanded in nineteen of the 27 industry sectors monitored by
the Index between November and December. Twenty two industry sectors registered
positive annual growth
�� Online demand escalated in 12 of the 13 occupational groups monitored by the Index.
The longer-term growth trends improved in 11 occupational groups.
�� Annual growth rate is positive and robust in all 13 cities;
Bull-run in global fixed
income is fading out
Bond funds were the recipient of strong inflows in 2010 as
perception over developed economy’s growth remained weak
The report from DB’s European Strategy team indicates that, Global bond funds were the
highest recipient of fund allocation in 2010 with bond funds in total witnessing a 17%
accretion in AuM. The corresponding number for global equities was rather muted at 2%.
Bond funds witnessed inflows worth US$223bn while equity funds saw inflows of ~93bn.
This behavior was in line with the excessive provisioning of liquidity by Central Banks globally
lowering policy rates to near zero, and fragile confidence over the global growth prospects.
With US economic data showing signs of improvement, asset
allocation should move up the risk curve; US equities should rise
We believe that the strong bull market in fixed income in 2010 may already be on its last legs
as there are several signs that growth in US economy is getting better by the day (with the
infusion of monetary stimulus and fiscal bounty in form of tax cuts), and European sovereign
risks are likely to be contained although there will be intermittent bouts of risk aversion (like
the Greece and Ireland bailouts that flared up in may and Nov 2010). On this premise it is
likely that inflows into bond funds may reverse and find home in more riskier asset classes
like equities, emerging markets and commodities.
Our US Equity Strategists also believes that there should be a reversal of 2010 flows with US
equities likely to witness greater flows and end the year positive. They observe that:
�� Flows will return to equities when they have in past cycles, which is once there is
confidence in the economic recovery and the Fed communicates it is done trying to
lower rates for the cycle.
�� The fixed income markets are under-pricing the strength of an economic recovery and
the likelihood of the Fed initiating a rate hiking cycle beginning (or even discussed),
which will begin to be priced into the market in 2011.
�� The asset allocation out of bonds as typical at this point in the cycle and as having much
further to go, eventually benefiting equities over the course of the year.
Positive US equity market not necessarily negative for Indian
equities
While the case for positive performance of US equities seem to be consensus now, several
skeptics have started to believe that this will likely lead to outflows from Emerging markets
like Indian equities and hence lead Sensex lower in 2011. We believe that:
�� It is a misperception that the inflows into US equities could be financed by outflows from
EM funds. Rather, bond funds are most likely to be used to fund the buying of equities
globally, in our view
�� Second, an outflow from bond fund is symptomatic of return of risk appetite
underpinned by confidence over DM economic recovery getting stronger. This should
benefit most of the risk asset classes (like equities, EM and commodities) and not just
US equities alone
�� Thirdly, the chart below suggests that a year of positive return for US equities is not
necessarily bad for Indian equities. On the contrary, in the past decade Indian equities
have outperformed S&P500 in all years when US equities have provided positive annual
performance. The underperformance has chiefly been in years when both the equity
markets ended the year negative – underscoring the high beta nature of the Indian
market. The risk to this hypothesis could probably be extreme developments either in
global economy (i.e. EU peripheral debt crisis blowing over) or idiosyncratic domestic
risk
Commodities to witness bull
market in 2011
DB is constructive on its outlook for commodities
As a corollary to the reversal of bond flows, our commodities team believes that 2011 will be
a positive year for all types of commodities. This expectation is underpinned by their belief
that: (a) emerging market growth will remain strong, (b) the Fed’s efforts to stimulate US
growth will be successful, (c) European sovereign risk will eventually be contained and (d)
physical fundamentals in many commodity markets remain tight. Our team believes that
2011 will be characterized by fresh investment inflows into the commodities complex. The
sector’s appeal reflects investor appetite to gain exposure to emerging markets, as a tool to
hedge against tail events and market anxiety towards higher inflation ahead.
China remains a bullish factor for commodity markets despite short term disruption risk from
monetary tightening. In 2010, the country had become an even greater source of demand for
commodities such as thermal coal, silver, soybeans and cotton. While industrial metals
demand has the highest correlation to credit growth and consequently would be the most
sensitive to monetary tightening measures, we believe the underlying growth outlook in
China remains positive.
Positive read through for Indian Metals: our key overweight
We are convinced that 2011 will see the word supercycle emerge once again in the lexicon
of commodity investors. Investors must position for all commodities ranging from oil and
metals to foodgrains going up and remaining at above trend levels throughout the year,
which may perhaps acclerate the return of the fed tightening cycle to 2011 from current
consensus expectations of early 2012. As highlighted in the inflation section above, a strong
global commodities price environment will be beneficial for those Indian companies which
have their revenues benchmarked to global commodities prices.
Flows and risk appetite
should improve
Despite a weak start to 2011, FII flows into Indian equities should
remain positive for full year 2011
After a record year of FII inflows (~US$29bn) in 2010, the start to 2011 has been rather
sedate (with FIIs withdrawing ~US$725mn YTD). Investors currently remain wary due to
�� Sharply rising food inflation, despite expectations to the contrary.
�� Concern over the policy environment. The winter session of Parliament closed without
any business being conducted.
�� Emergence of the DM vs. EM trade, where strength of US recovery, Irish bailout and
relative undervaluation of DM vs. EM has attracted investor flows into developed
markets.
Source: Deutsche Bank; Bloomberg Finance L.P.
While we expect a period of uncertainty over Indian equities in 1HFY11 (with interspersed
instances of strength), sentiment towards India should most likely improve once the current
environment normalizes as: (a) relative valuations are likely to become much more attractive,
(b) there should be some resolution to the prevailing political gridlock (c) India’s high growth
potential should start to reassert itself (d) with interest rate hikes by Fed and ECB expected in
2H2011, the massive flows into Debt funds in 2010 should witness some rotation back into
Equity oriented funds
Domestic funds have begun to witness net inflows – first time in
past seven months
Domestic mutual funds have been in regulatory crosshairs in 2010 with SEBI banning entry
load for Mutual Funds and the regulatory authority over the ULIPs devolving to Insurance
Regulatory & Development Authority (IRDA) instead of SEBI. This ensured that through a
better part of 2010 domestic mutual funds witnessed new outflows.
However, in past few months we have noticed a sharp turnaround in redemption pressure in
equity mutual funds while gross inflows have remained relatively stable. This has enabled
mutual funds to report a net inflow figure (albeit a moderate US$214mn) in Dec’10. This also
seems to have driven net buying by mutual funds in Jan 2011.
While it may be too early to extrapolate this trend of net inflows to the rest of 2011 (also
affected by recent hike in deposit rates which may lead to savings gravitating towards bank
deposits), we believe that the worst of the regulatory overhang for mutual funds is behind us
and hence should be incrementally positive for MF flows into Equity markets.
No comments:
Post a Comment