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India Strategy: Focus on Four ‘I’s
Inflation, Interest, Investment & Inflow
We expect the above four issues to weigh heavily on the market in 2011. While
inflation worries are now becoming consensus, we think the key surprises can
come from slower growth in investments as lack of reforms and strict
enforcement of environmental laws have stalled projects worth US$160bn. The
political balance might tilt post the upcoming elections in key states and has the
potential to push back economic reforms agenda even further. We believe that
post the current correction, valuations are reasonable but the market should
consolidate and wait for clarity on Indian Polity.
Themes to play are: a) Inflation; and b) global recovery. Key overweight sectors
are Materials, IT, Pharma and Oil& Gas. Key underweight ones are Financials,
Consumer Staples, Consumer Discretionary, and Utilities. Neutral on Industrials.
Investment growth to lag
Both public and private sector investments have slowed down considerably. The
government has been grappling with a belligerent opposition and rising food
inflation, and its focus on investments has been missing. New road projects
awards have been significantly lower than expectation and hence visibility for
growth is poor. The private sector has become more cautious in view of stricter
implementation of environmental laws, in addition to problems with land
acquisition. The number of stalled projects as a % of projects under
implementation has increased to a high of 50% and it should be some time
before activity picks up.
Inflation worries – becoming consensus view
Inflation remains a structural issue for India given the slower growth in supply
and increasing rural and urban food consumption. Rising food inflation and the
possibility of high oil prices are now becoming consensus views and are largely
factored in the recent correction. However, an oil price shock, coupled with a high
current account deficit and rising subsidy bill, could still lead to further de-rating.
Economic reforms – key elections in May’11 to set the tone
Economic reforms have taken a back seat and its continuance will depend on
the political situation post the elections in the key states of West Bengal and
Tamil Nadu in May ’11. Stronger results for regional parties will put intense
pressure in the free functioning of this coalition government.
Valuations – reasonable post correction, cyclicals cheap
Post this correction, Sensex is now at 14x PER on FY12E. While we see some
risk factors to earnings, we believe the market is now much more reasonably
priced, at below the five-year average of 14.8x and provides a reasonable upside
to our Sensex target of 22000 (17x FY12). Cyclicals are much cheaper relative
to Staples and appear to be in preference
Macquarie Top-10 Focus List
Our top ten stocks have continued to outperform and are now 600bp above
Sensex and 770bp above MSCI India since Aug ’10. We have introduced
Reliance Industries, also a member of the broader Asia MarQuee list, to our top
ten stock list, replacing PFC.
Inflation, Interest, Investment & Inflow
Investment Growth – can it revive as environment worsens
The overarching theme in 2011, in our view, would be investment growth in the economy.
Economic growth over the past two years has been resilient owing to support from strong
consumption growth which continues to hold its own. On the other hand investment demand
has shown strength in patches and the growth pattern has been sketchy. For the economy to
grow at 8-9% from here on, investment needs to show sustained growth over the next few
quarters. Public spending has been constrained and spends on infrastructure are running well
below target. While private sector has shown its intention to intensify capital spends, the
execution on the ground has been severely constrained by strict environmental norms and
lack of reforms on land acquisition. We think conditions have become less favourable over
the past few months and further risks are emanating from rising interest rates, sustained high
food inflation and rise in global commodity prices.
Political developments over the next 2-3 months will be key to pick up in investment cycle.
Inflation – has it peaked or can surprise again?
Normal monsoon weather and a low base of the Wholesale Price Index (WPI) had raised the
expectation of lower inflation, which has recently been dashed by unseasonal rains pushing
food inflation. Investors are also reconciling the view that developed economies might avoid a
double dip, as reflected in Macquarie’s house view of US GDP forecast at 3.5%, and may
stoke inflation. Energy prices have already moved up sharply given the severe winter and are
now threatening to go even higher, with supply disruptions in Australia. While we believe that
the current correction in the market is partly to discount this increased risk, further de-rating
can happen if oil price were to move beyond the psychological mark of US$100/barrel.
Interest rates increases, which until now were seen as normalisation of the policy, might now
be required to contain inflation.
Inflows - 2010 was liquidity driven; what about 2011?
The liquidity-driven market of 2010 had its underpinnings in loose monetary conditions in
developed markets, money chasing risky assets and the relative attractiveness of Indian
equities, resulting in a huge equity premium of India over its Asian and emerging peers. India
registered close to US$30bn of FII fund inflows in CY2010, around 30% more than the
amount received at the peak of the euphoria in CY2007. As a result, India outperformed
emerging markets and the rest of Asia for the first three quarters of CY10 while
underperforming in the last quarter. We believe CY2011 may not be as robust since we
expect majority of the incremental flows would go value hunting in other emerging markets
and the gradually recovering developed western markets. That said, while this readjustment
of flows may lead to a short-term correction in the market, the downside would likely be
limited and money would eventually find its way back into the Indian growth story. However,
we expect returns to be moderate at around 13-15%.
Economic reforms – can this coalition government muster numbers
The Indian government has been mired in issues of rising food inflation and corruption.
Opposition political parties have brought the parliament to a standstill and no sign of any
resolution is in sight. In this context, this coalition government has limited ability to push
through any difficult economic reforms. The situation could get worse from here as two of its
key allies (TMC and DMK) go to elections in their respective states (West Bengal and Tamil
Nadu) in May '11. Now, if these allies are able to get a majority on their own or lose the
elections, their bargaining power would increase significantly. The probability of TMC winning
in West Bengal seems very high if the results of recent municipal elections in Kolkata are
anything to go by.
This coalition government is on a weak footing and is holding up only because of a lack of
united opposition. The issues of food inflation and corruption have given a common cause for
the opposition parties. Out of the total parliament seats of 545, the coalition government holds
only 262 seats, which is less than 50% and also includes both TMC and DMK. Also, it is
dependent on the outside support of SP and BSP for a simple majority. Both these political
parties (SP and BSP) have a strong hold in the state of Uttar Pradesh, which goes into
election in 2012. It would be really interesting to see what stand these parties take this year
and more so as they inch towards elections.
Sensex target of 22000 by March-end 2012
Our Sensex target of 22000 implies a 13% return by March-2012, reflecting a 17x forward PE
multiple, which is derived using an earnings CAGR assumption of 22% over the next 5 years
and cost of equity assumption of 14%. Our FY12 PE estimate reflects a slight de-rating of our
earlier estimated fair multiple of 18x as we believe macro factors are sending mixed signals at
the moment and the uncertainty would drive investors to reallocate their funds to developed
markets or other emerging economies. Our bottom-up FY12 annual EPS growth estimate for
the Sensex stands at 19%, marginally lower than consensus growth estimate of 20%.
Playing global cyclicality while retaining defensive exposure
Our house view on global macro sees economic recovery in the developed markets of US
and Europe and high commodity prices in 2011. Keeping in mind the above factors, we
recommend playing global cyclicality while retaining our defensive exposure.
• Sectors like metals and energy would benefit from the rising global commodity cycle while
IT would continue to gain from recovering developed markets.
• Our defensive overweight exposure primarily includes Healthcare.
• We are now underweight financials owing to rising rates denting net interest margins and
an overhang from pension costs.
• We have reduced our exposure to capital goods to market weight due to worries around
execution and inflow of new projects.
• We have also downgraded both consumer staples and discretionary to underweight; the
former on the back of input price pressures impacting margins and the latter based on our
concerns around slowing discretionary spending amongst consumers.
Stock hunting continues to be the order of the day
The surge in fund inflows into Indian equities saw all sectors gaining in measure with some
significantly outperforming others. This had the impact of pushing up stock valuations way
above their 2009 levels. With valuation across most sectors and stocks hovering around or
above their long term averages, there seems little merit in focussing on value. The
differentiator amongst stocks would be ones that have clear visibility in earnings and are
investing for growth, thereby contributing to job and income growth in this high inflation
environment. We believe there are pockets of opportunity available across sectors that we
recommend buying.
Macquarie Top-10 Focus List
Our Top-10 Focus List is a concentrated list of stocks for those looking for high absolute
returns from good quality stocks. The recommended list consists of stocks that we believe are
ahead of their peers in terms of earnings visibility and growth potential. Our focus list has
outperformed the Sensex by 600bps and MSCI India by 770bp since August 24, 2010. We
have been making interim changes to the focus list based on our sector preference and
analyst conviction call on specific stocks. We are replacing Power Finance with Reliance
Industries based on our underweight call on utilities and overweight call on commodities. In
addition Reliance has been a laggard, underperforming the Sensex by 20% in CY2010.
Investment growth – Can it revive?
Clouds of Uncertainty over Investment Growth Prospects
The disruption in the investment cycle around 2008 due to the global credit crisis reversed
towards the beginning of 2010 and has looked promising since then. However, there have
been mixed signals over the past couple of quarters regarding the pace of activity – IIP
growth has been volatile and has moderated in the last two quarters while GDP data for Q2
showed healthy double-digit growth in gross fixed capital formation (GFCF). Data on project
investments in various sectors too suggest investment growth may be on track. However, we
think conditions have become less favourable over the past few months with rising interest
rates, sustained high food inflation and the rise in global commodity prices threatening to slow
economic activity.
Project implementation has recovered at the aggregate level but
more projects are also getting stalled…
Investment activity at the aggregate level appears to have turned after bottoming around 2-3
quarters back. Higher value projects are being added and the rate of implementation has also
improved. However, it is not clear yet whether this rebound in activity has enough steam in it
to sustain for another few quarters, primarily due to the fact that the number of projects
getting stalled has also increased.
…and project inflow has slowed, thereby showing a mixed trend
across sectors…
The manufacturing sector has shown a stable trend in project implementation, albeit slower
than the pace at which projects have been added. Areas that have contributed to this
somewhat muted pace of progress are big ticket sectors like machinery and transport
equipment. Additionally, although the pace of implementation of existing projects has
increased in sectors like mining and real estate, they have also shown a much higher
proportion of projects being stalled and fewer being added to replace completed ones. Areas
where the trend looks better are metal products, non-metallic mineral products and power.
…and various hurdles have raised concerns about project execution
With environmental norms becoming stricter, land harder to acquire and legal hurdles coming
in the way, a number of projects have hit roadblocks that have delayed their implementation.
Sectors such as Mining and construction have been particularly hit hard given the number of
approvals and clearances they require to get their projects rolling. Additionally, another area
of concern is the progress of infrastructure development which in most cases is a prerequisite
for attracting other investments into India. Progress in infrastructure projects in roads, ports
and power seem to be under a cloud of uncertainty given recent problems around land
acquisition, forest clearances and availability of resources (such as coal linkages for power).
This has slowed down the inflow of capital into states such as Orissa and West Bengal.
For instance, projects estimated at US$90bn are waiting to be cleared in Orissa due to the
above mentioned hurdles. In most cases it is either administrative failure to deliver what was
promised or resistance on the part of the people who are at the risk of being displaced. Either
way, it is blocking massive amounts of capital from being deployed that could be used in
alternative projects or in other states
Rising cost of funds pose additional risk to the pace of investment
One of the key enablers of the booming investment cycle from 2004 onwards was cheap
credit, not only in India but also abroad. The inflow of new projects and implementation of
existing ones reached new highs around the same time corporate credit spreads narrowed
substantially around end of 2007. Since then spreads have hardened through the course of
the credit crisis, then narrowed through the period of fiscal and monetary easing and have
now started to tighten again. The current rate tightening phase since early 2010 has so far not
seen any adverse impact on economic activity but is beginning to see its intended impact of
increasing borrowing rates.
Corporate borrowing spreads have already widened by 30bps in the past couple of months
and are expected to go up further as deposit rates have increased substantially, liquidity
continues to be tight and chances of another rate hike by the RBI seems likely in the next two
months. With inflation remaining stubbornly high this could potentially slow down consumption
and therefore investment even before it has begun to show any meaningful rise.
Corporate capex: Mixed signals and largely hinged on stable
consumption growth and pause in interest rate hikes
At the corporate level, capex has not picked up to the extent that was expected. At the same
time, the risk of rising interest rates slowing down consumption and investment looms large.
However, conditions broadly remain favourable for capex to pick up, although largely
dependent on sustained consumption growth.
�� The sharp rebound in GDP growth since mid-2009 has primarily been on the back of
consumption growth and government spending on infrastructure. On the other hand,
private investment, while having recovered, is yet to pick up in a meaningful manner.
Consensus has pegged real GDP growth at around 8.5% for FY11 and 9% for FY12, which
bodes well for corporate revenue growth. At the same time, given the lagged relationship
between GDP, revenue and capex growth, there does appear to be a good case for capex
to recover from here.
�� Recent surveys have indicated firms are operating at high capacity utilisation levels. In the
FICCI manufacturing survey conducted in Q2FY11, all the sectors surveyed indicated that
they were operating above 70% utilisation levels. Amongst the ones operating at 80%
levels and above were automotive, cement, pharma and chemicals while capital goods
was operating at 75%. All sectors, except metals and metal products and textiles, indicated
capacity additions in the coming quarters
�� In a related economic survey, the proportion of respondents indicating >75% capacity
utilisation in their firm has been steadily increasing; it currently stands at 61% respondents
versus 49% in Q1FY10. At the same time, the proportion of respondents indicating >50%
capacity utilisation stands at 88% versus 79% in Q1FY10.
But are firms ready to spend?
�� The picture doesn’t look too bad now given the conditions back in FY08: Capex-tosales
and capex-to-depreciation ratios came off their 10-year peaks post the global credit
crisis signifying a break in the booming investment activity since 2003-04 as a result of
which ROEs took a hit in the following period. However they have recovered gradually as
firms were able to maintain margins through cost controls even though asset turns
declined. From thereon firms have used their capacities built during the preceding five
years to cater to the rebound in domestic consumption. Assuming margins remain stable
owing to high costs and competitive intensity, consumption would need to show stable
growth for firms to step up their capex spending.
�� But increasing borrowing costs pose a risk: As noted above, increasing credit costs
may turn out to be a big factor in deciding the direction of firms’ investment plans. While
infrastructure spending will likely continue to get a fillip from the government, it is private
sector spending that is going to determine further job and income growth in FY12. Past
trends show that capex growth is indeed sensitive to rise in the cost of funds (see Fig 26
on next page). Given that capex didn’t pick up in the past 18 months when credit spreads
had actually narrowed, it may be a difficult case to argue a meaningful pick up now when
borrowing costs have already begun to rise. This necessarily means that underlying
consumption demand needs to be strong enough to incentivise firms to step in and invest
for growth.
Consumption needs to hold up to support capex…
After leading the economy out of the slowdown, consumption continues to hold its own. While
numbers have moderated from their peaks around the beginning of the year, this was to be
expected considering the high base effect and some impact of inflation feeding through to
demand. While food inflation continues to spike up household expenses, higher interest rates
run the risk of slowing down discretionary spending. However, we expect continued support
from rural demand owing to a good monsoon season and the positive income effects of the
government run NREGA scheme.
Auto sales have been robust throughout 2010 owing to high rural and urban income growth.
On the other hand cement demand has been weak throughout the year giving conflicting
signals. However rising input costs have pushed car prices up and coupled with rising interest
rates, may impact demand going forward. GDP data, which has so far continued to show high
consumption growth, would need to be monitored over the next few quarters for any signs of
impact from inflation and interest rates.
...However, inflation and interest rates may pose the main risks
Inflation remained stubbornly high throughout 2010 and unseasonal rains around the last
quarter did not help matters much as food prices continued to rise due to crop damage
resulting in shortage of primary food articles. This has ballooned into a major political issue
but we are more concerned about its repercussions on consumption growth. Given high oil
and commodity prices we expect inflation to remain at elevated levels primarily owing to
recent evidence on price hikes in petrol, steel and cars.
Inflation and interest rates – Potential risks
Inflation is a big worry on several counts – it may derail growth while rising rates may cut
into investment and consumer spending. The big swing in headline WPI inflation was initially
driven by food prices that were affected by the 2009 drought on the supply side and the
strengthening rural consumption on the demand side. Until recently, inflation drivers were
shifting – food inflation was easing while non-food inflation had started to pick up. The
expectation of inflation easing was hinged on good monsoon, which eventually turned out
normal. However, unseasonal rains post monsoon impacted harvest and damaged crops in
many states and has resulted in food prices rising again. At the same time, input costs
pressures are seeping into prices of manufactured goods, which would continue to push up
prices of non-food items.
Recent rise in primary food prices have raised inflationary concerns again: Monthly
figures of WPI have created an illusion of rapidly declining inflation, partly owing to high base
effect from last year. Even so, the last recorded WPI figure for November came in at 7.5%,
still a fairly high number. However, weekly inflation numbers for primary food and mineral oils
in December show a sharp spike up due to recent increases in vegetable prices, particularly
onions, and the impact of $90 crude on retail petrol prices.
Persistent high inflation would likely prompt the RBI to continue to raise interest rates.
We have already seen deposit rates go up over the past quarter and would soon see lending
rates going up too as higher costs of funds compress net interest margins, thereby forcing
banks to raise rates. Most rates on consumer loans such as autos and mortgage have started
climbing up and further rate hikes would likely push them up further. While high inflation
would dent household budgets due to higher spends on essential items, the combined effect
along with higher interest rates could lead to households cutting down on discretionary
spending. At the same, as noted earlier, it may impact investment demand as corporate
capex hasn’t picked up meaningfully but borrowing rates have already started climbing.
Portfolio inflows likely to soften
The incremental outcomes for India since the middle of 2010 have bordered on neutral to
negative. While food inflation continues to rise unabated, on the policy front, the rate
tightening cycle would likely continue for a few more quarters. We are concerned about the
impact this could have on slowing down consumption, thereby holding off on the corporate
investment cycle that we have been banking on. Recovery in developed markets would likely
keep commodity price levels elevated which may keep inflation levels high in India. We think
this would have implications for incremental fund inflows for India as a major part of these
flows would get redirected towards these economies.
Foreign Institutional Investor (FII) flows drove markets in 2010
FII flows were the main driver of the market in 2010. India received close to US$30bn of net
inflows, the highest ever in its equity market history. Domestic mutual funds on the other hand
were net sellers as they experienced redemption pressures from investors wanting to cash
out and recover their losses incurred during the credit crisis. However, the picture in 2011
may be different as incremental fund flows to India may be much lesser than what it was last
year owing to a recovery in developed markets and relative attractiveness of other Asian and
emerging economies.
Sensex Premium to the Rest of the World is High
The Sensex is currently trading at premium valuations to the rest of the world. The premium
currently ranges from 25% in the US to 60% in Europe. With its emerging market peer group,
the Sensex is currently at a rich premium of over 40%. At the same time, growth prospects
across most export oriented Asian and emerging countries have turned more positive,
especially given the turnaround in developed markets.
We believe CY2011 may not be as robust since we expect majority of the incremental flows
would go value hunting in other emerging markets and the gradually recovering developed
western markets. A look at the relationship between FII inflows and the change in the US ISM
manufacturing index shows a negative relationship in many instances, especially in the last
two years. As US recovery sets in and leading indicators start turning more positive, we would
likely see a reversal in fund flows back into the US. That said, while this readjustment of flows
may lead to medium term correction in the market, the downside would likely be limited and
money would eventually find its way back into the Indian growth story once valuations
become more attractive.
Excessive inflows in the past indicate modest returns in future
High liquidity has resulted in excessive fund inflows making the market more volatile. In many
cases the market has moved up too quickly, making valuations look unattractive as too much
money ended up chasing stocks. In the past, excessive flows have signalled modest returns in
the following 12 months. We do see support, however, from domestic investors who have been
net sellers lately and would likely be waiting on the sidelines to enter at more attractive levels.
FDI flows have not been encouraging in 2010
While FII flows drove markets, currency appreciation and bridging of the current account
deficit, what India needs is inflow of long-term investment capital in the form of FDI. The
inflow of FDI in 2009 was promising but lost steam in 2010. The cumulative flows from April-
September 2010 were US$11bn and it would take a lot for it to reach the highs of US$30+ bn
reached during FY08-FY10. Lower FDIs also run the risk of slowing down the investment
cycle as India is still a capital deficient economy and relies on the outside world for funding its
long term investment projects. At the same time, lower FDI and higher portfolio flows run the
risk of derailing markets as hot money tends to flow out quicker than it flows in.
Moderate capital flows, high commodity prices may widen current account
deficit
The current account deficit touched US$15bn as of the end of the September quarter while
FII inflows were close to US$20bn during the same period. Since we expect flows to slow
down in 2011, India would have to bank on a greater inflow of FDI, or conversely hope for
commodity prices to ease, to bridge the current account deficit. Crude prices have been
hovering around US$90 and likely to inch up during the course of this year, thereby putting
additional pressure on the widening deficit, and therefore the rupee. This would have the
effect of making oil imports more expensive, thereby putting more pressure on the current
account balance and domestic inflation. However, the magnitude of impact on the rupee
remains to be seen as higher interest rates may attract more capital, offsetting some of the
pressure on the currency. One positive aspect of a weakening rupee would be increased
competitiveness of the export sector, which could benefit on global recovery expectations
Shaky political balance – Reforms may
suffer
The Indian government has been mired in issues of rising food inflation and corruption.
Opposition political parties have brought the parliament to a standstill and no sign of any
resolution is in sight. In this context, this coalition government has limited ability to push
through any difficult economic reforms. The situation could get worse from here as two of its
key allies (TMC and DMK) go to elections in their respective states (West Bengal and Tamil
Nadu) in May '11. Now, if these allies are able to get a majority on their own or lose the
elections, their bargaining power would increase significantly. The probability of TMC winning
in West Bengal seems very high if the results of recent municipal elections in Kolkata are
anything to go by.
This coalition government is on a weak footing and is holding up only because of a lack of
united opposition. The issues of food inflation and corruption have given a common cause for
the opposition parties. Out of the total parliament seats of 545, the coalition government holds
only 262 seats, which is less than 50% and also includes both TMC and DMK. Also, it is
dependent on the outside support of SP and BSP for a simple majority. Both these political
parties (SP and BSP) have a strong hold in the state of Uttar Pradesh, which goes into
election in 2012. It would be really interesting to see what stand these parties take this year
and more so as they inch towards elections.
Market outlook
Expect Moderate Returns; Sensex Target of 22000 by Mar-12
Our Sensex target of 22000 implies a 13% return by March-2012, reflecting a 17x forward PE
multiple, which is derived using an earnings CAGR assumption of 22% over the next 5 years
and cost of equity assumption of 14%. Our FY12 PE estimate reflects a slight de-rating of our
earlier estimated fair multiple of 18x. We believe macro factors are sending mixed signals at
the moment and the uncertainty would drive investors to reallocate their funds to developed
markets or other emerging economies. This would likely cause the PE multiple to de-rate in
the medium term, till the time these uncertainties are addressed. That said, while this
readjustment of flows may lead to short term correction in the market, the downside would
likely be limited and money would eventually find its way back into the Indian growth story.
Stock Hunting Continues to be the Order of the day
The surge in fund inflows into Indian equities saw all sectors gaining in measure with some
significantly outperforming others. This had the impact of pushing up stock valuations way
above their 2009 levels. With valuation across most sectors and stocks hovering around or
above their long term averages, there seems little merit in focussing on value. The clear
differentiator amongst stocks would be ones that have clear visibility in earnings and are
investing for growth, thereby contributing to job and income growth in this high inflation
environment. We believe there are pockets of opportunity available across sectors.
Macquarie Top-10 Focus List
Our Top-10 Focus List is a concentrated list of stocks for those looking for high absolute
returns from good quality stocks. The performance of the portfolio is based on unweighted
averages of the stocks. There are no transaction costs involved. The recommended list
consists of stocks that we believe are ahead of their peers in terms of earnings visibility and
growth potential. Our focus list has outperformed the Sensex by 600bp and MSCI India by
770bp since August 24, 2010. We have been making interim changes to the focus list based
on our sector preference and analyst conviction call on specific stocks. We are replacing
Power Finance – thereby booking a loss of 11% -- with Reliance Industries based on our
underweight call on utilities and overweight call on commodities. In addition, we believe RIL is
best positioned to benefit from India’s untapped oil & gas potential and we see sizable upside
potential to upstream valuations and earnings. Reliance has been a laggard, underperforming
the Sensex by 20% in CY2010.
Sensex earnings growth of 19% for FY12
Our bottom-up estimates for Sensex stocks yields an 18.5% aggregate earnings growth in
FY12, marginally below consensus expectation of 20%. We, however, expect higher earnings
growth of 24% in FY11 versus consensus estimate of 23%. However, consensus earnings
revisions for FY11 have been quite muted over the past quarter with small negative revisions
wherever they have occurred. On our estimates, Sensex has so far achieved around 43% of
full year estimates in 1HFY11 and would probably achieve around 65% by the end of Q3FY11
results. This leaves around 35% of full year estimates to be achieved in the last quarter
against a ten-year average of 26-27%, thereby increasing risks of downgrades.
Sector preference
Play global cyclicality while retaining exposure to defensives
Globally, our economics team is expecting a recovery in the developed markets of US and
Europe while our commodities team is bullish on the continuing commodity up-cycle. Our
Asian strategy portfolio, taking cognizance of this, is overweight on export oriented countries
like Korea and Taiwan which would benefit from a turnaround in the US economy. At the
same time, recovery in developed markets would likely keep commodity price levels elevated,
which may keep inflation levels high in India. We think this would have implications for
incremental fund inflows for India as a major part of these flows would get redirected towards
these economies.
Keeping in mind the above factors, we recommend playing global cyclicality while retaining
our defensive exposure.
�� Sectors like metals and energy would benefit from the rising global commodity cycle while
IT would continue to gain from recovering developed markets.
�� Our defensive exposure primarily includes Healthcare.
�� We are now underweight financials owing to rising rates denting net interest margins and
an overhang from pension costs.
�� We have reduced our exposure to capital goods to market weight due to worries around
execution and inflow of new projects.
�� We have also downgraded both consumer staples and discretionary to underweight; the
former on the back of input price pressures impacting margins and the latter based on our
concerns around slowing discretionary spending amongst consumers
Cyclical sectors appear cheaper relative to staples…
In India, non-financial cyclical sectors such as consumer discretionary, materials, energy and
industrials have always traded at a discount to the defensive sectors such as consumer
staples, healthcare and utilities. In the past ten years, this discount has averaged 25% while
at the peak of the crisis, the discount stood at 44%. Currently the average 12-month forward
PE for cyclicals relative to staples stands at 37%, closer to the crisis level than to the longterm
average. Although concerns around investment growth are legitimate, the conditions
today are in no way comparable to the ones prevailing back then. This leads us to believe
that the recent sell-off in these sectors relative to defensives was probably overdone and has
made them relatively attractive.
…and their earnings estimate profile seems to be holding up
Forward earnings estimates for cyclical sectors have been increasing since recovery went
underway from early 2009. Although growth in EPS estimates has come off its peak from
early 2010, it continues to be high and well above estimates for staples. Given the positive
outlook for commodities, we believe estimates should hold up for some more time to come.
We believe earnings upgrades in cyclical sectors –particularly those linked to the global
commodity cycle, such as metals and energy – would allow them to outperform staples and
bridge the current valuation gap.
…but rising interest rates pose a big challenge
History shows cyclicals normally tend to underperform in a rising rate environment and
outperform when rates are falling. However, merely a rising rate environment does not spell
doomsday for cyclicals; sustained growth coupled with stable interest rates is a good
environment for cyclicals to outperform relative to staples. We note that rates are not yet
close to the levels of 2008, yet cyclicals have massively underperformed since the beginning
of 2010. Therefore sustained rise in interest rates from here could put pressure on cyclicals’
performance, in our view. At the same time, any expectation of a pause in the rate hike cycle
in the next couple of quarters could see cyclical sectors start to outperform sooner.
Earnings revisions hanging in balance
The trend in earnings revisions for FY11 and FY12 continue to remain in the neutral to
negative zone. The mixed outcomes at the macro level since mid-2010 have heightened the
uncertainties around the ability of firms to deliver the earnings growth being priced into
current numbers. The Q3FY11 earnings season, which is currently underway, would be
important in deciding the future course of earnings revisions. We think there is a greater risk
of downgrades to FY12 numbers over the next couple of quarters.
The trend so far has continued to be negative in Consumer Discretionary, Energy, Materials,
Telecom and Utilities. The market has taken cognizance of this fact as these are the same
sectors that have underperformed over the past couple of months. Heading into FY12, the
earnings revision profile looks a lot different now compared to what it did at the end of the
September 2010. However, with the commodities up-cycle expected to continue, Materials
and Energy should see some upgrades, which should drive their performance over the next
few quarters, in our view.
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