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We expect the Indian equity markets to end 2011 essentially unchanged from current levels, as
high inflation and oil prices and a wide current account deficit moderate investor enthusiasm.
2011 year-end target of 800-850 for MSCI India (-1 to +5% price return for full year)
We expect a weak macro environment and moderating foreign investor flows to lead to significant
multiple compression, offsetting the impact of earnings growth. At 800, the lower end of our
estimate for 2011, MSCI India would trade at 14.8x 12M forward RBS EPS estimates vs 17.4x at
the end of 2010. Current aggregate consensus earnings growth expectations per Bloomberg
assume significant margin expansion. We are less optimistic; our EPS estimates are 5-8% below
consensus.
The macro environment continues to be tough
Inflation continues to be a concern with the recent uptick in food inflation while the widening
current account deficit is being funded by volatile portfolio flows. High crude oil prices will likely
further pressure the current account and fiscal deficits.
Bullish on materials, telecoms and utilities, still bearish on financials
We are bullish on materials, telecoms and utilities, but have pruned our overweights in technology
and staples. Financials continues to be a key underweight. We still prefer large caps over
small/mid caps. Key stock overweights are CAIRN, HNDL, HZ, HCLT, BHARTI and PWGR. Key
underweights are BPCL, COAL, ACEM, JSTL, HDFC and ICICIBC.
Report card: how have we done so far?
Although our directional call on the Indian equity market did not work, our model portfolio has
outperformed MSCI India since inception (24 August 2010 through 5 January 2011) by 157bp,
and our key overweights outperformed our key underweights by 5.8%. Financials, our key
underweight sector call, underperformed MSCI India by over 8% from 24 August, 2010 to 5
January, 2011. MSCI India also underperformed MSCI Asia ex Japan by 5.5% in local currency
terms over the same time period.
Return forecast and earnings outlook
We expect 2011 to be flat for Indian equities, as a weak macro environment, coupled with
slight earnings disappointment should lead to multiple compression. Aggregate margin
expansion assumptions per Bloomberg consensus look aggressive to us.
We expect 2011 to be flat for Indian equities, with a year-end target of 800-850 for MSCI India
(full-year price returns of -1% to +5%). Our corresponding year-end price targets for the Nifty are
6,100-6,500, and the Sensex are 20,500-21,750.
Key to our thinking is that macro concerns regarding inflation, the fiscal and current account
deficit, and potential earnings disappointments could lead to significant multiple compression from
the current levels, which we see as elevated. Also, as the US economic recovery takes hold (RBS
expects qoq GDP growth in the US to accelerate to 3.8% in 4Q11 from 2.6% in 4Q10 – see
Global Economic Forecasts, dated 20 December 2010), there is the potential for foreign investor
inflows to slow from the large US$29bn in 2010.
MSCI India at 800 at year end implies a 12M forward P/E of 14.8x on RBS estimates , a bit above
the historical average of 14.2x since December 2000. The 14.8x forward P/E would be an 18%
premium to MSCI Asia ex Japan’s historical average P/E of 12.5x (we assume that MSCI Asia ex
Japan is at its historical average P/E at the end of 2011) vs the 2010 year-end level of 36%.
The MSCI India’s forward P/E at the end of December was 17.4x on RBS estimates – as such, we
are expecting multiple compression of around 15% to offset our forecast 16% increase in the 12M
forward EPS for the year. Keep in mind the forward P/E multiple compressed 6% even in 2010
(refer to the chart on the left). Please refer to the table on the following page for details.
As we highlighted in Tactically bearish, structurally bullish, dated 23 August 2010, we find India’s
current P/E premium of 33% to Asia ex Japan vs the historical average of 18% to be
unsustainable given the compression in relative returns on equity we have seen (Charts 4 and 5).
And valuations matter for India too – as Chart 6 shows, forward 12M price returns (the realised
price return 12 months from that date) for MSCI India are inversely correlated with the Future
Growth Ratio (FGR is a single metric which blends earnings multiples and the prevailing interest
rates. Specifically, the FGR is the proportion of the current stock or index price explained by its
future growth. For further details on the FGR please refer to Tactically bearish, structurally
bullish).
And 12M forward price returns relative to the region are inversely correlated to India’s forward P/E
premium
Current Bloomberg consensus expectations expect MSCI India’s net income to grow 23% in fiscal
2012, post a 30% gain in fiscal 2011. Sales growth expectations for fiscal 2012 are more muted at
15% – as such, around 8% of the bottom line expansion is coming in through net margin
expansion (accounting for 35% of the total net income growth).
We find these aggregate net margin expansion assumptions optimistic given the numerous cost
pressures in the system. The current level of commodity prices (as measured by the CRB Metals
Index) are 45% above fiscal 2010 levels, while interest rates (as measured by three-month CP
rates) are 88% higher.
We expect lower earnings growth for fiscal 2012 and 2013 primarily due to less optimistic
assumptions on margin expansion. Our FY12 and FY13 EPS estimates for MSCI India are 5-8%
below consensus.
For the Nifty index, fiscal 1H11 profit after tax grew 37% yoy. Full-year Bloomberg consensus
expectations for FY11 are for growth of 26% (this is higher than the expected EPS growth of 22%
because of equity issuance). As such, implied earnings growth in 2HFY11F to meet this target is
only 18% (a significant slow down from the 37% in the first half). However, earnings levels were
depressed in September 2009 (yoy earnings decline of 12%) but had recovered by March 2010
(yoy growth of 50%).
Foreign investor inflows into Indian equities totalled a record US$29bn in 2010. We think it may be
hard to replicate this in 2011 for a couple of reasons. As the US economic recovery takes hold,
investor funds may flow back into US equities at the expense of emerging market equities. Also,
we think that global investors may have been disappointed by the muted performance of Indian
equities in 2011 vs 2010 – as Chart 11 shows, MSCI India (Local) outperformed S&P 500 by 68
percentage points in 2010; the outperformance was only 1.3 percentage points in 2011.
We think upside risk to the Indian market could come from domestic institutional and retail
investors getting more excited about the market. Domestic institutional investors net sold
US$4.7bn of shares in 2010 vs purchases of US$16.7bn in 2008 and US$5.4bn in 2009.
However, we see this risk as being relatively limited, as equity mutual funds are still not seeing
any significant net inflows, and inflows into the equity unit-linked product for the insurance sector
are also down significantly (by up to 50% in some instances) post the new product regulations
introduced by the insurance regulator. Some media reports suggest that cash levels at some
insurance companies are as high as 25%, but these same media reports also suggest that
insurance companies prefer to invest in relatively risk-free 12-month certificates of deposits
yielding more than 9% rather than equities.
Macro not looking very friendly
Inflation continues to be a concern with the recent uptick in food inflation, and the
widening current account deficit is being funded by volatile portfolio flows. We expect high
crude oil prices to further pressure the current account and fiscal deficits.
India’s headline inflation per the wholesale price index (WPI) reached 7.48% yoy in November,
essentially in line with the Bloomberg consensus of 7.45%. As such, yoy inflation declined from
the 8.58% recorded in October. The decline was primarily driven by the decline in food inflation
(primary and manufactured products) to 6.11% from 9.97%, as core inflation (excluding food and
fuel) ticked up a bit to 7.4% from 7.26%. Core manufactured product inflation was 5.41%, up from
5.10% in the prior month.
The yoy decline in food inflation was linked to the base effect (food inflation spiked 4% mom in
November 2009). The moderation that was expected in food prices, due to a good monsoon, has
not materialised due to an uptick in manufactured food product prices (manufactured food product
prices up 1.07% mom vs a 6bp increase in primary food product prices).
The more recent weekly data on food inflation are quite worrisome as they suggest a significant
increase even in primary food product prices too. Primary food prices are up 3% in December
(through 18 December) driven by the 21% increase in the prices of vegetables. Taking into
account the weekly inflation data suggests that headline yoy WPI inflation could be north of 8% for
December vs the 7.48% in November.
We also think that headline WPI inflation will be close to 7% in March 2011, significantly above the
RBI’s target of 5.5%, and also above the finance minister’s recent expectation of 6.5%.
Separately, the government has repeatedly postponed a decision on raising diesel prices
(scheduled meetings of the Empowered Group of Ministers or EGoM to decide on this issue were
often cancelled), which has helped cushion the impact on inflation of higher crude oil prices.
Diesel accounts for 4.7% of the WPI basket – the speculated Rs2 per litre hike (5% increase) in
diesel prices will add 23bp to the headline WPI before accounting for any pass-through impacts.
Recent media reports suggest that the diesel price hike could be pushed to fiscal 2012.
India’s current account deficit reached US$15.8bn for the September 2010 quarter, a record level
in both absolute terms and a percentage of GDP (4.1%). The current account deficit for the June
2010 quarter was lowered to US$12.1bn (3.2% of GDP) from the earlier reported US$13.4bn. By
comparison, the current account deficit was only US$9.2bn (3.0% of GDP) for the September
2009 quarter.
The balance of payments of US$3.3bn for the September quarter represented 0.9% of GDP.
However, the basic BOP (excluding portfolio flows) was a deficit of US$15.9bn (4.1% of GDP),
also another record. The deterioration in the basic BOP supports our concerns regarding the
funding of India’s current account deficit via volatile portfolio flows.
The projected fiscal central government deficit of 5.5% for fiscal 2011 includes Rs1,063bn from
the 3G and broadband spectrum auction – around 1.4% of GDP. Excluding this bonus, and
adjusting expenses for debt waiver of Rs120bn and projected oil subsidy of Rs315bn implies an
adjusted fiscal deficit of 6.4% of GDP. The target for the fiscal deficit in fiscal 2012 is 4.8% per the
government’s medium term fiscal policy statement. As such, hitting the target would require a
fiscal deficit reduction of 1.6% of GDP (assuming no oil subsidy in fiscal 2012), which seems
unlikely. We believe a 50bp reduction is more likely (excluding the impact of any oil subsides). We
forecast a base case fiscal deficit of 5.8% of GDP for fiscal 2012 (excluding the impact of any oil
subsidy). We assume an oil subsidy bill of Rs246bn will result in a base case fiscal deficit of 6.1%
of GDP.
The 31 December price of India’s crude oil basket of US$91/bbl is up significantly from the
average of US$75/bbl in the September quarter. India imports roughly 75% of its domestic crude
oil requirement. Higher crude oil prices increase India’s trade and current account deficit. Also,
diesel, LPG and kerosene are sold at regulated prices which lead to under recoveries at the state
owned oil marketing companies. The government, in turn, provides funds to the oil marketing
companies to help share the under-recovery burden. Higher oil prices also lead to an increase in
the central government’s fiscal deficit.
Net crude oil imports are expected to be 907m barrels for India in FY12 per RBS forecasts. We
estimate a US$10/bbl increase in the Indian oil crude basket (a weighted average of Dubai/Oman
crudes and Dated Brent) will add US$9bn to India’s annual import bill. Such an increase would
imply a 0.5% hike in the trade and current account deficits as a percentage of GDP.
A base case US$80/barrel crude oil price leads to a 3.4% current account in FY12F. US$100
crude implies a current account deficit of 4.4%, on our analysis.
To estimate the impact on the fiscal deficit, we looked at potential under recoveries by oil
marketing companies, and the government’s share of these under recoveries. We assume a
higher government share of under recoveries at higher crude prices vs current levels (58% vs
50%) so that oil marketing companies’ share of under recoveries is capped at around US$3.5bn.
According to our analyst Avadhoot Sabnis, under recoveries will total US$11bn in FY12F at
US$80/barrel crude oil prices (this assumes a Rs2/litre diesel price hike in April 2011). Every
US$10/barrel rise in the price of the Indian crude basket will lead to under recoveries rising by
US$7.5bn, we estimate.
Because of the graded assumptions on government share of under recoveries, we believe the
sensitivity of the fiscal deficit to every US$10/barrel increase in crude oil prices ranges from 20-
30bp (vs the 50bp for the current account deficit).
The analysis in the following table assumes an adjusted fiscal deficit (excluding any oil subsidies)
of 5.9% of GDP; as such, US$80/barrel crude oil implies a base case fiscal deficit of 6.1% of
GDP; and US$100 crude implies a fiscal deficit of 6.7%, according to our model. Please note that
this analysis excludes the impact of fertiliser subsidies, as fertiliser prices are more closely linked
to natural gas prices than crude oil prices. Natural gas prices have been relatively subdued so far.
The Central Government decontrolled petrol prices in June 2010 and also raised the prices of
other petroleum products (diesel, LPG and kerosene), in spite of the political sensitivity of the
price hikes, given high inflation. The price increases were expected to reduce the under
recoveries of the oil marketing companies – however, the government has not put forward a clear
policy on how the under recoveries will be shared between the government, oil marketing
companies and upstream oil companies. This lack of a clear policy remains an overhang for the oil
marketing companies.
At the time, there was also a widespread expectation that diesel prices would be decontrolled
eventually. However, there has been no progress so far in decontrolling diesel prices. Moreover,
the government has repeatedly postponed a decision on raising diesel prices (scheduled
meetings of the Empowered Group of Ministers or EGoM to decide on this issue have often been
cancelled) to help cushion the impact on inflation of higher crude oil prices. Recent media reports
suggest the diesel price hike will be pushed out to fiscal 2012.
Initial expectations on tax reforms have been disappointed. The proposed Goods and Services
Tax (GST) aims to improve tax collections by integrating the Indian market through a uniform tax
rate – by subsuming various central and state taxes. Initially, it was widely expected to be
introduced in April 2010. The implementation deadline was then pushed back to October 2010,
and now stands at April 2011. However, the Central and the state governments have yet to
resolve their differences over the GST’s final structure, and we think that the April 2011 deadline
will also be missed. The Central government has now decided to consider a phased introduction
of the GST, and is also willing to accept a dual-rate structure for different goods and services,
which, in our view, would dilute the positive impact of the GST’s introduction.
The Direct Tax Code (DTC) Bill, 2010, was introduced in Parliament in August 2010, and is
proposed to be made effective from April 2012 (vs the earlier expectation of April 2011). The DTC
will replace the existing direct tax legislations constituted by the Income Tax Act, 1961, and the
Wealth Tax Act, 1957, and aims to simplify the tax structure and introduce more moderate levels
of taxation and expand the tax base. However, the tax proposals in the final bill were
disappointing compared to the bill’s 2009 draft in our view. Specifically, the corporate tax rate was
maintained at 30% vs the 25% mentioned in the 2009 draft. Separately, the income threshold for
the peak personal tax rate of 30% was reduced to Rs1m from 2.5m. In addition, the tax deduction
for pension fund contributions was also reduced to Rs100,000 from Rs300,000.
With state elections in four major states – Assam, Kerala, Tamil Nadu and West Bengal – slotted
in the first half of 2011, and the ongoing political stalemate around corruption (hardly any business
was conducted in the recent winter session of the Lok Sabha), we don’t expect much progress on
any politically sensitive reforms
Asset allocation and model portfolio
We are bullish on materials, telecoms and utilities, but have pruned our overweights in
technology and staples. Financials continues to be a key underweight. We still prefer large
caps over small/mid caps.
From a portfolio perspective, our key overweights are CAIRN, HNDL, HZ, HCLT, BHARTI and
PWGR and below we give our views on why we prefer these stocks.
1. Cairn India (CAIRN IN)/Energy: Cairn is levered to rising crude oil prices, and we also expect
production growth/new discoveries post the deal decision resolution in February.
2. Hindalco (HNDL IN)/Materials: Hindalco is leveraged to an increase in aluminium prices.
Aluminium is RBS’ preferred base metal exposure (refer “Global Economic Forecasts”, dated
20 December 2010). Also, the company’s capex plans should lead to significant volume
growth.
3. Hindustan Zinc (HZ IN)/Materials: RBS analyst Rahul Jain’s earnings estimates are 40%
above Bloomberg consensus for fiscal 2012, primarily linked to increasing silver production at
this zinc producer.
4. HCL Technologies (HCLT IN)/Technology: Has underperformed larger cap peers Infosys and
TCS, and is now trading at a 30% forward P/E discount to them which suggests margin
concerns are priced in.
5. Bharti Airtel (BHARTI IN)/Telecom: We think the company’s Africa business could surprise
positively on costs as it transfers best practices from its Indian business, and the worst in
domestic competition is behind it.
6. Power Grid (PWGR IN)/Utilities: A relatively inexpensive way to play the electricity
transmission and distribution story in India; underperformed market by more than 25% in
2010.
From a portfolio perspective, our key underweights are BPCL, COAL, ACEM, JSTL, HDFC &
ICICIBC.
1. Bharat Petroleum (BPCL IN)/Energy: Widening under recoveries at oil marketing companies
with the rise in crude oil prices, and the postponement of diesel price hikes.
2. Coal India (COAL IN)/Energy: The world’s largest coal producer trades at a significant
premium to peers, and RBS expects volume growth to miss consensus expectations.
3. Ambuja Cements (ACEM IN)/Materials: Expensively valued cement producer, in our view,
with earnings pressure as overcapacity leads to price declines.
4. JSW Steel (JSTL IN)/Materials: RBS’s earnings estimates are more than 30% below
Bloomberg consensus for this steel producer because of lower realisations and cost
pressures.
5. Housing Development Finance Corp. (HDFC IN)/Financials: Rich valuations for the core
mortgage business drive our underweight. Also, the rising cost of wholesale funds should
pressure margins.
6. ICICI Bank (ICICIBC IN)/Financials: We are cautious on the banks sector where we see rich
valuations and tight liquidity conditions. ICICI is the largest private sector bank, and we
believe profitability improvements are factored into the current price.
The key changes in our model portfolio vs August are as follows:
Significant overweight in materials (291bp) vs a slight underweight (41bp) earlier. Apart from
stock-specific reasons, the key to our thinking is that materials is the only sector in India that
trades at a discount to its regional peers (an 8% discount on forward earnings), and that improving
global growth will help commodity producers. However, we are primarily overweight on the base
metal producers, and are underweight on the steel producers (we think higher raw material prices
will pressure margins) and cement companies.
Raised overweight in utilities to 119bp from 40bp because of the significant underperformance
of the sector, and with significant equity issuance now out of the way for NTPC and Power Grid.
Trimmed technology exposure to a 71bp overweight from a 146bp overweight earlier. The
sector has performed very well, and we think the large cap stocks can tread water for some time
here as valuations now look quite full.
Trimmed consumer staples exposure to a 21bp overweight from 112bp earlier, because of rich
absolute and relative valuations.
Close to a neutral weighting on the energy sector (23bp underweight vs 228bp earlier), as we
don’t think our underweight bet on Reliance Industries (RIL IN) is warranted any more. The market
is now cognisant of the reduced gas production at Reliance’s offshore gas fields; meanwhile
refining and petrochemical margins have been improving. The slight underweight for the sector in
spite of the overweighting of CAIRN is linked to the underweighting of Coal India and BPCL.
No longer underweight on the real estate sector due to the sector’s significant
underperformance. Though fundamentals are not getting any better for this debt-burdened sector,
we think that current stock prices don’t have significant downside to merit an underweight stance.
Please refer to Table 10 for details on MSCI India stock and sector valuations, and key metrics.
We continue to be cautious on banks due to their rich absolute and relative valuations (18.5x 12M
forward Bloomberg consensus P/E in aggregate, a 14% premium to the market), and the tight
liquidity conditions in the money markets which we think will keep near-term net interest margins
under pressure.
The outstanding net repo balance averaged Rs1.2trn for the month of December; equivalent to
2.5% of outstanding deposits (the Reserve Bank of India (RBI) is comfortable with a net repo
balance of +/- 1% of deposits). High government cash balances with the RBI (recent average of
Rs1trn vs negligible balances generally) and muted deposit growth has been the key contributors
to the recent tightness in the money markets.
Deposits grew 14.8% yoy as of 17 December, vs credit growth of 23.8%. Reflecting the muted
deposit growth, the loan-to-deposit ratio reached a record of 75.8%. On a ytd basis for fiscal 2011,
credit has grown 12.3% vs only 7.0% for deposits. As the charts below show, ytd credit growth is
in line with the average for fiscals 2007-2010, whereas ytd deposit growth is running 5 percentage
points below the average.
Our cautious stance on banking also reflects the muted credit/GDP growth multiplier we have
seen recently. As the following chart shows, yoy credit growth has generally been 2x or higher
than nominal GDP growth. However, credit growth has been in line with nominal GDP growth for
the first three quarters of 2010. Partly because of the high multiplier in the past, investors have
perceived banks as a levered play on the Indian growth story. However, if the credit/GDP growth
multiplier stays subdued, it may disappoint investor expectations.
Small/mid cap stocks (using the Nifty Jr Index and the CNX Mid Cap Index as proxies)
underperformed their larger cap peers (ie, the Nifty Index) by 10-12% over the last four months of
2010. However, for the full year their price performance has been essentially in line with the large
cap Nifty Index (Chart 23). Also, looking at a longer time frame, the price performances of the
smaller/mid cap stocks seem stretched vs their larger cap peers in spite of recent
underperformance (Charts 25 and 26). Given our relatively muted market outlook, we continue to
stay cautious on the mid/small cap universe, as in the past four years or so (Chart 24), investing in
smaller/mid cap names has been a leveraged play on the overall market.
Report card: how have we done so far?
Our directional call on the Indian equity market did not work, however our key overweights
outperformed our key underweights by 5.8% from 24 August, 2010 (since inception).
Financials, our key underweight sector, underperformed MSCI India by over 8%.
Author’s note: We published our model portfolio for the first time on August 24, 2010. As such,
performance metrics are only provided since inception and not for a 12-month period. For
reference, MSCI India (local currency) saw a price return of 14.1% in 2010, and a price return of
12% for the twelve months ended January 5, 2011)
Our expectation of an 18% correction in MSCI India (see note, Tactically bearish, structurally
bullish) did not pan out with MSCI India up 9.1% between 24 August 2010 and 5 January 2011.
However, MSCI India did underperform MSCI Asia ex Japan in local currency terms by 5.5% over
the period.
Our recommendation to prune small and mid cap exposure performed quite well, with the Nifty Jr
Index and the NSE Mid Cap index underperforming the larger cap NIFTY Index by 10%, and 12%,
respectively.
From a sector allocation and stock picking perspective, the RBS model portfolio (please refer
report, “Tactically bearish, structurally bullish”, for details, and below table for the sector
allocations) outperformed its benchmark MSCI India by 157bp over the same period.
Our overweight position in the tech sector worked quite well, with the sector posting the best price
performance between 24 August 2010 and 5 January 2011, outperforming the market by 15.7%.
Financials, our key underweight call, underperformed the market by over 8%. A significant miss
for us was the health care sector, which outperformed the market by more than 13%.
Our key stock overweights were up 12.7% on average in the 24 August to 5 January period vs
9.1% for MSCI India. Mahindra & Mahindra (MM IN) and Infosys (INFO IN) were the best
performing stocks, while the performance of Bharat Heavy Electricals (BHEL IN) was a
disappointment.
Our key stock underweights were up 6.9% on average, slightly underperforming MSCI India over
the same time period, with three of the underweights (Ambuja Cements/ACEM IN, HDFC, and
Reliance Industries) outperforming the index.
All told, the overweights outperformed the underweights by 5.8%
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