Edelweiss, STRATEGY Sum of all fears: Macro headwinds continue to hurt sentiments

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STRATEGY
Sum of all fears: Macro headwinds continue to hurt sentiments


􀂄 Investment scenario still clouded by challenges
In our annual strategy report, “Bulls to hibernate”, published on January 02,
2011, we presented a cautious picture with regards to Indian economy and
financial markets. We have, however, re-assessed the macro-environment in view
of recent developments in the markets. Not surprisingly, a large number of risks
that we had highlighted – (1) deterioration in India’s Balance of Payments (BoP);
(2) lingering inflationary pressures; (3) persistence of liquidity deficit; and (4)
weakness in investment activity - still persist. Further, improving growth
momentum in developed world has also led to speculation about the reversal of
ultra-loose monetary policy stance sooner than anticipated, which, in turn, could
heighten the volatility in capital flows to the emerging economies.
􀂄 Inflation and BoP situation cause for concern; budget, too optimistic
Inflationary pressures continue to persist, reflecting both supply side and demand
side factors. Rising global energy and metal prices pose a significant risk to the
domestic inflation outlook. Against this inflation backdrop, we expect RBI to raise
policy rates by another 75bps through FY12, taking the monetary stance clearly in
the restrictive growth territory. The BoP situation is not encouraging either. With
wider current account deficit being funded largely through non-FDI flows such as
FIIs and ECBs, India’s BoP remains vulnerable The Union Budget, too, has failed
to deliver on big-ticket reforms and, we believe, there is significant
underestimation of subsidy burden by the government (given high and rising
crude oil prices). We foresee upside risks to both fiscal deficit as well as market
borrowing targets for FY12.
􀂄 Earnings susceptible to cost headwinds
Recently concluded Q3FY11 earning warrants a cautious outlook on markets.
Rising input cost/interest cost pressures continued to keep margins under duress
for a host of cyclical as well as defensive sectors. We believe this phenomenon
will continue to intensify in the coming quarters, thereby putting further pressure
on earnings. Hence, there has been a slew of downgrade of earnings estimates
for FY12E across construction, infrastructure, real estate and power sectors. We
believe further downside risks, in the form of increasing cost headwinds, have not
yet been fully factored in, and we run the risk of increasing downgrades in the
coming quarters. We believe that a tricky macro environment of rising cost
pressures will severely test the earnings growth trajectory.
􀂄 We remain O/W on global cyclicals; telecom upgraded to E/W
We continue with our sector allocations of underweight on banking, autos,
industrials, cement and real estate. We are overweight on energy, IT, metals and
mining, healthcare and consumer goods. We continue to focus on sectors
benefitting out of global recovery and QE-2. We are underweight on rate cyclicals
as we believe that the macro headwinds have not played out fully, be it inflation,
interest rate hike or corporate governance issues. Among the major changes, we
are moving telecom from underweight to neutral, with equivalent weight on
Bharti Telecom. We believe that the worst is behind the industry and, structurally,
we see ROEs bottoming out for the sector.