India Equity Research: J. P Morgan - Indian Equities The Risk Spectrum

Indian Equities The Risk Spectrum

· Cautious start to the New Year; exporters outperformed last week

· Liquidity situation improves; FX reserves above May levels.

· Growth indicators are subdued

· CMIE quarterly new projects announced “value” increases to a six quarter high; number of projects remain at a decade low

· Off the three key drivers of current rally – Political hope, Earnings surprise and FII buying support – political hope has turned more uncertain

· FII flows in 2004 and 2009 did not show any notable slowdown before the national election; the extent of FII over-ownership and relative growth outlook vs. EM peers is a risk

Cautious start to the New Year. Three-year old problem of low macro visibility in India is continuing. The main driver of current equity rally – political hope – is facing renewed uncertainty. The expected result of the national election has become more uncertain with the recent political development around a newly formed party. Also, uncertainties related to the policies ahead of the national election have made investors risk averse. The other key drivers - growth and inflation indicators - suggest continued challenges. The first week of the year started with a marginal decline in Indian equities; Sensex lost 2%. High beta sectors corrected. Exporters - IT Services and Health Care – gained over the week.

Growth indicators disappoint. Government attempts to revive corporate confidence and growth momentum continues. Last week, FIPB approved investment proposals by Tesco and Voadfone, Government announced a hike in petro product prices and CCEA announced an amendment in the mega power policies. These measures are incrementally positive but the real growth indicators do not reflect any signs of a notable improvement. Unsurprisingly, FY14 consensus earnings expectations for MSCI India were cut by a marginal 0.2% last month. Key indicators are:

1. December vehicle sales were weak. Domestic car sales declined 2% oya. Two-wheelers sales increased 8% oya, led by Honda and Yamaha.

2. CMIE quarterly new projects announcement increased to Rs.1.5 trn, a six-quarter high. The number of projects announced remains at a decade low, indicating no change in cautious corporate confidence.

3. December PMI manufacturing declined marginally from 51.3 to 50.7. Details indicate that the new orders to inventory ratio declined month-on-month but remained above one, mainly supported by the export orders.

4. Deposit growth increased to 17% oya, largely led by RBI’s special FX windows. Credit growth is relatively lower at 15% oya. Leading banks have lowered mortgage rates last month. Indians banks have been risk averse and are exploring growth opportunities in retail assets. In the last one year, banks’ housing credit growth rate has accelerated from 15% to 18%. Note that housing asset accounts for 10% of Indian banks credit outstanding.

Liquidity situation improves; stable currency. The preparatory phase of QE tapering is over. The actual start has been well-handled by the Central Bank. INR has been one of the better performing EM currencies since the announcement on tapering (chart below). Going ahead, the continuous announcement of QE tapering should continually be complemented with a lower twin deficits in India and lower inflation to ward off the currency risk. India’s FX reserves increased to US$268bn, which is higher-than-the May level. Liquidity situation within the banking system has improved significantly. The amount under the daily LAF window has reduced toa comfortable Rs.200 bn. Long bond yields have been stable at ~ 8.80% level. Next week’s inflation prints would be important. Vegetable prices have corrected sharply and a 30% correction would reduce CPI by 1.6%.

The risk spectrum. Indian equities’ Sept – December rally has been aided by: 1. Effective policies on INR and RBI’s supportive policy bias. 2. Better-than-expected quarterly earnings 3. Political hope. 4. Continued FII buying. A quick review of how these drivers are appearing and related risks:

1. INR risk appears manageable for now, in our view. The side effect of the QE tapering - rising yields in DM - is a risk and the RBI will have to closely monitor that. Central Bank’s positive surprise in the December policy meeting was based on the expectation that 1. Vegetable price inflation is likely to stabilize lower, and 2. Disinflationary implications of a stable INR and weak growth. The first has materialized but there is hardly any room for complacency given the level of core CPI inflation and elevated inflation expectations.

2. After a better-than-expected last quarter, expectations are higher now from global sectors. Domestic business environment has been challenging with adouble digit CPI inflation and weak growth. A stable currency and rates markets, however, provided some relief over the last quarter.

3. Political environment will continue to exert significant influence on Indian equities. The recent political developments of a new entrant with a different ideology can be argued to be constructive from a specific (anti-corruption) perspective. But the implications on the investment cycle and concerns on fiscal deficit are unlikely to be favorable for Indian equities in the short term.

4. Over dependence on FIIs has been a perennial risk for Indian equities. Retail investors are still disinterested in equities here. Two risks need to be watched closely, 1. Flows shift towards DM exporters 2. FII behavior around the national election. The first did happen over the last quarter with Korea and Taiwan attracting increased flows. The extent of current FII over-ownership of Indian equities (180 bps as on end-November as per EPFR) and relatively challenging outlook on growth differential vs. EM peers are not as favorable currently. The trend of FII flows before the national election in 2004 and 2009 does not indicate any marked slowdown in flows before the national election.

Figure 1: Exchange rate vs. US$ - Since the start of QE tapering