India Equity Research: J.P. Morgan -Indian Equities

Indian Equities REER Implications for Foreign Equity Investors

· Upward momentum stabilized in policy-hope-sectors last week; IT Services and Consumer Staples outperformed

· Voting completed in 231 of 543 constituencies; increased voter turnout across

· Current market valuation seems to be pricing in a higher probability of a favorable verdict in the election compared to last two post-election equity valuations

· FIIs turned marginal sellers of Indian equity last week; selling continued in debt

· Monthly growth and inflation indicators have been disappointing

· 4Q earnings started with the expected trend of positive surprises form IT companies ; earnings increased 24% yoy

· Overvalued INR on REER has coincided with lower forward returns for FIIs in Indian equities

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Point of discontinuity. India remains hugely dependent on external developments and perception of EM as an asset class. The outperformance EM vs. DM last quarter has raised question whether the three year old EM underperformance is nearing an end. Equity market performance seems to be suggesting that the fundamental adjustment process in EM is in the right direction. In the current phase of EM-disinterest, India has consistently received substantial FII flows, despite not having supportive fundamentals. Going forward, it can be argued that if fundamentals improve, India’s relative attractiveness as an investment destination will improve further. The reverse also holds true.

Last leg of disconnect. Last week’s equity performance was not a continuation of political hope rally. Large cap indices ended flat, supported by IT Services and Consumer Staples. Trading value and market performance indicator however suggests that the underlying bias remains constructive. We seem to be in the last leg of divergent economic and market performance phase. Post the election the expectations on both are likely to converge. Market performance so far suggests increased probability of a favorable electoral verdict. Performance and valuation facts around last two election results:

· Positive surprise. Strong equity performance in 2009 election can be linked to the current investor expectations of a decisive verdict. MSCI India (US$) outperformed MSCI EM by 24% during January to 31st May 2009. MSCI India valuation was 16.1 times 12 months forward PE as on 2009 May-end, vs. current valuation of 14.6 times.

· Disappointing election year. MSCI India (US$) underperformed MSCI EM by 16% during January to 31st May 2004. MSCI India valuation was 11.5 times 12 months forward PE as on 2004 May end.

Disappointing monthly indicators. January to March quarter was a phase of positive surprises on muted expectations for equity investors here. In contrast, April has turned out to be a month of disappointment across growth and inflation indicators. PMIs ticked down, inflation surprised on the upside, exports declined faster than imports and IP disappointed. Consensus earnings expectations for MSCI India have also been trimmed for FY 15, led by IT Services, Industrials and Materials companies.

A good start to 4Q FY earnings season. Quarterly earnings season started on the expected lines with healthy earnings growth by IT services companies. Key highlights:

· Only ~ 15% of Indian large cap companies have reported earnings

· Adjusted profit for the J.P. Morgan covered large cap companies grew 24% yoy.

· IT Services companies managed to meet tempered down expectations. Guidance for the next fiscal has been mixed. Company managements seem to be more focused on margin performance.

· Only one private sector bank has reported earnings so-far (Indusind Bank) with a healthy growth in fee income and stable asset quality.

· RIL reported in-line earnings supported by better refining margin and weaker INR. .

For our coverage universe, we expect an earnings growth of 14%, (Ex Tata Steel).

Real Effective Exchange Rate and equity returns for FIIs. Earlier last week, Indian Central Bank released a CPI based REER index. In the absence of a composite CPI, WPI was used as the deflator index for REER calculations. The wide difference between CPI and WPI seems to have necessitated this index. CPI based REER is also in synch with the RBI’s earlier signal of shifting policy focus from the WPI to CPI. The index appears to be more relevant for foreign investors vs. domestic investors as is linked to the external value of INR. See below some observations on REER and equity returns:

· REER and equity returns are, as expected, strongly correlated in the short run. FII flows momentum does tend to have meaningful impact on equity performance and INR (Charts below).

· Overvalued INR on REER index has coincided with low returns ahead for FII investors.

· Historical relationship indicates that the range of 95 to 100 has been sweet spot for WPI inflation. India’s over dependence of commodity imports makes sharp INR depreciation inflationary.

Currently, REER based on WPI is closer to 100 is largely “Neutral” for equity investors. INR, however, appears overvalued / uncompetitive based on CPI based REER (Six country trade based index is closer to 111). The index number seems to be a fact, and can also be interpreted as a signal.

Figure 1: INR REER* and MSCI India