2012: No bull market in sight �� A broader market range… BofA Merrill Lynch

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2012: No bull market in sight
�� A broader market range…
We expect the Indian equities to head lower in 1H2012 led by the falling growth,
worsening domestic macro fundamentals, deteriorating earning profile, slowing
global economy and elevated risk of more adverse outcome from Europe. We
also expect the market to get slightly de-rated, given the Indian equity valuations
are still at premium to peers.
…would provide better trading opportunities
Nonetheless, we see the likely fall in equity prices as a ‘big’ trading opportunity.
The current cycle is proving to be quite similar to 1990’s where markets remained
in a broad trading range during 1994-1999. The long term (5yr) Sensex returns
chart suggests that 2012 may see market record the bottom of the cycle. Though,
a new secular bull market does not appear to be in sight as yet.
The upside to be driven by rate cuts and policy initiatives
We see tough times for markets near term and believe that market could recover
in later part of the year, to end 2012 with a positive return. The recovery would be
triggered by the RBI easing the policy stance, cutting rates and Government
taking policy decisions to kick-start investment spend. In our view, RBI should
start easing from March and lending rates may fall by 150bps during April-
September period.
Strategy: gingerly buy the dips below15K, sell above 18K
Given our view that on top down basis Sensex may fall to 14500 level in 1H2012
and see a recovery to 19K level by the year end, we suggest buying the dips
below 15K and selling above 18K levels. As we expect rate cuts to be a key
theme for the market in 2012, we suggest rate sensitives for trading. However, we
would prefer to play rate sensitives through consumer discretionary, i.e.,
passenger auto, and defensive large private sector banks rather than
infrastructure and real estate.
GDP growth to slow; downgrades likely
We expect FY13 GDP to slow to 6.8% and consensus to cut GDP forecasts over
the next few months. GDP growth in the next few quarters is likely to come even
lower at around 6.5%. A slower GDP will be led by: (a) a slowing global economy,
(b) impact of high rates and (c) slowing investment spend.
Earnings downgrades to continue
We continue to expect earnings downgrades, led by slowing sales and sustained
margin pressure from rising labor and interest costs. We expect the bottom-up
Sensex EPS of Rs1,275 to be downgraded to Rs1,200 (growth of under 10% vs.
e xpectations of nearly 15%).
2012: key trends
Market may move in a broader trading range
Unlike 2011, where market was bound in the most narrow range in at least two
decades, 2012 is expected to see a wider trading range, making it attractive to
trade actively.
Long term Sensex returns may bottom out
Long term (5yr rolling) Sensex returns at the end of 2011 were close to 12%. In
the previous cycle, long term returns had bottomed out at (-)9% in 1998. A close
in the range of 18000-19000 in December 2012 would result in negative 5ry
rolling returns to the tune of 11 to 6%.
Volatility may rise, more big daily moves likely
Market tops and bottoms have usually been associated with higher volatility. In
past two years volatility in Indian markets has been low to moderate. In recent
months volatility has shown a tendency to rise. We expect volatility to inch up as
the markets look out for a bottom.
GDP growth to slow; downgrades likely
We expect FY13 GDP to slow to 6.8% and consensus to cut GDP forecasts over
the next few months. GDP growth in the next few quarters is likely to come even
lower at around 6.5%. A slower GDP will be led by: (a) a slowing global economy,
(b) impact of high rates and (c) slowing investment spend.
Earnings downgrades to continue
We continue to expect earnings downgrades, led by slowing sales and sustained
margin pressure from rising labor and interest costs. We expect the bottom-up
Sensex EPS of Rs1,275 to be downgraded to Rs1,200 (growth of under 10% vs.
expectations of nearly 15%).
Valuations will see slight de-rating
Based on analysts’ forecasts, Sensex at 13x one-year forward PE is at a slight
discount to long-term averages. Slow down in GDP and earnings growth as well
as falling RoEs will likely lead markets to trade lower. Secondly, on a relative
basis, India still trades at substantial premium to GEM vs. a 10yr average of 17%.
Inflation and rates to peak off
We expect inflation to peak off in 1H12 with a good harvest dousing agflation,
commodity prices stabilizing and a tight monetary policy curbing demand. RBI
may start cutting rates by 100bp from March onwards. We expect, in follow up to
RBI easing, lending rates should ease by 150bps.
Strong US Dollar, weak INR
We expect the US Dollar to appreciate to sub-1.30/Euro levels through 2012 on
the European crisis. It is expected to peak at 1.25/Euro in March and June and
then moderate to 1.30/Euro by December 2012 and 1.35/Euro by December
2013. In tandem, the INR is seen to persist at Rs50/USD levels for the most of the
year and appreciate to Rs49/USD by December 2012. Do not expect significant
foreign flows in Indian equities in 2012
Political stability to continue
We believe the stability of the Congress-led UPA Government is not an issue
since: (a) most political parties do not want an election so soon and (b) none of
the allies of the Congress want to see the Government fall. They seem content to

distance themselves from some measures of the Government and make a show
of opposing it, without withdrawing support to the Government. We do not see the
situation changing materially post state assembly elections in 5 opposition ruled
states in 2012.
Global equities: the beginning of the end of great bear market in sight
Despite our short-term caution, we believe that global equities on a 2-3 year view
look compelling. Investors enter 2012 in a fearful state, but we believe any sharp
falls in equities in 2012 should be bought. The ingredients for equity
outperformance over the medium-term are being put in place and 2012 could
represent the beginning of the end of the great bear market in equities.
The US economy to slow down sequentially
While 2011 is ending on a strong note, we expect the US and European fiscal
crises to lower growth to just 1% in Q4 2012.
Large scale deleveraging will pull down DM growth in 2012
We expect the need for higher Tier 1 capital ratios in Europe and falling real
estate values in US will likely keep developed economies on a deleveraging
mode. In fact, the deleveraging cycle that affects 50% of the global GDP and twothirds
by wealth will likely remain a significant impediment to growth in developed
markets. Burgeoning government deficits, unfavorable demographics, and
fractious politics will likely continue to prevent the textbook Keynesian response.
Easy policy and high liquidity will keep markets afloat
Easy policy and high liquidity has so far helped to counterbalance large-scale
deleveraging in developed economies by holding down debt service ratios and
supporting asset values. Heading into 2012, real interest rates should remain low,
and we expect the Fed and the European Central Bank to fight the growing
deflationary pressures with quantitative monetary easing.
Global inflation to remain elevated, EMs may suffer more
The quid pro quo of easy liquidity is higher tolerance of inflation, which is already
hitting real incomes as energy, food and other commodity prices keep on rising
fuelled by negative real rates, in our view. The impact of higher commodity prices
is greater on emerging markets where energy and food make up 9% and 27% of
the CPI basket respectively, although rising incomes somewhat mitigate the
higher costs. On the other hand, G5 economies face stagnant incomes, while
energy and food make up 8% and 15% respectively.
Commodities – headwinds for cyclicals, gold to reach US$2000/oz
Given expectations that demand growth for cyclical metals will slow, micro
fundamentals are important and we see substantial divergence on that front. We
see limited upside in Crude oil on improved demand supply balance, dated Brent
crude oil to average US$108/bbl in 2012. We expect gold reach US$2000/oz led
by continued Central Bank demand and persistent negative real rates.
Key global risks: Euro break-up, Iran & China hard-landing
A deeper-than-expected Euro zone recession could lead to a sequential drop in
both equity and commodity prices. US Treasuries would outpace credit in this
case. Meanwhile, increased Middle East tensions could lead to another largescale
physical oil supply disruption and exacerbate the recession in Europe.
Finally, we think two key risks worth highlighting are those coming from faster
than expected US fiscal tightening next year, and the perennial China hardlanding
scenario


Investment strategy
Moderate strategic asset allocation, u/w equities
We expect the markets to continue moving in a broad range in 2012. During next
several months the Sensex may keep oscillating mostly between the range seen
in 2011 with occasional violations on either side. Given the high opportunity cost
of holding equities, we continue to suggest a moderate strategic asset allocation
— predominantly high yielding debt, adequate cash and select large cap
defensive equity portfolio.
�� Overweight high yielding debt
�� Overweight cash
�� Underweight equities
We prefer expensive defensives vs. inexpensive cyclicals
One of the key decisions facing investors at the moment is whether to continue
paying a premium for expensive defensives or to position in inexpensive cyclicals
in preparation for the next economic upturn.
In our view, expensive defensives are preferable at this stage, for the simple
reason that in slowing growth environment, fraught with significant uncertainties,
defensives have historically outperformed.
Pharma is our top defensive play
In past couple of years, the defensive sectors have done very well, led by
consumer staple companies. Given our view of slowing domestic and global
growth, we believe defensives will continue to do well over the next few months.
Given that the consumer staple companies are extremely expensive, we prefer
the pharma sector, which is relatively cheaper. Moreover, the pharma sector
should benefit from the rupee’s depreciation over the past few months.
Positive on staples, valuations not attractive
We are constructively positive on the consumer staples. We are though worried
on valuations in the sector. Volume growth for organized players is expected to
remain robust despite price hikes led by rural demand as well as growth in
modern trade. Raw material costs are expected to stabilize. A strong correction in
raw material costs can provide an upside to margins. Also, while competitive
intensity will remain high, margin destructive competition will likely be limited as
per channel checks
Avail the trading opportunity
Given our view that Sensex may slip below 15K in early part of 2012, and end the
year with positive returns, we expect the market to provide an attractive trading
opportunity during 2012. We suggest investors should avail this opportunity.
Given our belief that monetary easing and subsequent rate cut will be a key theme
for the market in 2012, we suggest availing this opportunity through buying rate
sensitives on dips below 15K level.
However, we would prefer to play rate sensitives through consumer discretionary,
i.e., passenger auto, and defensive large private sector banks rather than
infrastructure and real estate.


Prefer consumer discretionary as rate-sensitive plays
We prefer consumer-oriented rate sensitives rather than investment plays
currently. Autos are our current preference to play the pause and subsequent cut
in the rate cycle. Another positive trigger for the auto sector could be a possible
fall in commodity prices.
Banks is the other rate-sensitive overweight
Presently our preference currently is for the defensive large private sector banks.
However, we expect to get more aggressive on the PSU banks later in 2012 after
the NPA cycle has played out.
Buy volatility
We expect volatility to increase as the market begins the process of forming a
strong cyclical bottom. We suggest this trade, at opportune moment, through
buying deep out of money calls or selling deep out of money puts
Very selective in investment space
We are underweight the investment space as we expect the capex cycle to slow
down further. However, within this space we prefer the capital goods players to
the infra/utility companies. Prefer large capital goods companies with strong
balance sheets and industry leadership.
Avoid utilities, industrials
We expect weakness in utility stocks on account of (a) lack of fuel and business
case certainty, (b) the relatively expensive valuations of large IPPs, (c) increase in
competition (regulated utilities) post the closure of MoU window (in Jan 2011) for
winning projects as India moves to a competitive bidding regime and (d) limited
near-term growth catalysts. Competition for new generation capacity could make
returns volatile and we believe that merchant power is a new ‘hype’ and
potentially a ‘fad’.
Buy gold
We expect the tighter fiscal policies in the US, Europe and Japan to be offset by
accommodative monetary policies around the world, aided by lower inflation.
Importantly, our economists expect fresh rounds of quantitative easing by mid
2012 in both the US and Europe. This will prove to be an important inflection point
for risk assets. We suggest buying gold to take advantage of likely quantitative
easing. Incidentally, BofAML Commodity Strategy has a 12-month gold price
target of $2000/oz.







Key trade ideas
Trade #1: Buy Value, Small, Risk. Inexpensive small cap high beta stocks tend to
perform well in the early stages of an upturn.
Trade # 2: Buy Japanese exporters – Autos and consumer electronics.
Trade # 3: Buy cyclical sectors such as Australian Materials, Taiwan Tech
Hardware, Korean Industrials, Thailand Materials. Sell defensives such as
Australia Banks, Hong Kong Utilities, Malaysia Banks, Singapore Consumer
Staples, China Telecom.
Trade # 4: China – Buy Developers, low to mid-end Consumer names, Property
Developers, IPPs and Water stocks, Sell Banks.
Trade # 5: Long Asian High Yield credit. Buy Asian HY credit, particularly
Chinese real estate bonds. China HY bonds are offering the widest spreads and
even if we incorporate a discount over US HY, we still see significant spread
upside potential.
Trade # 6: Sell JPY against buying KRW. The JPY/KRW cross is highly sensitive
to risk aversion and is relatively pro-cyclical. Moreover, from a valuation
perspective we still see KRW as fundamentally undervalued by 12%. A
normalization of global conditions would allow currencies to better reflect their
underlying fundamentals. Finally, Korea would continue to benefit from foreign
inflows into its equity and local bond markets that are attracting an increasing
share of global portfolio flows.
Trade # 7: Sell JPY/KRW. While not our central scenario, positive surprises to
global growth and risk sentiment would weigh significantly on the Yen, which has
been a major beneficiary of global risk reduction, while Asian currencies,
particularly high-beta ones such as KRW, would resume appreciation.
Trade # 8: As in the 2008 financial crisis, Asian markets have underperformed
most developed markets despite superior economics. We may therefore expect
that once again Asian markets will bottom earlier and outperform to the upside if
all turns out to be well in the world. Asian volatility levels have retreated recently
and do not price in the EM risk they used to. We like HSI out-of-the-money (OTM)
call options as an upside hedge. Their cost could be offset by selling OTM puts or
put spreads, taking advantage of some of the steepest skews in history, and low
forwards. They can also be traded against S&P500 calls or call spreads. For
example, buy HSI 110% 6Mth call for 3.71%, vs. sell a HSI 85% 6Mth put for
4.13%.