Conclusion: We expect inflation to continue to be a major headwind for the Indian economy and we see further tightening on the horizon. In addition, the potential for destabilizing withdrawals of foreign investment has breached its 2007 highs, which suggest Indian equities could experience major declines should global markets come under pressure.
Position: Bearish on Indian Equities
In line with our call that 1) global growth is slowing 2) inflation is accelerating and 3) global interconnected risk remains near all-time highs, we’ve been making a series of contrarian calls of late – none larger than our recent decision to short U.S. Equities (SPY) and go long the U.S. dollar (UUP). We don’t wake up every day trying to be perpetually bullish or bearish; rather our proprietary risk management models are signaling to us deterioration in the economic fundamentals of several key countries globally.
India is one of the countries we’ve had our eye on of late. While we tip our hats to India’s long-term TAIL outlook for growth and development, we are becoming increasingly cognizant of the two near-to-intermediate-term risks to Indian equities. Those risks are:
- The potential for accelerating inflation and further tightening; and
- The potential for destabilizing withdrawals of foreign investment
On the inflation front, there are several factors at play here. India, like many other countries in the developing world has been struggling to contain inflation, which is currently running at more than double the target rate (+8.6% YoY in September). Accordingly, India’s central bank has hiked its benchmark interest rates six times this year to the current 6.25% (RBI Repo Rate) and 5.25% (RBI Reverse Repo Rate).
Central bank governor Duvvuri Subbarao said at a recent press conference that India probably won’t raise interest rates in the immediate future barring any shocks, which suggests they are comfortable with letting their actions take effect for now. Further, they expect inflation to decelerate to a more tolerable +5% YoY rate by March 2011.
We are much less comfortable with that projection, given the recent global speculation brought on by QE2 and Bernanke’s dare for investors to chase yield. That dare has been and is continuing to be an issue for the Indian economy, given the recent price moves in many commodities globally. Since Heli-Ben called his shot in Jackson Hole on 8/27, the Reuters CRB Commodities Index is up nearly 20%. Even more astonishing are the price moves in many agricultural commodities over the same period: Soybeans (+26%); Rice (+32%); Corn (+36%); Oats (+41%); and Sugar (+65%). If commodity prices stay at/near current levels, we don’t see any reason for India’s benchmark WPI index to decelerate in any meaningful way.
Despite India having roughly 816 million citizens who live on less than $2/day at PPP – with food being their largest expense – India’s central bank has shifted its stance on the margin towards supporting Indian manufactures and investors by choosing not to support further rupee strength via additional rate hikes (up 4.7% vs. the U.S. dollar YTD). Rather, it has chosen to embark on its own version of QE2, buying back 83.5 billion rupees of government bonds on 11/4 to help ease a cash shortage among Indian banks – an action not taken since September 2009.
In recent weeks, Indian banks have been borrowing anywhere between 500 billion and 1.2 trillion rupees per day in overnight loans from the central bank to meet record demand from investors for loans, as well as new capital requirements. Bank lending has accelerated to +21% YoY through October, buoyed in part by investor demand for state asset sales (i.e. Coal India Ltd’s recent IPO) and Indian banks and corporates’ demand for dollar-denominated borrowing, which are at ten year highs, according to Bloomberg data. On 11/2, the RBI asked commercial banks to increase provisions for home loans of 7.5 million rupees and above and for floating rate mortgages as well.
All told, the cash shortage has dampened Indian lenders’ ability to fuel burgeoning speculative demand for Indian assets; as such, Money Supply (M3) has fallen to a near-five-year low (+15% YoY) in the two weeks through mid-October:
What irks our Hedgeye’s is the RBI’s recent decision to aid the speculation by helping banks raise cash in their recently-announced version of QE2-lite. We understand the India is a robust and growing economy with a great deal of internal demand; nevertheless, we see the RBI’s recent actions and tone shift as a major potential hindrance in their bout with inflation. As such, we expect a) inflation to continue to dampen Indian corporate profits as both COGS and borrowing costs remain elevated (rates on three-month commercial paper issued by Indian companies have nearly doubled this year to 8.16%) and b) further monetary policy tightening on the horizon once the RBI grows uncomfortable with the growth rate of speculative lending.
On the global speculation front, the yield-chasing frenzy inspired by dovish monetary policy in the developed world (namely the U.S. and the E.U.) and QE2 speculation has prompted foreign investors to buy a total of $35.5 billion of Indian equities and bonds YTD – up 93% YoY vs. the full-year 2009 total of $18.4 billion. In recent months we’ve seen India get more comfortable with foreign participation in their capital markets, as evidenced by Prime Minsiter Manmohan Singh’s recent decision to increase the overseas investment cap on Indian government and corporate bonds by $5 billion to $30 billion each. In light of such favorability, foreign holdings of India’s corporate and government debt has more than doubled in 2010 to a record $17.4 billion as of September.
Two things here are cause for alarm in our opinion: 1) foreign investor participation is volatile and can be withdrawn in a heartbeat and 2) India itself may eventually clamp down on yield-chasing capital seeking to enter the country as it did in October 2007 – just three months before the prior peak in the Sensex. Keep in mind that foreign investors withdrew $14.84 billion from Indian equities in 2008, which contributed to the 2008-09 crash in the Sensex. At $15.62 billion through September of this year, foreign investors have plowed capital back into India equities, which suggests a substantial amount of damage could be done should they feel compelled to withdraw for any reason.
As we mentioned at the outset of this report, interconnected global risk continues to remain quite elevated and global risk aversion will surely lead to a major correction in the Sensex, which is trading near its all-time high. To that point, since Bernanke dared the world to lever up and take on risk in Jackson Hole on 8/27, the Sensex is up +16.3% and has an inverse correlation of 0.91 to the U.S. dollar. Should the dollar catch a meaningful bid over the near-to-intermediate term, which we believe it will for a variety of reasons (not the least of which are accelerating sovereign debt concerns out of Europe’s periphery), expect to see a major correction in Indian equities.