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Takeaway: To know where you’re headed, you’ve got to know where you’re coming from.

SUMMARY BULLETS:

  • We are now fundamentally bearish on Indian equities with respect to the intermediate-term TREND duration and view the current price setup in the SENSEX as asymmetrically stretched relative to India’s economic fundamentals.  
  • From a GROWTH and INFLATION perspective, India’s economic outlook looks quite poor when applying a forward-looking (3-6 months) analytical lens. Moreover, India’s POLICY outlook is rapidly deteriorating and we believe this risk is not being appropriately discounted by the market – no doubt a side-effect of the global yield chasing born out of QE3.
  • From a long-term perspective, we think the Indian economy represents a classic turnaround opportunity, as policymakers there have quite a few POLICY levers that they can pull that would be positive for sustainable organic economic GROWTH. In the interim, however, there will have to be some short-term economic pain as it relates to quashing structural INFLATIONary pressures and reigning in the fiscal deficit. Unfortunately for anyone currently buying what we view as a cyclical top in Indian equities, the India of today is not the “India of tomorrow” just yet.

It would be a remarkable understatement to say the YTD has been a volatile year for Indian equity investors. At the start of the year, the SENSEX ramped up +19.2% to a then-cycle peak on FEB 21. That was followed by a -13.5% drop to a then-cycle trough on MAY 23. Since MAY 23, the SENSEX has ramped +15%, making a new YTD high in the process. As a point of reference, we helped clients reorient their fundamental bias on Indian stocks in an appropriately-bearish manner ahead of the FEB highs and did the inverse of that right around the YTD lows:

  • TRIANGULATING ASIA – IS IT TIME FOR INDIA TO TAKE A BREATHER? (2/17): “While the fundamentals would suggest that India is not necessarily a top short idea, the risk of a short-to-intermediate-term correction in Indian assets is inflated, given that monetary easing might be farther out in duration than consensus hopes. We point to a developing trend of incrementally-less pricing in of monetary easing into Indian rate markets as supportive of this view.”
  • BACKING OFF OF INDIA – AT LEAST FOR NOW (6/4): “We are suspending our bearish bias on rupee-denominated assets – particularly Indian equities – on the event that INR-supportive inflows pick up in the immediate-term ahead of a potential rate cut. Further, higher lows in the rupee has the potential to develop into a sustainable TREND, making the risk/reward on shorting India from here a lot less asymmetric than it has been recently.”

To the latter point, INR-supportive capital inflows into India's debt and equity markets did in fact rebound from their mid-summer lows, with foreign PDI stock in Indian equities currently at an all-time high.

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Our neutral, but directionally-bullish bias on Indian equities and the Indian rupee (relative to prior bearishness) was also supported by what we viewed as probable upside for the Indian sovereign to push through much-needed fiscal and economic reforms, as outlined in our AUG 6 note titled, “DO INDIAN EQUITIES HAVE ROOM TO RUN?”:

“Indian equities may be on the verge of a sustainable quantitative breakout driven largely by improving POLICY fundamentals (namely the passage of key economic reforms). Conversely, a failure at the SENSEX’s TREND line of resistance would likely be a leading indicator for Indian policymakers running into the proverbial wall – again. As such, we’ll be keeping a close eye on the Indian political landscape over the intermediate term.”

On the heels of a disastrous month-long parliamentary session that was India’s least productive in 17 months and saw opposition-led protests wipe out the last 13 days of the session, we subsequently reduced our expectations for an upside surprise(s) to Indian fiscal policy over the intermediate term. As such, we too were pleasantly surprised by the recent Congress Party-led push to approve the previously-stalled multi-brand retail and airline FDI initiatives, as well as the recent +14% diesel price hike.

To the casual investor or asset allocator, Indian policymakers pushing through these crucial reforms at such a critical juncture is quite positive and evokes memories of a young Monmohan Singh (current prime minister) who was very active in implementing reforms early in his career as finance minster in the early 90s. Additionally, the confluence of these latest measures is likely to contribute to India maintaining its sovereign rating (as opposed to being downgraded to junk status, which Standard & Poor’s and Fitch have both threatened to do via “negative outlooks”) – at least for now.

Looking past these positive headlines, which should also include a -25bps cut to Indian banks’ cash reserve ratios on Monday, all is not well beneath the surface of Indian POLICY. In fact, we’d argue that conditions are rapidly deteriorating and are not being appropriately discounted by the market – no doubt a side-effect of the global yield chasing born out of QE3. On Tuesday, the largest ally of Singh’s Congress Party’s ruling coalition defected, leaving them 24 seats shy of a majority in the lower house of parliament (assuming the move is not reversed). Trinamool, the defecting party, followed its president’s lead in protesting the aforementioned reforms – which, of course, were pushed through amid heightened resistance. That resistance led to a very loose version of the policy being announced, as Singh conceded sovereignty to India’s State governments with regards to deciding if and when they implement the FDI initiatives.

Trinamool’s defection from the ruling coalition does come at a political cost for its leader Mamata Banerjee, who is seeking a federal bailout of her State (West Bengal). On the flip side, she may be choosing to preemptively realign her party with a perceived new ruling coalition if the opposition parties are able to force Singh and his Congress Party to a vote of no confidence. To that tune, a recent Pew Research Center study found that only 38% of Indians felt satisfied with the country’s direction, down from 51% in the year prior and good for the sharpest YoY decline in their 17-country sample. Sluggish growth and persistently high inflation have weighed on the Congress Party’s ability to govern and connect with Indian voters – 75% of them living on less than $2 per day.

All that being said, no election has to be called until early 2014, so all this political wrangling is likely to merely perpetuate political stagnation in India with respect to implementing much-needed economic and fiscal reforms. It’s worth noting that the Indian government passed the 2nd fewest bills since 1952 last year amid elevated political infighting. Moreover, that infighting appears poised to actually accelerate over the intermediate term as parties increasingly jockey for political position.

From a GROWTH and INFLATION perspective, India’s economic outlook looks quite poor when applying a forward-looking (3-6 months) analytical lens. The recent diesel price hike and QE3-inspired run-up in world food price inflation is in support of our view that India’s reported WPI and CPI measures are poised to continue accelerating over the intermediate term. That will likely contribute to tighter credit conditions domestically – which had improved in recent months – that ultimately weigh on Indian economic growth – especially in an environment of prudence out of an RBI that officially wants to see YoY WPI readings ~250bps lower. Layer on the potential for a reversal of capital flows – which India needs to grow via supplementing its elevated current account deficit – and it’s not difficult to get to a scenario whereby Indian real GDP growth resumes its downward trend in 4Q12E and heading into next year.

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From a long-term perspective, we think the Indian economy represents a classic turnaround opportunity, as policymakers there have quite a few POLICY levers that they can pull that would be positive for sustainable organic economic GROWTH. In the interim, however, there will have to be some short-term economic pain as it relates to quashing structural INFLATIONary pressures and reigning in the fiscal deficit. As it stands currently, Indian equities are in a Bullish Formation, which we’d argue is discounting India’s potential rather than its likely path - though, to be fair, QE3 has had large role in perpetuating SENSEX and INR strength. Unfortunately for anyone currently buying what we view as a cyclical top in Indian equities, the India of today is not the “India of tomorrow” just yet.

Stay tuned.

Darius Dale

Senior Analyst

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