PATIENCE SHOULD PAY DIVIDENDS IN INDIA

Takeaway: We are warming up to India on the long side, but plan to wait ~2-3 months for what we think could be a much better entry point.

SUMMARY CONCLUSIONS:

  • Given our short-cycle outlook for the Indian economy (i.e. Quad #3 in 1Q = Growth Slowing as Inflation Accelerates), we don’t think the RBI, led by Governor Duvvuri Subbarao, will be inclined to ease as soon as many are hoping (~MAR) and we believe this pushing out of monetary easing expectations by at least one quarter is one of the core reasons the SENSEX and the rupee have underperformed over the past month.
  • However, we don’t think the aforementioned timing catalyst is strong enough to run out and short the SENSEX or the INR with. If anything, it should just keep India’s benchmark equity index from making a new all-time high (north of 21k on the SENSEX) in the coming 1-2 months.
  • Moreover, a probable ~six-month stay in Quad #1 (Growth Accelerating as Inflation Decelerates) of our G/I/P chart starting in 2Q should provide the RBI with the macroeconomic cover to acquiesce to market demands for aggressive monetary POLICY easing – especially if Singh & Co. make additional headway in the fiscal reform department.
  • Regarding fiscal reform, the key India-specific catalyst that looks to dominate domestic headline risk between now and then is undoubtedly the unveiling of the FY14 budget. For the sake of India’s investment-grade credit rating, Finance Minister Palaniappan Chidambaram and his team must get serious about fiscal sobriety. Ultimately, that means cutting spending, overhauling the tax code and just saying “no” to subsidies – a very difficult task indeed, given the political pressure to “buy” votes ahead of the MAY ’14 parliamentary elections.
  • All told, we will patiently look to use any US Debt Ceiling-induced weakness to increase our allocation to India on a pullback(s) heading into 2Q – provided our quantitative signals support that move at the time.

Since the start of DEC, India’s 10YR sovereign debt yield has plunged -27bps to a ~two-year low of 7.91% on the strength of widespread expectations for monetary POLICY easing in the next 1-3 months. The aforementioned move on the long end has pancaked India’s 10YR-1YR* (no actively traded 2YR note) yield curve to a nine-month low of -3bps wide – a move that is likely foreshadowing a trip to Quad #3 (i.e. Growth Slowing as Inflation Accelerates) on our G/I/P chart.

 

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - 1

 

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - INDIA

GROWTH should slow from somewhat impressive rates within this current cycle (DEC Manufacturing PMI: 54.7 from 53.7 prior; DEC Services PMI: 55.6 from 52.1 prior) and INFLATION should be buoyed on the margin by the late-year diesel price hike and a weak currency, which has fallen -6.5% vs. the USD since its cycle peak on OCT 4; that compares to a regional median gain of +0.5% and is good for the second-sharpest decline in Asia over that duration (the JPY fell -10%).

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - 3

By the end of the second quarter, Bloomberg consensus has the RBI cutting its benchmark repo and reverse repo rates by a cumulative -50bps each. Directionally similar, the buy-side is a bit reserved in magnitude, pricing in -42bps relative to the benchmark on the 1YR OIS tenor and -6bps relative to the benchmark on the 1YR sovereign debt note.

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - 4

Given our short-cycle outlook for the Indian economy (i.e. Quad #3 in 1Q = Growth Slowing as Inflation Accelerates), however, we don’t think the RBI, led by Governor Duvvuri Subbarao, will be inclined to ease as soon as many are hoping (~MAR). Moreover, India’s deteriorating current account dynamics and a still-underwhelming fiscal POLICY outlook are likely to continue keeping RBI board members awake at night just enough to remain data dependent on monetary POLICY. Despite the RBI’s recently adopted focus on GROWTH, we view rate cuts in India as more of a 2Q-3Q event as opposed to a 1Q catalyst.

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - 5

Jumping back to Indian fiscal POLICY, Finance Minister Palaniappan Chidambaram has pledged to narrow the budget shortfall to 5.3% of GDP this fiscal year, from 5.8% in FY12. With a decade-low fiscal year GROWTH target of +5.7%, we don’t think Chidambaram’s deficit-to-GDP target is sober enough to warrant Subbarao abandoning his long-held view that India requires meaningful fiscal retrenchment to create ample space for the RBI to meaningfully ease monetary POLICY.

We believe this pushing out of monetary easing expectations by at least one quarter is one of the core reasons the SENSEX and the rupee have underperformed over the past month. Since our 12/6 note backing off of the short side of Indian equities and the rupee (“SINGH WINS THIS ROUND IN INDIA”), the SENSEX has appreciated just +1.3%, which compares to a regional median gain of +4.4%. The INR has fallen -1.3% vs. the USD over that same duration, which compares to a regional median gain of +0.1%.

If just on the strength of our quantitative factoring alone, however, we don’t think the aforementioned timing catalyst is strong enough to run out and short the SENSEX or the INR with. If anything, it should just keep India’s benchmark equity index from making a new all-time high (north of 21k on the SENSEX) in the coming 1-2 months.

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - 6

Moreover, a probable ~six-month stay in Quad #1 (Growth Accelerating as Inflation Decelerates) of our G/I/P chart starting in 2Q should provide the RBI with the macroeconomic cover to acquiesce to market demands for aggressive monetary POLICY easing – especially if Singh & Co. make additional headway in the fiscal reform department. That would be supportive of continued inflows of foreign capital into both India’s debt market (which foreign investors have been increasingly allowed to participate in; up +26% in 2012) and Indian stocks. Importantly, such inflows would be supportive of the INR, which Bloomberg consensus sees strengthening +4.7% by year-end from near all-time lows vs. the USD.

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - 7

 

PATIENCE SHOULD PAY DIVIDENDS IN INDIA - 8

All told, we will patiently look to use any Debt Ceiling-induced weakness to increase our allocation to India on a pullback(s) heading into 2Q – provided our quantitative signals support that move at the time.

The key India specific-catalyst that looks to dominate domestic headline risk between now and then is undoubtedly the unveiling of the FY14 budget. For the sake of India’s investment-grade credit rating, Finance Minister Palaniappan Chidambaram and his team must get serious about fiscal sobriety. Like yesterday. Ultimately, that means cutting spending, overhauling the tax code and just saying “no” to subsidies – a very difficult task indeed, given the political pressure to “buy” votes ahead of the MAY ’14 parliamentary elections.

Darius Dale

Senior Analyst