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Takeaway: The fundamental research signals suggest the respective outlooks for Indian and Brazilian stocks is not a clear as it once seemed.

SUMMARY BULLETS:

  • By cutting interest rates today, India's central bank sent a clear message to the market that it no longer takes the threat of structural inflation very seriously. In doing so, the RBI has risked perpetuating key tail risks that threaten the very sustainability of the Indian economy.
  • It’s unclear whether or not the mere threat of a sovereign downgrade to junk status would be enough to derail Indian financial markets without actually being a tangible, near-term event(s). In light of this, we’ll continue to wait for both a better time (start of 2Q) and price (TREND support if it holds on any [pending] correction) to increase our long exposure to India.
  • All told, if you missed the move up in Indian equities, there’s no sense in chasing ‘em up here with a dour near-term fundamental outlook. From a index constituent factor risk perspective, tech, telecom, low debt, low beta, and large caps are all outperforming of late and pose the most risk from a mean reversion perspective on any potential correction – which should be shallow in and of itself if our fundamental outlook materializes. Macro markets are already discounting for a fair amount of economic surprise risk via the recent run-up in implied/historical volatility spreads.
  • Jumping to Brazil, it appeared the market was not yet prepared for the central bank to step in and intervene directly on the currency and probably took it as a signal that Finance Minister Guido Mantega isn’t yet ready to ease capital controls, which more-or-less translates to Brazilian policymakers not yet being ready to be friendly towards foreign capital.
  • Still, this is ultimately a positive fundamental signal (assuming the resulting currency strength is sustained) as FX appreciation continues to be the only way for Brazil to combat accelerating inflation readings amid President Rousseff’s prohibition of higher interest domestic rates, which should continue to stay glued to the floor, per Central Bank Governor Tombini’s guidance. BRL appreciation remains a critical factor underpinning our intermediate-term bullish bias on Brazilian equities.
  • The Bovespa, now bearish-TRADE on our quantitative risk management factoring, looks like it wants to hold its TREND line of support here. A recapture of the TRADE line would be an explicit signal to investors who aren’t yet involved on the long side of Brazil to do just that (i.e. get involved). From a index constituent factor risk perspective, consumer staples, industrials, high debt, large caps and cheap (EV/EBITDA) are all outperforming of late.

Central banks in India and Brazil were very active in the past 24 hours. The former expectedly/unexpectedly (depending on who you asked) eased monetary policy by lowering interest rates -25bps across the board:

  • Repo cut to 7.75% from 8% prior;
  • Reverse Repo cut to 6.75% from 7% prior and;
  • Cash Reserve Ratio cut to 4% from 4.25% prior, which should free up 180 billion rupees ($3.4B) into the Indian banking system

The latter pseudo-tightened monetary policy by auctioning FX swap contracts, which is the functional equivalent of selling USD to the market on favorable terms for the domestic currency. The BRL strengthened +1.7% on the day (yesterday) and is up an additional +0.5% today, bringing its week-to-date gain to an impressive +2.2%.

WHY THAT WAS BAD FOR INDIA

Given our short-cycle outlook for the Indian economy (i.e. Quad #3 in 1Q = Growth Slowing as Inflation Accelerates), we didn’t think the RBI would be inclined to ease as soon as many market participants were hoping for and we thought this likely pushing out of monetary easing expectations by at least one quarter would lead to the SENSEX and the INR underperforming and/or outright correcting in 1Q.

 

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - INDIA

 

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 2

With the advent of today’s -25bps rate cut, our fundamental research call has been wrong here. We do, however, find a small degree of solace in the fact that the SENSEX closed down -0.6% on the day. Is this as good as it gets in the near-term for Indian financial markets?

From our analytical purview, there’s hardly any reason for the market to believe the RBI will continue cutting rates as more inflation data comes in during 1Q, but Governor Subbarao and his motley crew have obviously been surprised here before. Year-after-year, the RBI is surprised to the upside with respect to its inflation forecasting, but their recent focus on shoring up Indian growth takes credibility pressure off of them for now – at least for financial market participants. We’re all but certain the ~800-plus million Indian citizens living on less than $2/day aren’t too thrilled with this gross lack of vigilance on the inflation front.

What is perhaps most alarming about today’s policy maneuvers is that the RBI confirmed to us that it has absolutely no clue what it’s doing with the following commentary:

  • “There is an increasing likelihood of inflation remaining range-bound around current levels going into 2013-2014.”
  • “This provides space, albeit limited, for monetary policy to give greater emphasis to growth risks.”
  • “[Further] policy guidance will be conditioned by the evolving growth-inflation dynamic and the management of risks from twin deficits.”

Inflation staying “range-bound” around +7% YoY on the WPI series and +10% YoY on the CPI series is not supportive of any sustained pickup in Indian economic growth. In fact, we’d argue a lack of control over inflation is the key factor underpinning the country’s most pertinent economic risk – i.e. twin deficits (sovereign budget balance and current account).

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 3

Both Fitch and Standard & Poor’s have warned in 2012 that this risk continues to threaten the country’s investment-grade status, so a continued lack of commitment towards addressing these imbalances in a meaningful way may culminate in the country being downgraded to junk by one or more of the “Big Three” ratings agencies at some point over the intermediate term.

That would have negative implications for Indian debt inflows – which are at/near record highs a TTM basis (aided by various policy maneuvers such as multiple increases to foreign institutional investment quotas) – and the country’s ailing currency, which is at/near all-time lows.

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 4

 

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 5

Still, it’s unclear whether or not the threat of the aforementioned catalyst would be enough to derail Indian financial markets without actually being a tangible, near-term event(s). In light of this, we’ll continue to wait for both a better time (start of 2Q) and price (TREND support if it holds on any [pending] correction) to increase our long exposure to India.

Additionally, we’ll likely have more color on Finance Minister Palaniappan Chidambaram’s FY14 budget by then. We’re on record stating that it’s somewhat imperative for continued strength across Indian financial markets that his team proposes a meaningful reduction in public expenditures and subsidies and/or a complete overhaul of the Indian tax code (lower rates; wider base).

A failure to do either will likely culminate in the market challenging his already-lethargic fiscal consolidation platform: the 5.3% of GDP budget deficit in FY13 is projected to narrow to only 3% of GDP by FY17 – very underwhelming indeed.

All told, if you missed the move up in Indian equities, there’s no sense in chasing ‘em up here with a dour near-term fundamental outlook. Our updated quantitative risk management overlay is highlighted in the chart below.

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - SENSEX

 

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 7

From a index constituent factor risk perspective, tech, telecom, low debt, low beta, and large caps are all outperforming of late and pose the most risk from a mean reversion perspective on any potential correction – which should be shallow in and of itself if our fundamental outlook materializes. Macro markets are already discounting for a fair amount of economic surprise risk via the recent run-up in implied/historical volatility spreads.

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - India Macro Factor Model

For more details behind our intermediate-term outlook on India, please refer to our 1/8 note titled: “PATIENCE SHOULD PAY DIVIDENDS IN INDIA”.

WHY THAT WAS GOOD FOR BRAZIL

It appeared the market was not yet prepared for the central bank to step in and intervene directly on the currency and probably took it as a signal that Finance Minister Guido Mantega isn’t yet ready to ease capital controls, which more-or-less translates to Brazilian policymakers not yet being ready to be friendly towards foreign capital.

Still, this is ultimately a positive fundamental signal (assuming the resulting currency strength is sustained) as FX appreciation continues to be the only way for Brazil to combat accelerating inflation readings amid President Rousseff’s prohibition of higher domestic interest rates, which should continue to stay glued to the floor, per Central Bank Governor Tombini’s guidance. BRL appreciation remains a critical factor underpinning our intermediate-term bullish bias on Brazilian equities.

 

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - BRAZIL

 

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 10

All told, we continue to like Brazilian consumer names and industrial names on the combination of currency strength promoting domestic purchasing power and lower interest rates reinforcing penned-up demand for capital outlays (World Cup and Olympic Games preparations are generally well behind schedule) boosts both sectors.

The Bovespa, now bearish-TRADE on our quantitative risk management factoring, looks like it wants to hold its TREND line of support here. A recapture of the TRADE line would be an explicit signal to investors who aren’t yet involved on the long side of Brazil to do just that (i.e. get involved).

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - Bovespa

That [pending] signal would be supportive our view that there is indeed a silver lining to what the Brazilian central bank is doing – specifically in that in the absence of rate hikes, currency strength really is the only way for Brazil to combat the bevy of inflationary pressures being built-up across its economy.

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 12

Moreover, the county’s multi-year international debt binge has really exposed Brazilian corporations to a fair amount of currency translation risk with respect to earnings growth. It’s easy to see why the Bovespa Index has an -0.78 inverse correlation to the USD/BRL exchange rate (trailing 5Y).

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - 13

From a index constituent factor risk perspective, consumer staples, industrials, high debt, large caps and cheap (EV/EBITDA) are all outperforming of late. Also, the 400bps spread between 3M and 1Y BRL non-deliverable forwards suggests the FX market expects further strength in Brazil’s currency in the weeks to come.

INDIA AND BRAZIL: UN-ACCORDING TO PLAN? - Brazil Macro Factor Model

For more background on this thesis, please refer to our 12/5 note titled: “DID MANTEGA JUST GIVE US THE GREEN LIGHT ON BRAZILIAN EQUITIES?”.

Darius Dale

Senior Analyst