Stick With The Buy-And- Hold Strategy

What is your take on the current investment climate of the country? Do you think that the Modi-led NDA government can impact economic stagnancy in the country?

There is a doubt that Modi’s leadership and policies can transform India’s growth prospects immediately as there is a lag between plan gestation, implementation and higher productivity that could take several years to eventuate. But we presume that Narendra Modi knows that his reputation rests on boosting growth momentum over the medium term and getting the Indian economy moving once again. Both the Indian electorate and equity investors are likely to allow Modi some time before they expect to see real evidence of results at the macro-economic level.

What they will expect without any delay is a road map setting out the key measures that the government intends to focus its energy on. We expect a determined effort to push forward with meaningful supply-side economic reforms. Boosts to infrastructure projects are likely to be announced, including several mega projects such as the “Diamond Quadrilateral” rail system. BJP’s support for the business sector could also see a number of market-oriented micro measures. Good news for investment activity from the government should put an end to policy uncertainty. This in turn will lead to rising business confidence and more private sector capex initiatives.

Beyond any short-term cyclical improvement, however, the real test for the new NDA government (which will largely determine how it is judged by history) is whether its policies are effective in raising the underlying trend in output or productive potential. Hopefully, by attacking the problems of inefficiency, supply-side blockages and over-regulation across a wide front, sustainable growth rate can be increased significantly. This would be a great achievement. The output gap or the difference between the level of potential output and actual GDP is thought to be one of the major drivers of inflation. With hindsight, the Indian economy was simply unable to grow at 8 per cent or 9 per cent on a sustained basis without experiencing severe overheating, which over time became entrenched in wage and price expectations.

One major reason for this structural weakness in the Indian economy is that not enough had been invested in infrastructure. The ratio of public sector infrastructure to GDP in India has remained firmly stuck in a low 2 per cent to 3 per cent range since 2005. Moreover, the large stimulus package enacted by India after the global financial crisis in 2009 with the benefit of hindsight proved unnecessary. It was also poorly designed, as it was light on public investment and heavy on subsidies, wage hikes and current expenditure, thereby encouraging inflation pressures.

Potential output is a difficult concept to measure, especially for an emerging economy like India that is experiencing rapid structural change. A key unknown for the Modi government is how much of the recent sharp slowing in GDP growth to 4.5 per cent was cyclical and how much of it was structural, due to slower growth in potential output. This is an important issue for the new government, because if it was the latter, then any attempt to regain strong 8 per cent GDP growth in 2015 would soon come unstuck, ending in another ratchet up in inflation. One recent IMF study looked at a number of different ways of estimating India’s growth in productive potential. The good news is that the IMF researchers argued that it has only fallen from around 8 per cent in 2008 to around 6 per cent to 7 per cent currently, which is close to the OECD’s figure. So the safest strategy for Modi might be to encourage GDP growth to recover to 7 per cent fairly quickly, but not to aim much higher than that until he is confident that his supply- side and administrative reforms are succeeding in improving the underlying output/inflation trade-off.
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What is your outlook on the equity markets for this fiscal? Will the ‘Bull run’ continue as it has been doing so far?

Historically, India’s elections and change of government have only had a limited, short-term impact on the stock market. But if the NDA-coalition and Narendra Modi hold onto their key policy objectives as set out in the BJP’s manifesto, then markets should start to anticipate a cyclical improvement in the economy beginning early in 2015 that in turn will feed through to company profits, margins and earnings, holding out the prospect of significant upgrades to 2015 Sensex earnings. Over the medium term, sustained earnings CAGR growth of 15-20 per cent is achievable.

And beyond a near-term cyclical rebound, we also envisage a brighter medium-term outlook for the Indian economy that could start to become visible by 2016. For now, a cyclical rebound in GDP growth to 7 per cent by FY16 (a figure close to India’s potential output growth) and CPI inflation easing gradually to 6 per cent, accompanied by only a moderate widening in the current account deficit, look achievable. It is unlikely that all the positives have been priced into the stock market. Investors in Asian equities should look to any temporary post-election dip in Sensex to add to their India exposure, as a significant structural overweight is strongly recommended.

Which are the global cues that you are looking forward for?

I am less worried about all the negative headlines on various Emerging Market economies. As long as China holds up, then combined growth downgrades to other EM are not enough to pose a systemic threat to the world economy. We have revised down our global GDP growth forecast for 2014 by around 0.5 per cent because of weaker expected EM growth.

So as ever, what investors must follow most closely this year is the US for signs that the American economy is picking up speed in the second half. The majority of recent high frequency data releases have been reassuring in this respect. Surprisingly low T-bond yields YTD, diverging strongly from the consensus expectation at the start of the year of a trend higher, are clearly becoming both a puzzle and a concern to investors. One explanation could be a downward location shift in the equilibrium level of the long term real interest rate, though this will only become clear with hindsight, looking back some years from now.
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What is your take on the interest rate front? Do you expect any major changes going forward?

Inflation remains a key challenge and upcoming monthly releases may continue to disappoint for a while, as with the recent April release. Then the CPI rose to 8.6 per cent y-o-y versus 7.3 per cent in March, with most of the acceleration driven by higher food prices. “El Niño” has also been much mentioned in the media this year as a potential threat to food prices and inflation in India this year via its impact on the upcoming monsoon. Thus, in our view, interest rates, which are not even in positive “real” territory when deflated by the CPI in place of the PPI, should not be cut, but ideally further increased into a recovering economy.

Linked to the need to fight stubborn price and wage inflation, tight monetary policy could also be a headwind for markets initially if it causes tensions between the government and the RBI, even sowing doubts as to Rajan continuing as Governor. The latter is not a big risk in our view. Foreign investors have a high regard for Raguram Rajan, who in his first baptism of fire at the RBI did a superb job in stabilising the rupee after “Fed taper fears” hit emerging markets last summer.

Do you think that the RBI will move ahead with rate cuts in this fiscal?

Not while Raghuram Rajan remains in charge at the RBI. It would be a huge mistake to ease monetary policy prematurely, before the job is done, which I interpret as getting the annual increase in the CPI down to 6 per cent. Thus, a possible point of contention between Modi government and the RBI could be to meet the 6 per cent CPI inflation target recommended by the Urjit Commission, an advisory body to the central bank, some further rate hikes would be required, which would hardly be popular, as many in India believe that the RBI has finished raising rates. But Modi is also well aware that if the inflation expectations dragon is not overcome now, then any subsequent boost to aggregate demand from BJP policies could easily end in tears and even more monetary tightening. So arguably, it is in the government’s own interests if inflation can be beaten down to a much less threatening level in the RBI’s current tightening cycle.

Do you see the GDP of the country reviving any soon and what are the reasons that you attribute for the same?

As ‘animal spirits’ revive and ‘policy paralysis’ fades, then, yes, India’s GDP growth will improve from last year’s decade low of 4.5 per cent.

But from such a sluggish trajectory a V-shaped sharp rebound is unlikely, assuming that the new government avoids Keynesian-style fiscal stimulus but rather focuses mostly on supply-side measures that only bear fruit in the medium to longer term. A V-shaped rebound in the Indian economy is also not particularly desirable in present circumstances, as there are still far too many speed limits and supply bottlenecks that could jumpstart inflation.

Nevertheless, the Indian economy in my view has reached a bottom after a prolonged period of subpar performance. That is very lucky for Modi as the NDA has returned to power just at the right time, with the economy already gaining some short-term (cyclical) momentum regardless of what the government does. It is a very sweet spot to be in.
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What are the triggers that you are looking forward to with regard to the markets?

Beyond Modi announcing his team by the end of the month, the next trigger for markets will be the revised fiscal budget for this year. This could prove a marginal headwind, leading to a temporary dip in the Sensex as fiscal discipline could be a dampener on growth in the near term. The fiscal position inherited from the outgoing administration is widely expected to prove less healthy than the official numbers suggest. Cooking the books is not the problem. Rather, all governments are capable of putting a more positive gloss on things when it is in their interests to do so.

So one of the hurdles for the new government when it introduces its first budget within the next month or so will be to come clean and put the figures on sounder, more realistic footing. That is expected to inevitably result in a revenue shortfall for FY14. Rather than allow the budget deficit to widen, the BJP is likely to follow its fiscally conservative bent and introduce some short-term revenue measures, such as asset sales or a tax amnesty. Some state-owned banks in India may also need substantial re-capitalisation, though any problems here are likely to be left to a later date before being addressed.

We feel that investors will be inclined to be forgiving when it comes to unveiling any fiscal shortcomings inherited from the UPA outgoing administration. Moreover, there is little direct correlation between the CGBR and the Sensex, and investors understand that putting India on a sounder fiscal trajectory is a medium term objective, as in the short run there is no such thing as ‘growth friendly austerity.’

But beyond the budget announcement, ‘Modinomics’ contains much that could become a key catalyst for markets, sectors and stocks viz.

• Enhance manufacturing competitiveness to create jobs 
• Increase fuel availability to improve power generation 
• Make railways a key enabler of the economy- The ‘Diamond Quadrilateral’ project 
• Improve agricultural productivity • Focus on tourism as an employment opportunity

What are the sectors that you are currently betting on, and in which areas should investors take caution?

Our investment process in India is essentially bottomed-up and is not sector driven, but having said that, valuations are relatively attractive for cyclical versus defensives currently. The decline in cyclical’ relative PER has formed a strong base over the past 18 months and looks set to make a decisive upwards break. Mid and small cap valuations are also cheap versus the large Sensex index constituents favoured by FIIs and we are actively seeking to raise exposure to this area.

Our Indian equity portfolios are well positioned for a cyclical recovery, with financials are our biggest overweight followed by other domestic cyclical sectors such as cement and materials. More defensive, expensive sectors such as telecom, staples, pharma are viewed as potential sources of funding for further raising exposure to domestic cyclical stocks. We are thus biased towards optimism and high beta.

What advice would you like to give retail investors at this juncture?

Always invest for the longer term and when you think long term you should feel very positive on Indian equities. For now don’t try to be too smart when it comes to market timing. Many financial advisers thought you could ‘trade’ around the election date, but there is little evidence in India’s case to back such a view. Even if the Indian equity market corrects over the summer as Modi euphoria fades and the reality of the deep challenges that the new government faces sinks in, we believe sticking with a buy-and-hold strategy is the best course for the retail investor. History and a thousand academic studies show clearly that inept timing skills can savage investor returns, even in the case of a stock market as sophisticated as that of the US (see the annual study on this important topic by Dalbar).