• MSCI India outperformed the global indices for the first time in March 2011. In March, India emerged as the second best-performing market (after Korea) in the world. Although, year-to-date and on a six-month basis, India’s ranking is still among the bottom five (at 17th position) in emerging markets.
• Mid-caps and small-caps underperformed the Sensex for the fifth month in a row.
• Telecoms and consumer staples were the best- and worst-performing sectors, respectively.
• FIIs turned buyers of stocks. Domestic mutual funds remained buyers for the fourth consecutive month even as insurances companies turned sellers of stocks.
• Breadth gained 20 percent during the month.
• Volatility reached its highest level since Nov 2009.

FY 2011 thus far: key highlights

• For the first three quarters of FY2011, Sensex and broad market (for 1,717 companies) earnings grew at 23 percent and 22 percent year-on-year respectively.
• Industrials and telecom have reported the strongest and weakest earnings growth so far, respectively.
• More than one-half of the companies have beaten expectations during the last two quarters.
• The global earnings of Sensex companies in FY2011 grew by 48 percent year-on-year, while the domestic earnings for the index companies grew by 8 percent year-on-year during the period.

Quarter ended March 2011 earnings expectations

• Sensex companies are likely to grow 17 percent year-on-year during the quarter ended Mar 2011.
• Excluding the telecom sector, Sensex growth is likely to be 26 percent year-on-year.
• The biggest contributors to Sensex earnings growth are expected to be ONGC, Tata Motors, Reliance Industries, and Tata Steel (in that order).
• The largest negative contributors to Sensex earnings growth are expected to be Bharti and RCOM.
• Industrials and telecom are likely to continue to report the strongest and weakest earnings growth, respectively.
• The narrow market beat the broad market earnings growth in the previous quarter, and this should continue for the quarter-ended March 2011.

Sensex earnings growth is unlikely to be at risk due to GDP growth downgrades, as global earnings account for almost half the Sensex earnings. In FY 2011, the share of global earnings for the Sensex companies is at the highest level (of 45 percent) in history and likely to remain at those levels through FY 2012. This is almost double the share of exports in GDP.

Margin compression in seven of ten sectors
We expect aggregate (ex-government-owned oil companies) revenue to grow 21 percent year-on-year with an expansion of 69bps year-on-year in EBITDA margins. Telecoms likely to see the most margin expansion, while Healthcare followed by Consumer Discretionary is likely to see the most contraction in margins.

We expect the strongest earnings growth for Industrials at 37 percent year-on-year (for the third straight quarter, 22 percent ex-Tata Motors) followed by financials (at 29 percent year-on-year), whereas telecoms earnings (down 40 percent year-on-year) are likely to be the weakest for the sixth quarter in a row.

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The FY 2012 Union Budget is largely a neutral event:

The Budget provides incentives for increased infrastructure spending along with increased funding sources while highlighting supply side issues in agriculture with an effort to provide solutions.

It also creates an avenue for funding of the current account deficit (albeit still linked to capital markets) and creates a roadmap to rationalize subsidies, moderates expenditure growth and takes another small step towards the implementation of DTC and GST.

From a macro perspective, the budget was largely a neutral event. It did not make a major announcement of acceleration of key reforms. At the same time the government maintained restraint by not making populist announcements, such as immediate plans to please the lower- and middle-income sections of the population, considering there are a few state elections due in the current year.

Key Budget Announcements

Overall Budget

• Aggregate expenditure up 3.4%
• Aggregate tax revenues growth at 18.5%
• Market borrowings estimated at 3.43 trillion rupees
• Fiscal deficit estimated at 4.6%
• Subsidy spending estimated to decline 12.5%
• Social sector spending increased by 17% YoY
• Divestment target of Rs400 billion
• Substantial increase in health and education spending

Tax Proposals

• Marginal corporate tax rate reduced by 0.8%
• Marginal change to personal taxation
• Baby steps towards GST – Excise duty unchanged – implying GST rate could be 10%
• No tax hike for cigarettes, autos; 20% export duty on iron ore
• No rationalization of fuel duties
• SEZs to be charged MAT rate of tax
• Tax on dividends received by Indian companies from its foreign subsidiary reduced to 15%
• Total tax proposals neutral to revenue

Other Announcements

• Infrastructure – FII limit on infra bonds from USD 5 to 25 billion and plan spending for infrastructure is up 23% over budget estimates for FY 2011, Tax free bonds of 300 billion rupees to be issued , reduction in withholding tax for FIIs
• Nandan Nilekani’s committee to evaluate direct transfer of cash subsidy to people living below poverty line and execution of recommendations by end of FY2012
• Fertilizer, cold chains made infrastructure sub sectors
• Foreign investors who meet SEBI KYC norms can invest in domestic mutual funds
• Agriculture – focus on increasing storage facilities, credit target to the sector upped by 27%
• UID to achieve daily enrollment of one million by October 2011
• Steps to counter black money generation
• Performance monitoring and evaluation system introduced for 62 government departments

New deficit target is optimistic: The government is targeting a deficit of 4.6% of GDP in FY 2012 against the revised estimate of 5.1% of GDP in FY 2011. The government has been optimistic on revenue estimates and has assumed very low expenditure growth in FY 2012.

Market implications – more positive than negative:

There is a small upside to profit forecasts owing to the net change in tax rates. Apart from this, there are a couple of sentiment boosters.

• The biggest positive impact on sentiment is the move to allow foreign individuals who meet SEBI’s KYC norms to invest in domestic mutual funds. This opens up a new source of funding for the current account deficit as well as for Indian equities.

• The divestment target of Rs 400 billion does not appear disruptive to the market.

• A committee will make recommendations on direct cash transfer to provide subsidies to poor people. This is a move to rationalize subsidies longer term.

• There are a few small steps towards GST and a focus on infrastructure spending.

The immediate market outlook remains largely dependent on oil prices and global equities: Rising oil prices and a selloff in global equities are possibly the greatest risk factors to Indian equity performance.

Independent of the Budget, the market has been concerned about two key macro issues inflation and acceleration of private corporate capex and infrastructure spending.

Given the price erosion and negative position in the market, the current market levels provide attractive entry opportunity in select sectors such as infrastructure, engineering & capital goods, financials.

The Union Budget is likely to look into the following themes: (a) Deficit reduction plan; (b) Measures to boost investment sentiment, particularly for the infrastructure sector; and (c) Redistribution focus to support lower income segment households.

• Theme #1 – Fiscal consolidation: In its medium fiscal plan published in 2010, the finance ministry indicated that the central government would aim to target a deficit of 4.8% of GDP in F2012.

Achieving this reduction in deficit will be difficult without a meaningful cut in government expenditure growth in F2012. Currently, our forecasts assume that the government will target expenditure growth of ~7.5% in F2012 (the lowest in seven years). Even at 4.8% of GDP, the government’s overall borrowing program will remain at broadly similar levels to F2011.

In F2011, the government had the support of US$35.5 billion, including US$23 billion from 3G and broadband wireless access (BWA) license fees and US$12.5 billion of open market operations (OMO) involving buyback of government securities by the RBI.

Why Fiscal Policy Reversal Is More Critical?

The credit crisis had a significant impact on investment in India. India’s investment trends tend to be highly influenced by the capital market environment.

As the global credit crisis impaired capital markets, investment declined from 38.1% of GDP in F2008 to 34.5% of GDP in F2009. More importantly, the most productive investment component — private corporate capex — declined to 11.5% of GDP in F2009 from a peak of 17.3% of GDP in F2008. In the face of this decline in investment to GDP, the central government pursued a massive 4% of GDP increase in total expenditure. The fiscal deficit has risen from 2.5% of GDP in F2008 to 6.3% of GDP in F2010.

While the headline deficit has fallen in F2011 thanks to one-off revenues, the central government expenditure relative to GDP in F2011 is expected to remain close to peak levels of 15.3% of GDP.

During the trough of the growth cycle this focus on consumption was necessary to revive confidence and capacity utilization, over the past nine months this has been only adding to inflation pressures.

While investment relative to GDP has risen from the trough levels, it is still far from pre-crisis peak levels. Hence, the continuation of such high levels of government expenditure in nature of consumption in F2012 will only add to inflationary pressures.

• Theme #2 – Efforts to boost investments to GDP:

It is important to have a maximum focus on boosting investment to ensure that GDP growth sustains above 8% without causing inflation pressures.

The government is conscious of the adverse impact of these issues on business confidence and hopefully this year’s budget will focus on pick up in policy action to encourage investments in agriculture, manufacturing and infrastructure.

The credit crisis in 2008 has resulted in a significant decline in total investment to GDP (excluding investments in gold by households) to 33.2% of GDP in F2009 from 37.1% of GDP in F2008.

More importantly, the private corporate capex, which is the most productive component of the total investments, declined from the peak of 17.3% of GDP to 11.5% of GDP in the same period. While there has been some rise over the last two years, the pace of increase in investments has been slower than warranted.

Total investments (excluding gold investments by HH) and private corporate capex has improved to 35.2% of GDP and 13.5% of GDP respectively in F2011, according to our estimates.

Post credit crisis, the corporate confidence to push for higher investments is taking time to rebound to the levels seen in 2006 and 2007. In 2009, companies were focused on repairing their balance sheets. In 2010, the corporate confidence recovered only gradually as the global macro environment was still not comfortable enough.

Right up to August 2010, the sovereign debt concerns in EU had meant that the companies were not ready for an aggressive capex plan. Just as the global environment improved, domestic factors such as corruption-related investigations and rise in cost of capital have held back the investment cycle.

Indeed, there was a recovery in order backlog for engineering and construction companies in the first half of 2010. However, since then, it has again decelerated during the quarter ended December 2010.

It is important to have a maximum focus on boosting investment to ensure that GDP growth sustains above 8% without causing inflation pressures. Corruption allegations over the recent months had disrupted the operation of parliament in the winter season affecting the pace of government clearance for key infrastructure and mining related projects.

However, the government is conscious of the adverse impact of these issues on business confidence and hopefully this year’s budget will focus on pick up in policy action to encourage investments in agriculture, manufacturing and infrastructure.

In this context, over the past few days the government’s action does raise our optimism that it will get back into initiating efforts to clear investment projects transparently.

For instance, the environment ministry has started to clear key projects. After long delay, POSCO’s steel project received approval in January 2011. Similarly, the ministry awarded approval for a 4000 MW power project in Orissa.

Recently, the government has approved the constitution of a ministerial panel (to be headed by the Finance Minister) to sort out environmental issues currently holding up the development of coal mines. In lieu of this, the environment ministry has recently cleared 16 coal projects that had seen little progress over the past year.

The government may do a major campaign style effort to revive the corporate confidence to ensure that private corporate capex picks quickly to achieve our recently downgraded GDP growth of 8.2% for F2012.

• Theme #3 – Redistribution focus to support lower income segment households

Strong demand and rise in food and other commodity prices have ensured that headline inflation (WPI) has remained above the RBI’s comfortzone of 5-5.5% for the past 14 months. Headline inflation averaged 9.2% during this period. CPI (Industrial Workers) has averaged 12.4% during this period.

While the rural population has been protected to some extent with subsistence farming and government’s large transfers to households via overall increase in spending and the national rural employment scheme, the urban poor has been hit the most.

There is a possibility that the finance minister may announce a reduction in income tax burden for the lower income segment in the budget.

(The views expressed in this column are the author’s own and do not represent those of Reuters)

2010 was the year of the “E”s. Equity markets across the world delivered positive returns in 2010, even though sovereign issues in Europe caused periods of market volatility.

Quantitative easing brought a flood of liquidity to Indian equity markets. Domestic factors also influenced Indian market performance, from the RBI’s Exit to questions on government’s Execution on reforms and the debates on corporate and political Ethics. Despite the uncertainty, backed by strong Earnings, India posted outperformance vs. the global indices for the second consecutive year.

KEY LESSONS FOR HNIs

1) Optimisation of risk – return through proper asset class/manager/market allocation
2) Disciplined investing – predetermined stop loss and book profits
3) Regular portfolio monitoring
4) Consider factors such as liquidity, capital preservation and absolute return while making investment decisions
5) Seek professional advice on investments

MACRO-ECONOMIC VIEWS FOR 2011

Indian policy makers have been boosting growth at the cost of macro stability risks, reflected in high inflation, a widening current account deficit and tight inter-bank liquidity due to low deposit growth.

WPI headline inflation and non-food inflation have moderated to 7.5 percent YoY and 7.9 percent YoY in November 2010 from the peaks of 11 percent YoY and 8.9 percent YoY (in April 2010) respectively. Monthly trade deficit narrowed to 7.1 percent of GDP, annualised in November, from the peak of 10.8 percent of GDP, annualised in August 2010.

Inter-bank liquidity should also improve over the next three months as recent aggressive deposit rate hikes will help improve deposit growth. Private sector capex has been accelerating over the last 10 months and it will soon begin to reflect in the form of commissioned capacity. At the same time, monetary tightening — as reflected in the 300 bps rise in short-term rates (91-day T-bill yields) over the last eight months — is beginning to help reduce the above macro stability risks.

Overall macro conditions will remain vulnerable over the next 4-5 months. Inflation, while moderating, will remain above the RBI’s comfort zone; while we believe the current account deficit will also stay relatively high.

Recent optimism in the developed world growth outlook has increased the risk of a potential rise in crude oil prices to $110-120/bbl. Similarly, there is additional risk of pass through of agricultural and commodity prices.

MARKET OUTLOOK FOR 2011

Relative valuations are on the richer side and hence we expect moderation in index returns for 2011 (in the 10- 15 percent zone from current levels). That said, we remain in a structural bull market so any dip will enhance returns and provide an opportunity to buy equities. The market is likely to consolidate in its current range in the near term and then a steady but not spectacular rise for the rest of 2011. We expect style rotation in 2011. Watch out for the beaten-down low ROE, high beta plays and stocks of less dividend-focused companies.

India’s policy favours a change in mix of growth from consumption to capital spending. An improving global growth environment could be the trigger for higher-than anticipated capex. We favour capex proxies such as industrials, materials and property over consumption sectors.

NINE MONEY MAKING THEMES FOR 2011

1. Buy disinflation trades – India’s inflation is likely to decline. Inflation has been sticky over the past 12 months, driven by a slow supply-side response to a significant recovery in demand helped by strong stimulus and a negative food supply shock. We expect both these factors to recede in 2011. If inflation declines, it could be positive for equity returns. Key sectors that do well during disinflationary cycles are industrials and financials. Technology tends to underperform. A corollary of declining inflation is that real rates are rising – this may not augur well for consumer stocks.

2. Surprise from the government? There are three areas where the government could spring a surprise: a) Accelerate infrastructure spending further; b) FDI liberalisation in retail; and c) Rein in the fiscal deficit more aggressively – long bond yields decline.

3. Protect the portfolio from tail risks. India’s key risk is that it is pursuing growth assertively. Consequently, public spending is still at elevated levels and the current account deficit is at record levels. The economy and the market may not tolerate extreme outcomes. A deep risk aversion event could cause India’s growth to stumble and markets to react adversely. The flip side is that the world recovers and commodities do well – India could still falter.

4. Macro in Vogue – Focus on sector trades. Through 2010, stock-picking has been in fashion. It is unlikely that the macro effect falls further, and, to that extent, stock pickers may have to take a back seat in the coming months. The message is to focus on sector trades.

5. Buy long bond proxies. Equities look more attractive than long bonds but not by a big margin. Equities may continue to beat long bonds in 2011, although the gap may narrow compared to 2010.

6. Buy Capex proxies. We expect a disciplined capex cycle in 2011 and capex-related sectors, such as industrials, property and materials (most of these have underperformed in 2010), to do better. Consequently, the consumer sector, could underperform.

7. “Growth” is policy. The significance of the Bihar election outcome reaffirms the evolving dynamics of “development” politics in India. The government is taking risks with the external deficit to fulfil its target of 9-10 percent GDP growth.

8. From cash flow generators to asset gatherers. 2010 was all about cash flow generators. Stocks of companies with long duration cash flows distinctly underperformed. We are now in a hesitant bull market. As the bull market matures, it may shift its attention to longer duration cash flow companies.

9. Market is at fair value – Buy Undervalued, Under-owned and Unloved stocks (3Us). Our residual income for the Sensex implies long-term valuations are at a fair level. At the sector and stock level, we are focused on the 3Us. Key sectors to own are materials and utilities. The consumer and financial sectors fail the test.

(The above article is not intended to be a financial advisory. Readers must seek specific advice from experts before making investment decisions.)