India a buy in short term, but risks remain for long term

Financial markets are opportunistic. The markets will turn around on a dime if it feels that there is money to be made. Indian equities, bonds and currency are seen as a place where there is money to be made in the short term.

The reason for this short term outlook is that the price earnings ratios of the Sensex and Nifty are still well below highs seen in late 2007s and early 2008s. Moreover, the economy is likely to have bottomed out, the government has suddenly turned reformist, the RBI is likely to ease monetary policy in 2013 and the Indian Rupee (INR) is trading just 5.5 percent off from all time lows.

[caption id=“attachment_544768” align=“alignleft” width=“380”]  FIIs investing in India believe that risk-return trade-off is positive. Reuters[/caption]

FIIs investing in India believe that risk-return trade-off is positive, given the current levels of the Sensex, Nifty, 10-year government bond yield and the rupee.

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Investors are calling for upsides of 10 percent each on the Sensex, Nifty and the rupee. They also expect a fall of at least 50 bps on the 10-year government bond yield.

Why bullish in short term

The price earnings ratios of the Sensex and Nifty at around 17x of 2012-13 earnings are below the 25x levels seen in 2007.

Earnings growth of Sensex and Nifty companies are seen to have bottomed out in 2012-13 at around levels of 10-12 percent and with prospects of uptick in earnings growth, markets are pulling the indices higher given the reasonable price-earnings ratio.

The bottoming out of earnings growth of Indian equities coincides with the bottoming out of India’s economic growth. India’s GDP growth for the second quarter of 2012-13 came in at 5.3 percent, a three-year low. GDP growth is expected to pick up from the lows in the second half of 2012-13 on the back of factors such as lower interest rates, reform push and low base effect.

The RBI had signaled in its October 2012 monetary policy review that it is open to lowering interest rates starting January 2013. The central bank will have the low GDP data to work with as it goes into its January policy review.

There are expectations that RBI could lower benchmark policy rates in its December 2012 policy review but that is a separate debate by itself. Financial markets expect interest rates to be lower than current levels in 2013 and that is adding on to positive sentiments for bonds and equities.

The government is pushing through FDI in retail in the current parliament session and indications are that it will succeed in its efforts. The government has also opened up aviation, insurance and pension sectors for FDI.

Once the policy to allow FDI in the multi-brand retail sector is passed in Parliament, it will give the UPA government a much needed political victory and it sends out signals of a reformist government to investors.

The rupee at 54.80 against the dollar is trading around 5 percent off its all time lows. The rupee has room to gain given the government’s is resolve to open up the country for capital flows.

The government has increased limits of FII investments in debt by $10 billion to take the total limit to $75 billion. The government is encouraging capital flows to narrow current account deficit, which is expected at around 3.5 percent of GDP in 2012-13.

FIIs have invested close to $22.5 billion in Indian equities and debt in 2012 until now and more are expected given the positive outlook for Indian markets. FII flows help improve sentiment on the rupee and this lift the currency going forward.

Long-term risks are high.

In the short term, Indian markets will do well on the back of the reasons given above. However, in the longer term, markets are in danger of falling off. The reason is that the government is progressively increasing India’s macro economic risk.

India at present requires structural reforms in the form of fiscal consolidation, fuel price decontrol, improving infrastructure, and state level reforms.

The government is yet to show seriousness in the long-term fiscal consolidation measures such as improving the tax-to-GDP ratio (stagnant at 10 percent levels for the last decade) and lowering subsidy-to-GDP ratio (sticky at around 2 percent).

Fuel prices are yet to be decontrolled and if oil prices rise from levels of $110 per barrel, the government will have to be more worried.

India’s infrastructure is a mess with vital sectors such as railways and airlines making losses. The government does not have money to spend for infrastructure and corruption is keeping out serious private sector players.

States are a law unto themselves and there is no accountability for their finances. Chief ministers use public funds as their own personal treasury and give out freebies for votes. States level reforms are a must for the country’s finances to improve.

India is trying to plug the current account gap through encouraging capital flows. Higher exposure to external capital flows that are short term in nature increases India’s vulnerability to external shocks. India does not seem to have a long-term solution to reduce its current account deficit and that will keep the rupee volatile.

Buy India now but sell at the right time.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.