Why India is not a favoured investment destination

High inflation and high interest rates are the key factors muddying the outlook for Indian equities, despite their reasonably attractive valuations after the recent global sell-off, according to the views of some top foreign brokerages.

High inflation translates into higher interest rates and prices, which have weighed on corporate investment and consumer demand. As a result, margins have been increasingly squeezed.

That’s one reason why JP Morgan is pessimistic about India as an investment destination currently, despite the fact that the country is relatively insulated from the ongoing turmoil in global financial markets. The brokerage noted that while the earnings growth of 11 percent in the June-ending quarter met expectations, growth was practically flat if the earnings of commodity companies were stripped out. The brokerage has also downgraded earnings of 55 companies for the year ending March 2012, while the earnings of 50 companies have been downgraded for the next 12 months.

Not surprisingly, at the moment, most global investors aren’t inclined to view India as a preferred emerging market investment destination. According to a Bank of America-Merrill Lynch Fund Managers Survey for August,India is the least favoured investment destination for emerging markets investors, although emerging markets are the only destinations that investors are optimistic about.

Worries over inflationary pressures and high interest rates recently prompted Citigroup to slash its year-end target for the BSE Sensex by nearly 10 percent to 19,700 from 21,500. “India will also likely lag any sharp global bounce-back,” the Wall Street bank said in a note. However, the house said it believed India’s negatives – high valuations, inflation, the central bank’s tight monetary stance, GDP downgrades and an apparent policy paralysis – could have already peaked.

But experts at some other foreign institutions thought otherwise.

“I think we have seen downgrades in the first quarter of the current year and we believe that there is still a risk of further downgrades moving forward,” Abhay Laijawala of Deutsche Equities India told CNBC . “…in the first quarter itself we have seen our team of analysts cut earnings by close to about 300 basis points and we believe that there is probably more to follow.” Still, like a growing band of financial experts, he also believes that emerging markets are starting to look attractive again.

Morgan Stanley Smith Barney, while also quite optimistic about emerging markets, remains “slightly underweight” on India. The brokerage said it wanted to see more evidence that inflation is cooling before choosing India as a top investment destination.

Unlike some other brokerages, it says it remains positive on earnings growth and stock valuations. The financial institution expects earnings to grow by 24 percent this year, and by 17 percent next year. On a valuations basis, the investment house says the market is looking attractive too: 14.1 times the estimated earnings of 2011 and 12 times the estimated earnings of 2012. “We like India in the longer term, but, for the time being, we are slightly underweight in these portfolios, pending a feeling that the inflation rate is under control and there are no more interest rates in the offing by the Reserve Bank of India,” David Darst, chief investment strategist of Morgan Stanley Smith Barney told CNBC .

Indeed, most foreign brokerages are waiting to see what the central bank will do before rushing to recommend Indian equities.

In that aspect, Christopher Palmer of Henderson Global Investors believed there is one key difference between India and most other investment destinations. “India is one of the few economies in the world, along with Brazil and China, where the central bank really holds its destiny in its own hands. When the right moment comes, the Reserve Bank of India can play a role in getting India going. Many countries are quite hamstrung in (their ability to do that) because their interest rates are already so low. India could be a good play for the fourth quarter provided the central bank sees that opportunity to begin easing interest rates and other macro financial measures,” pointed out Palmer.

Whether the Indian central bank likes it or not, investors will be looking at monetary officials for further guidance.