Despite an uncertain global backdrop, 2010 was the biggest year in terms of FII inflows, with FIIs pumping in $28 billion and markets posting modest returns of 18 per cent. The year 2011, however, is likely to be a year of dealing with complexities and paradoxes. With more than half the world fighting for growth and the other half against inflation most investors are grappling with a) Do you play the US recovery or quantitative easing (QE) next round? b) Do you play the US recovery with or without Europe stability? c) Do you play global recovery or EM growth with inflation?, and d) How will China react: Revalue or status quo?
The biggest paradox we will have to deal with this year is - QE versus inflation. There is no doubt about the recovery/growth in developed markets and Emerging Markets (EMs). There are two highly probable scenarios. If the US grows, quantitative easing will stop/slow, which will reduce inflationary threats in EMs, although not entirely, as commodity prices may continue to be higher. US equities will do well and might see moderate flows to EMs. This, I think, is the most likely scenario, but is unlikely to deliver great equity returns. The second is if the US sees poor-to-moderate recovery, QE3 will happen, which will put inflationary pressures on EMs, both through commodities and capital flows. Hence, there are high chances of capital controls and trade protectionism, leading to risk aversion and higher market volatility.
Without sounding sceptic on the India growth story, the country is amongst the most expensive EMs with lots of headwinds. Inflation in India will continue to surprise, and strong demand across the board, strong commodity prices and rising oil prices will continue to put pressure. In my opinion, RBI will have to react sooner than later. Slowdown of foreign flows will most likely have an impact on rupee. Any development leading to expectation of rupee depreciation could trigger funds outflow.
Broadly, while corporate India will face margin pressure due to cost escalations (higher commodities prices and interest rates), there is very high risk of earnings downgrade, especially in banking, auto and FMCG, and foreign flows should slow down.
Investors should stay invested in large, liquid and quality stocks and maintain good cash levels to encash opportunities. While Banking, Auto and FMCG are likely to underperform, Oil & gas and IT will continue to do well. Fertilizer, Sugar, Textiles & Chemicals are also some of the sectors likely to do well in 2011.
Only risk to this hypothesis is, if US and Europe recover, without any major event risk, there could be return of risk appetite into the system which would be more favourable for them than for EMs. Market cycles are becoming shorter and sharper, given the complexity of issues and environment, hence this view should be considered with dynamic in constantly changing scenario.
The author is Head-Institutional Equities, Edelweiss Capital