Have a conservative strategy

Invest in short-term debt instruments till clarity emerges.

During the first UPA regime, there was a period when India received less FDI than Botswana. In the past six months, FIIs have been net sellers of Indian equity while investing in even Pakistani stocks. In 2011, India has been the worst performer among emerging markets.

There are many reasons for this. There are obvious problems with inflation and especially, high crude prices. That has caused deterioration of government finances due to the fuel subsidies. As interest rates have risen, there have been earnings downgrades as well.

Most investors have given up on hopes of reform, or even speedy implementation of infrastructure projects. The sequence of scams that have surfaced, has also led to the belief in many quarters that the government is irretrievably weakened.

The above have all played a part in the downrating of India as an investment destination. Another reason worth mentioning is that, when North America, Eurozone and Japan are under pressure, investments into non-convertible currencies always slowdown. Pakistan actually has an advantage because the Pak Rupee is convertible.

What would bring investments back into India and make local investors more enthusiastic? Reform is not going to happen since the Indian economy is not yet in the kind of desperate straits where politicians take hard decisions.

Infrastructure project activity will also continue to be low key. Apart from tight financing, the intractable issues include political minefields like land acquisition and environmental clearances. Scams surfacing are actually healthy, in my opinion, and at worst, just reinforce the long-standing opinion that India is badly-governed.

The issues and challenges of inflation, energy security and interest rates are partly structural and partly cyclical. The fiscal is certainly going to overshoot projections by a large margin. That too, is due to partly structural, and partly cyclical reasons. It'll be a welcome surprise if any structural changes occur - this government lacks the courage. But one can wait for the cyclical factors to turnaround. That will eventually happen so, we can hope for positive changes on these fronts.

The question is how long must one wait for a cyclical turnaround, in the absence of reforms? Also, what indicators could have predictive value for the cycle? One obviously positive leading indicator would be significantly lower crude prices. Higher advance tax collections would be a good predictive signal as well.

When it comes to equity, India is over-valued both in terms of domestic fundamentals and in comparison with other emerging markets. Historically, we’ve seen Indian bear markets bottoming at valuations of 11-12 Nifty PE. The Indian market has always been a great investment below PE 14 since equity valuations tend to climb back to the PE 22 level at the very least.

Currently the Nifty is at PE 20. Assuming 15 per cent EPS growth through 2011-12, valuations of around 4500 (roughly PE 14) would be attractive. The stock market may hit rock-bottom at much lower levels. But an investor can buy heavily and confidently if the Nifty falls to 4500.

Interest rates will rise for a while at least. Peak levels of inflation and interest rates are not predictable in such a fluid scenario. The yield curve for government securities and T-Bills is likely to be an useful indicator of changes in rate trends. The curve is inverted now, with yields on short-term securities higher than yields on long-term securities. Changes in the rate trends will be reflected by the yield curve returning to normal.

What is the potential upside to debt? Interest rates can reasonably be expected to ease down by 400-500 basis points from current levels. A drop in rates will mean rising net asset values (NAVs) for both long-term and medium-term debt funds. In the early stages of the next up-cycle, for the first year or so, debt funds will generate serious capital gains. Unfortunately, with domestic and global economies in a sour spot, few investments have apparent defensive strength during the next few months. The standard prescription for inflation is bullion - either physical or exchange-traded funds (ETFs). But bullion has been going up for quite a while and it carries risk at the current high price levels. It's also counter-cyclical. Once a global recovery is underway, bullion holdings will depreciate in value.

The conservative strategy would be to look at short-term debt because a short-term debt portfolio has a lower opportunity cost in a regime of rising rates. Then, wait for the predictive signals mentioned above to start kicking in. As crude gets cheaper, the yield curve normalises, and equity valuations drop nearer PE 14, start moving into more long-term instruments.