A further rise in crude oil prices can widen India’s current account deficit and weaken the rupee. It can put pressure back on inflation, thwarting RBI’s scope to ease liquidity and worsen the fiscal situation, Richard Gibbs, global head of economics, Macquarie Research, tells Puneet Wadhwa. Edited excerpts:
The first quarter of CY12 has seen a stupendous liquidity-based rally across global equity markets. Do you expect things to be different for the next couple of quarters?
The rally in the first quarter of CY12 represents a classic bear market rebound, following investor angst and a spate if less risky trades in the closing months of CY2011.
The major catalyst for this rally was the successful deployment by the European Central Bank (ECB) of the first round of its long-term refinancing operations (LTRO). Although ECB has recently engaged in a second round of LTRO and the size of the euro rescue fund has been expanded to $1 trillion, it is unlikely to result in the same liquidity-driven rally witnessed early this year. It is also unlikely for liquidity-driven rallies in equity markets to be maintained when there is uncertainty over global growth.
How do you see the US markets playing out ahead of the Presidential elections slated for this year? How will this affect global markets, including India?
They will remain volatile and at times in conflict during the lead-up to the elections in early November. In the first instance, there remains concern about the persistent high levels of unemployment and under-employment in the US economy.
Second, the pivotal housing sector remains a major burden with respect to economic recovery and is impeding mobility of labour across the US. Third, the recent surge in crude oil prices has resulted in an unwelcome headwind, which is likely to manifest itself in terms of weaker domestic demand, rather than higher prices. For global and emerging markets, the ongoing volatility in the US equity markets will continue to contribute to ‘risk aversion’ and concerns about capital preservation. As such, cross-border investment flows are expected to remain fractious and concentrated in the most liquid segments of asset markets.
What are your biggest worries on the macroeconomic front that can upset global equity markets?
The speed and extent of China’s economic slowdown will be fundamental for the growth of the global economy. At present, we still anticipate a ‘soft-landing’ for China with real GDP growth consolidating between at 7–7.5 per cent in CY12.
(Another worry is) the potential for further financial and credit ructions in the euro region and possible contagion of the banking sector. This could result in a significant dislocation in cross-border capital flows. At the current juncture, further sizable rise in crude oil prices can be expected to dampen global growth outcomes.
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Macquarie still remains cautious about India. Why?
We are mindful of the excess momentum generated in the liquidity-driven rally in the first quarter of CY12. According to historical evidence, following surges in FII inflows the markets deliver negative forward returns over the next 12 months.
We are also mindful of the likely downward shift in return on equity across the Indian equity market. The key culprits of this decline are low asset turnover and margin contraction. Companies were in massive capex mode over the last three to four years in anticipation of demand growth, which failed to materialise.
Following the recent correction, Indian markets are now comfortably placed at 13 times price-earnings ratio, below the 10-year average. We expect consensus estimates for FY13 to move down from the currently projected 15 per cent to sub-10 per cent. So, the price-earnings ratio would be around the long-term average of 14.5 times.
What key factors will make you change this stance?
We would need signs of a strengthening of domestic demand growth and/or a noticeable decline in crude oil prices. The Reserve Bank of India’s (RBI) moves to ease liquidity are welcome, but at this stage should only be seen as helping to stabilise domestic demand growth. High and unstable crude oil prices remain the greatest external risk to the Indian economy and equity markets.
Do you think the recently released current account deficit targets are achievable?
India runs the largest trade and current account deficit (CAD) in the Asia, ex-Japan region. For FY13, we expect CAD to remain high at 3.5 per cent of gross domestic product (GDP). India imports around 80 per cent of its oil requirements and therefore, faces a higher risk from rising oil prices, which can widen CAD further and weaken the rupee. This can put pressure back on inflation; thwarting RBI’s scope to ease liquidity and worsen the deteriorating fiscal situation.
Which sectors/themes are you underweight and overweight on India and globally?
In the Indian context, we retain our preference for global recovery sectors, like information technology, pharmaceuticals and energy.
Recently, we have increased telecom to overweight, while retaining a big underweight for financials and capital goods.
In the global context, we continue to favour sectors closely aligned with the rising middle income cohorts of major emerging economies.
We maintain overweight positions in discretionary consumer (high-end retail), diversified financials (wealth management) and listed property sectors. In addition, we continue to favour the energy and resources sectors in recognition of the ongoing industrialisation and urbanisation dynamics in emerging economies.
Overall, we remain cautious in respect to the financial services (banks) and residential construction sectors, as we believe both continue to undergo significant structural change.