Pull out of metals and IT, re-enter the globalised sectors when the rupee rises.
“Globalisation” is short-hand for a bundle of concepts. The most widely accepted definition would be good transnational linkages allowing the easy transfer of capital, goods, labour and know-how across borders.
The debate as to whether that is a good thing, and how policy should enable (or retard) it, is politically-loaded. Nevertheless India's economic growth in the past 20 years is largely tied to increasing globalisation.
In early 1991, India was broke and edging towards external default. The Gulf War, sparked by Iraq's invasion of Kuwait, led to a jump in crude prices. Since India is heavily dependent on crude imports, it faced an impending energy crisis as well.
The forex crunch coupled with fears of energy crisis led to the easing of some internal controls and some external controls to encourage exports and attract overseas investment. There was also a sharp rupee devaluation. These measures paid off soon enough to build consensus for more liberalisation.
As a result of internal liberalisation and globalisation, India's trade sector has grown faster than the overall economy. In many areas, domestic prices are aligned to international prices because there are few non-tariff barriers and easy import and export is possible. Foreign investors have steadily increased India exposure through both direct investments (FDI) and indirect portfolio investments (FII) including Private Equity and Hedge Fund deployments.
In such situations, price arbitrage occurs naturally and price-equalisation is apparent across commodities like precious and base metals, and in engineering goods and other manufactured items. Indian prices in those globalised industries, and in financial instruments pertaining to those sectors are very sensitive to overseas price fluctuations and external events, allowing for differences in customs tariffs, taxes, forex rates and so on.
The fundamental analysis of the globalised sectors of the Indian economy is both easier and more difficult. It is easier because the global variables count for a lot and there is plenty of high-quality information available about those variables.
It is more difficult because of mindset issues. It is not intuitively obvious at first sight that it makes sense to track London, Chicago or Nymex metals prices to judge the future prospects of Indian metals producers. After all, they have huge domestic markets.
Nor is it apparent at a glance how much of rupee volatility is due to short term portfolio inflows versus long-term macro factors like trade deficits and comparative interest rates. Obviously portfolio flows are influenced by macro factors so it's even more complicated.
Behavioural analysis runs into similar, worse problems. If you're tracking investor-trader behaviour, it's more “natural” to look at advisories by local players. But the overseas perspective may actually be more relevant simply because the foreigners have deeper pockets. There is also a tendency for behavioural analysis to be coloured by political and moral value-judgements. Very few analysts, perhaps none, retain their objectivity under circumstances.
The price movements of the past five months have been driven by FII perceptions. Between May and October 2010, they indulged in close to Rs 50,000 crore of net equity buying. That more than absorbed the impact of Rs 35,000 crore of domestic institutional sales and pushed the broad market up by 30 per cent.
Sectoral out-performance was visible in base metal producers (both ferrous and non-ferrous) and in IT because a lot of the overseas money was focussed there. The rupee strengthened 5 per cent versus the $.
It appears as though FII optimism is easing off with several days of net sales and a 4-5 per cent Nifty correction in the past fortnight. If the correction continues, the sectors mentioned above will be disproportionately badly affected and the rupee should weaken.
From a trader's perspective, shorting IT companies and metals producers is an easy play and certainly, I'd be tempted to do this through November. Obviously shorting stocks is a high-risk action but the circumstances seem propitious. If you do this, keep tight stop losses.
Shorting the rupee by buying $Rs futures contract is also an easy play and given the inherent leverage in the forex contract, it is perhaps the best hedge against a major correction. FII inflows played a huge part in driving up the rupee. FII outflows would certainly push the rupee down.
From an investment perspective, anybody who is overweight in metals and IT should look at rebalancing. Put into less globalised areas such as FMCGs and automobiles, where domestic considerations are more important than overseas perspectives. Re-enter globalised sectors again, when the rupee starts rising because that will indicate the FIIs are back in action.
