The outlook for global equities has been uncertain the past few weeks, with serious concerns around European sovereign contagion and insider-trading allegations. However, the developed markets (DMs) now seem to have begun a cycle of outperformance vis-a-vis their emerging market (EM) counterparts. Most economic commentators are revising upwards their global growth outlook for 2011 and 2012, driven by higher expected growth in the US and the OECD. Many leading economists now expect the US economy to exit 2011 on a growth trajectory greater than 4 per cent (above the trend rate of US growth) and maintain this rate in 2012.
The growth gap between the EM and DM worlds is expected to narrow both in 2011 and 2012, as the EM economies consolidate. The inflation and liquidity outlook for the DM economies looks to be more benign and better suited to risk asset performance compared to the EM universe. Investor positioning also supports DM outperformance, as going long in emerging markets had become a consensus trade. As investors pull capital back into DM equities, emerging markets will face outflows. In the developed markets, many institutions will also complete long-pending rebalancing between debt and equity allocations, with money moving towards equities. As interest rates on bonds in the US rise in response to an improving growth outlook, the EM carry trade will lose attractiveness.
While this phase of developed market outperformance will continue for some time (a few months, maybe even a year), at some stage, the structural fiscal and financial leverage problems of the developed economies will come back to haunt them. The emerging economies will also eventually tackle their inflationary pressures either through appreciating currencies or rising rates. Once both these dynamics are in place, the EM world should recommence its economic and financial market outperformance.
However, within the EM world, India has begun to underperform quite noticeably. There are various reasons for this:
First of all, with the expectation of a strong and more balanced global growth, global commodities are expected to perform well in 2011. Easy liquidity has combined with improving economic fundamentals to drive crude prices above $90 per barrel. Many of the best commodity strategists are already calling for crude prices to cross $100 in 2011. Rising commodity prices, especially crude, are a clear negative for Indian equities. We get hurt through rising inflation, an expansion of the current account deficit and a blowing out of the fiscal. With inflation still near double-digit levels, we have no capacity to handle a commodity spike, at either a micro (corporate earnings) or macro level.
Second, the series of scams has obviously not helped. In many global investors’ minds, the media in India is now seen to be severely compromised, crony capitalism rampant, the system of checks and balances non-operational, and there is general amazement as to how the government functions. The dismal level of execution, lack of policy vision and general poor governance have been exposed for all to see. Not all of these perceptions are fair or accurate. However, many investors cannot understand how India can command the highest multiples in the entire EM universe, with this quality of governance and policy formulation. The cynical view among most investors is also that nothing much will change, and government will not alter its style of functioning.
The third fear of investors is around the macro. Local liquidity conditions seem very tight, banks are hiking rates and this will have an impact on growth. Rising interest rates and falling growth are normally toxic for valuation multiples. The current account is seen as also being vulnerable given the quantum of the deficit and the composition of how it is financed. The European sovereign crisis serves as a stark reminder to investors of how macro imbalances can damage markets. Investors worry about the lack of reforms and the Budget for 2011-12. How will the government meet its fiscal targets? GST seems to be seriously delayed, the DTC a shadow of its original version in terms of removing exemptions and broadening the tax base, and no rationalisation or better targeting of fuel, fertiliser and food subsidies in sight. The government also seems unable to control spending, with a slew of new and modified social sector schemes on the agenda. We were able to meet our 2010-11 fiscal targets due to the 3G and PSU disinvestment bonanza, no such windfall seems to be in sight for 2011-12. With fiscal slippage, the issues of crowding out of private sector investment, falling national savings rates and sticky interest rates all come back on the table.
Investors are also worried about policy risk around projects and investments. The number of high-profile projects caught in land and environmental issues is amazing. What were the previous operating procedures of this ministry, if most large projects are now shown to have violated environmental guidelines? Will this not impact project completion, and ultimately economic growth? As another example of policy risk, what about financial investors in stock exchanges? Suddenly they find that their investments may have no listing and a cap on profitability, a sure recipe for capital loss. A lack of predictability around policies and their implementation is a cause for worry.
From a micro perspective, the earnings season for Q2 was a slight disappointment, with no earnings upgrades. Many strategists have, in fact, cut their earnings estimates, as can be seen from the consensus numbers. A market like India, given the premium valuations at which it trades, cannot afford to have earnings downgrades. To sustain its multiples, earnings have to continually beat expectations, and estimates have to keep rising. This upwards revision cycle seems to have been temporarily short-circuited.
The markets also seem to be going through a cleansing process. After the Money Matters scam, many speculative positions have been squared up, market operators forced to liquidate and Sebi has seemingly been very active in pursuing stock price manipulation. Mid-cap stocks have been decimated and stock-specific risks never higher as Sebi seems to have succeeded in scaring many corporate houses and getting them in line. All this is very healthy for the markets but will cause pain in the short term.
India will go through a period of relative underperformance until some of these issues get sorted out. Ultimately we are a resilient democracy and we will find our way through most of these problems. We will find our own unique way to bring in the required changes and the government will eventually realise that you cannot get 9 per cent growth without serious reforms in policy and government functioning. Bihar has shown politicians once again that people are hungry for governance and growth. India is a huge leveraged bet on economic growth. Without 8-9 per cent growth, we will not have the tax revenues or international capital flows to finance the fiscal and current account deficits. We frankly have to make the changes, for we need international capital to be able to grow at the rates we aspire to. International capital will shy away till we make India once again a predictable and hospitable place for investing.
The author is the fund manager and chief executive officer of Amansa Capital
