India emerges above the emerging markets; How to profit from this

Summary

Emerging Market Overview - Bullish on India and Mexico. Uncertain about China’s direction. Concern over stalling growth rates in China.

China’s lack in sustained growth in 2014-factors such as housing bubble, over capacity and a slowdown in exports and import

India’s Economic state- positive manufacturing, service industry data coupled with macroeconomic stability keeps India in a good economic and financial state. Key indicators such as PMI, current account levels, GDP growth show reasons for optimism

Recap of India’s recent budget- Tax cuts, infrastructure boosts and AIF’s are some reforms to be made this year. The government has hence focused on giving the economy the necessary push to take off.

Growth Factors and Investment Catalyst – Factors like favourable demographics, commodity cycles and Modi effect spur investor confidence in the long run

Indian Stock Market Outlook- positive and may be over priced, but now may be a good entry time. Sector and stock recommendation should be based on a top down approach and few recommendations in the Banking and Construction industry give.

Introduction-

The purpose of this article is to analyse the current economic condition of the emerging market countries (BRIC nations) and show why India is in the most promising situation. The length at which India and China have dominated the Asian markets can be seen by the names encapsulated by the images used to portray them. China, conned the dragon is a giant, aggressive force while the Elephant describes India’s big, powerful but limbering ungainly image. I will show reasons for the optimism surrounding the recent budget proposed by the Indian Finance minister, thus explaining why India is a potential outperformer. Brief exploration of the key investment and growth catalyst coupled with investment ideas should allow an investor to profit from this boom. The question is, can India outpace the dragon? If so how, why and what can you do to gain from this.

Emerging Market Overview

The outlook for the emerging market covers 25 countries, but for perspective we will only be considering India and China. It is sufficient to know that performance in emerging markets have been varied, hence the overused but underutilized tool Diversification comes into play .The relevance of emerging market equities lies in the fact that investors need to adapt to future lower interest rates and stalling growth. Tepid growth implies that valuation of stocks will be on the lower side, making macroeconomic research on sectors or countries

that will outpace the rest very relevant. India Sensex was the best performer in 2014 as clearly seen in our table graph below.

Figure 1 Table shows varied growth among different indexes in Emerging Markets`

“Lower interest rates, combined with the lower bond yields they have created, will allow stock returns to be better than they might be otherwise. Lower fixed-income yields can provide a partial offset, as equities will look more attractive on a relative asset return basis,"

Figure 2 World Economy Forecast

Our attention is first directed towards China where economic growth is stalling. It is expected that growth will decelerate. Firstly, we are aware that there is minimal data available around the Chinese New Year period which implies momentum has been shifting. Stalling growth can be attributed to the falling PMI. PMI (Purchasing Manger’s Index) has often been used as an indicator of economic health of countries that are have a major chunk of their GDP attributed to manufacturing. This implies that China's production , new order,

supplier deliveries, inventories and employment levels have fallen in 2015 and is looking to head in that direction.

‘The official Purchasing Managers' Index (PMI) inched up to 49.9 in February from January's 49.8, a whisker below the 50-point level that separates growth from contraction on a monthly basis’.

Figure 3 China's GDP forecast

Slowly, it has become evident that China’s initial rise which was built mainly on manufacturing export led activity is now one of its greatest liability in its growth potential. China’s growth currently is at its weakest in 24 years. 2014 was the first time in a century that China has missed its official growth target, falling just short of the official goal of 7.5%. In the last two years, growth deceleration moderated significantly, largely thanks to a variety of stimulus measures. The People’s Bank of China cut interest rates and bank reserve requirements to make more credit available, and financial deleveraging—reducing the growth of debt—has been put on hold. Without such policy support, China’s GDP growth would have fallen further.

My personal prediction is that over the next 2 or 3 years, performance in China is not likely to improve because of the following reasons 1) Potential real estate housing bubble (60 million empty apartments await buyer, 2) Manufacturing dependence, over capacity, 3) Slowdown in exports and imports, 4) Lack of driver, of growth Catalysts and 5) Investment is much larger than consumption as a percentage their GDP. Note that these factors in themselves entail a lot of analysis and hence we just take the key points without dwelling much into it. That being said I will be more than happy to talk to any reader who wants to learn more about those resounding factors.

India’s Current Economic State

India can be analogized to an Elephant riding in a wave of optimism albeit vulnerabilities associated with persistent currency devaluations, economic slowdowns and persistent inflation in the last 3 years. “Encouraged by the greater macro-economic stability and the reformist intent and actions of the government, coupled with improved business sentiments

in the country.” Institutions like the IMF and the World Bank have presented an optimistic growth outlook for India for the year 2015 and beyond. The possible headwinds to such promising prospects, however, emanate from factors like inadequate support from the global economy saddled with subdued demand conditions, particularly in Europe and Japan, recent slowdown in China, and, on the domestic front, from possible spill-overs of below normal agricultural growth and challenges relating to the massive requirements of skill creation and infrastructural up gradation. The encouraging results from the Advance Estimates for 2014-15 suggest that though the global sluggishness has partly fed into the lacklustre growth in foreign trade; yet this downward pressure has been compensated by strong domestic demand, keeping the growth momentum going

Key Numbers and Facts for the Manufacturing Sectors (Indian Budget Volume 2)

The PMI has risen from 52.9 to 53.3 which is signs of growth in the private sector. We however do see that the manufacturing sector has outpaced the service sector at the beginning of 2015Q1.

a growth of 6.2 per cent and 5.3 per cent respectively in 2012-13 and 2013-14 growth in manufacturing sector was chiefly on account of robust growth in textiles, apparels,

and leather products The upward revision in manufacturing growth in the new series also owes to inclusion of

trade carried out by manufacturing companies in the manufacturing sector itself, which was earlier part of the services sector.

Key Numbers and Facts for the Service Sectors (Indian Budget Volume 3)

Indian services companies reported sustained growth of new business in January, extending the current sequence of expansion to nine months

Input costs faced by Indian services firms rose for the second straight month in January, having fallen for the first time in more than five-and-a-half years in November.

The rate of cost inflation picked up to the sharpest in six months, although remained muted in the context of historical data

A factor that may be concerning is that job creation rate was slower than historical averages. Weakest sectorial performance was financial services

Figure 4 CPI Trend (downwards and promising)

The figure above shows how inflation now is more controlled and pronounced. There is a steep decline from Q42014 to Q1 2015. Though discussed later, India’s economy is highly dependent on oil imports just like any other developing country. Sharp fall in commodity prices not only propelled the manufacturing sector but it also controlled inflation.

Figure 5 Current Account

Key Facts about Current Account

2012 and 2013 saw the widening of this deficit mainly because of currency fluctuations and increasing imports

In 2014/2015 lower trade deficit along with moderate growth in invisibles that resulted in lower deficit and surge in capital inflows, enabled by higher portfolio investment, foreign direct investment (FDI), and external commercial borrowings (ECB)

Among the major economies with a CAD, India is the second largest foreign exchange reserve holder after Brazil. India’s foreign exchange reserves at US$ 330.2 billion as on 6 February 2015 mainly comprised foreign currency assets amounting to US$ 305.0 billion, accounting for about 92.5 per cent of the total.

With increase in reserves in the first half of 2014-15, all reserve based traditional external sector vulnerability indicators have improved

USD and Rupee exchange rate has remained stable. Rupee has appreciated wrt to the Euro and Yen owing to their weak outlook.

Improvement in this account is a positive for the economy for the years to come. We normalize the effects of commodity prices and currency fluctuation to come to that conclusion

Figure 6 India's GDP growth looks promising and 2016 may even hit double digit growth

‘The economy has been balkanised by local taxes levied at state borders, but cross-party support for a national goods-and-services tax could create a true common market. The potential is there; the question has always been whether it can be unleashed.’

Recap of Key points from India’s Budget

Arjun Jaitley- India’s finance minister recently unveiled the 2015 budget for the country. We will recap the key factors to take from this from an international investor’s perspective. The total size of the budget was $290 billion.

Tax - Corporate tax rates have reduced by 5% to now 25% over the next 4 years. The purpose of this is for boost in spending and job creation. Prior to this change India’s corporate tax rates was 33.99 percent, including various surcharges over the base rate, was higher than Asia's average corporate tax rate of 21.91 percent in 2014, and a global average of 23.64 percent, according to consultant KPMG. The importance of this news can be seen by how the Sensex (Bombay Stock Exchange) shot up by 250 points. Thus not only will this increase value of revenues for firms in India but it also welcomes foreign investment. There is room for personal tax cuts, which will boost real income boosting the domestic economy. This is likely to happen in the following years, considering the vastness and size of the Indian economy this can be a real GDP per Capital booster. There was a complete abolition of the wealth tax.

Infrastructure - The budget included more than $11 billion in new infrastructure spending aimed at upgrading the country’s overloaded roads, railways, ports and power plants. “I think we’ve done a number of things here that are truly ground-breaking,” said Jayant Sinha, the minister of state for finance, on Sunday. He cited the increased share of total tax revenue being transferred to state governments and the creation of a sovereign-wealth fund to invest in large infrastructure projects. The key impact of such investment projects in boost in growth and attracting more investments.

Alternative Investment Funds- category of pooled-in investment vehicles for real estate, private equity and hedge funds, is expected to give a boost for private equity industry in India. The basically makes it easier for domestic investors , but the 2 existing vehicles ( Foreign Direct Investments and Foreign Portfolio Investors) will be removed making the AIF the all inconclusive vehicle for foreign investors as well. The AIF’s come in 3 categories 1, 2 and 3.

Growth Factors and Catalyst 2015 and Beyond

Average workforce age - roughly half of the population of 1.25 billion is under the age of 25. The people in India are entrepreneurial and the more the workforce gets trained the better the future reduction in unemployment. The government has increasingly taken interest to nurture the nation’s youth to take any economic opportunities that may arise. The formation of the National Skill Mission that will consolidate efforts and outcomes and budgetary allocations to financially support youth in their skilling efforts will enable the country to benefit from its demographic dividend. The focus on job creation through the Make in India program, and providing gainful employment to India's youth is commendable and a future oriented outlook. The global economy is going to witness a shortage of young population by 2020 while India will be the one country youth surplus of 47 million . “India would need is that these ‘surplus’ young people are healthy, suitably educated, and appropriately skilled to contribute optimally to the economy.”…as stated by its 2015 Economic Survey.

Figure 7 GDP per Capita, shows increase in consumption likely in the future

As an oil importer- With commodity prices ranging on the lower side, India will benefit for this in the medium to long term. Remember that India is a net importer of Oil, and the lower commodity prices reduces its overall imports and flushes it with more foreign currency. This may have an effect of keeping its currency relatively stable which is imperative for its success in the next 3 to 5 years.

Modi Effect-

Figure 8 Impact of Politics, Positive Modi Effect

How India has responded to government reforms

Narendra Modi’s India’s prime minister’s dynamic nature with expectation of reforms increases the necessary hope the country needs to engage its resources. Over the past year, since he was elected into power his main focus have been civil reform and structural changes. The budget under Jaitley was the first reform outside the above mentioned facets and personally I am very optimistic about. Arun Jaitley has pledge plans to create 100000 km’s of roads and commission five "ultra mega" power projects to help end electricity shortages. The delay in deficit reduction gives the public sector the necessary kick-start it needs to be the engine of growth.

India’s Equity Market Outlook. - Outperformer in 2014 despite weaker earnings in 2014Q4

Figure 9 Equity Market India

‘India is riding a wave of optimism after pro-business Narendra Modi won the elections. Indian debt looks like good value with inflation falling. Robust earnings growth supports (pretty heady) equity valuations, but visible progress on reforms is needed for markets to advance further’

The key driver to the Sensex last year was FDI’s and with our thesis before of potential increased investments we project Indian equities to do better this year. The relative pricing of Indian stocks may be high as the market trades at around 16 times.

This presents a good entry position for investors, as the budget is projected to cause the Indian market to be lower by 150 points by the end of the year.

Stock Picks

Larsen & Toubro (LTOUF)

ICICI Bank (IBN),

IShares MSCI India ETF (INDA)

HDFC Bank (HDB)

Sector Picks

Banks

Transportation

Power Stocks

Tech

Conclusion

Government reforms in the backdrop, its commitment to growth and investment might bolster the Indian economy in the long run. The external sector includes the optimistic macroeconomic outlook, oil prices remaining relatively low and stable. We must not ignore uncertainties surrounding conditions in the Eurozone, Greece. The likelihood that interest rates in the United States will increase are factors to be incorporated in any evaluation that is to be done with the pricing of assets. Given the above, and assuming normal monsoons better prospects in the world economy that could provide impetus to higher exports for Indian products and services, a growth of around 8.5 per cent is in the realm of possibility in 2015-16. From my analysis, I would rank India as one of the most attractive investment destinations, well above other countries. It ranks well above the mean for its investment grade category, and also above the mean for the investment category above it (on the basis of the new growth estimates). The reality and prospect of high and rising growth, combined with macroeconomic stability, is the promise of India going forward. The key will be the response of savings to improved price and financial market stability, and of investment, particularly in the crucial infrastructure sector, to reform efforts of the Government that are underway.