High Interest rates and stock markets

High interest rates will have a negative impact on earnings. Growth can also slow down as investments get curtailed or postponed. It’s possible that GDP growth rate can be knocked down by 1% if we were projecting an 8.5% GDP growth, perhaps it is sensible to look at 7.5% now. The Indian economy has lived through many periods of high interest rates, without it doing too much damage to the economy. Yes, some impact will be felt – but we don’t think the underlying bull case for Indian equities is to be questioned by higher interest rates.

From an equity market perspective, we must appreciate that in an economy like India, inflation is more often than not a pass through. Good companies have pricing power – they should be able to pass through the impact of inflation by means of marginally higher prices. So, the direct impact of inflation on earnings is expected to be rather muted. What would be a concern is if we see demand destruction as a result of consumers’ inability to absorb this inflation. We are not seeing significant evidence of demand destruction as of now. We must look at this fear of demand destruction in context. First, the proportion of middle class household income that is spent on food has come down substantially in the last decade as incomes have risen quiet rapidly. Food inflation – which has been the biggest concern – does impact the poor severely. But the consuming class – the middle class- has been able to absorb this impact to a large extent, thanks to rising income levels.

Then, if you look at the discretionary spends of the middle class, the story on inflation is completely different. Consumer electronics prices today are lower in absolute terms than where they were 5 years ago, same is the case with cable TV costs, with airfares, with hotel room tariffs. Consumers have not really felt any inflationary impact of all these items, which are increasingly becoming a big portion of their spending patterns. What RBI is trying to do is to postpone consumption by pushing up financing costs. If demand for consumer durables, automobiles, homes etc gets postponed and thus inflation can be cooled down, it is for the good of the economy. That consumption is most likely going to get postponed – not destroyed.

Sectoral impact of high interest rates

Auto and Banking stocks have come under pressure as a result of the recent interest rate movements. Regarding automobile companies, we suppose some of these concerns are warranted, at least in the cars segment. Footfalls in car showrooms have decreased. 7 out of 10 cars in India are sold on the back of car loans. As car loans become expensive, some consumers have sought to postpone their purchases which can impact near term earnings of these companies.

As regards banks, we are not sure that a high interest rate environment is so bad for banks. Well managed banks have close to 40% of their deposit base in the form of low interest bearing savings and current accounts. A stable base of low cost deposits should help manage a rising interest rate environment. Banks who depend on wholesale deposits are the ones who may be impacted adversely. Banks have corrected to fairly attractive levels. Some of large well run PSU banks are available at 1 time book value on a FY13 valuation basis. That’s not really expensive.

Oil and Stock markets

This is the one factor that we ought to be worried about. Last year, a robust export growth helped camouflage the impact of rising oil prices on our current account balances. If oil prices continue to rise to say $140, it will have a material impact on our fiscal deficit, on inflation, on aggregate consumption and therefore on growth. If on the other hand, oil prices cool off to under $90, that will be a big positive for India and therefore for our markets.

Outlook for markets

We don’t see why people should become bearish on the Indian market from a long term perspective. Let’s remember that this market is where it was three years ago. And in these three years, earnings have grown and therefore valuations have become reasonable. So, when people talk about the bull market ending, our only question is : has the bull market started yet? We are only where we were three years ago! One can describe this as a flat market – not a bull market.

Markets are fairly valued – while we can’t see huge room for near term appreciation, we don’t see a case for a drastic fall as well. The structural case for Indian equities continues to be strong it will play out over the next several years. One should expect markets to deliver returns in line with earnings growth, over time. There is one more thought if you look historically whichever economy has grown at significantly higher than global averages tends to become very popular asset globally whether it was Japan in 80s or south East Asia in 90s, we think that way India could acquire similar status sometime over the next few years and if that happens, the PE multiples could go much higher. We are not saying one should invest with that basis or premise but possibility of that cannot be ruled out. So if that happens it would be a great exit and equities may give you much more than what one is budgeting for but we think it would help to keep the possibility, the presence of that possibility at the back of your mind. But, for that, one needs patience and conviction to stay invested through volatile conditions.

It’s Time for Smart Indian Investors to show Long-term Greed for Equities

Last week I came across a very interesting article in Economic Times by Mr. Vikram Kotak, CIO, Birla Sunlife Insurance. I wanted to share this with you all. Below is the article.

Which country is likely to emerge as a winner in terms of growth, investment opportunities and wealth creation for retail investors over the next 10 years? In terms of growth and investment opportunities, it is undisputedly India, but the future prospects of successful wealth creation for the Indian households look challenging, considering the asset allocation strategy of many investors.

Indian households affinity to gold and the virtuous effect in terms of wealth creation of the gold investment made by them over the years allow us to conclude that, at least so far, Indians have been smart investors, definitely smarter than their counterparts from the developed economies who have only recently woken up to the charm of gold.

Due to the uncertainty surrounding global growth, the demand for gold in 2010 reached a 10- year high of $150 billion, a 38% growth YoY. The official sector turned net buyer after 21 years and demand also surged in many developed countries, including Germany, Switzerland and the US. Indians, the world’s largest buyers of gold, accounted for 32% of the global demand in 2010. India’s demand for gold rose by 106% Y-o-Y, substantially higher than 60% recorded by the second fastest growing market, China. Indians invested over 11% of the gross savings in gold, against less than 2% by their Chinese counterpart.

India’s annual consumption demand has risen from an average of 300-400 tones (1998-2004) to about 900-1000 tones in the last three years (2008-2010).

The household stock of gold is currently estimated at 18000 tones (up from 10000 tones in 1991-1992), worth over $950 billion, which is equal to 55% of India’s GDP and about 11% of the global stock of gold. It is 2.2 xs higher than the official gold reserves of US and more than the combined gold reserves of the top-15 countries after US.

The Indian practice of excessive investment in this asset class is partly because of deep cultural implications and somewhat due to a strong preference for safety and liquidity. After all, during the balance of payments crisis of 1991, India had to airlift its gold reserves to pledge them with the IMF for a loan to save the Indian economy from bankruptcy.

It is true that over the last 10 years, gold has outperformed equities. It delivered 18.7% CAGR returns against 18.3% generated by the Sensex and less than 1% by US equities. But the question is can it outperform again over the next 10 years? The answer, probably is NO. The past outperformance was driven by stupendous return generated in the last three years due to heightened demand for the yellow metal in the wake of the global financial crisis. A crisis of this magnitude occurs only once in a while. Equities, which have outperformed gold over the last 2-3 decades, are poised to glitter more than gold over the long term going forward.

With the world economy recovering gradually, the risk appetite is going to remain high, driving the demand for equities. It is worth noting that in the Indian context, equities have been more effective than gold in fighting inflation over the last three decades—gold has delivered 3.5% CAGR, barely beating inflation, while the Sensex has generated 17%. Further, given that the Indian economy is likely to grow at a nominal rate of 13-15%, equities are likely to generate returns in excess of 15%. While investors world over are directing their funds towards Indian equities-India received 50% of the FII net flows into emerging markets Asia ex China in 2010- Indian household have allocated merely 10% of their financial savings to equities. All these, coupled with the fact that gold earns no interest or dividend and one has to even spend money to store it safely, point to the need to revise the average Indian household’s investment strategy.

To ensure long-term wealth creation, it is important to invest in equities in line with one’s risk appetite, life stage and investment horizon. Some allocation to gold is desirable as it can enhance the risk adjusted returns of a portfolio—it does not carry credit & liquidity risk, has low to negative correlation with other asset classes and protects wealth during uncertain times. However, since Indian households already have huge investments in gold, bank deposit and real estate, it is advisable to incrementally invest in equities.

At the end of the next decade or so, will we get an opportunity to look back and say that Indian households have been smart investors and have created wealth? With economic growth and savings poised to remain robust, the answer will lie in the asset allocation. The choice is ours maximizes wealth through investments in equities and a small quantum in gold or park our hard earned savings in gold and bank deposits to earn a cumulative return, which, over the long-term, will barely beat inflation. So far, Indian investors have been “long-term greedy” towards gold as an asset class. However, it is now time to show the same long-term greed, coupled with discipline, towards equities as well.

Inflation – What to do with it

Market was taken by surprise after 50 bps hike in both repo & reverse repo by RBI. Even interest rates on saving account have been increased by 50 bps from 3.5% to 4%. GDP growth forecasts also revised downwards which has dampened sentiments. This has led to a fall in markets. After almost 9 hikes in repo & reverse repo and number of hikes in CRR still inflation has been sticky & not coming down. This is due to imported inflation caused by international commodities. So the steps taken by RBI are a bit harsh & will impact demand to certain extend. The fact of the matter is that RBI's monetary policies are more effective in controlling asset bubbles rather than inflation. As an example take the tyre industry. Natural rubber that forms the majority of the cost of raw materials for the industry shot up by an average of 37% last year. Now if tyre manufacturers would not pass on the cost price increase they will make huge losses. As such tyre prices went up by an average of 18% last year and as a result of this the companies were able to cut down the losses; however tyre companies still made losses in the last quarter. However the reality is that the pass through of costs has happened only partially and a part of this cost absorption has happened because of increased volumes and better efficiencies. Now rubber, carbon black & nylon tyre cord that are the three major raw materials for tyre manufacturing are all global commodities. As such how is tight monetary policy of the RBI going to bring down the prices of these commodities? At best a very tight policy will cut down demand of tyres in India and make these companies make more losses.

Yesterday I was hearing video of Udayan & Mitali who were hosting the Investors camp at Jaipur. They were of the view that Retail participation is at the lowest & there is no interest among investors. Delivery volumes have fallen to 9% of the total volumes which is again an ALL TIME LOW. The argument investors make for not investing is that in last three years they have not made money. This makes me feel that this is the best time to buy. Every other person I meet is interested in buying Gold, Silver, Real-estate, Fixed deposit etc. My sense says that something unknown thing can only drift down market substantially from here as everybody knows what the problems are. A man fallen on the back can only rise. Government has also started taking actions against corrupt ministers, M.P.s, bureaucrats, high profile businessman etc which to my knowledge has never happened in India where a ruling government punishes his people. I am hopeful that from mid May after assembly election results we may see big steps taken by government.