Monetary and Government Policy self goals evident – GDP growth at 6.1%

We are aware and it has been discussed ad nauseaum about how the lack of decision making at the government levels has bought the investment cycle at a standstill. I think we will need to discuss more about the same after the 6^th of March and the Union Budget. It is obvious that this part of policy making cannot deteriorate further, however how fast it improves is critical to see.

I am more worried about the academic response on slower growth from the monetary authorities. I was particularly disturbed to see the comments of one of the key spokesmen of RBI who propounded that “Rise of crude prices over the last few days makes the task of monetary policy complicated”. My question is that should central banks be looking at weekly price movements of commodities for taking a call on monetary policy. What if this is used as an excuse not to cut policy rates and then crude prices crash by 10% in the following week. Has monetary policy become so shallow?

The important things that need to be noted are whether the increase in prices at this stage in the economy is demand related. The more important factors are

• The GDP growth has declined to a multi year low in the third quarter of the current financial year. Manufacturing growth is down to a mere 0.4%.
• Credit growth has slowed down substantially and is running below the RBIs target by nearly 150 basis points
• Money supply growth has fallen much below RBI’s forecast level for the current year
• The capital expenditure cycle is in doldrums not only due to government inaction but also crippling interest rates
• Demand growth of interest rate sensitive industries across the board has fallen substantially. Be it real estate, automobiles, consumer durables etc
• Most central bankers across the world have moved to a more accommodative monetary policy as they have taken into consideration increasing growth concerns
• The liquidity deficit in the system continues to be at all time highs. Baby steps by the RBI have not done much to alleviate the situation. There is need for much stronger action
• The incremental value of a tight monetary policy has diminished significantly and the negatives of the same outweigh positives hugely

The fact of the matter is that most large commodity players worldwide are very well off financially and enjoying huge cash flows. This combined with ultra low interest rates available to these companies has increased their ability to hold prices by holding on to their products and restricting supplies. This is a structural change (at least for some time) and as such despite extremely bleak economic growth scenario worldwide the prices of most commodities continues to remain elevated. As an example, as per the International Energy Association the growth in demand for crude in the year 2012 is expected to be virtually flat and if at all a 500000 bpd increase is possible. This is down from a forecast of over 1.5 mbpd increase just a few months back. In this scenario crude price at almost all time highs reflects extreme speculation, even after taking into account the Iran factor. For a large part of last year 1.8 mpbd of Libyan production was out of the system, this is coming back now. As such incremental reduction in production due to Iran is not likely to be much. As such commodity speculation is responsible for a great part of the rise. Under this scenario how can Indian monetary policy control fuel prices? Fuel price inflation should ideally be taken out of the overall inflation figure for formulation monetary policy

The Indian economy needs significant monetary easing as the tight policies have not had the desired impact. The utopian dream of a 4-5% inflation target should be put aside for the time being. In the new normal of zero percent interest rates in Western economies we will need to live with higher commodity prices for some time and as such inflation targets should be kept higher. As and when the US Fed starts its tightening cycle we will see much lower commodity prices, however this still has a couple of years more to go.

On a separate note I wanted to comment on the rampant commodity speculation on Indian commodity exchanges

Commodity exchanges have become the fresh grounds for rampant speculation. Commodities like guar, pepper, jeera etc have become the new penny stocks that are the favorite of speculators. The price swings in some of these commodities is much higher than in the equity markets. In the absence of commodity trading we never saw such swings. The only beneficiaries of these seem to be large speculators and not farmers or consumers. It is important for the commodity regulator to look into how trading is happening in some of these commodities. In case of global commodities where the Indian prices largely follow international prices this issue is not so significant. However some domestic consumption oriented agri commodities are falling prey to this extreme speculation.

Markets

The Indian stock markets have become volatile after a strong up move. This has largely been due to higher crude prices and the expectation that monetary easing might be pushed back. Let’s hope better sense prevails and the easing cycle in terms of policy rates starts this month itself.

Typically bull cycles have lasted 14-24 months before any major correction sets in. Under the circumstances the current bull market is still in its infancy and has a long way to go. Small dips at various points of time will be good buying opportunities. That said the importance of the 6^th March election results cannot be discounted. The pace of the up move is going to be clearly dependant on the result of this event. As far as I am concerned the budget is a non event and with the little maneuverability that the finance minister has not much should be expected. Overall I continue to be constructive on the markets and am keeping my fingers crossed for the 6^th of March. 

QE’s, LTRO’s, Asset Buying Programs etc. RBI needs to just focus on growth

As we all know the US Federal reserve has created a huge amount of USD liquidity with its quantitative easing policies where more than USD 1 trillion was pumped into the system. This has been accompanied by statements propounding the pledge to keep short term rates near zero for an extended period of time. This extended period keeps on getting extended every six months and now stands at till the end of 2014. This was followed by operation twist whose aim is to keep long term interest rates down so that the economy can be revived. Weak housing and employment situation in the US is prompting this move from the FED. With their view that there is sufficient slack in the system and that inflation will not come up anytime soon this policy suits them fine at this stage. However at some stage it will certainly create inflation and how they unwind at that stage will be important to see. However with M3 growth in the US now picking up the policy seems to be having its desired effect.

The ECB although refusing to print money like the FED has come out with a unique idea of creating quasi cash through their Long Term Refinance Operations ( commonly known as LTRO’s). Here the ECB is taking pools of government bonds, corporate bonds, other pools of bonds etc with haircuts depending on the quality of the collateral and giving money to banks in the Euro zone. One such move a couple of months back saw banks taking in nearly 400 billion Euros for three years at around 1% cost. Another LTRO is planned at the end of the month where it is expected that another 600-700 billion Euros will get taken out and as such increase the ECB’s book by more than 1 trillion Euros. Now this is different from pure money printing as here banks need to keep capital for the collateral they are providing and there are also haircuts so the effective cost might be higher than 1%. The main aim of this program again is to boost lending into the economy in light of significant deleveraging of balance sheets of banks. Also with banks not lending to each other the ECB needs to provide liquidity in order to prevent a freeze in the monetary system. Also by creating a carry trade where banks are borrowing long term money much cheaper than what they can do under the current circumstances it is estimated that this move will boost bank profits by nearly Euro 20 billion per annum which is required by banks to boost their capital. This will have two effects; since capital gets boosted the requirements to deleverage will go down. Secondly deleveraging will be more structured and less disruptive.

The Japanese in the midst of all of this and a decline in GDP of nearly 2.3% in the last quarter of 2011 have suddenly got up and realized that we are getting left out in the entire game. As such the Japanese central bank has also announced an asset purchase program of $ 128 billion on the 14^th of February as a Valentines Day gift to the Japanese economy and punters all around.

In midst of all of this our dear RBI is still bothered about inflation despite the inflation numbers being at 6.55% and below estimates for January 2012. I believe that inflation targets cannot be set in isolation and have to be set in the kind of scenario in which we are operating today. With so much money being printing all around and a large part of the inflation being contributed due to cost pressures of global commodities, there is little RBI can do except kill economic growth in India at a time when there is so much cheap money available globally and it is an ideal time to get money into the economy. On the other hand getting the money in is actually the government’s job and they need to pursue FDI reforms vigorously and also create a situation for project specific investments to come into the country in infrastructure projects. With infrastructure projects in India offering IRR’s of over 15%, it is a perfect investment destination for foreign investors.

RBI needs to take its threshold level of bearable inflation much higher than the utopian dream level of 4-5%. Given the global commodity inflation even if we are at 6-7% for a couple of years it will not be a bad achievement. We need to expand manufacturing capacities, improve infrastructure and productivity to bring down inflation in the long run. By keeping interest rates prohibitively high all RBI is doing is creating stress on corporate balance sheets and reducing their ability to invest in the future. We need both policy actions from the government in order to boost investments and much lower interest rates to get back to high rates of growth. In any case 2.2% of the 6.55% inflation for January was out of Fuel inflation which is not controllable by RBI in any case.

Till a couple of years back policy makers well very concerned about the expected deluge of liquidity that might come into India and whether it will create a scenario of overheating in the economy & also its impact on the exchange rates. Things have totally been reverse with capital flows drying out and the current account deficit increasing. As things stand now, it looks like we are now set to get that deluge of money. Given that the economy is growing slowly and there is headroom for investments and growth that should not be an area of worry today. I don’t think that RBI should be very focused on the rupee at this point of time and waste forex in protecting the rupee. The rupee in all probability has started a long appreciation cycle (with corrections in between). RBI’s forex operations unfortunately have the side affect of sucking out rupee liquidity from the system which is already in a huge deficit.

MARKETS

The markets have shaped up as expected and are near the first target of 5600-5700 for the Nifty. Most bears for now seem to be throwing in the towel after the 5300-5400 level (which was considered sacrosanct and will not be breached kinds) having been taken out easily. I think the 5600-5700 range could be toppish for the near term and should be followed by some correction and consolidation. March has important events for India with the election results and the Union Budget both coming in middle of the month. As such there is no harm being cautious prior to the event. However the bottom up approach should still continue as there continues to be huge value in the broader markets. “The Contra Investment theme” that I had written about in December 2011 has played out very well with huge outperformance from the stocks falling into that theme. Mutual Funds and other domestic investors have increased cash through the rally in January and as such cash in the system is not an issue at this stage. Equity flows into Emerging Market funds have also picked up lately.

We could be in the early stages of a new long term bull market; however I am not calling that at this stage and will watch fundamental developments before making that comment. 

ONLY GROWTH CAN ADDRESS DEFICIT

Over the last few days there has been an increased clamor for controlling the Fiscal Deficit by increasing taxes in the forthcoming Union Budget. In my view raising taxes in a slowing economy is a retrograde step that will create further headwinds for the economy and slow down growth. Indirect tax increases are also inflationary in nature and given the fact that India has been facing issues related to high inflation for a prolonged period of time this might not be the time for tax increases.

We have seen that in a large number of Euro zone countries that are facing financial troubles the panacea for all ills has been proposed to be increased austerity and higher taxes to reduce the fiscal deficit. However in reality we have seen that a combination of reduced money velocity, deleveraging and higher taxes lower expenditure has infact led to countries missing their Fiscal Deficit goals as the denominator itself has shrunk (i.e. the GDP). On the other hand a combination of extremely benign liquidity provided by the US Federal Reserve combined with a still high Fiscal Deficit has stabilized the situation in the USA and things seem to be improving out there. It can obviously be argued that some of these countries had no way out as the markets were punishing them disproportionately with a liquidity crisis being possible. The key for all these countries is to pursue reforms and push asset sales rather than focusing on short term measures of cutting expenditure as typically the most wasteful i.e. revenue expenditure is normally difficult to cut and the most beneficial i.e. capital expenditure is easier to cut.

Nevertheless the Euro situation is a topic in itself. More important is to look at what the government should be doing. Given the fact that the currency has stabilized and inflation is clearly on the way down, it is important to now focus on growth from both the monetary and fiscal angles. From the fiscal side it essentially means not increasing taxes at this stage. RBI obviously needs to cut aggressively. The government needs to focus on cutting subsidies, pursuing reforms and taking a better stock of expenditure under schemes like NREGA where not much capital formation seems to be taking place. Government measures need to be counter cyclical. Once growth has clearly revived and things are on a more assured path that will be the time to actually take harsher measures on cutting Fiscal Deficits and creating a buffer for the next downturn.

Results

Company results that have come out till date have largely been in line with expectations and in most cases have held on pretty well. Topline growth for the companies that have reported till date have been nearly 27% with a profit growth of 6%. Margins have come down on the operating front mainly due to a lagged impact of higher input costs. Also interest costs of companies in general have gone up sharply due to both higher rates and longer debtor cycles or lower creditor cycles. The last two years have been ones of margin compression in India. Higher commodity prices and a falling currency have been key contributors. I expect this cycle to reverse from the current quarter going into next year where the margins should start moving up as cost pressures have reduced and interest rates are likely to come down. Improved liquidity should also reduce the debtor cycles. As the chart reflects, there are cycles of margin compression and expansion. We are through with the worst of the compression cycle and the expansion cycle should start going forward. At the beginning of last financial year the projections were for a 22-25% growth in earnings for the current financial year. We are likely to end at more near 5-10%. As an extrapolation most analysts have reduced forecasts for next year’s growth to 12-15%. We are more likely than not going to see a significant outperformance of earnings next year. As such the results that will follow next year will justify the market movement that is happening this year. 

The Elliot Wave Theory

Although I am personally not a big believer in Elliot waves, mainly due to the amount of exceptions and variables involved the psychology of Elliot Waves is very interesting and reflects market psychology. As you read through Wave 1 you will realize how true it is to the current market psychology. 

Five wave pattern (dominant trend)	Three wave pattern (corrective trend)
Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.	Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.
Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and "the crowd" haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% (see Fibonacci section below) of the wave one gains, and prices should fall in a three wave pattern.	Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative.
Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to "get in on a pullback" will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three's midpoint, "the crowd" will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.	Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.
Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three (see Fibonacci relationships below). Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, fourth waves are often frustrating because of their lack of progress in the larger trend.
Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is often lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high but the indicators do not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).

Markets

Stock markets have behaved as per expectations this year and have shown a strong up move. In all probability a new bull phase has started in the midst of extreme pessimism. The markets have moved up by nearly 15% since the beginning of the month. Momentum can carry the markets forward after which we could see a correction that is short and swift. Most people have been left out in this move and are waiting on the sidelines for an opportunity to move into the markets. The cash on the sidelines is quite substantial and in terms of asset allocation equities are at very low levels. Specific to India most global investors were heavily underweight India and are in the process of coming to equal weight right now. The European developments seem to have been discounted by the markets; however one event that can cause bigger corrections is IRAN and its resultant impact on oil prices. I believe that this is the event to watch for the year 2012. If the Iranian situation remains controlled the current year should be an extremely good year with lower volatility for equity investors. Market outlook continues to look constructive for the reminder of the year with intermittent corrections. 

AS HEADWINDS BECOME TAILWINDS

The last year was a tough year for the Indian markets for more reasons than one. The impact of the US slowdown as well as Euro zone issues was generic to everyone globally, however the specific issues that were headwinds in the last calendar year are now providing tailwinds for the markets and it is possible that these tailwinds become stronger as the year progresses.

My last article was at a time of extreme pessimism, sentiments seem to be a bit better now after a 10% market up move, however the underlying pessimism and a disbelief in what is happening is all pervasive. I just completed a visit to Gujarat; traditionally a market of bulls and the kind of extreme pessimism I saw all around further reinforced my view that the year 2012 on an overall basis will be a good year. The three most important Headwinds of last year were

High inflation leading to high interest rates – The inflation cycle has clearly reversed. The reversal would have come a bit earlier were it not for the unprecedented fall in the value of the rupee in the last 4 months of 2011. Inflation has come off sharply in December and we are likely to see a further fall off over the next few months. The figure for January in all probability will go below 7%. RBI has refused to cut rates or CRR till now but has changed its monetary policy stance quite clearly by undertaking significant amount of OMO’s. The huge up move in the global commodity cycle has stalled with sharp correction in a large number of commodities. The impact was not felt on the manufacturing inflation in India due to the fall in the rupee. However we will start seeing the impact from February onwards. As such we will see interest rates and liquidity continue to improve from here till the end of the year 2012. This will provide impetus to both consumption and investment demand which got stalled last year due to various reasons which included continually increasing interest rates.

No policy initiative- A lot has already been written on this so I will not write more. However in reality last year decision making came to a standstill and impacted investments across sectors. Over the last few days we have seen initiatives on Retail FDI, Aviation FDI as well as on power sector woes. I believe that this process will further pick up post election in February. From its absolute bottom we should see significant improvement during this year and the expectations today are so low that small initiatives will be taken positively.

The Rupee movement – The movement of the Indian Rupee became the final nail in the coffin last year end. The unprecedented fall by over 20% shook the confidence of investors and also impacted companies with Forex liabilities adversely. However the INR has reversed direction in line with my expectations but at a pace faster than what I expected this year. We have already seen a 5% plus appreciation since the beginning of the year. Typically INR appreciation cycles and stock market movements are positively correlated and we are seeing signs of that in the current month.  The stated policy of the central bank is that they will not provide a direction to the currency but will reduce volatility. However that does not seem to be happening on either side. Overall prospects for the rupee continue to be constructive, however the pace of appreciation should slow down and there is an increased likelihood of two way movements with reduced volatility going forward.

As such the three major headwinds are now tailwinds for the markets. Typically in bearish phases of the markets the markets will always surprise us on the downside and similarly on up moves there are likely to be upside surprises.

Some areas of concern still remain which include the high Fiscal Deficit and the measures taken to address the same. Increasing taxes will be a retrograde step, as in a slowing economy increasing taxes will cause inflation and hurt growth. Steps should be more on the expenditure side. Growth boosting measures will also be constructive for the Fiscal deficit as it will boost government revenues. Although lot of armchair economist will push for higher taxes that is clearly not the way to go. Tax increases will further curtail demand and as a result of that the expected revenues from higher taxes will not flow through as both top line and bottom-line growth gets compromised. The time to address the fiscal deficit in right earnest will be in a recovery cycle as that is the time harsh decisions get adapted in the momentum of growth. An extreme example of this is seen in the Euro zone where troubled countries are being forced to under take austerity measures, however due to its negative impact on growth the Fiscal Deficit targets are going way off mark. Maybe those countries have not option, however Emerging Economies like India do have that option as the nominal GDP growth even in the worst of times is expected to be 13-15%. How subsidies are addressed in the budget will be keenly watched.

Growing NPA’s in the banking system is also an area of concern. However a large amount of that can be addressed through policy measures. Most of the stress is coming from infrastructure sector investments where real assets exist. However they are in a situation where the expected returns are not flowing through and projects are stuck due to one reason or the other. These issues should be addressed to a great extent over the next 12 months. The consumer side & the unsecured side seem to be under control.

Results & Markets

Results till date have not played out to the doomsday scenario.  The early birds in the IT sector have shown mixed results which are not bad in the current global macro scenario. Banks seem to be doing better than expectations and some Auto companies that have reported have seen a decent set of numbers. A large number of companies are yet to report.

Markets have rallied sharply in the midst of extreme gloom and doom. We have seen a 10% up move from the bottom. The pace of the up move is clearly unsustainable; however what this move has done, along with the buyback announcement by Reliance Industries is that it seems to have clearly put a bottom to the markets around last years closing levels. Directionally markets still look constructive, especially in the broader market sense. I still stick with my view of this being a 15-25% kind of return year in the absence of any fresh cues to indicate otherwise. This will be a good year for stock pickers as macro concerns recede and investors start looking at pockets of value.

The interesting thing is that some markets globally already seem to be in a new bull phase. India and China do not fit into that right now and we need to evaluate things over the next few weeks to take a bigger call on the same.

Will write more soon as we get fresh indicators of where things could go.

2012

It is quite amazing but true that the year 2011 has been the second worst year in the history of Indian markets with a decline of 25% in the Nifty and 35% in the Mid cap indices(since the 1980s at least). No prizes for guessing which was the worst year i.e. 2008. In USD terms the performance was even more disastrous with losses of 44% given the 19% decline in the value of the INR. The year began with cautious optimism after the fall that the markets had seen post peaking off in November 2010. However a sequence of events, foreseeable and unforeseeable made this a disastrous year for equity investors. A lot will be written on the year ahead and I have touched on some subjects in my previous articles a few weeks back. However sentimentally one thing is very apparent from all the strategy reports that I read today, as well as the commentary in various media.

1. 2012 will be a very tough year for equity investors and it is unlikely that there will be significant returns during this year.
2. India will continue to underperform given concerns on inflation, high interest rates and poor governance.

I have infact not read more pessimistic commentary on India for a very long time as we see today. The same brokerages/research houses that were predicting Sensex at 23-24000 by the end of 2011 a year back are now forecasting markets at 12000 (at the lower range) to 18000 (at the median of the upper range). There are some who, albeit apologetically are predicting a move above 20,000 levels this year. However this is being done with a lot of caveats. The funniest are those reports where there are bull case, base case and bear case views where the difference between the bear case and the bull case is over 50-60%.

My take on the markets in 2012 is that we will see the Nifty/Sensex return anywhere between 15-25% and the broader markets by 25-35%. I believe that sentimentally the markets have bottomed out and the bottoming out, value wise will happen over the next few days or weeks. This should lead to a durable bottom being formed for the markets. I have touched on the logic for the same to a large extent in my article on the 5^th of December, an updated version of which I will present in brief and then more on the domestic situation and the markets.

The Euro zone Crisis – The Euro zone crisis and the debt issues related to Greece, Italy and Spain have been the main contributory factors to the nervousness in the global equity markets over the last several months. The crisis has got accented by a lack of faith in the political system and its ability to resolve the issues. This issue has been discussed a lot so I will not go into the details of all of this, however I do have a contrarian view on the future direction of news flow from Euro zone. We now have new governments in Italy, Spain and Greece i.e. all the troubled countries. Two of them are lead by technocrats and one by the right wing party. As such, in my view the worst of the news flow from Europe is now in and we might not get incremental negative news flow over the next 4-5 weeks. This is likely to be similar to the negativity due to news out of the US around 3-4 months back, which suddenly died out as the economic data started to improve. The entry of the IMF in the entire discussion combined with greater urgency to resolve the issues is also encouraging.  Overall I do not expect Europe to create any deep cuts in the markets going forward.  This was the view that I had put out a few weeks back and seems to have played out well. It seems clear now that although Euro zone will go through a cycle of deleveraging, slow growth, intermittent issues related to fiscal issues of troubled countries etc, the probability of a Euro zone breakup seems remote at this stage. Intermittent occasions of bond issuance of Italy and Spain will create volatility on those days. Infact if investors were so concerned on the Euro it would not have fallen by just 2-3% against the USD in the year 2011. As I wrote a couple of weeks back “Europe has clearly avoided its Lehman Moment”

US News flow – The news flow from the US has been mixed. Over the last few weeks there seemed to be clear indications of an improvement in economic activity. The Fiscal issues will keep on creating volatility periodically, however low borrowing costs and an improving economy could lead to a Fiscal surprise next year.Overall economic activity seems to be improving, albeit at a slow pace in the US and there does not seem to be the likelihood of a double dip recession at this stage. Most corporates in the US are cash rich and market valuations are at just around 11X P/E for next year. Earning expectations for the year 2012 are pretty low with earnings growth forecast in the range of 0-5%. As such US news flow will create volatility but it does not look that it can create a fresh down move at this stage.

Infact US has not only created conditions for a down move, but it has actually supported global markets due to continuously improving economic data, especially related to employment numbers. Technically too the movement of the key indices above 200DMA’s and the breakdown of the similarity of the move from 2008 indicates further gains for US equities. The breakdown of VIX below 23-24 levels also indicates reduced risk aversion and greater confidence. Typically such breakdowns are followed by multiweek up moves.

GOLD – As I have written in detail in my previous article I expect 2012 to be a difficult year for gold. I expect a 20-25% correction before prices come to a level where actual demand rather than pure investment demand can support prices. Since I have written in detail earlier I will not repeat, however the most fancied asset class will have a tough time holding on.

China – China is one aspect about which I have not written earlier mainly due to the fact that it is difficult to analyze it. However pessimism on China seems to be at its peak with the Chinese markets trading at valuations that are at multiyear lows. The expectations of some, of a hard landing in China do not seem to be playing out. The move from investment to consumption led growth seems to be moving slowly. By letting the Yuan appreciate in light of pressure on exports seems to have played out well. Inflation has also been controlled well by demand & supply led measures as well as administrative dictates (which can only work in that country and not in countries like India). The moderation in economic growth has been happening at a steady pace. However the key challenge will be holding up growth in light of falling export demand, controlling excessive investments in unproductive areas and the biggest factor will be the asset quality of Chinese banks and how they will hold up in light of increasingly challenging environment and pressure on profitability of Chinese corporates. The corporate sector in China is likely to be hit on two fronts i.e. higher wage costs due to rapidly increasing salaries as well as the strong up move of the Yuan against most other competing currencies. Just as an example, over the last one year the Indian rupee is down 20% against the USD and the Yuan is up nearly 6%. The way things look to me it seems the base case will be a soft landing rather than a hard landing for China in the near term. The two big surpluses that China has i.e. Current Account & Fiscal are vastly undervalued by the markets in my view. Officially China seems to be aiming at an 8% growth next year which is extremely strong in the current environment. The challenge is health of the banking system and how much it needs to be capitalized in order to support this growth as well as the state of health of the Provincial Governments about which there is very less transparency.

India domestic factors & outlook

The Indian markets had to make do with not only global issues but also several domestic issues in the year 2011 making it one of the most turbulent years in recent memory. Although 2008 was challenging for India, it was generally perceived at that stage that the factors are largely external and as such should not have a lasting impact on the performance of the economy. We had also started giving lesser importance to the government as the economy became more and more open. However 2011 was a year which showed the importance of governance in promoting and sustaining economic growth as well as macroeconomic stability. The year 2011 was a year of high inflation, high interest rates, lack of policy making as well as the most challenging year for the Indian rupee since 1992 (ex of 2008).

The Rupee - The fall in the rupee is being attributed to high current account and fiscal deficits, which is true to some extent. However it is more due to a lack of confidence in the economy in the near term as well as cash flow mismatches on exports and imports. This aspect is extremely important to understand. Given the way the rupee fell and the continuous statements by policy makers that we are helpless in managing the rupee all importers have run to hedge their positions and no exporter is hedging. This creates a very huge mismatch in the short run. Let me try to explain. India has exports of broadly USD 20 bn a year and imports of USD 30 bn. Now this is a gap of USD 10 bn which is bridged by invisible flows, capital receipts, foreign borrowings, FDI etc etc. Now in a situation where everyone believes that the rupee can only fall all importers want to hedge, however no exporter wants to do the same. This creates a huge mismatch in the short run till the export proceeds flow in after a period of 90-120 days. This also creates a tendency to delay export inflows in order to realize a better rupee value. This actually makes me believe that the first quarter of 2012 can be a good period for the INR as the panic fall period now seems to be over and export realizations will start to come in. Other measures like reduction in holding period of Government and Infrastructure bonds as well as higher interest rates on NRI deposits should boost inflows. My base case view will be for a 3-4 % rupee appreciation in the first quarter of 2012 unless and until there are huge capital outflows.

Policy making – Initially we had a period in late 2010 and early 2011 when a large number of projects got held up on environmental issues. Later on after the 2G issue we have seen a significant decline in project approvals, takeoffs etc. This has got exacerbated by the continuous increase in policy rates by the RBI which has made lot of projects unviable. Reform measures have also got stalled. I believe that we are now at the absolute nadir of the decision making cycle and things can only improve from here on. I expect this to happen post election in February after which things would be much better.

Inflation would have come off much more sharply had it not been for the decline in the rupee. However the absolute correction in commodities and food prices combines with the strong base effect will take inflation down to nearly 5% by March 2012. In case the rupee also appreciates as I expect it too the overall scenario could be much better in 2012. As such we should have improving liquidity and much lower interest rates as we go through 2012 and this will provide a tailwind for economic activity to pick up.

Markets

Taking most things into account and also taking into account the market psychology as well as valuations I am of the view that the current situation of the markets is akin to early 2009 where one could see only negativity and that was the time that markets bottomed. Valuations, especially of the broader markets are today nearing historic lows and the overall market is also trading at 12X 2013E earnings which is very attractive. My view of the markets over the next one year is that of a worst case of 14500-14800 for the Sensex (at 12X P/E) and 26000 as the best case (on a 20x P/E.) 

The markets are today trading at a Mcap/GDP of 50%; in the beginning of 2008 this had gone up to as high as 160%. The Profits to GDP ration of corporates goes through phases of compression and expansion. Right now both gross margins as well as net margins are suppressed due to the huge input cost pressure that we have seen over the last 18 months as well as high interest costs. This is likely to reverse over the next two years. Eventually the Market capitalization will move towards the 100% level to GDP, if not more. This will provide strong returns over the next 3-4 years.

Markets seem to have taken most negatives in their stride as of now. The risk reward is strongly in favor of investing into equities at this stage. As inflation falls and interest rates come down there will be a revival in the economy and growth prospects will start improving. The timing of the bottom formation is difficult to predict, however it will happen in weeks not months.

Markets should be able to return 15-25% at the middle of the pessimistic/optimistic range over the next one year. 

BEST WISHES TO EVERYONE AND HOPING FOR A GREAT 2012

GOLD – END OF CYCLE

Over the last few days I have become more and more convinced that the up cycle for gold is now coming to an end and we will see a significant correction in this commodity before prices stabilize and move up again. My conviction has become greater after I talked to a vast variety of Investment Advisors/Fund Managers/Investors in general and took their view on Gold and other Asset Classes. Not to my surprise the only commodity that everyone had a buy on was GOLD. Gold today has become the most overowned and oversold ( in terms of it being sold as an investment idea) commodity. Infact the data coming out of Indian Mutual funds is also reflective of the sentiment where the inflows into gold funds have been higher than that of Equity Funds for a number of months over the last six months. This is despite the fact that the total assets under equity funds are more than 20-30 times that of gold funds.

I was frankly waiting for the technicals to become supportive of the fundamental view before putting out this piece. This now seems to be happening with Gold breaking down from a Symmetrical Triangle reversal pattern ( which is normally a continuation pattern and is rarely a reversal pattern which makes it stronger). As the chart reflects, there is now a breakdown which should see Gold moving down sharply over the next few weeks.

 The biggest consumer of gold in the world has traditionally been India. It is likely that this will be the case going forward also, despite their being talk of China becoming the biggest consumer. The traditional jewellery demand in India is not  a fad or fashion but something that is ingrained in the Indian system. This is very different from buying into an asset class that is fancied and where the prices are continuously going up. The significant increase in gold prices over the last few months have bought physical gold demand in India to a virtual standstill. 

As per the data coming out of the World Gold Council Gold demand in the third quarter of 2011 reached 1,053.9 tonnes, an increase of 6% compared to the same period last year. This equates to US$57.7bn, an all-time high in value terms.

According to the World Gold Council’s Gold Demand Trends report for Q3 2011 this increase was driven by investment demand which rose by 33% year-on-year to 468.1 tonnes, The demand for physical demand for the traditional purposes fell by 15% in this quarter. Gold supply was 1,034.4 tonnes in the third quarter of 2011

Overall, Indian jewellery demand in Q3 saw a 26% decline in tonnage, when compared to the same quarter in 2010, to 125.3 tonnes.

The question then is, for how long can investment demand hold up the price of a commodity in light of falling end user demand. The most drastic example of this was the way in which oil prices fell in the year 2008 from levels of USD 150 to USD 30 in a period of just six months. That is not to say that such a thing is possible and likely in the case of gold However the truth of the matter also is that lot of investment demand  is trend following demand  and also exists because of the fear phycohsis that prevails globally today. Investment Advisors and asset allocators find it easy to sell Gold ETF’s to investors who are running scared of investing elsewhere. In a number of European countries investors are running scared to putting deposits in the banks of their own countries. Similarly, given the way global equity markets have performed and the kind of volatility that we have seen investors are unwilling to allocate much to equities at this stage. As a result deposits of banks perceived to be safe, bonds or Germany, UK and the US have become save haven investment plays. Besides this gold is perceived to be the reservoir of value (and not without reason). However investors investing into gold need to be clear of their expectations from this asset class. The probability that gold will yield much below what investors can earn via fixed deposits of banks in a country like India where 5 year deposits of the safest of banks yield near 10% is extremely high at this stage.

As gold prices start to first stagnate and then fall, there will not only be low incremental flows into gold linked investment products but there will also be outflows. A large number of Hedge funds that have built up significant long positions in gold might also go short as the trend reverses. Given the fact that the supply of gold continues to be strong this will ultimately lead to a period where there could be a sharp sell off in gold. The only saviours for gold at this stage are the Central Banks that continue to buy with the trend. As price correct even they will move out and further accelerate the correction.

Contrary to views of gold prices moving to USD 2500 etc. my view at this stage would be for a correction in prices by atleast 20-25% over the next one year.   

Europe seems to have avoided its Lehman moment, focus shifts to growth

The EU summit started with extremely low expectations and that was also reflected in the movement of the markets prior to the summit where most markets sold off going into the summit. This by itself was a good sign that post event; at least we will not have a severe market selloff.

The key takeaway as far as I am concerned s that the so called “Lehman Moment” has been avoided by the decisions taken at the summit and with the moves of the ECB. Although most people have taken the resolve of the ECB not to print money negatively I think that it is a positive move as money printing at a time when the overnight deposits with the ECB are at all time highs and the discount rate is 1% will only accelerate inflationary expectations without contributing significantly to growth. This was the very reason why the US FED decided not to go in for another QE at the end of the last one and opted for Operation Twist.  At that time also I had pointed out that it was a good move, however in the short run markets had taken it negatively, however its positive impact showed up after a few days.

The main concern in the Euro zone is not the availability of money but the lack of faith. In order to restore faith the new deal that has been proposed which will put strict limits as well as monitoring of Fiscal Deficits is a good move for the long run. Over the short run my view has been that with there now being Technocrat led governments in Greece and Italy and a new government in Spain there is unlikely to be any significant negative news flow from this part of the world over the next few months. The commentary that I read seems to suggest that the lack of offer from the ECB to buy large amounts of bonds is being taken negatively. However the key is that there needs to be a return of faith in the Euro’s future existence and once investors are convinced on that they the negativity will start reducing gradually. If the entire market is on one side and the ECB is on the other side, irrespective of how much they buy the markets will not turn. I believe that the key from here on is on implementation.

Directionally I believe that volatility in the markets should reduce as most key events are behind us now. From there on economic data will become more important.

In the Indian context this week is full of data with the Industrial Production data that came out today was in line with the number that came out in the Times of India a few days back at -5.1%. The consensus was for a half percent decline. Capital goods data has turned extremely negative with no new projects taking off.  Inflation data on Wednesday and Thursday & the RBI policy on Friday. No major economic decisions are likely from the governments’ side till the 21^st when the winter session of parliament comes to an end. Post that we could see the government becoming more serious on the economy. It is likely that economic activity would have bottomed out in India now, the key will be to  see the pace of revival. The revival will be slow given the way the economy has come to a standstill due to extremely tight liquidity conditions and high interest rates. Inflation out on Wednesday should be in the region of 8.6% vis a vis Reuters consensus of 9.04%. 

With global commodity prices ex of crude cooling off and food inflation coming off sharply we are likely to see a sharp decline in inflation in India over the next three months. This will set the tone for significant easing from the RBI. Interest rates a year from now should be at least 150-200 basis points lower from the current levels. This will be supportive of both consumption and investment demand. However lack of policy response to boost capital formation might lead to India continuing to underperform other Emerging Markets. Sentiments for investment into Indian equities is at its nadir today and the key is to see when the sentiments turnaround. Since early October when the markets bottomed out after their last selloff, key large EM's like Brazil, Korea, Hong Kong etc are up nearly 15% and India is almost flat, thus reflecting domestic growth concerns. 

It was interesting to read the panel discussion of ET NOW in the economic times today where most investors seemed to be on the pessimistic side. I remember attending a similar discussion in February 2009 where the sentiments were similar and the markets turned around within a few weeks of that. Let’s hope it is the same this time too.