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11th December 2013 |
Leaves are turningShiv Puri
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- Our base case scenario is for gradual improvement in infrastructure spend, GDP growth around 5%+, inflation and interest rates moderate, stable to slightly declining currency, leading to EPS growth in high teens and mid-high teen returns for the stock markets
- The single biggest short term risk remains high inflation. Thus, the CPI is at 8% and the WPI at 6%. Inflation will structurally ease once the supply bottlenecks are eased, which will come from enhancing capacity in the manufacturing and infrastructure sectors.
- If India can accelerate growth and start the infrastructure cycle, then capital will likely flow in to capitalize on the growth prospects rather than flow out.
- While state run banks will continue to suffer, they pose no systemic risk at this point. On the contrary, since their balance sheets are wounded, they have limited ability to grow and the private sector banks will keep taking market share at probably a faster pace than the 2% per year rate historically.
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Over the next 24 months, we may reasonably expect one of the four scenarios to play out.
| Scenario |
Probability |
Currency |
P/E |
EPS
Growth |
CAGR
(USD) |
| 1 |
Infrastructure spend picks up, GDP growth in 6 – 7% range, inflation and interest rates ease |
30% |
stable |
15-16x |
high teens/
low twenties |
30% |
| 2 |
Gradual improvement in infrastructure spend, GDP growth around 5%+, inflation and interest rates moderate* |
50% |
stable/slight decline |
13-14x |
high teens |
high/mid teens |
| 3 |
Infrastructure spend remains stalled, GDP growth stays around 4%+, inflation and interest rates remain elevated |
15% |
slight/moderate decline |
11-12x |
mid/low teens |
high single digits |
| 4 |
A systemic issue in the banking sector and/or long term political vacuum |
5% |
decline |
<10x |
unclear |
negative |
The single biggest short term risk remains high inflation. Thus, the CPI is at 8% and the WPI at 6%. There are two things that are important to remember. First, inflation will structurally ease once the supply bottlenecks are eased, which will come from enhancing capacity in the manufacturing and infrastructure sectors. Second, the inflation data will start looking better from May 2014 as the base effect of high inflation from last year (which was due to a 20%-50% hike in the price of most regulated items such as coal, power, petrol, diesel, railway fares) takes effect. The rate of inflation will be the main determining factor of when the central bank can start to ease rates. The central bank appointed a new governor – Dr Raghuram Rajan in September. Dr Rajan was chief economic adviser to India's Ministry of Finance during the previous year and chief economist at the International Monetary Fund from 2003 to 2007. He is on a leave of absence as a professor of finance from the University of Chicago. We feel there is a very sensible person at the helm of the central bank.
While there is concern that the Fed tapering in US will make the macro conditions harder in India, we wish to point out two observations. First, the interest rate differential between India and US is very high. Thus, the short term rate in India is 8.5% while in the US it is near zero. This high differential means it is not a certainty that a gradual tightening in rates in the US will directly correspond to rising rates in India. Interestingly, since the start of the “taper talk” last summer, the US 10 year bond yield has moved up from 1.4% to 2.8% while the Indian 10 year bond yield has moved down from 9.2% to 8.6%. Second, while there is much media concern on the current account deficit (CAD) and its negative impact on currency, it is important to realize that the CAD has fallen from 4.8% in 2012 to 2.3% in 2013. As a result, the currency has appreciated by 10% from its lows of last summer and since then remained fairly stable. If India can accelerate growth and start the infrastructure cycle, then capital will likely flow in to capitalize on the growth prospects rather than flow out. But capital flows and sentiment have a big impact and currently the consensus is forecasting a 3% to 4% annual decline in the currency.
Another short term/medium term risk is the rise in non-performing assets in the banking system that some fear could pose a systematic risk. Again, much has been written in about this in our last three letters. Since then, we feel the underlying conditions for the private banks in general have started to improve. However, the state run banks that have 75% market share of bank lending in India, have only partly recognized the non-performing loans. While state run banks will continue to suffer, they pose no systemic risk at this point. On the contrary, since their balance sheets are wounded, they have limited ability to grow and the private sector banks will keep taking market share at probably a faster pace than the 2% per year rate historically.
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