UNDER NEW MANAGEMENT OUTLOOK FOR INDIA S MARKETS SEPTEMBER 214 BLACKROCK INVESTMENT INSTITUTE Under New Management India has gone from a castaway market to investor darling in the space of a year. The
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UNDER NEW MANAGEMENT OUTLOOK FOR INDIA S MARKETS SEPTEMBER 214 BLACKROCK INVESTMENT INSTITUTE Under New Management India has gone from a castaway market to investor darling in the space of a year. The election of Prime Minister Narendra Modi and the appointment of economist Raghuram Rajan as head of the Reserve Bank of India (RBI) have much to do with it. We recently debated what is next. Our main conclusions: } Modi and Rajan have set in motion an apparent virtuous cycle: increasing business confidence, accelerating growth, deficit reduction, receding inflation, a stable currency and inbound investment. Modi is acting as a hands-on CEO. He has revived stalled investment projects and further curbed government spending. Neeraj Seth Head of Asia Credit, BlackRock Fundamental Fixed Income } Under Rajan s watch, inflation is coming down, real interest rates have turned positive and the currency has stabilized. India s economy is now at an inflection point: We expect GDP growth to accelerate to 7% annually in 215, 216 and beyond, driven by implementing half-finished projects. } Risks include a re-run of the 213 bloodbath in emerging markets (EM) in anticipation (or fear) of a U.S. rate rise. India is in better shape these days, yet the country is still dependent on external funding. } We also have yet to see progress on structural reforms and resolving policy ambiguities in the power sector. The next six months are crucial for investor confidence: Markets are anticipating a clear policy road map in the November- February parliamentary session and budget presentation, as well as rate cuts in 215. Bottom line: Markets need performance above promise. Naganath Sundaresan President and Chief Investment Officer, DSP BlackRock THREE KEY POINTS GROWTH India s GDP growth is accelerating and inflation is receding. REFORM PM Narendra Modi has a mandate for change but delivery is key. MARKETS Stocks have upside while bonds are supported by likely rate cuts. } Fixed income is supported by a stable rupee and slowing inflation. We expect India will add to its foreign reserves in the next year as the RBI keeps the rupee from appreciating. We see room for a rate cut in in the first half of 215, as inflation edges toward the RBI s target. } Rate cuts are likely capped at.5% as the RBI wants protection against another EM downturn, we believe. Currency swaps may start to price in the prospect of rate cuts of.25%-.5% before year end ahead of any actual rate reductions. A stabilized currency and used-up foreign investor quota on government bonds support local currency credit, but liquidity is in short supply here. Ewen Cameron Watt Chief Investment Strategist, BlackRock Investment Institute } Equity valuations are reasonable, earnings momentum looks set to take off and domestic investors are buying. We therefore think the 3-stock BSE Sensex index has material upside in the next three years. Any corrections (a 5% 1% decline is a possibility) are likely to be short-lived, we believe. We like financials, consumer discretionary and small caps, but are lukewarm about staples. The opinions expressed are as of September 214 and may change as subsequent conditions vary. [2] UNDER NEW MANAGEMENT ECONOMIC ALIGNMENT India overdosed on monetary and fiscal stimuli after the 28 global financial crisis. Annual GDP growth spiked to 9% for two years but then halved while inflation remained high. Real interest rates turned negative, the current account deficit widened and the currency weakened. This stagflation period now appears to be coming to an end. See the chart on the right. Reasons include cuts in government expenditures such as energy subsidies, and falling inflation due to decelerating rural wage growth. Why is this happening? Modi and Rajan are at the heart of it: Modi received the biggest mandate of any Indian PM in decades, with his Bharatiya Janata Party (BJP) gaining a simple majority in parliament. This goes some way toward defusing regional interests opposing change. Modi has assumed the role of CEO of India Ltd, stressing implementation. Modi has helped clear 176 projects valued at $15 billion, according to Morgan Stanley, and is drumming up investment on overseas trips. Measures and proposals to fix infrastructure, fiscal balances, the ease of doing business and the key financial sector abound. See the table below. Finance minister and BJP veteran Arun Jaitley is a key player in Modi s cabinet and in the hot seat to deliver on market expectations of reforms in India s annual budget presentation in February. STAGFLATION NO MORE India GDP and Inflation, Y-O-Y CHANGE 15% 1 5 Consumer price index Real GDP Sources: BlackRock Investment Institute, OECD, India Ministry of Statistics and Implementation, Oxford Economics and India Central Statistical. Note: Consumer price data before March 212 is based on OECD data. Rajan is bringing down inflation. Real interest rates have turned positive, stabilizing the rupee, attracting portfolio inflows and reducing corporate funding costs. We expect consumer price inflation (CPI) to settle at 6.5% in the third quarter of 215, from around 8% now. The RBI has been buying U.S. dollars to keep the currency from appreciating, and there s talk of a rate cut. Quite a change from a year ago when the rupee appeared to be in freefall. MODI S BUSINESS PLAN Selected India Reforms, September 214 INFRASTRUCTURE Power: Extending tax breaks, implementing $2 billion of transmission works and initiating four new power projects with 16, MW of capacity. Land purchases: The Land Acquisition Act is likely to be amended to streamline the process of buying land. Transport: Cleared $6.5 billion in road projects. Developing rail freight corridors at a cost of $13 billion. Proposing to award 16 new ports and set up airports in secondary cities. Oil and gas: Proposing 15, km of gas pipelines through privatepublic partnerships. Rivers: Inter-linking key waterways to better distribute water and setting a three-year target to clean up the Ganges. Financing: Proposing to set up real estate investment trusts and infrastructure investment trusts. FISCAL Goods and services tax: Agreed in principle but the timeline of implementation is still unclear. Cutting subsidies: Gradually increasing diesel prices to reduce subsidies. EASE OF DOING BUSINESS Streamlining projects: Increasing the timeliness and transparency of approvals with the launch of an online portal to track progress. Scrapped the Planning Commission. Labor laws: Piecemeal changes such as increasing overtime limits. State-level changes include Rajasthan s move to raise the firm-size threshold for retrenchment rules. Foreign direct investment (FDI): Increasing FDI limits in defense, railways and insurance. Considering special economic zones. FINANCIAL Bank recapitalization: Potential holding company to recapitalize stateowned banks and accelerate credit growth. Monetary policy: The RBI targets CPI at 8% by January 215 and 6% by 216. Bad loans: New legal powers for banks to take charge of companies that wilfully default on loans. Private banks: New RBI guidelines on licensing of banks to encourage greater private sector participation. Financial inclusion: Push to provide the poor with bank accounts. Sources: BlackRock Investment Institute, September 214. BLACKROCK INVESTMENT INSTITUTE [3] VIRTUOUS CYCLE India s twin deficits (the fiscal and current account shortfalls) have improved thanks to the fiscal and monetary measures albeit from a very low base. See the chart below. The current account balance has also benefited from a hike in gold import tariffs as well as lower international oil and gold prices. (Both are swing factors; India imports about three-quarters of its oil consumption, according to the EIA, and is the world s second-biggest gold consumer, according to the World Gold Council.) GLACIAL IMPROVEMENT India BSRI Score, BSRI SCORE Click for interactive data + External Finance Financial Sector Fiscal Space Willingness to Pay Overall Our 5-country BlackRock Sovereign Risk Index (BSRI) is showing an improvement in India s metrics although the country is ranked at a lowly 39th place. An increase in the government s perceived effectiveness (Willingness to Pay score) has driven the change. See the chart on the right. We would expect further improvement in the next two years; the BSRI is a slow-moving credit barometer. We expect India s GDP growth to accelerate to 7% annually in 215, 216 and beyond when many other EM economies are expected to slow. The growth is driven by implementing halffinished projects. Another booster: A drive to provide the poor with bank accounts will enable direct transfers of subsidies to the needy, leading to less wastage. Combine this with India s long-term advantages such as an expanding working age population, low debt-to-gdp levels, an edge in key industries such as IT and potential for financial sector growth, and the investment case starts to look pretty compelling. What does this add up to? An apparent virtuous cycle of increasing business confidence (India s companies could start investing at home rather than buying assets abroad), accelerating economic growth, fiscal consolidation, receding inflation, a stable currency and foreign investment. -.6 June 211 June 212 June 213 June 214 Source: BlackRock Investment Institute, July 214. Note: The bars show the contribution to India s overall BSRI score. The risks? A re-run of the 213 EM downturn in anticipation of a U.S. rate hike. India these days has strong political and policy leadership, a slimmer current account deficit and topped-up foreign exchange (FX) reserves. Yet the country is still dependent on external funding. In addition, we have yet to see structural reforms in the power, labor and retail markets to make the economy more efficient. Modi s newly energized bureaucrats arguably have been doing the (relatively) easy stuff and markets will expect them to do some heavy lifting soon. Bottom line: A clear road map is needed to move from promise to performance. The next six months are crucial for investor confidence with expected land reforms, the introduction of a goods and services tax, a detailed budget in February and rate cuts in the first half of 215. The higher markets rise, the higher expectations grow. REHABILITATING TWINS EM Current Account and Fiscal Balances, Click for interactive data + 12% Taiwan CURRENT ACCOUNT SHARE OF GDP South Korea Malaysia China Russia Thailand India Mexico Poland Indonesia South Africa Brazil Turkey Chile % FISCAL BALANCE SHARE OF GDP Sources: BlackRock Investment Institute and IMF World Economic Outlook. Notes: Fiscal balances represent general government deficits and surpluses, including state and local balances. 214 is the IMF s forecast. [4] UNDER NEW MANAGEMENT MOMENTUM IN EQUITIES Rajan s appointment, Modi s candidacy and a subsequent currency rally ignited India s stocks bull run. Equities got another lift when it became clear Modi was poised to win big in the election. The post-election surge, however, has tracked the MSCI EM index, making it arguably part of an overall EM move. See the chart below. We believe the benchmark BSE Sensex index has material upside in the next three years. Equities could dip 5%-1% in the short run, pummeled by a geopolitical hiccup (pick your poison) or the anticipation of a U.S. rate rise. Any correction, however, is likely to draw in buyers, we think. Consider: 1. Valuations do not appear stretched versus their own history and look reasonable compared with other EM equities. See the chart on the right. 2. GDP acceleration should translate into compounded annual corporate earnings growth of 18% in the next three years, we believe, up from a post-crisis average of 8%. Many analysts have yet to factor this into their individual company estimates. 3. Domestic mutual funds are buying stocks for the first time in years. It always helps when locals support investment tourists. (Foreign ownership is at a high of 23%, according to Bank of America, but has proven relatively sticky over time.) We like private sector financials due to the untapped potential for banking. India s mortgage debt made up just 9% of GDP in 212, versus 2% for China, according to IIFL Research. We favor consumer discretionary stocks thanks to the expanding middle class. We are underweighting consumer staples, which look pricey given their growth prospects. We like small caps as they tend to outperform in cyclical upturns. THE POWER OF INDIVIDUALS India Equities Performance, TOTAL RETURN 6% 4 2 MSCI India relative to MSCI Emerging Markets Bernanke taper speech MSCI India Rajan takes office Modi elected Sources: BlackRock Investment Institute and MSCI, September 214. Note: Total return is in U.S. dollars and measured from the start of 212. MIDDLE OF THE PACK Emerging Equity Valuations vs. Historical Norms, August 214 South Africa Mexico Brazil India Taiwan South Korea China Russia CHEAP AVERAGE EXPENSIVE STABILITY IN FIXED INCOME We see room for a rate cut in the first half of 215. This should underpin fixed income. India s 8% policy rate is firmly above real GDP growth a global rarity these days. CPI is closing in on the RBI s preferred 6% level. Rate cuts are likely capped at.5% as the RBI wants positive real rates as a protection against another EM downturn, we believe. A slowdown in GDP growth momentum could change this equation. We believe five-year currency swaps may start to price in the prospect of rate cuts of.25%-.5% before year end ahead of any actual interest rate reductions. U.S. dollar bonds are fairly valued, but we could see spreads tighten further if Standard & Poor s upgrades its negative outlook on India. A stable currency supports local debt markets. The RBI appears in wait-and-see mode until the impact of U.S. rate hikes on global liquidity becomes clear. It is unlikely to let the rupee appreciate much, enabling it to expand its FX reserves beyond the current $316 billion. We expect it to loosen the reins in the second half of 215 if India s downward trend in CPI is intact. Foreign investors have used up their quota of government bonds, so AAA-rated public sector undertaking (PSU) bonds and selected corporate credits are likely to benefit. Warning: Liquidity is in short supply in India s local currency corporate bond markets. Two- to five-year PSU bonds could generate good risk-adjusted returns in case of a yield curve flattening or range-bound market until rate cut expectations build up. 5 August 213 1% PERCENTILE Sources: BlackRock Investment Institute and Thomson Reuters. Notes: Valuations are in percentiles of available history of earnings yield, cyclically adjusted earnings yield, trend real earnings, dividend yield, price to book, price to cash flow and forward 12-month earnings yield. The data series start between 1992 and BLACKROCK INVESTMENT INSTITUTE [5] WHY BLACKROCK BlackRock helps millions of people, as well as the world s largest institutions and governments, pursue their investing goals. We offer: } A comprehensive set of innovative solutions } Global market and investment insights } Sophisticated risk and portfolio analytics We work only for our clients, who have entrusted us with managing $4.6 trillion,* earning BlackRock the distinction of being the world s largest fiduciary investment manager. BLACKROCK INVESTMENT INSTITUTE The BlackRock Investment Institute leverages the firm s expertise across asset classes, client groups and regions. The Institute s goal is to produce information that makes BlackRock s portfolio managers better investors and helps deliver positive investment results for clients. EXECUTIVE DIRECTOR Lee Kempler CHIEF STRATEGIST Ewen Cameron Watt EXECUTIVE EDITOR Jack Reerink * AUM as of 6/3/14. Source: Pensions & Investments as of 12/31/13. This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 214 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This paper may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader. In the EU issued by BlackRock Investment Management (UK) Limited (authorized and regulated by the Financial Conduct Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No Tel: For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. 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