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Make hay while politicos squabble

The probable periods of great uncertainty can be exploited by buying heavily at those times to lower the average cost of holdings...

The attempts by the Congress to get some policy action rolling suggests that the macro-economic situation has hit crisis point. Historically, Indian governments have refused to consider reforms unless there’s a gun held to their heads. The macro-economic situation has been deteriorating for quite a while so one may wonder, what has triggered the change in attitude.

Cynically speaking, I’d guess that the fund-raisers in the Congress have reverted to the High Command with bad news. Even industrialists who are committed Congress supporters are reluctant to shell out money under the current circumstances. Without an ability to make money, there’s no point to being in Indian politics or even trying to fight elections. So the logic of Indian politics dictates that some policy action should now be taken to at the least, enable raising money.

The “reform” (for want of a better word) momentum would increase if the Congress genuinely believes that UPA II is on its last legs and it’s likely to lose the next general elections. Under those circumstances, everybody with influence would want to make some money while still in power and that would entail passing a few orders. In turn, that would translate into “reforms”. I am using the quotation marks because the Indian political system’s definition of reform doesn’t exactly gel with the dictionary definition. In dictionary terms, reform means changing something to improve it. In the Indian context, it usually means selling off some discretionary power or privilege. Sometimes of course, the removal of discretionary powers (such as embodied in the licensing raj) is in itself, a huge improvement.

In this particular instance, the government has carried out only one genuine reform in September. It has capped the number of gas cylinders available at subsidised rates and together with that, given the gas sector more freedom to set market-related prices for non-subsidy gas. The reset of diesel prices merely exercises the government’s discretion to tinker with energy prices; it doesn’t free diesel or even link price revisions more closely to market reality. The loosening of FDI caps in retail, in civil aviation, etc, are also essentially tinkering with rates — the policy of allowing FDI into various sectors was actually set long ago.

The proposal to restart the disinvestment programme doesn’t involve the government giving up its control over the PSUs where shares are being sold. It is just a way of raising money, perhaps only a way to transfer funds from government-controlled entities such as LIC and UTI to the consolidated funds of the government. We would have to wait for actual FPOs and IPOs to judge this. Of course, if the disinvestment programme is successful, it will make at least some cosmetic difference to the fiscal deficit and that in turn, might help to stave off sovereign rating downgrades.

The policy movement in the past month has certainly led to improved sentiments. That could help the Indian economy to cash in on excess liquidity being pumped out by the European Central Bank and the US Federal Reserve. If the RBI plays along by cutting rates soon, it could also aid domestic liquidity. However, if extra liquidity doesn’t translate into meaningful investments and a turnaround in the real economy, it will just mean inflated asset prices and a bubble developing.

But that’s a potential worry for the future. In the present, we may have a sweet spot where an insecure government, which thinks it’s going to lose the next elections anyway, decides to sell off some of its discretionary powers and also tinkers in a positive way with other policy. Any such action could be backed by an excess of global liquidity chasing few assets. So this might spark a bull run across the equity market.

Such a bull run could get derailed in the long-run if the economy continues to under-perform. In the short-run, it would be vulnerable to political shocks. Mamata Banerjee’s reaction to the FDI issue makes political shock quite likely in the near-term. So let’s look at some timelines and consider some likely scenarios.

From now on, with the TMC out of the picture, the UPA II is living on borrowed time. Every time Parliament goes into session, the UPA II could get voted out on a No-Confidence Motion. Any lame duck government gets a grace period of six months to conduct elections.

Parliament goes into session again in December. Until then, this government remains in charge. If trouble erupts during the Winter Session and an early election is forced, it would probably happen about four to six months down the line, sometime in April-June 2013. The period in-between would see an acceleration in the “reforms” programme. The market response would be a brief downturn in December-January followed by a bull-market sustained by the lame-duck reforms.

If the government survives the Winter Session, the timeline for trouble gets moved back till the Budget Session in February. Again, even if an early election is forced, it would lead to a similar lead-time of about four to six months. If the Budget session goes through, there could trouble during the Monsoon Session in 2013 and so on. It is not impossible that UPA II will survive until its full-term and actually run elections as scheduled in mid-2014. It all depends on the mindsets and calculations of various unpredictable players such as Mamata, Mulayam, Mayawati, etc.

The interesting thing for an investor is that, whenever it happens, it will create two windows of investment opportunity. The first will occur as the market corrects during the period of uncertainty before the UPA II officially becomes a lame-duck government. The second will occur during the election period itself.

Political uncertainty always creates a bear-market and every Indian election in the past 20 years has sparked off a temporary but deep correction. In between the fall of the government and the next election, there will probably be a rally as many policy decisions will be taken and ordinances passed. The smart trader could buy during the first crash and sell into the following rally and buy again during the second crash.

What happens after the next elections, whenever that may be? If there’s a stable coalition led by either the Congress or the BJP, the market will rally in relief. If there’s a third front situation, the market will probably stay depressed for an indefinite period. A Third Front could lead to a long period of instability as occurred between 1996-1999. Investors hate that sort of situation.

I have very little faith in any Indian political coalition’s genuine commitment to reform but a Third Front will be worse in this respect than either the UPA or the NDA. It’s likely that a Third Front will have a high component of competing egos as well as competition between many economic illiterates. It will also lack a “core party” that holds a minimum of say, 120 seats and therefore, acts as the senior partner. It may well be dependent on “outside support” from either the Congress or the BJP, which will both continue to hold a substantial number of seats in any conceivable scenario. So it’s very possible that a Third Front will be extremely unstable, and collapse fairly soon.

The best situation one can hope for in fundamental terms is a period of frantic policy-making during the last days of the UPA, followed by a new coalition led by either Congress or BJP. In analogy with 1999, when the NDA carried out multiple reforms after losing a vote of Confidence it’s possible that the UPA II will only act seriously on policy matters once it is lame-duck.

The political uncertainty creates what can be called a systemic risk for any business operating out of India. This sort of systemic risk cannot be diversified away in a portfolio because it is shared by all businesses. Under those circumstances, a passive investor may as well continue to hold a widely diversified portfolio, such as an index fund or ETF.

The probable periods of great uncertainty during Parliamentary Sessions and at election time can be exploited by buying heavily at those times to lower the average cost of holdings. An interim rally sparked by a lame-duck government’s actions could be exploited to book some profits. If you’re pursuing a systematic investment strategy, exploit the dips by doubling or trebling the equity commitments during those periods, while paring down equity weight by selling during rallies.

Unfortunately, a timeframe for a buy-and-hold strategy cannot be determined due to the political uncertainty. If the market stays depressed for a two- or three-year period, the patience of even the most committed equity investors will be stretched. In these circumstances, make sure that you are not personally committing funds that you will need to redeem any time before 2015 or 2016.