As we head into the New Year, bullishness about Indian equity market performance persists. India is a growth island in a world bereft of growth. Valuations, though high, are still not in a bubble territory. With equity returns expected at over 20 per cent CAGR for the next 24 months and no other asset class promising such returns, it appears that all investment should be in equity assets. Or should they?
Dollar strength - end of the dollar carry trade?
The US dollar has appreciated, backed by good jobs data and improving economic climate in the USA. However, strength of the US dollar also means that globally central Bank monetary policies are less likely to be co-ordinated. While commentary from the US Fed is likely to turn more hawkish, Japan is likely to persist with its quantitative easing. Europe will maintain a benign monetary policy despite German opposition to easing.
If US interest rates rise, it will likely lead to an unwinding of the 'dollar carry trade'. US may not continue to be a provider of capital to the rest of the world. Japan may replace US in that position through yen carry trade.
India will likely see the rupee weaker over calendar 2015 as dollar strengthens. However, it may continue its relative outperformance against the yen. From a portfolio point of view, importers from Japan (like Maruti) will benefit even as exporters to the US (IT services) benefit from currency translation effects. While sectoral impact may vary, volatility in the market will be inevitable and may cause some stomach churning gyrations as capital sources are replaced.
Inflation and interest rates may fall slower than expected
Expectations are currently high that RBI will cut policy rates in the early part of 2015. Fall in the international price of crude has built expectations that the recent fall in inflation (CPI) will accelerate. This may not be the case. Consumers surveyed for 'inflation expectations' still reveal assumptions of rising prices. Government's increase in excise tariffs on petro products will also ensure that domestic prices do not fall in line with international prices. Additionally, the base effect will ensure that CPI may actually pick up back to 6 per cent plus range in the New Year. This provides less room for the RBI to cut rates.
The rupee has been relatively stable against the dollar, but has appreciated against many other currencies. This gives the RBI head-room to allow it to depreciate as dollar strengthens further. However, it is likely that RBI would like an orderly weakness in the rupee as against the collapse that we have recently witnessed in the yen. Lower interest rates in India without significant reduction in inflation can cause the rupee to fall sharply. Another factor to note is that much of recent portfolio flows into India have been in Indian debt markets. As the relative interest rate differential narrows and the rupee weakens, these trades will reverse rapidly. The RBI will have this on its radar too.
Geopolitical situation will worsen
The rise of ISIS has had a limited impact on global growth thus far. This may change in 2015. With the US withdrawing from Afghanistan and India pursuing a more robust defence policy against its two neighbours, China and Pakistan, geopolitical environment for India is deteriorating. Russia has decided to supply arms to Pakistan in protest against India's defence purchases from the USA and France. Russia has also signed up a gas supply agreement with China. This aligns the interest of Russia to two countries most hostile to India's interest. India should not expect the same level of political support from Russia as it used to in the past.
US withdrawal from Afghanistan will free Pakistan to focus more on the Indian border, where it will receive adequate support from China. A rise in political tensions in India's immediate vicinity is a given. An upheaval strong enough to shake market confidence is a low-probability event but not something one can write off.
Banks will begin to own infrastructure companies - a different and higher risk profile
A recent move by the RBI to allow banks to convert bad loans into equity has the potential to unlock many projects that are stuck. It also opens the door for possible mis-allocation of fund by banks. In any case, many infrastructure projects are unviable without fresh fund infusion - and new funds are likely to come in only if debt is reduced. This permission to convert is therefore a welcome move. That said, given the inability of banks to evaluate project risk (as witnessed in the volume of bad debt created), the likelihood of them being able to make wise equity decisions is suspect.
In the short term, banks are likely to become significant shareholders in infrastructure projects. In the longer term, this may work well for banks if investee companies revive. However, for now, banks offer a different category of risk to investors.
Gilts offer 15 per cent returns as well
A debt security of thirty-year tenure offering an 8 per cent coupon will yield approximately 15 per cent gains if interest rates fall by 100 basis points. Expectations of the market border around a policy rate cut of that magnitude over the next 12 months. In the event that none of the scare factors outlined above impact India adversely, it is likely that such an interest rate cut can indeed come through. This will be bullish for equities, which is what is being factored in by the markets. However, it will also be bullish for debt - in particular long-dated debt. As explained above, a gilt fund invested in a long-duration paper could well return 15 per cent over the next 12 months - without attendant risks of corporate non-performance or malfeasance.
So is this the right time to push out of all other investments other than equity? Appropriate asset allocation ensures that the unforeseen does not blindside the investor. In a world as uncertain as the one we face today, there is no better time to stick with diversification as a portfolio strategy.
Anand Tandon is an independent analyst.
This column appeared in the January 2015 issue of Wealth Insight.