Agricultural Growth bounces back

A correction seems to be unfolding in equity markets across the world. The macro data emerging from US is getting bleaker by the day. With unemployment numbers steadfastly staying close to ten percent, the consumption numbers might stay subdued for next several quarters. The bigger pain for the American economy is the state of the housing market. U.S. existing homes in July fell to their slowest pace in 15 years and it is now clear that housing made a false bottom last year. The probability for housing to drag the US economy back into recession is increasing every day. Global equity markets now look forward to next round of quantitative easing which looks imminent followed by some form of fiscal incentives to drive up consumption.

Back home, the GDP growth numbers for Q1 came in at 8.8%, broadly inline with expectations. During the quarter, industry growth was at 10.3% compared to 13.3% (QoQ).The industry growth is expected to come down to 10% in the subsequent quarters due to the high base effect of last year’s numbers. Service sector grew 9.7% versus 8.4% (QoQ) despite a slowdown in construction activity due to monsoons. As construction activity picks up in the subsequent quarters, the Service sector could cross the 10% mark. Farm sector has seen a growth of 2.8% compared to 0.7% (QoQ). This year would see a huge bounce back in agricultural production as the country comes out of a severe drought situation. Leap of Faith would now expect the full year agricultural growth at 3% taking the full year GDP growth to 8.5%.

Direct Tax Code 2010 Bill has pushed back the implementation by one year and the code would be effective only from Apr-12. The Long term capital gains tax stays at zero which comes as a big relief for equity markets. The Bill proposes to reduce the effective corporate tax rate to 30% versus the existing 33.2% rate (30% corporate income tax rate + 7.5% surcharge + 3% cess), with the proposed removal of the surcharge and the education cess. So the proposed rate, inclusive of surcharge and cess is now lower by 320 basis points. However, the effective tax rate for most Indian companies is around 25% so the removal of exemptions means that effective tax rate is likely to go up slightly.

The mid-term review of the 11th five year plan has been announced. The investments have kept pace with the estimates with total capex of 266bn$ in the first three years which is equal to the total amount spent in 10th plan. The five year target has been maintained at 500bn$ with Power generation, telecom and roads sectors expected to make the biggest contribution. The macro numbers announced reinforce Leap of Faith’s view that infrastructure sector is poised to show huge growth in the next few years and remains the most attractive investment bet from a stock market perspective. Leap of faith would use any global turbulence driven stock market correction to increase weight in the infrastructure story primarily in the roads and ports space.

The tale of Hindenburg Omen

Word on the Wall Street is that the Hindenburg Omen has reappeared. The phenomenon was reported to have appeared on Tuesday and than again on Thursday last week. For the uninitiated, Hindenburg Omen is a technical analysis pattern that is said to portend a stock market crash. It is named after the Hindenburg disaster of May 6, 1937, during which the German zeppelin Hindenburg was destroyed.

While Leap of Faith would not give it too much importance, it is interesting to see that kind of buzz this has created on the Street. The talk of impending gloom and doom with US going into a double dip has resumed with a vengeance. Comparisons with the great Depression and Japanese style deflationary cycle are back in vogue. While there are clear signals of US economy slowing down, Leap of Faith does not envisage a Lehman like event happening, at least for now and would use any panic driven Global market sell-off to buy more.

Back Home, Indian equities made their fresh 2010 high during the last week, as FIIs continued their buying spree. The good show by the banking industry continued with surprisingly positive numbers from State Bank of India. The 20% growth in earnings was way above the consensus expectations and was led by lower than anticipated provisioning. A closer look at numbers reveals that close of 20% of the restructured assets have slipped into NPLs and would require accelerated provisioning in the next nine months. Leap of Faith would maintain a cautious stance on asset quality of public sector banks and prefer private sector names in the medium term.

The week saw yet another foreign acquisition by an Indian automobile player with Mahindra & Mahindra emerging as the preferred bidder for the acquisition of a majority stake in South Korean SUV maker Ssangyong Motor Company. The deal gives M&M not only a strong foothold in Korea, but also a definite push towards becoming a global player in utility vehicle space. Ssangyong has over 1300 dealers outside Korea particularly in Western Europe and Russia which could be leveraged to sell the existing M&M products. Apart from distribution, Ssangyong allows M&M to extend its product line-up and apply Ssangyong’s engine technology. With an earnings growth in excess of 25%, M&M remains highly leveraged to the booming Indian automobile growth story and Leap of Faith is adding it to the model portfolio.

Over the last couple of weeks, Mumbai has seen some very aggressive land auctions. Indiabulls winning bids of Rs1.8bn/acre for the two adjoining mill land parcels in Central Mumbai has set new benchmarks for land price. These closely fought mill auctions betray the optimistic view that the developers currently have about real estate prices in the medium to long term. Despite concerns on high prices, transaction volumes have held on quite well in the last six months. IT industry is giving generous salary hikes to employees and is expected to add more than one lakh people this year which would give a big boost to residential estate demand. The funding scenario has also become easier. With prices on a clear uptrend, Leap of Faith would continue to be positive on Tier I Real estate developers.

The WPI inflation for July came in at 9.97%, lower than the consensus estimate of 10.4%. The food prices inflation is well off its highs and has almost halved from 20.04% in December to 10.29% in July led by the big fall in sugar prices. The prices of manufactured goods also fell on a sequential basis. While this is good news, the tightening cycle is far from over. Leap of Faith believes that demand side and cost push factors are still exerting pressures on price level and monetary tightening would continue though the pace could moderate to allow for soft landing.

Chasing the American Dream

The Indian Stock markets continue to inch up while the corporate earnings continue to be muted. Fresh allocation of foreign capital to Asia ex –Japan funds is leading to huge money inflows from foreign investors. So far this year, India has already received more than ten billion dollars of FII money. With interest coming back in the Chinese market, Leap of Faith believes there could be more allocation to BRIC/ emerging market funds leading to further inflows.

While the infrastructure story is taking its time to play out, consumption activity is seeing unprecedented growth. Leap of Faith visited High Street Phoenix, a high end south Mumbai mall over the weekend and was surprised to see the sea of people present in the premises. From apparels to consumer durables to mobile phones to Movie shows, it seems the great Indian consumer is splurging like never before. There were long queues to get inside Big Bazaar, the discount retail store from Pantaloon Retail India which occupies 100,000 square feet of retail space in this mall. After having been turned away from fine dining places because of long wait lists, Leap of faith had to contend with a takeaway at MacDonalds, because there was no place to sit!

The high end section of the mall, Palladium, has become home to the biggest luxury brands in the world with Diesel, Canali and Guess opening their stores in early 2010. As the 400 room luxury Hotel Shangri La gets inaugurated next quarter, the footfalls to the mall would only increase.

As more and more Indians enter the middle class and start living the ‘American Dream’, the demand for cars, premium housing, retail spaces, high end gadgets and tourism is only going to increase. Phoenix Mills plans to replicate this success in other Indian metros with expected operational retail space of 25 mn square feet in next four years. With a new revenue sharing model instead of an outright lease one, Phoenix mills is highly geared to capitalize on the booming Indian retail story. This got reflected in the company’s earnings which grew by 60% on yoy basis this quarter. Leap of Faith believes Pantaloon Retail and Phoenix Mills remain the best bet on the booming India consumption story and would keep both as a core part of the Model portfolio.

While consumption booms, the commodity complex continues to be under pressure because of subdued demand from China. China's imports of industrial commodities is slowing as export growth slows down. That is going to have a bearing on industrial metal prices across the world. The surplus steel making capacity in China is going to keep steel prices depressed in the world market at least for the next few quarters. Arcelor Mittal in its commentary this quarter, pointed towards a softer third quarter with pressure also coming from muted European steel demand. The positive side of softer commodity prices is that it would ease margin pressure on manufacturing companies in India. It is to be noted that raw material price and interest cost increases have been the biggest source of margin declines for India Companies this quarter.

In US, the corporate earnings have been above consensus expectations. However there have been big concerns whether the jobless recovery can continue for a long time. While concerns have increased about fresh jitters coming out of Europe, so has the expectation that a new stimulus package is coming. The equity markets there have already started discounting the coming monetary and fiscal stimulus package and another round of quantitative easing looks imminent. Leap of faith would believe that incremental benefits of further quantitative easing would be minimal, though it could take equity markets even higher in the short term.

Keeping the Faith in the Infrastructure Story

The first quarter earnings for Indian Corporates that have come in so far have been disappointing. The sectors which did well are Banking and Automobiles. The list of laggards is much longer with Infrastructure, Capital goods, cement, metals and information Technology surprising on the negative. Leap of faith would now peg the FY11 earnings growth expectations at 20% down from the 25% at the beginning of the result season.

The biggest disappointment has been in the Infrastructure & Capital goods space. Larsen & Toubro, the biggest company in the construction space, came up with the revenue growth of 6% on yoy basis against a guidance of 20% by the company in the beginning of the year. While core Engineering and Construction order book increased by 65%, Larsen is still grappling with issues on the execution side. Several projects on the infrastrucre and metal side were either shelved or failed to achieve financial closure during the recession. It seems the progress is still slow on those projects. However, one should not rush to judge the basis of just the first quarter numbers A lot of construction sector companies have lumpy orders and sales booking. Leap of Faith believes that the bulging order books would start getting reflected in the topline and bottomline in an accelerated manner in the coming quarters.

The infrastructure segment that looks most promising is the roads segment. With the change in leadership of the ministry last year, several policy changes have been carried out to improve the financial viability of highway projects, streamline procedural bottlenecks and increase access to financing. This is evident in the increase in bidding and awarding activity of road projects by NHAI in the last six months. Leap of faith’s interaction with infrastructure lenders confirms the huge growth in financial closures and disbursals for the road space. Around 30,000 new highway projects are slated to be awarded in the next four years, opening up a US$60bn investment opportunity. IRB Infrastrucre and ILFS transportation Networks are best geared to ride this investment boom and remain a core holding in the model portfolio.

The RBI in its credit policy on last Tuesday has unequivocally shifted the focus on inflation management. Leap of faith would expect another 100 basis points hike repo and reverse repo in the next 2-3 quarters. The fact that food inflation has dropped down to below 10% provides some relief. However, inflation expectations especially in the core sector are now firmly on the uptrend and therefore a continued tightening stance is warranted.

While Indian markets have been flat in July due to muted earnings numbers, the Shanghai composite market has rallied very sharply. It is up almost 15% from its recent lows. The Chinese government’s attempt at trying to slow down the Chinese economy seems to be working. A purchasing managers’ index released today by HSBC Holdings Plc and Markit Economics slid to 49.4 from 50.4 in June. The Government has taken measures to reduce overheating risk in the economy especially in the real estate pace. Leap of faith believes that concerns on further tightening are overdone. The Chinese government, considering the fragile economic scenario in Europe and its dependence on exports, is expected to desist from further tightening.

While the corporate earnings in US surprised on the positive, concerns on economic recovery continue. The remark of Fed chief Ben Bernanke that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period” indicate the fragile nature of the recovery. With the congressional elections in November and unemployment running at over 9%, Leap of Faith would believe new stimulus package would be announced soon. As the result season is out of the way, the next trigger for equity markets would be the announcements of that stimulus package which could contain both monetary and fiscal measures.

Rising risk of a Hard Landing

Indian markets made a new 30 months high on the back of strong global cues. A relief rally seems to be playing out globally as a result of positive news coming out Europe and China. The best Q1 results so far have come out from the Financials space. Midcap private sector banks like IndusInd and Yes have delivered a growth in excess of 40% in the Net interest income. Leap of faith would expect the performance to be maintained in the next few quarters. While larger PSU banks like PNB grapple with poor asset quality, smaller PSU banks continue to shine. Allahabad bank came up with Net interest income growth of 35% and continues to be the top pick in the space. Despite an adverse interest rate scenario, the annual credit growth number should exceed RBI forecast of 20% and an overweight on the Banking & Financials would continue to be maintained

Inflation continues to be out of control. Leap of faith believes that the government’s calculations on inflation front have gone horribly wrong. Inflation might continue to be in the 9-10% range for next several months, belying all claims made by the government that it would come down to 6%. If that happens, RBI will be forced to slam the brakes hard with the risk of a hard landing increasing by the day. Inflation is no longer a supply side issue with demand leaping ahead with a strong bounce back in economic activity. The fact that all capacity expansion plans had been put on hold due to recession in last few years is adding to the problem.

RBI will come up with the credit policy on Tuesday, 27^th. The consensus expectation is of a 25% basis point hike in both repo and reverse repo rates. Leap of faith believes that a higher 50 bps rate hike would be in order with maybe a reduced interest rate corridor. It seems Finance Ministry’s money raising compulsions have been holding RBI’s hand so far. However, the time has come for RBI to bite the bullet and increase the rates to the pre crisis level.

Stock markets across the world showed some strength this week. The Shanghai composite market has rallied almost 10% from its recent lows. The market seems to be indicating that the recent tightening initiatives by the Chinese government are almost over. With the government having been successful in slowing down the GDP growth last quarter, there should be no further tightening in near future. Leap of faith believes the rally in Chinese markets in good news for all emerging markets. As fund managers of Emerging market and BRIC funds start allocating money back to China, some part of that is bound to come to India too which might result in further upside in Indian markets.

The European markets also bounce back. The trigger was the supposedly ‘positive’ stress test results for European banks. It is very clear to everybody that these results were a sham and provide no comfort to investors looking for any definitive evidence of improvement in Euro area macroeconomic scenario. However, from tactical perspective, it has given some breathing time to the regulators in Europe to deal with the gigantic problems, which could lead European markets still higher in the short term.

The Result picture looks encouraging in US with Ford coming up with good numbers and Apple delivering a stunning 61% growth in revenues. While the robust sales of iphone, ipad, and ford cars indicate a robust consumer demand, the low advertising revenue for yahoo search engines indicates the still low business confidence in US. The remark of Fed chief Ben Bernanke that US economy prospects remain ‘unusually uncertain’ also added to the nervousness about the health of US economy. Leap of faith believes that these comments have laid the ground work for another stimulus package from Obama administration which should be coming very soon. While that would be positively received by the stock markets, questions about long term health of developed market economies still remain unanswered.

Leap of Faith

Indian stock market continues to surprise the investors across the world with its resilience. Last week was the first week of quarterly results for FY11. IT giant Infosys started the season with a disappointing set of numbers. With Infosys carrying over 10% weight in the benchmark, this performance did cap the upside on the broader markets. Its competitor TCS came up with a much stronger set of numbers. With the quarter on quarter volume growth in excess of 5% for both companies, the demand outlook seems to be holding up, for now. However, the most concerning aspect was the offshore pricing scenario especially for Infosys. This was the seventh straight quarter of decline in offshore pricing and it implies that IT firms are still price takers in the fiercely competitive market. The sector could, at best, be a market performer forms these levels.

Financials continue to surprise the market with their numbers. Axis bank came up with a sparkling performance with a 45% growth in net Interest income. Although the Net margins declined on a quarter on a quarter basis, they should stabilize around 3.7- 3.8 levels. The bank continues on a robust growth trajectory and remains a high conviction pick for all long only investors. HDFC net profit came in slightly below expectations at 23% above last year levels. Leap of Faith believes that the number to focus on is NII income growth which came in at 30%. It indicates the robust demand for credit in the system expecially for housing. The annual credit growth number should exceed RBI forecast of 20% and a big overweight on the Banking & Financials space should be maintained.

Moving to the topic of Inflation. There seems to be no respite from high food price inflation which has now seeped into manufacturing price inflation. With the June inflation number nearing 11%, RBi is left with no choice but to raise interest rates quickly. RBI is already looking behind the curve and serious questions are now being raised whether the independence of the institution has been compromised. With Governor SubbaRao finally speaking up against the finance ministry’s attempt to become a super regulator, it seems RBI might try to reassert itself. Let’s not forget that India has traditionally been a high inflation economy and panic driven aggressive rate hikes have derailed the growth story quite a few times. Therefore it is necessary that interest rates are raised regularly and gradually over the course of this year.

The IIP Numbers surprised on the negative with growth coming in at 11.5% against the consensus expectations of 16% . There was considerable slowdown in capital goods activity and consumer durables number. Leap of Faith would not read too much into the number as the capital goods numbers tend to be lumpy and fluctuate wildly between months. India should end the year with IIP growth in excess of 10%, stellar by even emerging market standards.

While Indian markets continue to be strong, Stock markets across the world continue to be weak. Concerns on European crisis and its ramifications on global growth remain. Growth seems to be slowing down in China. The growth for the quarter ending June came in at 10.3% slower than the 11.9% in last quarter. The Chinese government has been trying to slow down the Chinese economy for some time. It had pumped in huge stimulus into the economy during the height of the recession most of which found its way into the real estate sector. Chinese authorities imposed strict controls on the real estate sector in April this year making it difficult for investors and speculators to buy property. That seems to be working as the volume of real estate transactions has come down drastically compared to last year although prices have not fallen that much. The fall in Industrial metal prices by almost 30% from the peak of last year also indicates weak Chinese demand. The Shanghai composite index has fallen almost 40% from the peak achieved in August 2009 and is trading at 11 times one year forward earnings compared to 17 times for India!

The euro has rebounded sharply against the dollar with the current levels being close to 1.3 to a dollar. Leap of Faith believes that could be short-lived as European economy continues to flounder with economic growth forecasts looking grim. Pain in the Euro area economy continues to be the biggest risk to global asset markets and the stress test results of European banks coming next week need to be monitored very closely.

The result season has started in US. The picture looks mixed with JP Morgan and Google coming up with good results while Citibank disappointed. The consumer confidence number released yesterday came in far below expectations. The recovery in US is looking weaker by the day and there is a serious risk of a double dip recession. With the congressional elections due in November, Leap of Faith believes it is almost certain that President Obama will need to announce a new stimulus package soon. The direction of equity markets globally would largely depend on the size and contours of this stimulus package.

The time has come for people of India to start believing in the growth story that continues to play out in the thousands of villages and towns of India; every day, every hour, every second.. It is time for us to stop being cynical and believe in our ability to create a future of prosperity and abundance. That is why yours truly decided to name this weekly column ‘Leap of Faith’. Any comments on the same are most welcome.