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.