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.