Wealth managers remain upbeat despite Indian sell-offs

“There is no magic wand,” said Raghuram Rajan, India’s newly appointed central bank governor last month, referring to a solution to India’s economic woes against the backdrop of the US expected to taper its quantitative easing programme.

The ex-IMF head, who foresaw the 2008 financial crisis, was satirically named “India’s messiah” by media critics as reams of newspaper columns and editorial space in leading national and international dailies and business journals were devoted to his appointment as the leader of the Reserve Bank of India (RBI).

However, India’s worsening economic conditions proved Mr Rajan did not have a magic wand. The rupee fell to all-time lows, declining as much as 20 per cent against the US dollar this year, reflecting a general shift in global sentiment against emerging market currencies.

Foreign investors pulled out $8.9bn (Ä6.6bn) from the country’s local bonds in the three months to August 31, according to the Securities and Exchange Board of India. Moreover, they withdrew $3.7bn from equities, as capital flight from emerging economies continued, reacting to the US measures. Globally, reserve assets hit an all-time high of $11.2tn in August, as risk-averse investors pulled out from emerging markets.

Though all emerging markets have suffered, India has been hit harder than most, owing to its large current account deficit. With growth weakening, India’s ability to manage its borrowings is being questioned. In order to finance the deficit, Indian policymakers have raised tariffs on gold imports and tightened limits on Indians moving money abroad. But these measures have been ineffective in supporting the rupee.

Nevertheless, wealth managers are not bearish on India. “Over the medium-term outlook, two factors should make us more constructive on the outlook for India,” says Rajendra Nair, managing director and portfolio manager of the JP Morgan India Fund. “The Reserve Bank of India’s action should make rupee speculation more expensive.”

Mr Nair also expects the current account situation to improve as gold prices come off, which he feels will help put India on a sounder macroeconomic footing. “Despite the current growth setback, it’s worth bearing in mind that valuations of the Indian stockmarket offer upside both in terms of currency and market appreciation,” he says.

But any reversal of foreign inflows will weigh on Indian equities, Mr Nair warns.

Manpreet Gill, senior investment strategist at Standard Chartered Bank, has a neutral view on Indian equities. “We recognise there is a risk of further volatility, especially in the short-term ahead of upcoming elections,” he says, referring to India’s upcoming national elections in 2014.

However, Mr Gill says two points stand out to him following the recent volatility in
equities, which prevent his bank from changing position to underweight. “Indian equities are now trading at valuations that are at the lower end of their historical range,” he states. “The rupee is also arguably inexpensive based on valuation measures.”

The key risks according to Standard Chartered are interest rates and liquidity. “The longer the current tight liquidity conditions remain in place, the greater the risk for equities,” says Mr Gill.

There are still opportunities in India, albeit in names that offer a degree of protectionism, says Manish Bhatia, manager of the Schroders ISF Indian Equities Fund. “The flipside to the weakening rupee is that export-oriented sectors, such as IT services and pharmaceutical firms will benefit. Indeed, stocks within these sectors have held up relatively well amidst the current correction,” he says.

Furthermore, Mr Bhatia believes India’s consumer sectors are proving relatively defensive. “Any financials that we hold in India are private banks, which tend to be better-managed and more transparent than their state-owned brethren.”

“Some of the actions I take will not be popular,” Mr Rajan said when taking office on  4 September  2013. “The governorship of the central bank is not meant to win one votes or Facebook ‘likes’.”

The RBI has since tightened liquidity and increased funding costs for banks significantly. The central bank governor stated that these measures were taken to “quell excessive speculation and to reduce volatility in the rupee”. However, in JP Morgan’s view, the currency policy is unconvincing.

“Our investment thesis for India has been that with inflation easing, the focus of monetary policy would shift to growth,” Mr Nair says. “The rise in interest rates has impacted this view and there is a risk that the rise in interest rates holds back the economic recovery that we had been anticipating. As GDP growth decelerates, we expect loan growth to slow and credit costs to rise,” he adds.

Mr Rajan has also introduced a slew of measures on the liberalisation of the financial sector. It has become easier for banks to open new branches and entry by foreign banks is encouraged. Banks will be given more freedom in lending decisions, allowing them to shift their focus from the rural and small businesses sector, towards the private. Rules requiring banks to hold large volumes of government bonds will be eased, as the government’s fiscal situation improves, which will free up cash for funding companies and projects. According to JP Morgan, these steps will have a “major long-term impact” on the earnings of financial institutions.

Yet, there are challenges that remain outside the central bank’s ambit. The Indian government’s reforms, opening foreign investment in a range of sectors has yet to fulfill. The new land acquisition bill requires developers to get consent from 80 per cent of the displaced before acquisition and increases compensation to landowners.

This can end up increasing time needed to acquire land, which is already significant according to global standards. India’s parliament has passed the food subsidy bill, which aims to provide subsidies to approximately 67 per cent of the population from next year. Such a move could double the cost to the taxpayer from the current 1 per cent of GDP.

“Structural reforms and not just foreign capital are urgently needed to remove the obstacles to economic growth,” says Deepak Lalwani, director of Lalcap, a London-based investment consultancy specialising in India. “Manufacturing needs to be kick-started which will also help lost exports.”

Also, there are political hurdles in the way, as the government lacks a majority in both houses of parliament and cannot push through tough reforms, he says. The prospect of an indecisive election in 2014 is further eroding confidence amongst global investors.

However, the immediate response is that the RBI has passed into surer hands, says Daniel Martin, an economist at Capital Economics Asia.

Umang Papneja, chief investor officer at IIFL Wealth, agrees. “Rajan on his first day outlined a near term agenda demonstrating the required urgency to move forward with reform measures in financial markets,” he says. “This led to some recovery.”

Being a manager investing primarily in the Indian markets, Mr Papneja had kept some cash positions recently, to cushion the portfolios from the currency fall. He says a rapid depreciation of a currency usually means exports growing. Thus, he says the export-oriented sectors, such as IT, pharmaceuticals, cement, and food sectors are the ones to watch out for in the coming quarters.

An interesting opportunity would be to play local currency bonds, he feels, as the rupee shows signs of stabilisation and other factors like inflation and growth remain in favour of fixed income investing.

“Private clients from the Indian diaspora would be seen investing in deposits and bonds of banks in India, both local and foreign, over the next couple of months,” says Mr Papneja, stating that banks, which will benefit from concessional swap lines, will pass on lucrative deposit rates for clients to participate in.

“Other clients could look at India-dedicated debt funds to invest in the local currency fixed income markets,” he says. 

Emerging Market Outflows

Though India has proven most vulnerable, other emerging market currencies have also been tumbling due to the Fed’s plans to reduce the stimulus that had debased the dollar.

The South African rand, Brazilian real, Indonesia rupiah, Indian rupee and Turkish lira have been been tagged as the “fragile five” by Morgan Stanley strategists, due to their reliance on foreign capital for financing needs.

According to EPFR Global, a US-based research organisation, over $47bn (€35bn) has left funds investing in emerging markets since May, and this year’s net outflow stands at $7.5bn.

However, the dismal data has not led Standard Chartered to change its stance on emerging markets, and the bank is still underweight Indonesian and Brazilian equities. “The key difference for us is where these equity markets stand on valuations,” explains Mr Gill.

“Unlike Indian equities, Indonesian equities, for example, are still not cheap,” he says “Value is emerging, no doubt, but we believe a better entry opportunity may yet present itself.”

While weaker exchange rates typically make a country’s exports competitive, the speed of the decline for nations such as India and Indonesia threatens to increase inflation and discourage investment, according to Westpac Banking Corp.

However, Capital Economics Asia’s Mr Martin believes that though Asia has been hit harder than most in the ongoing emerging market sell-off, capital does not appear to be fleeing the region. “Foreign investors have been net sellers of Asian equities in August, but on a relatively small scale and recent outflows have been smaller than the inflows over the months before.

There is little reason to expect this trickle to turn into a flood, he feels.