Marcel Porcheron, our Emerging Market analyst, recently attended this year’s Euromoney Indian Investment Conference in London for an update on one of the World’s key emerging markets. He heard from representatives of government, corporate India and the investment and banking industries.
View from the ground- Inflation starts to bite
A 35%fall in India’s equity market from its peak in January this year demonstrates that the emphasis amongst investors in India has shifted within the last twelve months from the prospects for growth to the risks of stagflation. Similarly the focus of the conference was on the challenges faced by India’s economy in the shorter term.
From a macro economic point of view, India’s policy makers will have to exercise considerable skill to navigate higher inflation and manage the country’s budget which is in deficit. Energy and fertiliser subsidies place a considerable strain on government finances as the oil price has rocketed above $140 per barrel. India’s government has been forced into passing on cost increases to the general population which will have a negative impact on consumers. The IMF recently calculated that the cost of increases in fuel price subsidies between 2006 and 2008 was over 1% of GDP. Consumer price inflation has risen to almost 8%, although many forecasters are expecting it to fall back in the next twelve months as oil prices stabilises and the supply of food improves. However, the bottom line is that Indian consumers are likely to have to spend more of their income on food and energy and for developing nations these are bigger components of spending than in the West.
Economic and Market Update
As for many other emerging economies, the direction of India’s equity market is influenced to a great extent by foreign investment. Foreign fund flows into Indian equities have turned negative in 2008 causing the market to fall as that source of demand dried up.
Overall, Indian economic growth is likely to remain very high by global standards, above 6% in 2009 and the long term outlook for India remains good. However, some short term challenges have appeared on the horizon, which make the delivery of high growth less certain in the short term. As a result the equity risk premium has risen. Kotak, the Indian financial services company, estimates that the equity risk premium has risen from just 3.5% to about 5% since January this year, leading to a 34% decline in Bombay’s Sensex Index over the last 6months (in local currency). In layman’s terms, prices have fallen because investors believe they are taking on a perceived increase in risk.
The nervousness of international investors in India is supported by the more opaque operating environment that has emerged. This means that the profits outlook for many Indian companies is less certain than it was a year ago. This change results from the global credit crisis, which is having an impact in India and from higher inflation which has the potential to impact Indian consumers and the government’s own pocket.
The Impact of the Credit Crunch
Despite widespread belief that India’s growth can be self sustainable even in a global slowdown, the country is not escaping from the impact of the credit crunch. Improvements to its physical infrastructure are vital if India is to sustain its high rate of growth in future and $500bn of spending is planned over the next 5yrs, with $211bn of that in the power sector. However, massive planned spending has to be paid for by someone, and with the government in deficit, private capital will be a vital source of funding for these projects. Bank funding is generally not accessible for these projects because of the size of funding requirements and so private equity, global investors and the Indian capital markets are likely to be a major source of funds.
The feedback from infrastructure companies at the conference was fairly cautious overall. Local infrastructure companies such as GVK reported that they were still able to secure funding for the highest quality projects, but the consensus was that both the availability of funding had diminished and the cost of capital had increased. That means that it will be harder to secure financing for projects, whilst the increased cost of borrowing will render projects with a low potential return uneconomic. Experts like Vikram Limaye, of IDFC, an organisation involved with financing infrastructure projects, agreed that funding will be difficult for all but the best infrastructure projects, although he believes that there is still plenty of interest from global investors.
Conclusion
The big risk for India now is whether or not it can deliver on its huge growth potential. The short term risks associated with India have certainly increased and emerging market investors are more cautious on the country’s outlook. India also has elections sometime between November this year and April 2009, which helps to increase uncertainty in highly democratic but typically fractured political system. The government has made a number of poor decisions for example by suspending futures trading in some commodities. There is also a risk that the Reserve Bank of India will misjudge monetary policy in these current difficult conditions. However, the Indian market’s valuation has fallen to only 16x 2008 earnings, although arguably earnings estimates for the future may still be too high.
What should you do?
For long term investors the current valuation of the Indian equity market may be attractive and fund managers who focus on identifying good companies on attractive valuations are starting to find a number of opportunities. In some industries, such as outsourcing, India is globally competitive on price and so some companies could actually be beneficiaries from the downturn as Western organisations outsource further functions to India in order to reduce costs. However, the macro economic and political outlook for India is uncertain in the short term, so investors should be prepared for the potential for further volatility in the short term.
For investors seeking direct exposure to India, we recommend investing through the First State Indian Subcontinent fund. The fund’s manager Vijay Tohani focuses on stock specific opportunities and his cautious approach and focus on quality companies should help to protect the downside in this less certain environment. Tohani told me: “we are beginning to see pockets of value emerging in some sectors and are adding selectively. A good example is Mahindra and Mahindra. The core business is autos and tractors but is also has a number of valuable business franchises via associates or subsidiaries. The stock currently trades at single digit earnings multiples, and while I accept the near term outlook is challenging, this would appear to be a good opportunity to accumulate a stock with a good quality management and sound business franchises and a fairly robust long term opportunities.”
However, most investors are better off in a global emerging market fund, where the fund manager can allocate between global markets and exploit opportunities as they arise. We currently favour the Aberdeen Emerging Markets Fund run by Aberdeen’s Emerging Markets Team, which is headed by Devan Kaloo. The fund currently has 11% invested in Indian equities.