Investment Adviser:

Reliance Wealth Management Ltd.

(December 2014)

Since the election of Narendra Modi in May Indian stock markets have been rising and some indexes have hit record highs. Have you been surprised at how enthusiastic investors’ response has been to his election?

The recent rally in Indian markets in our opinion is just a good start, as we all know that equity, like other asset classes, goes through cycles. During the last six years Indian stock markets have virtually remained flat giving almost zero returns. The Sensex reached a high of around 21000 in January 2008 and was hovering around 28,000 at the end of October 2014.

Just to put the current rally in context, one way to look at it is that the Sensex is up about 31% (6,700 points) YTD (as of the end of October). However, the other way to look at it is that in the last six years from January 2008 the Sensex is up only 32% (6,800 points).

Investment sentiment in Indian markets dampened in the last 3-4 years, primarily because of indecision by the previous government on issues like taxation, foreign investment, land clearances, etc. Recent election results have been a confirmation of an existing anti-incumbency mood prior to elections. More importantly, the government came to power with a rousing majority (unlike the coalition governments we have had in the past).

The results were easily one of the most positive pieces of news for the sagging economy. The investor community has always been optimistic on Mr. Modi (given his track record as head of Gujarat state). Given this background, we are not entirely surprised about the investor response to the election results.

Is the relatively strong performance of the main Indian markets this year solely down to the election results or have there been other factors behind the gains?

One can’t deny the fact that positive sentiment has played a part in recent stock gains. However, factors such as the current account deficit (CAD) narrowing sharply, fiscal deficit (FD) slowly but surely moderating, inflation steadily coming down with visible moderation in key constituents (i.e. food and fuel) should also not be ignored. We therefore would not say that elections have been the sole reason for Indian markets’ outperformance this year.

As mentioned earlier, the strong performance has come on the back of a long period of consolidation.

Stocks that seem to have benefitted most from the market rally that has been seen over the last four or five months have been in sectors which benefit most from longer-term economic growth e.g. the auto sector, engineering companies. Is this a sign that investors think the economy is going to be improving for years and years and is this going to translate into stock market growth for years and years?

YTD we have seen stocks in auto-ancillary, engineering and infrastructure move up sharply. However, in the last couple of months, many of the non-performing companies in these areas have seen a stock price correction. Primarily because many of the companies have yet to post good results (profitable growth). Investors are bullish on the economy, however, it may take slightly more time that had previously been expected. On the contrary, IT, pharma and consumer discretionary names have continued to outperform the markets.

One other point that should be made is that, in bull-runs returns are generally multifold even after the initial spike (which we have seen – Sensex up 31% YTD). During the last bull-run which started in 2003-2004, the Sensex rose from 3000 to 5000 in just one year giving 66% returns, but it also gained almost four-fold to around 21000 in the following three years between 2004-2007. Moreover, stocks from some sectors such as engineering, infrastructure and real estate posted multifold gains. We therefore feel now is a very good time to invest in equities, as the next 4-5 years may be extremely good for corporate India. Further, domestic, FIIs and retail investors are still underinvested in equity as an asset class and would look to invest if there were any corrections.

Foreign investors have played a significant part in the market rally with FIIs putting a fair bit of money into local markets. Has demand among domestic investors been similarly healthy?

Domestic investors have been seeing redemptions and as a result have been net sellers in the past six months.

Economists are now predicting that India’s rapidly-growing middle class will account for almost a quarter of the entire global middle class spending within 15 years. How is that growth in middle class being translated to stock market growth and greater investment opportunity? Are there any sectors specifically already benefitting, or which will benefit in the next few years, from it?

The IT sector is one of the key beneficiaries of the rapidly growing middle class in India. The nation has already seen the top IT companies’ employee count growing multi fold over the last decade. Further, we feel labour-intensive manufacturing sectors like textile, engineering and infrastructure will stand to benefit in the longer run. On the stock market front, IT and manufacturing names should stand to benefit on a longer term basis. The growing middle class population will provide productive employees at reasonable cost, thus leading to profitable growth in the longer term.

Turning back to the broader economy, Modi’s election is expected to usher in a lot of economic reforms. While it is still early days, what are the signs that those reforms are going to be implemented?

As mentioned earlier the new government, which has a majority mandate, has definitely woken the positive spirits of the nation. Mr. Modi is expected to successfully implement the Gujarat state (where he was the state’s chief minister for more than 10 years) development model at national level, so hopes are definitely very high. However, a practical view has to be taken on this as the immediate implementation of many of developmental decisions will be difficult at national level (given India’s large geographical and population size). Thus expectations of a ‘quick fix’ may be met with disappointment. However, I feel investors will not be disappointed at the overall implementation of important economic and market reforms over the longer term.

What are the key reforms that Modi has pledged which the markets see as a priority and how soon are they likely to get implemented?

In our opinion, reforms are needed to improve coal production, make the process of land acquisition easier, implement the Goods and Services Tax (GST), reduce subsidies on oil, improve availability of power, boost the textile sector and address supply side issue to reduce inflation. These would structurally improve the efficiency of the economy.

These reforms will help India to become more export oriented, substitute critical imports with domestic production, bring about a capex cycle revival, boost employment and reduce inflation. More importantly, they can structurally bring down the CAD deficit. The government aims to implement the GST by April 1 2016 and reforms for the coal sector have already been initiated. Further, the “Made in India” initiative will be a long term positive for domestic manufacturing companies.

Modi is also making significant efforts to attract more foreign investment into the country and has recently made a number of high-profile foreign trips promoting India as an investment destination. To what extent will this positively affect Indian stocks, both in the short and long term?

Right from the start Mr. Modi has continued to orate powerfully and charmingly. His visit to the US and Japan have calmed the nerves of many foreign investors. Some Indian start ups have already started witnessing fund flows from Japan. I expect foreign funding to encourage new generation entrepreneurs for new economy business and companies like Snap Deal, Flipkart, Just Dial and Make My Trip will benefit from these fund flows.

His election has coincided with what appears to be a new recognition, globally, of the true potential of India’s economy. Many economists are even saying that in the not too distant future India, rather than China, will be Asia’s key economy and partner for the West’s biggest powers e.g. the US. Do you agree with this?

India has always been a nation with great potential. India being one of the biggest democracies in the world is a huge positive compared to China. Further, India has a distinct advantage because of its English speaking population (thanks to the huge English educational system spread across India). IT and Pharma can both be said to be industries in which a lot of trust is need (IT being involved with security concerns and Pharma because of healthcare questions). In both cases, India has won the trust of US and Europe. Compared to China, which has been a leader in manufacturing, it should be added that Indian manufacturing companies are already proving to be a worthy alternative for clients. In the past 2-3 years, many chemical companies in India have witnessed a huge growth in volume because many of US and European clients want to de-risk themselves from China as a main supplier.

Where do you see India having a competitive edge over China when it comes to attracting investors? Why do you think investors should be looking at India instead of China?

At a macro level, it seems that India is in a very sweet spot. Global commodity prices have corrected sharply in the recent past and crude oil and gold account for the largest portion of India’s import bill. Gold is trading at multi year lows and crude oil has corrected by 20%, thus the current account deficit is expected to fall below 2% of GDP by the end of FY15 (it was 4.7% at the end of FY13). Furthermore, the new government’s decisions have given confidence that a lower fiscal deficit is a priority and it should continue to fall. The fiscal deficit was 5% in FY13, but is expected to be 4% by the end of FY15.

A lower CAD and fiscal deficit coupled with a stable INR, diesel prices near market prices and moderating inflation should result in lower interest rates in India in the near to medium term. This will help initiate the much-awaited investment cycle, eventually benefiting India in the medium term. Furthermore, global credit rating agency Moody's Investors Service has said that the government and central bank’s recent economic, fiscal and financial measures will, if successfully implemented, sustain higher GDP growth and address some of the constraints on India's sovereign credit profile. China has seen an increase in interest rates and appreciation in its currency and a strict environmental drive has forced many manufacturers to shut down capacities. These factors, along with the Indian currency depreciating and expectation of lower interest rates, should make India a more favourable investment destination than China.


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