FIIs to soon resume equity shopping

The interest of Foreign Institutional Investors (FIIs) has been one of the most critical factors driving the Indian markets. In fact, FIIs were solely responsible for the dizzying heights that the markets attained during the bull-run spanning from 2003 to the early part of 2008. Their participation can make or break the fortunes of the market. Worries of an FII pull-out have always spooked the market, while expectations of their participation have never failed to lend a positive bias.

After receiving record funds from FIIs in CY10, the first half of CY11 has turned out to be relatively low key. In CY10, the total FII inflows were around USD 30 billion. This was almost 30% of the cumulative flows since 1992. In comparison, the total inflow till June 2011 has been just USD 740 million, a fall of almost 70% from the same period last year. It has long been established that Indian equity markets are slave to FIIs inflow, and dance to their tune. An empirical study of funds flow and equity market performance also points towards the same thing. There has been a strong correlation between FII flows and the performance of the equity bellwether index, Sensex (see graph), CY10 being a notable aberration. The reason for such an exception was that, most of the flows went into new issues like Coal India, non-index companies and qualified institutional placements.

Nevertheless, the situation has been improving in the last few weeks, and India is on the FII radar once again. Until the time of going to press, the total net FII inflow was USD 2437.6 million. Has something changed in the last few weeks, leading to a reversal of the trend, or is it just an aberration? Can anything concrete be concluded from this? Before we answer this, let’s first understand the reasons why FIIs were shying away from the Indian equity market, and how those factors will play out in the second half of the year to impact FIIs inflows.

In truth, it is hard to point to any one factor that has led to such a lacklustre performance of the FIIs. We believe that a combination of a host of factors has led to such a slowdown. Tarun Anand, MD and Senior Officer, South Asia, Thomson Reuters, says, “Uncertainty in the US and European markets have contributed to FIIs preferring to sit on cash. With concerns of US credit rating downgrades, and volatility in international markets, FIIs are cautious in their own markets, and are hence not making aggressive investments in emerging markets at this stage”. However, it is not only international disorders that are containing the inflows; domestic factors are equally responsible for keeping FIIs at bay. According to David Gordon, Head of Research, Director, Global Macro Analysis, Eurasia Group, “Rising inflation and the move by the RBI to increase the interest rates to check inflation, combined with a slowing down of governmental reform programmes, has had a serious impact on FII inflow”. Therefore, it is evident that a combination of international factors as well as domestic factors is responsible for reducing FIIs.[PAGE BREAK]
Inflation

Let us first start with examining the domestic factors. If one has to identify the single-most important domestic factor that has made the Indian markets unattractive to FIIs, it has to be the rise in inflation. The three main factors that spooked inflation were Food, Fuel and Commodities. Initially, it was the supply-side reaction due to deficient monsoon in 2009 in most parts of the country, which lead to lower agricultural production and higher prices. But soon, the trend moved beyond food prices. As the economy picked up due to fiscal and monetary stimulants, the demand too started gathering up, leading to demand-side pressures. However, now the situation is improving on all three fronts. Food inflation for the week ended July 09 has come down to 7.58%, compared to 8.31% in the previous week (July 2), the lowest in last 27 months. In addition to a fall in prices of some food items, a higher base will also come into play. This was as much as 19.52% in the corresponding week of July 2010, suggesting a high base. This will further cool down with a normal monsoon this season and a record foodgrain production of 241 million tonnes (MT) in 2010-11, due to a record yield of wheat, maize and pulses.

Crude prices was the next big item fuelling inflation, surging by almost 50% in the last nine months due to geopolitical risk. Nevertheless, the situation has improved in the last few weeks, and the price of crude oil has stabilised by now. The contagion of the “Jasmine revolution” has now stalled, and further addition of risk premium on crude price due to geopolitical risks looks negligible.

Another factor that spurred inflation is commodity prices, which have also surged dramatically in the last couple of years. The S&P GSCI, a benchmark for investment in the commodity markets and a measure of commodity performance (comprising 24 commodities from all sectors), has been more than doubled from where it stood in February 2009. One of the prime reasons for this increase was the monetisation of the commodity market. What really spooked the price of commodities was a huge flood of dollars after QE1 and QE2, which chased the risk assets.  We believe that commodity prices will cool down following the end of QE2 on June 30, 2011, and no announcement of any further quantitative easing by the US. This will help to keep the prices somewhat under check. Therefore, we hold that the three major factors of food, fuel and commodity inflation are not as major a concern as they were at the start of the year. This puts to rest one major worry for the FIIs – that of rising inflationary pressures. The developments will, in all probability, help in changing the minds of FIIs.[PAGE BREAK]

Interest Rates

For an economy to grow at its true potential, it is imperative that the inflation rate should remain benign. For the Indian economy, the RBI’s comfort level for inflation is between 5-5.5%. Regardless of this, the headline inflation measured by the wholesale price index has stayed above eight% consistently, from January 2010 onwards. To bring the monster of inflation under control, the RBI has increased key policy rates eleven times since March 2010. This has already started impacting the GDP growth rate of the country. While the economy witnessed decent growth momentum in the first three quarters of fiscal 2010-11, posting a growth rate of 9.4%, the fourth and last quarter (January to March 31, 2011) recorded a lower growth rate of 7.8%. This further lowered the attractiveness of the Indian equity market. According to Gordon, “Rising interest rates do not draw major foreign funds”. But, when will the RBI apply brakes to the rising interest rates? As we write this story, the RBI has already hiked key rates by another 50 basis points. This is exactly what Jyotivardhan Jaipuria, Managing Director, Head of Research, DSP Merrill Lynch had predicted when he said, “We think that there will be another rate hike at the end of the month, and we expect one more rate hike before the end of the year. The consensus is between 25-50 bps. Beyond that, there is a consensus that there will be a pause”. The latest rate hike is an indication of the final assault by the RBI on the problem of inflation. There is general agreement that we could probably be looking at the peaking out of interest rates. In that case, the stage is set for FIIs to come back to India in a big way.

Governance Issues and Inaction on Policy and Reforms

Governance issues are among the biggest worries that have plagued the outlook of FIIs on the Indian front, with a host of scams hitting us, coupled with clear inaction from an incapable government on the reforms and policy development front. “I do think that, in policy, the lack of structural reforms is hurting FII inflows more than any action taken by monetary action”, says Gordon. In addition to policy inaction, India is in a negative climate due to a string of scams like the 2G, CWG and others. This has had repercussions on the business environment and sentiment, creating substantial uncertainty on the policy front. According to some media reports, there are 80 draft proposals pending in the parliament which need to be cleared. The general feeling is that progress in India is not because of the government, but in spite of the government. Nevertheless, even as we complete this story, things seem to be changing for the better.  Over the past fortnight, the government has made announcements on the policy front. Bihar’s Deputy Chief Minister, Sushil Kumar Modi, has been appointed as the new head of the empowered group of finance ministry, which is looking to usher in the biggest tax reforms in the country, the Goods and Service Tax (GST). This is  a much-awaited development, which was deferred for several months. The second update was the recommendation by the committee of secretaries for 51% FDI in the retail sector. The Cabinet Committee on Economic Affairs (CCEA) has cleared the USD 7.2 billion[PAGE BREAK]
deal that BP Plc struck with Reliance Industries Ltd. (RIL) in February, under which Europe’s second-largest energy giant will acquire a 30% participating interest in the 21 oil blocks that Mukesh Ambani’s flagship operates in India. All these decisions show that the government has started to act in the right direction to attract foreign flows, which might increase going forward. This will help to improve the investment climate in country. We feel that, this is one of the major factors that will make the Indian market attractive once again from the viewpoint of FIIs.

Valuation

The problems discussed above have already started reflecting in the performance of the Indian equity market and in the financials of India Inc. If we take into account the performance of the MSCI Index of all emerging markets, India stands at a considerably low rung. The country’s Year-to-Date return is at negative 9.89%, compared to just negative 2.46% of the MSCI BRIC index in the same time period. The reason for such a dismal performance is the continuous earnings downgrade of India Inc. For example, when the Bank of America Merrill Lynch first projected FY12 earnings at the end of May 2010, their projection of an EPS for Sensex-based companies was Rs 1282, which was as high as Rs 1300 at the end of December 2010. Their latest projection at the end of June 2011 is Rs 1225, which is down by six% from the December projection. Going forward, there will be some downgrad-ing for the current earning seasons too. This view is echoed by Jaipuria when he says, “My view is that, by the time we end the earning seasons we may find some more drop in the earnings, which is three% according to the consensus.”  What is important to note here is that for FIIs, the emerging markets are an asset, like commodities, and their fund allocation depends upon the attractiveness of the Indian equity market against other emerging markets. Although the Indian market has underperformed various emerging markets since the start of the year, it is still trading at a premium to other emerging markets. What has changed in the last six months is the narrowing of the premium that the Indian market was enjoying. In terms of the price to earnings ratio multiples, it has fallen from 31% last September to around 18% currently. One of the reasons Indian companies enjoyed higher earnings multiples was due to the higher return on equities (ROE) earned by them. However, if we look at the MSCI India Index (see chart) for year-end ROEs for the past three years, we can see that they have been declining, and are currently at a five% premium to other emerging markets. But, according to Jaipuria, “all this has been discounted in the price”. Now that the situation is improving on various fronts for India and valuation has also come down to a long-term average, the Indian equity market will once again start attracting FII inflows.[PAGE BREAK]
Alternatives to India?

Although there have been talks about other emerging markets, particularly Indonesia, turning out to be more attractive than India, this is not practically the truth. One of the major factors that goes in favour of India is the Indian economy’s capability of offering a whole range of business sectors for investment. We asked Ambareesh Baliga, COO, WAY2WEALTH, about how the Indian market is different from other emerging markets. According to him, “The Indian markets are core consumption-liquidity driven, as compared to other EMs, which are manufacturing-led economies. Hence, the base models of economies are structurally different”. He further added, “Other emerging economies are also dependent on exports to a large extent, which makes them susceptible to changes in the international environment, with a far greater impact of any adverse developments as compared to India.” With the second-largest population in the world, India offers a huge opportunity for businesses to tap. All this puts the economy in a more favoured situation than that of its emerging market peers.

While all this indicates a sureshot return of FIIs to the Indian market, it must be remembered that these factors are just about beginning to turn positive for that kind of a move. The improvement in the situation is clearly reflected in the recent (July 2011) Fund Manager’s survey by Bank of America Merrill Lynch. Though they remain underweight on India (-17%), the situation has improved from last month’s (June) survey, where they were underweight by a little more than 20%. The next quarter is certainly something that needs to be watched closely, and the real expectations should unfold only after that. For now, look out for sectors and companies within those sectors which could ride the wave of FII favouritism going forward. Says Tarun Anand, “FIIs are hunting for value deals across all sectors, and the midcap market is also very attractive”. When asked to Baliga which are the sectors that are looking attractive he said “Consumption or related sectors like FMCG, consumer durables, pharma, agriculture (food processing, fertilisers, seeds, irrigation etc.), infrastructure, telecom, gas, auto ancillary etc. would enjoy higher FII inflows going forward.”