jpm-india ahead of the pack-100222.pdf

Asia Pacific Equity Research 22 February 2010 India Ahead of the Pack Contents India Bharat IyerAC (91-22) 6157-3600 bharat.x.iyerjpmorgan.com J.P. Morgan India Private Limited See page 55 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Strategy Stratoscope, Bharat Iyer Budget expectations Results and Company Views ABB Ltd (Neutral), Sumit Kishore Read through from ABB group Dec-q results - ALERT Sector Research Cosmetics b) underweight the Consumption cycle; c) in Financials, we prefer the private sector to state-owned banks; d) be selective on global sectors. Sensex performance One month pre- and post-budget announcement (%) Pre budget Post budget FY02 (2) (9) FY03 7 (7) FY04 0 (6) FY05 (2) 5 FY06 9 (3) FY07 7 10 FY08 (9) (5) FY09 (3) (12) FY10 (6) 8 Source: Bloomberg 3 Asia Pacific Equity Research 19 February 2010 Bharat Iyer (91-22) 6157-3600 bharat.x.iyerjpmorgan.com Equity Market Review Global and local concerns weigh markets down MSCI India (US$) lost 8% over the month, in line with peer group. Worries with regards to sovereign risk in a few European economies and monetary tightening in India and China dampened investor sentiment. In the quarterly credit policy announced in late January, the RBI hiked the cash reserve ratio (CRR) by 75bp. The central banks tone was hawkish. WPI inflation reported for January, at 8.56%, has already breached the RBI's fiscal year end estimate of 8.5%. Market technicals are also being impacted by a bunching up of equity issuances and an increase in risk aversion FIIs have sold Indian equities aggregating US$2.2 billion over the past four weeks. Support from insurance companies (typically receive 40% of their annual flows over Jan-March) is however providing support. Table 1: MSCI Index performance (%) 1 mth 3mth 6 mth 12 mth World (6) (4) 9 45 USA (4) (1) 12 39 Japan (8) 3 (1) 22 Euro (12) (13) 2 41 Emerging Markets (8) (5) 14 79 India - US$ (8) (3) 20 107 India (7) (3) 13 92 Consumer Discretionary (3) (1) 29 141 Consumer Staples (3) (5) 10 23 Energy (9) (4) 4 61 Financials (6) (11) 9 93 Health Care (7) 4 29 88 Industrials (9) (3) 12 124 IT (6) 6 31 137 Materials (11) (1) 27 188 Telecom (10) (0) (30) 0 Utilities (10) (6) 1 51 Source: MSCI, Bloomberg. Figure 1: Macro events and Sensex 14,000 15,000 16,000 17,000 18,000 14-Aug-0914-Sep-0913-Oct-0911-Nov-0910-Dec-098-Jan-108-Feb-10 Q1FY10 and Q2FY10 GDP growth at 6.1% oya and 7.9% oya resp. IIP for December grew at a robust 16.8% Draft direct tax code released RBI hiked CRR by 75 bps Overseas borrowing norms tightened Chinese reserve requirement hiked by 50 bps Heightened concern over soverign risk in Greece Source: Bloomberg, J.P.Morgan Materials, Telecom and Utilities underperformed the broader market. while Consumer, Financials and IT services outperformed 4 Asia Pacific Equity Research 19 February 2010 Bharat Iyer (91-22) 6157-3600 bharat.x.iyerjpmorgan.com Consolidation ahead? Following the 8% correction over the past month, we expect the markets to go into consolidation mode and await the Union Budget for FY11, scheduled to be announced on February 26. We maintain that the first half of 2010 will be a volatile phase for the Equity markets as the RBI continues to normalize monetary policy to tame inflation and the Government likely withdraws fiscal stimuli to reign in the fiscal deficit over this period (for details please refer to Year Ahead 2010: A Bumpy Ride, dated January 14). J.P. Morgan Economists expect the RBI to increase the CRR by 25-50bp and the benchmark repo rate by 25bp in the April Credit Policy review. Benchmark rates will further likely be raised by 50bp by the July Credit Policy Review. A roadmap for gradually unwinding the fiscal stimulus package is also likely to be announced in the Union Budget. We however remain positive over a 12-month horizon. The positive stance is premised on 1) growth continuing to revive, 2) a stable Government at the centre with the policy freedom to pursue reforms and revive the investment cycle. It is worth highlighting that the ruling UPA coalition does not face any pressure from state level elections over 2010. Despite the recent correction, valuations remain at middling levels. In the backdrop of the challenges mentioned above, we believe that sustainable market returns into 2H would be driven more by earnings growth forecast (26% estimated for FY11E) rather than further re-rating. Figure 2: MSCI India 12-month forward P/E 6 12 18 24 Jul- 95 Jul- 96 Jul- 97 Jul- 98 Jul- 99 Jul- 00 Jul- 01 Jul- 02 Jul- 03 Jul- 04 Jul- 05 Jul- 06 Jul- 07 Jul- 08 Jul- 09 +1 Std Dev -1 Std Dev Source: MSCI, IBES, Bloomberg A key risk to our positive stance over the medium term remains liquidity constraints, particularly in the international financial markets, given the dependence on external capital. The timing and extent of monetary tightening and withdrawal of fiscal stimuli also pose risks to current earnings estimates, particularly for the financial and consumer sectors. Equity markets are expected to remain choppy over 1H 2010 Valuations are at middling levels 5 Asia Pacific Equity Research 19 February 2010 Bharat Iyer (91-22) 6157-3600 bharat.x.iyerjpmorgan.com Budget FY11 A Preview The financial markets are going into the FY11 Budget with a fair degree of caution. The equity markets have corrected 8% over the past month. Bond yields that had stabilized after the credit policy review in end January, have risen by about 40bp over the past two weeks, given concerns over the borrowing program to be announced for the next fiscal year. Growth has been reviving meaningfully over the last year. Sustaining the momentum herein remains key. But with the consolidated fiscal deficit reaching double digits and the debt burden increasing to 85% of GDP, the focus is likely to shift to fiscal consolidation. Social spending on poverty alleviation programs, health and education is unlikely to be compromised. Consequently we expect the Government to begin the process of gradually withdrawing fiscal stimuli given out over FY09 to boost revenues. The financial markets immediate focus will likely be on the Governments borrowing program for FY11E. But we believe it would also be important to pay attention to the roadmap outlined for fiscal consolidation over the medium term, including rollout of the Goods and Services Tax, the new Direct Tax Code and subsidy reforms in sectors like fertilizers and energy. Specific to the Governments borrowing program, we expect the net amount for FY11E to be largely in line with that for FY10E. But the task for the RBI will likely be more difficult in the next fiscal, as it also has to cope with surging inflation, shrinking liquidity and a pick up in credit demand from the private sector. Consequently we expect the pressure on bond yields to be likely sustained. From the growth perspective, it is also worth highlighting that the revival over the past year has been largely led by consumption. The investment cycle has lagged behind, though recent data points do hint at a revival even here, albeit off a low base. If India is to sustain high growth rates, as was achieved during FY03-08, the investment cycle will have to revive substantially. Against this backdrop we would expect the Governments policy bias to tilt in favor of the investment cycle vis a vis the consumption cycle. From a policy perspective, the decisive mandate in the National Elections last year and a relatively light political calendar through 2010 imply that the year ahead represents a solid opportunity to tackle the fiscal deficit, pursue reforms and kick- start the investment cycle. Fiscal consolidation likely to be the focus FY11 Government borrowing program likely to be more challenging for the RBI We expect the Governments policy bias to tilt in favor of the investment cycle vis a vis the consumption cycle 6 Asia Pacific Equity Research 19 February 2010 Bharat Iyer (91-22) 6157-3600 bharat.x.iyerjpmorgan.com How will the Equity Markets react? Over the last decade the equity markets have typically sold off subsequent to budget announcements on expectations pertaining to either tax cuts or reforms, particularly the latter, being belied. The cautious mood in the run-up to this budget implies that expectations remain fairly muted, particularly on fiscal sops, limiting the scope for disappointments on this front. Table 2: Sensex performance One month pre- and post-budget announcement (%) Pre budget Post budget FY02 (2) (9) FY03 7 (7) FY04 0 (6) FY05 (2) 5 FY06 9 (3) FY07 7 10 FY08 (9) (5) FY09 (3) (12) FY10 (6) 8 Source: Bloomberg From a taxation perspective, an increase in excise and service taxes, by at least 200bp, is largely expected, though this may not be fully factored into current earnings estimates yet. Any increase beyond expected levels could however evoke a negative reaction. Sectors that are vulnerable include Autos, Consumer Staples and Cement. The Governments borrowing program will be under scrutiny too. The financial markets currently expect the borrowing program for FY11 to remain at more or less the same levels as in FY10. A substantial deviation on the upside or lack of confidence in growth and revenue estimates could cause bond yields to spike up further and put pressure on financials. We do not expect the budget to lead to any broad based upside to current earnings growth estimates. Potential downside however exists depending on the pace of withdrawal of fiscal stimuli. It is worth highlighting that while the withdrawal of fiscal stimuli may affect earnings trends over the near term adversely, a well structured fiscal consolidation roadmap should augur well for valuations over the medium to long term. From a sector perspective, we believe the budget should on the margin be positive for the investment cycle and negative for the consumption cycle. Our model portfolio composition reflects this expectation (for details please refer to the section on Model Portfolio, Page 25). In the following pages, we present the expectations of our Economists and Sector Analysts, for the FY11 Budget. Table 3: Union Budget expectations and sectoal impact Positive Negative Energy, Capital Goods and Infrastructure Automobile , Consumer Staples, Cement Source: J.P. Morgan. Historical performance indicates relatively weak performance post budget announcements We prefer beneficiaries of pick- up in the investment cycle vs. the consumption cycle in our model portfolio 7 Asia Pacific Equity Research 19 February 2010 Bharat Iyer (91-22) 6157-3600 bharat.x.iyerjpmorgan.com India: Pre-Budget 2010-11 Jahangir Aziz, (91-22) 6157-3385, jahangir.x.azizjpmorgan.com Gunjan Gulati, (91-22) 6157-3386, gunjan.x.gulatijpmorgan.com J.P. Morgan India Private Limited The big picture The February 26 budget will take place against the background of a global economy that is no longer flat, as it was last year, but intricately contoured. While a synchronized global recovery is underway, recent data has rudely reminded us that material economic and policy risks are palpable. With job creation in the US stumbling, the UK and German economies stagnating last quarter, and the contagion in sovereign stress in the Southern European economies spreading, global risk reduction is back. One is still confident that globally policy will remain highly accommodative and limit the contagion of market stresses emanating from Greece, but beyond this year there is little clarity that policy will be normalized smoothly. Last year, with the possibility of a drawn out global recession high, the budget provided measured stimulus, adding to that already in the pipeline from the fiscal support provided in earlier in the year. Growth in India held up well and almost all demand indicators have turned hot now. Despite the deficient monsoon, FY10 GDP growth will likely top 7%. December IP dazzled at 16.8% oya (2.8%, m/m, sa), January PMIs new orders index rose to its highest level since August 2008, and December non-oil imports surged. However, Indias main growth driver investmenthas remained dormant. With easy financing, investment will likely rebound in FY11 once there is a bit more conviction in the recovery. If this happens, FY11 GDP growth could be close to 8%. This will inevitably narrow the output gap, stretch capacity, and raise core inflation. So appropriately the RBI has begun to move quickly to a neutral policy stance, such that it has the option to ease if the global recovery falters later or tighten if domestic inflation picks up. The government will likely follow the RBI and begin withdrawing stimulus. For the last two years, the fiscal deficit has surged to double digits (including central and state) and the debt burden has risen to over 85% of GDP. But with growth likely to strengthen, the government will begin consolidating this year. Closer home in India, the problems in Europe and the end of easy money by the RBI have plummeted financial markets. But the RBI was right in starting to normalize monetary conditions. The numbers: FY10 deficit at 6.8% of GDP, FY11 target around 5.7% The July FY10 budget targeted a deficit of 6.8% of GDP. Despite the economy turning around more sharply than anticipated at the time of the budget, the overall deficit is likely to come out around the budget target. Higher than budgeted corporate and income taxes and disinvestment proceeds are likely to offset lower indirect taxes. The fate of the 3G licenses auction, targeted at Rs350 billion, still hangs in the air. In our projection for FY10 deficit we do not include the auction proceeds; instead it is carried over to FY11. But the government is unlikely to borrow more than what it has already done (Rs3.6 trillion). To fill the gap it is likely to run down its cash surplus and push some of the subsidies to fertilizer companies to next year. 8 Asia Pacific Equity Research 19 February 2010 Bharat Iyer (91-22) 6157-3600 bharat.x.iyerjpmorgan.com For FY11 we expect the government to gently withdraw stimulus targeting a deficit of 5.7% of GDP. Much of this reduction is unlikely to be a genuine withdrawal of stimulus. Rather the cyclical upturn in the economy and the absence of any wage arrears payments (the arrears from the 2008 wage hike were paid in two installments: 40% in FY09 and 60% in FY10) should lower the deficit by 0.75% of GDP. As can be seen in the chart below, the large stimulus came during FY08 and FY09 when subsidies to oil and fertilizer companies ballooned, government employee wages rose, and the government