India - Rajan surprises markets, again.

01 October 2015

Raghuram Rajan certainly enjoys to keep markets guessing! It seems after many, many years where most central banks followed the US model of keeping markets fully informed of their thinking, certain central bankers are now carving reputations by regularly surprising markets - and Reserve Bank of India (RBI) Governor, Rajan, leads this pack.

Anyone listening to him talking last week would have come away with the view that it wasn’t even certain he'd cut rates at all on Tuesday. Whilst consensus was firmly in the 25 bps cut range, there were some who doubted a cut at all and even fewer who predicted the eventual 50 bps cut he delivered. Whilst we applaud the decision as the correct one, we struggle with the need to keep markets on their toes and continually guessing. Investing money is never an easy decision, but it helps greatly if we at least have a little more certainty in the thinking of a country's central bank.

Turning to the decision itself, we have been saying for some time that we were worried that the RBI was on the verge of a policy mistake by keeping rates where they were. Whilst there were many factors behind the need to keep policy tight, some which we have sympathy with, the fact was that with no inflationary pressure and indeed rampant deflation in WPI (wholesale price index), real rates were too high (Chart 1). With domestic growth only slowly recovering, and the international outlook clouded by China and the uncertainty about US rates, this cut takes India’s repo rate down to 6.75%, a four year low.

Chart 1 – Indian policy rates versus CPI & WPI (%)

^{Source: Bloomberg, date 29/10/15}

It was interesting that in the statement following the cut, it appears that Rajan has certainly become more dovish. The RBI is seemingly adopting a clear data-driven framework for future monetary policy – and if inflation remains benign we can expect more cuts to come. Our base case had been to expect 50 bps of interest rate cuts by March 2016. Now that the cuts have been front-loaded, if inflation remains controlled then we might see further cuts sometime early next year.

Rajan also remains concerned about global growth, and hence the outlook for Indian exports and imported inflation. Therefore, the cut can be seen as a boost to the slow domestic recovery we are currently witnessing. Focus is now turning very much to growth and capacity formation, which a falling cost of capital will help. The key therefore lies in banks passing on the series of cuts we have seen. With India’s largest bank today announcing they would cut their base rate by 40 bps, we remain hopeful that banks will indeed transmit the bulk of the cumulative 125 bps of cuts we have recently seen.

We retain a very high conviction positive bias on India here, but there is no doubt that India has suffered from the significant withdrawals seen in EM and BRIC-type funds. According to data today issued by The Institute of International Finance, global investors have sold US$40 billion worth of EM assets in Q3 2015 (nearly equal amounts of equity and debt). This is the worst quarter since Q4 2008.

Whilst there were many factors behind the need to keep policy tight, some which we have sympathy with, the fact was that with no inflationary pressure and indeed rampant deflation in WPI (wholesale price index), real rates were too high.

Despite this, Indian mid-cap stocks and indices are still outperforming large caps. This suggests to us that we have seen very little India-focused redemption pressure. Most of the selling has been seen in large cap names where generalist EM funds tend to be concentrated. This point can be illustrated by looking at Hindustan Unilever, one of the largest consumer staples names in India. This company is the seventh largest weighted stock in MSCI India, and it would be expected that the name should have outperformed in the recent market volatility. However, relative performance has been very disappointing, particularly its performance following the August sell-off (Chart 2).

Chart 2 – Hindustan Unilever / MSCI India

^{Source: Bloomberg, as at 30/09/15}

The externally generated sell-off that we have seen in India has started to push valuations down to interesting levels. Whilst India retains its large valuation premium to other emerging markets, when looking at valuations compared to its own history we believe markets are giving India very little credit in terms of the underlying fundamentals of both companies and the economy.

Chart 3 – Nifty Index estimated P/E ratio (Blended 12 months)

^{Source: Bloomberg, as at 24/09/15}

Valuations are not reflecting India’s growth potential in a growth starved world. Bloomberg is currently showing the Nifty’s blended 12 month forward P/E at 14.83 (as at 24 September). On the same measure, the US is trading at 15.18. It can be argued that the US deserves a premium for various reasons, but when considering the relative attraction of the two on the outlook for earnings, profits, ROE trajectory and growth, India really should be trading at a significant premium to the US and global markets. Add into this a more dovish RBI and the outlook improves further.