Hi,
Thank God that 2011 is getting over!
It was a painful year for both investors and businesses. Policy uncertainty, higher cost of money, sticky inflation and global risk aversion created a toxic mix for risk takers. Equity investors struggled through the year with unprecedented volatility. Businesses were struggling with all the pain of directionless government, rising input, personnel and capital costs. No asset class managed to beat inflation, though fixed income came very close to protecting the purchasing power of your savings. 2012 holds better promises, particularly for fixed income. Most probably, it will beat inflation hands down and earn you real returns over next 1-2 years. However, investors have to evaluate the fixed income assets space a bit more rigorously.
Before you get lost in translation, here are the key economy forecasts for 2012:
- 1. Indian economy will grow at near 6.5% in calendar year 2012.
- 2. Inflation (both WPI and CPI) would average at 5.50%-6.5% in this year.
- 3. Effective monetary easing of 100 bps will materialise in this year, starting with April Policy. RBI will cut CRR by more than 2% during the year, bringing liquidity to near neutral in second quarter of the year.
Why would economy slow so much? For that, lets understand the actors which drove growth in our economy after the 2008 crisis. Massive fiscal and monetary stimulus were given to our economy as world was facing the financial crisis of 2008. Government spending shot up, taking our fiscal deficit to near 10% from 2.5%. Most of the incremental spending by the government went to the wallet of a common man, whose propensity to consume is very high. Sixth pay commission, farm waiver, NREGA and various such schemes unleashed the consumption boom. Your uncles and aunts splurged. Life looked easy. Pundits concluded that India had decoupled from the rest of the world.
Alongside, there came a huge asset price boom. Everyone in this country had a story to tell about how his friends and relatives became millionaires by buying some parcels of land. An already ‘earning more’ Indian got a booster dose of wealth effect. He was suddenly, richer too. And property price rise wasn’t the only reason for it. A typical Indian is over owned in two asset classes, gold and real estate. At one end, government spending and loose monetary policies did magic to real estate prices and on the other, gold prices rallied for non-Indian reasons (Largely, driven by the chase for an alternate currency, as confidence in global currencies sank). Gold which is typically bought as an insurance by an average Indian, began to appear as investible surplus. Gold loan companies flourished as people began to leverage their gold holdings. So both gold and real estate price boom added fuel to the consumption boom.
But the times are different now. Both wealth effect and income effects, which drove consumption growth are fading. Property prices have stopped rising in most of the country for past 6 months. Gold prices too have come off (optically, they still look high due to currency depreciation) and are likely to come down secularly through 2012.
There are potentially three levers which can pull out the economy from cyclical slowdown i.e. government spending, exports (for that rest of the world should do well) and lower rates. Unfortunately, government spending, which is most potent of all doesn’t exist given that our government is already running very high fiscal deficit. Markets are punishing governments who borrow recklessly, and that’s why our Government bonds in India are trading at such high levels (near 8.30% right now) despite a significant risk of slowdown.
We struggle to forecast any optimistic growth scenario for most of the developed world and China, thus export is unlikely to prove as a major stimulant for domestic economic growth. The only good thing, in generally abused INR depreciation of last 3 months is that it will yield competitive advantage to our exporters and that will help reduce our current account deficit next year. We think current account deficit in 2012 will be less than1.5% vs near 3% at the moment. Rate cuts appear to be the only stimulus that will come over next few months produced by our central bank. Thankfully, RBI has a lot of room to cut rates…
But many argue that until inflation comes off significantly, its difficult for RBI to cut rates. We agree. But we find it difficult that inflation’s legs won’t break over next few months. Fundamentally, there are three key drivers of inflation, domestic demand, international commodity prices and domestic supply side. The most important driver, empirically, has been domestic demand which explains more than 60% of inflation moves in our country, is going to turn disinflationary. A growth of 6.5% in 2012, is 100-150 bps lower than our potential and this itself should break the legs of inflation. World growth for 2012 will be at least 100 bps lower than last decade’s average and that itself should be benign for international commodity prices. Even China, which has been the key driver of commodity demand is likely to slow down quite rapidly. China commodity consumption is likely to peak in this decade and more importantly, its likely to climb down secularly over next many years. We are still not sure of commodity prices coming down secularly, but we assign a good probability that 2011 saw peak commodity prices for next few years. The third driver of inflation, Indian production/supply side has been the most frustrating reason of inflation for all of us, as its reason lied in our poor planning and policy inertia. Unfortunately, there is no great news on this front, as India remains supply constrained economy. The only silver lining is that capacity utilisation has come down by at least 7-8% over last 4-5 quarters in aggregate terms and that should bring down the pressure on inflation. Net, net all three drivers of inflation are likely to be either absent or less potent. So I believe, inflation would oscillate between 5.5-6.5 during 2012.
With low growth and low inflation, what does RBI do? It will cut rates and ease liquidity conditions. How will Gsec/Corp bonds behave? We predict:
- 1. Corporate spreads for Good quality AAA bonds will narrow by 20-30 bps, falling to near 50 bps from current 80 bps.
- 2. 10 year Gsec will average at 8% through the year, but its likely to see some very low levels during the year (This one is the most difficult to predict, but may be closer to 7.5% during Q2/Q3 of the year, unfortunately it will not be permanent adobe for it given the state of our profligate government )
- 3. 1 year CD rates, which are currently trading at near 9.9% should get priced 100-125 bps lower over Q2/Q3 of 2012. Two or three year bonds too should get priced lower by 50-75 bps. Curve should bull steepen through 2012.
So what should you do? For those details get in touch with us over a personal meeting, phone call or email us. You can get in touch with us on 022-40156688/99 or dewang@denip.in / nimesh@denip.in.
Thanks,
Dewang K Mehta
DENIP Consultants Pvt. Ltd.
