>2012: Key trends & Investment Strategy

■ Market may move in a broader trading range
Unlike 2011, where market was bound in the most narrow range in at least two decades, 2012 is expected to see a wider trading range, making it attractive to trade actively.


■ Long term Sensex returns may bottom out
Long term (5yr rolling) Sensex returns at the end of 2011 were close to 12%. In the previous cycle, long term returns had bottomed out at (-)9% in 1998. A close in the range of 18000-19000 in December 2012 would result in negative 5ry rolling returns to the tune of 11 to 6%.


■ Volatility may rise, more big daily moves likely
Market tops and bottoms have usually been associated with higher volatility. In past two years volatility in Indian markets has been low to moderate. In recent months volatility has shown a tendency to rise. We expect volatility to inch up as the markets look out for a bottom.


■ GDP growth to slow; downgrades likely
We expect FY13 GDP to slow to 6.8% and consensus to cut GDP forecasts over the next few months. GDP growth in the next few quarters is likely to come even lower at around 6.5%. A slower GDP will be led by: (a) a slowing global economy, (b) impact of high rates and (c) slowing investment spend.


■ Earnings downgrades to continue
We continue to expect earnings downgrades, led by slowing sales and sustained margin pressure from rising labor and interest costs. We expect the bottom-up Sensex EPS of Rs1,275 to be downgraded to Rs1,200 (growth of under 10% vs. expectations of nearly 15%).


■ Valuations will see slight de-rating
Based on analysts’ forecasts, Sensex at 13x one-year forward PE is at a slight discount to long-term averages. Slow down in GDP and earnings growth as well as falling RoEs will likely lead markets to trade lower. Secondly, on a relative basis, India still trades at substantial premium to GEM vs. a 10yr average of 17%. 


■ Inflation and rates to peak off
We expect inflation to peak off in 1H12 with a good harvest dousing agflation, commodity prices stabilizing and a tight monetary policy curbing demand. RBI may start cutting rates by 100bp from March onwards. We expect, in follow up to RBI easing, lending rates should ease by 150bps.


■ Strong US Dollar, weak INR
We expect the US Dollar to appreciate to sub-1.30/Euro levels through 2012 on the European crisis. It is expected to peak at 1.25/Euro in March and June and then moderate to 1.30/Euro by December 2012 and 1.35/Euro by December 2013. In tandem, the INR is seen to persist at Rs50/USD levels for the most of the year and appreciate to Rs49/USD by December 2012. Do not expect significant foreign flows in Indian equities in 2012


■ Political stability to continue
We believe the stability of the Congress-led UPA Government is not an issue since: (a) most political parties do not want an election so soon and (b) none of the allies of the Congress want to see the Government fall. They seem content to distance themselves from some measures of the Government and make a show of opposing it, without withdrawing support to the Government. We do not see the situation changing materially post state assembly elections in 5 opposition ruled states in 2012.


■ Global equities: the beginning of the end of great bear market in sight
Despite our short-term caution, we believe that global equities on a 2-3 year view look compelling. Investors enter 2012 in a fearful state, but we believe any sharp falls in equities in 2012 should be bought. The ingredients for equity outperformance over the medium-term are being put in place and 2012 could represent the beginning of the end of the great bear market in equities.


■ The US economy to slow down sequentially
While 2011 is ending on a strong note, we expect the US and European fiscal crises to lower growth to just 1% in Q4 2012.


■ Large scale deleveraging will pull down DM growth in 2012
We expect the need for higher Tier 1 capital ratios in Europe and falling real estate values in US will likely keep developed economies on a deleveraging mode. In fact, the deleveraging cycle that affects 50% of the global GDP and twothirds by wealth will likely remain a significant impediment to growth in developed markets. Burgeoning government deficits, unfavorable demographics, and fractious politics will likely continue to prevent the textbook Keynesian response.


■ Easy policy and high liquidity will keep markets afloat
Easy policy and high liquidity has so far helped to counterbalance large-scale deleveraging in developed economies by holding down debt service ratios and supporting asset values. Heading into 2012, real interest rates should remain low, and we expect the Fed and the European Central Bank to fight the growing deflationary pressures with quantitative monetary easing.


■ Global inflation to remain elevated, EMs may suffer more
The quid pro quo of easy liquidity is higher tolerance of inflation, which is already hitting real incomes as energy, food and other commodity prices keep on rising fuelled by negative real rates, in our view. The impact of higher commodity prices is greater on emerging markets where energy and food make up 9% and 27% of the CPI basket respectively, although rising incomes somewhat mitigate the higher costs. On the other hand, G5 economies face stagnant incomes, while energy and food make up 8% and 15% respectively.


■ Commodities – headwinds for cyclicals, gold to reach US$2000/oz
Given expectations that demand growth for cyclical metals will slow, micro fundamentals are important and we see substantial divergence on that front. We see limited upside in Crude oil on improved demand supply balance, dated Brent crude oil to average US$108/bbl in 2012. We expect gold reach US$2000/oz led by continued Central Bank demand and persistent negative real rates.


■ Key global risks: Euro break-up, Iran & China hard-landing
A deeper-than-expected Euro zone recession could lead to a sequential drop in both equity and commodity prices. US Treasuries would outpace credit in this case. Meanwhile, increased Middle East tensions could lead to another largescale physical oil supply disruption and exacerbate the recession in Europe. Finally, we think two key risks worth highlighting are those coming from faster than expected US fiscal tightening next year, and the perennial China hardlanding scenario.



Investment strategy


Moderate strategic asset allocation, u/w equities
We expect the markets to continue moving in a broad range in 2012. During next several months the Sensex may keep oscillating mostly between the range seen in 2011 with occasional violations on either side. Given the high opportunity cost of holding equities, we continue to suggest a moderate strategic asset allocation — predominantly high yielding debt, adequate cash and select large cap defensive equity portfolio.
■ Overweight high yielding debt
■ Overweight cash
■ Underweight equities


We prefer expensive defensives vs. inexpensive cyclicals
One of the key decisions facing investors at the moment is whether to continue paying a premium for expensive defensives or to position in inexpensive cyclicals in preparation for the next economic upturn.


In our view, expensive defensives are preferable at this stage, for the simple reason that in slowing growth environment, fraught with significant uncertainties, defensives have historically outperformed.



To read the full report: KEY TRENDS
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