>INDIA STRATEGY (MORGAN STANLEY)

What Tightening Could Mean for Equities?

• Liquidity is still favorable: As we pointed out recently (see Market Uptrend Intact, August 13), liquidity remains accommodative of the Indian equities. The 91-day yield is a good indicator of liquidity in the system and in our view its current low level augurs well for the market’s near-term outlook. Perversely enough, the prospects of a drought favor liquidity as both the government and the central bank may hesitate to initiate tightening steps in the face of an impending drought.

• How Has the Market Historically Responded to RBI Moves? Over the past 13 years, there have been two tightening cycles. The first one followed the tech bubble starting in July 2000 and ended into January 2001. The second one began during the bull market of 2003-08 in October
2004, and culminated in July 2006, after which the RBI held rates steady until September 2008, when the global financial crisis hit India’s shores. The direct impact of policy rates on the market is always hard to isolate, as is the case with say the monsoons or any other market
driver, but here are some key observations:

• Over the past few years, the RBI has seemingly lagged the US Fed in terms of rate action. Based on our economist forecasts for 2010, it appears that the RBI may lead the Fed in the coming tightening cycle. Our India economist Chetan Ahya expects a rate hike from the RBI in late 1Q10, whereas our US economist Dick Berner expects the Fed to move in June 2010.

• The short-end treasury yields (91-day) have moved in sync with effective policy rates, especially over the past decade. Not surprisingly, they correlate inversely with equity returns, although there is no discernable lead or lag.

• Purely from a policy rate environment, the previous two policy rate hike cycles were preceded by flat returns (relative to emerging markets) from Indian equities. In the 2000 cycle, Indian equities underperformed emerging markets by 3% whereas Indian equities outperformed EM by 5% in the six months preceding the next tightening cycle in 2004.

• Given that RBI is expected to lead the US Fed in this cycle, the market’s response is harder to forecast. Our view is that India will likely outperform, but unrelated to the prospective monetary policy and largely due to superior growth and our expectation of persistent reforms/infrastructure spending.

• To the extent that excess money will decline in the coming months as growth accelerates, the pace of equity gains could also slow. This may coincide with higher credit growth and, hence, lower commercial bank liquidity leading to a similar conclusion. However, for the time being, liquidity remains supportive of equity markets.

• There is little historical evidence of distinctive sector performance patterns related to policy rate moves. During the previous two rate hike cycles, energy and industrials did better than other sectors. However, sector performances ahead of a rate hike appear random.

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