Tuesday, November 24, 2009

>Prospects for Economies and Financial Markets in 2010 and Beyond (CITI)

After the most severe global recession for decades, we now expect a sustained but uneven global recovery. Almost all major economies exited recession in Q2 and Q3, and on balance our GDP forecasts continue to rise. The initial bounce in output is likely to be quite solid and even across major economies. Thereafter, we expect recovery to be uneven across regions: strongest in non-Japan Asia, slowest in Europe and Japan. For the US, a fairly solid recovery is likely in 2010-11 — despite lagging credit availability — but the medium-term fiscal outlook poses major policy challenges.

As recovery strengthens, many emerging markets — especially in Asia and Latin America — are likely to hike rates in H1-2010, with the PBOC’s first hike forecast in Q3-2010. Australia and Norway also are likely to tighten further in early 2010. But with subdued inflation and some residual worries among policymakers over recovery’s sustainability, we are postponing our forecast for the first Fed hike to Q4-2010 (Q2-2010 previously), and for the first ECB hike
to Q1-2011 (from Q4-2010). Rising inflation may still lead the UK MPC to hike in Q2 or Q3 2010, while we still expect the BoJ to keep rates on hold in 2010.

This month’s Overview highlights key themes for 2010 and beyond: a solid, but uneven recovery; why Asia’s quick rebound is sustainable; central bank exit strategies; bank retrenchment and credit availability; unsustainable fiscal trends; and longterm trends in the size of major economies. This month’s GEOS also gives detailed forecasts for a wider range of emerging market countries.

Returns from risk assets are unlikely to be as stellar in 2010 as in recent quarters. Nevertheless, Citi strategists believe that with improving growth prospects, strong corporate earnings, and gradual central bank tightening, risk assets will continue to do reasonably well — outperforming government bonds and cash — in the next couple of quarters. We expect interest rate term structures to normalise, with higher yields and flatter curves.

To read the full report: ECONOMIC OUTLOOK

>The Stock Picker Has a Job (MORGAN STANLEY)

Key Debate: One of the themes that emerged from our recent Asia summit was the relative rise in interest in company meetings versus macro. The influence of the market (read: macro) on stock returns has been high over the past 18 months. with stockspecific idiosyncratic factors taking a back seat during this period. With the pace of returns likely to slow in the coming months, the key question is whether it is the right time to abandon macro over stock picking.

Macro effect has been in vogue: The fact that macro is the biggest influence in determining the behavior of stocks is most evident in the way the correlation of returns from individual stocks (market effect) with the market has held high over the past 18 months. Conversely, the average relative volatility of the stocks in our coverage universe had plummeted to a decade low. The
rise in market effect tells us that individual stocks were being influenced more by market performance-related factors than by idiosyncratic or non-market performance–related issues. However, we think it is unlikely that the macro effect will rise further and, to that extent, stock pickers may have a better season next year.

Sector correlations are also running high: Another indicator of the dominance of macro is how various sectors are correlated. Inter-sector correlations (across the 45 pairings of sectors using the 10 MSCI sectors) are around their highs, thus neutralizing sector- and stock-level idiosyncrasies. For investors who expect macro factors to continue to be the force du jour, rotating sectors is the way to make money. However, if macro takes a back seat and stock picking comes back into fashion, correlations will fall. Energy seems to be an exception versus history and could be a good hedge against a fall in these correlations.

Micro factors still not in favor but that is usually the time to inflect:: Indeed, the dispersions in fundamentals, valuations and stock returns all appear to be at middling levels. Usually, extreme dispersion is necessary for a very attractive stock picking environment. The bottom line is that the micro environment is not very appealing for stock picking. That said, as growth accelerates in 2010, these micro indicators are likely to change in favor of stock picking.

Trading beta may not be a panacea: Investors who are wary of the market may seek to buy protection by going down the beta curve. However, they need to bear two points in mind: a) beta is constantly evolving – for example, since Jan-08 energy beta has declined whereas materials beta has gone up. We expect more beta from energy in 2010. b) The components of beta (relative volatility and correlation of returns between the stock and the index – i.e., market effect) are as critical in a “beta strategy” as the beta itself.

To read the full report: INDIA STRATEGY

>RELIANCE INDUSTRIES (bid for Lyondellbasell)

Impact on our views: We believe RIL’s proposed bid for Lyondellbasell would be EPS accretive for RIL shareholders, based on a bid EV value of US$11-US$12bn, assuming an annualized US$2bn EBITDA for Lyondell (current YTD EBITDA run rate of US$1.7bn) and a hurdle IRR rate of 18% for RIL. We maintain our Overweight on Reliance Industries.

Non-organic Growth – Part I - Bid for Lyondellbasell

What's new: RIL has today announced a preliminary non-binding cash offer to acquire a controlling interest in Lyondellbasell upon its emergence from Chapter 11 reorganization. Lyondellbasell filed for Chapter 11 bankruptcy for its US operations in January 2009. Facts on Lyondellbasell: Lyondellbasell is one of the world's largest polymer and petrochemical companies
and is privately-owned by Prochoice GmbH. Lyondell has debt of US$25bn (as of Sept 30, 2009) with a market value of US$12-13bn. The company has year to date operating profit of US$1.68bn for F2009 as against peak and trough EBITDA of US$4.4bn and US$2.0bn respectively.

Facts on RIL: RIL has debt of US$14.6bn with debt:equity of 0.42, cash of US$4bn (as of Sept 30, 2009) and a T-stock valued at current market price of US$8bn giving it sufficient liquidity to fund acquisitions. We estimate RIL generating US$4-US$5bn of free cash flows over the next three years post the next quarter.

Hurdles for the deal: We believe the key hurdles to the deal are: 1) Clearance from the Bankruptcy Committee and bankruptcy judge 3) Private equity owners who have purchased first and second lien debt may want to block the deal 4) Regulatory hurdles for foreign investors
in certain jurisdictions. Chinese companies were prevented from buying Unocal.5) Access Industries (the current owner) and Apollo have bought a lot of the 1st/2nd lien debt, so they will have a say in approving any bid.

To read the full report: RIL


Indian power sector: A growth story from 2003 to 2030
Key structural changes in the Indian power sector since 2003 include lower credit risk for asset owners and higher incentives for private sector participation. We believe these are likely to drive the long-term growth story in the sector. India is projected to have power generation capacity of ~750 GW by 2030, ~5x the current capacity, which is expected to be the third highest globally. This implies annual capacity addition of 20-25 GW against the average annual capacity addition of 5-6 GW in the Eleventh Plan so far.

Opportunities galore; key concerns continue to be an overhang
Opportunities in the power sector across various segments are immense and are likely to remain lucrative over the Eleventh and Twelfth plan periods. However, it is noteworthy that even after the Electricity Act 2003, some key issues persist in the sector. While policy actions of the central government and regulators have been in the right direction, implementation of those regulations, which rests upon state governments, has been found wanting. Further, due to the sector’s concurrent nature (implying it is under the purview of both Centre and states), the central government has been unable to implement reforms.

Introducing peak value: BTG, BoP to create most value till FY12E
We believe attractive opportunities exist across the power value chain. However, given the staggered expansion mode, these need to be analysed with regards to their risk profile and long-term potential. We introduce the concept of peak value creation (PVC) for such analysis. Peak value is created when the business maximises growth and RoCEs over the business cycle. We also note that market capitalisation tends to be a lead indicator. Our analysis highlights that all power equipment and contracting companies will enjoy PVC till FY12. Hence, upsides to valuation exist till FY12E, post which, valuations could de-rate as changing industry dynamics will result in lower value creation.

Top picks
Based on our analysis, we believe equipment and contracting companies and merchant power utilities are likely to reach peak value during FY10-12; regulated utilities will achieve their peak value over the next five years and competitively bid tariff companies are likely to reach peak value after FY12. Our top picks are Tata Power and CESC, amongst utilities. Amongst equipment and contracting companies, we like BHEL, BGR Energy, and KEC International.

To read the full report: POWER SECTOR

>Capital Controls … Back in Vogue, Will India Follow? (CITI)

Flows to EMs results in appreciation, reserve accretion and controls — Growth and interest rate differentials are causing a renewed surge in capital flows to Emerging Markets. This has resulted in currencies appreciating, forex reserves rising (in most cases to pre-crisis levels) and some countries imposing controls on capital flows. How a country deals with capital flows depends on (1) its export dependence and (2) inflationary/sterilization costs associated with dollar inflows.


India: What should one expect? — We believe that similar to FY08, the RBI could once again be caught in the trap of the ‘impossible trinity’. In response to rising flows, we expect (1) the initial goal would be to re-build reserves that were run down during FY09, (2) some INR appreciation to offset inflationary pressures, and (3) although we do not expect that India will impose ‘punitive controls’, one could see a reversal of some measures taken last year. This could include tightening ECB and banking capital norms, reducing interest rates on NRI Deposits, and encouraging capital outflows.

Macro – The good, the bad and the ugly — Starting with the good: upside surprises in industrial production could offset a weak summer crop; likely resulting in GDP growth of 6.2%YoY. The bad: drought relief measures, oil related subsidies/bonds and 3G auctions are potential pressure points on the deficit, but recent clarity on disinvestments could minimize slippage. The ugly: higher food/oil could result in WPI breaching 6% levels by March.

Monetary Policy and Financial Market Forecasts — While loan growth remains anemic, better-than-expected IIP data and rising WPI will likely prompt steps towards normalizing rates by early 2010. We maintain our call of a 125bps rise in rates in 2010, as inflation is primarily supply-driven and excess tightening would have implications for the INR. With the underlying theme of dollar weakness and relatively strong domestic growth, we see the INR trending to Rs44/US$ and Rs41/US$ in Mar10 and Mar11 respectively. However, similar to other EM assets, there would be a tussle between ‘risk on’ and ‘risk off’.

To read the full report: INDIA MACROSCOPE