Monday, January 25, 2010

>Equities in the Coming Decade: Gold Class (MORGAN STANLEY)

Equities finish the decade as the best asset class: Over the past 5, 10 and 15 years equities has been the best performing asset class in India. That said, equities was also the riskiest asset class (measured using volatility in annual returns) over these periods. The one-year bank deposit and the 10-year government bond finished at the bottom in terms of returns for 10-year and 5-year horizons, respectively, disadvantaged by duration. Surprisingly, property was the worst performing asset class for the 15-year period. These conclusions come from our research on returnsand the volatility of these returns across five key assets classes (one-year bank deposit, 10-year government bond, gold, property, and equities represented by the BSE Sensex).

The key debate: There is a view that Indian households have missed the boat by having preferred gold and fixed income assets to equities over the past decade or so. Indian households have reduced their share of equity savings in financial assets from 23% in 1992 to 0% in F2004 before raising it to 10.5% in F2008. The share of physical investments (property, gold and micro businesses) in households’ balance sheet has gone up from 46% in F1995 to 51% in F2008 at acquisition cost. However, our research shows that on a risk-adjusted basis, equities may not have been the best asset class and that gold and property may have been superior asset classes. To that extent, the portfolio choices of Indian households of the past decade stand vindicated. The key debates are a) which asset class is likely to top the return and risk-adjusted return chart in the coming decade and b) whether households are set to change their preferences for various assets. In this essay we focus on the first debate. We shall address the second debate in a separate note in a few weeks from now.

Equities will likely be the best performing asset in the coming decade: We expect the BSE Sensexto deliver annual returns of 14% over the next 10-years based on our residual income model. Our view is that Indian equity returns are likely to be less volatile in the coming decade than in the previous ten years. This view is premised on the starting point of volatility which is ata historical high and the low relative cyclicality in earnings that Indian companies have been exhibiting vis-à-vis the rest of the world. Return volatility in the coming yearsis likely to be reminiscent of the post-1987 period when the volatility in equity returns moderated after hitting a peak. Fundamentals of the Indian corporate are in good shape backed by the strong domestic growth, robust balance sheets, high capital efficiency and the likelihood of decoupling from the rest of the world. Thus, on a risk-adjusted basis, equities are likely to be the most attractive asset class in the coming years.

Gold tepid outlook for the next five years: Gold has delivered positive returns for 12-consecutive years. However, our global commodities team expects annual returns to flatten over the next five years after gold touches a new peak in 2010 and then gradually declines in the subsequent years. (See Peter Richardson’s reported dated December 16, 2009 titled Gold –The Bull Market Reaches Maturity for details).

Property –favorable price outlook: Favorable demographics, rapid urbanization and formation of nuclei families will drive demand for property. Over the past fifteen years, India’s annual income growth of 12.9% exceeded the increase in property prices across eight cities (of 7.9%), highlighting improving affordability.

Bonds and deposits –are likely to continue to underperform: The near term outlook for 10-year bonds is mired by our forecast of rising yields in the US notwithstanding our view that 10-year treasuries are interesting from an ownership, supply and valuation perspective relative to equities. The long-term returns implied in the current yield of 7.6% make bonds unattractive even on a risk-adjusted basis. In a fast-growing economy like India, bank deposits will continue to be disadvantaged by duration and underperform other asset classes.

Our assumptions : For the return from 10-year treasuries, we assumed that the annual coupon was reinvested in one-year bank deposits post the payment of tax at the marginal tax rate. The bank fixed deposit return is the sum total of returns in annual bank fixed deposits together with the return on the reinvestment of post-tax interest earned on the deposit. The tax rate used is the marginal tax rate for individuals. The return on gold is the delta in the domestic gold price, which is determined by the import tariff on gold, the exchange rate and the global gold price. For equities, we have taken the BSE Sensexas the proxy for returns and reinvested post-tax dividends into the Sensex. For measuring return on property, our sample consists of residential properties in various localities across seven cities (Mumbai, Bangalore, Delhi, Kolkata, Ahmedabad, Pune, and Chennai). The gains on property, equities and gold are reduced by the long-term capital gains tax of 10% at the end of the period.

To read the full report: INDIA STRATEGY