>MARUTI SUZUKI LIMITED: No valuation cushion at current stock price; down to Sell

■ Current price discounts optimistic outcome; downgrading to Sell
Our Sell rating reflects the rich valuation (23x FY13E core EPS) on our estimates which factor all likely positive outcomes on volumes, mix and margins. The current price implies a reversion to peak profitability levels of the past – an optimistic expectation. In addition, Maruti’s margin is significantly affected by FX fluctuations and hence it should command a lower valuation multiple. We note that Hero and Bajaj, with comparable financial metrics, offer higher FCF yields (7-10% vs. 4% for Maruti). Mahindra remains our preferred stock in Indian autos.


■ Our estimates factor in positive outcome on volumes, mix and margins
We forecast Maruti’s domestic volumes to grow at a CAGR (FY12-14E) of 21% vs. 14% for the industry. This implies Maruti's market share at 44% by FY14E (490bps gain). We forecast volume share of higher ASP models (Swift, Ritz & Dzire) to increase by 200bps to 34% by FY14 due to easing of capacity constraints’ improved supply of diesel engines. On profitability, we expect EBITDA/car to increase from Rs18,011/car in FY12 to Rs27,472/car (90% of peak) by FY14. Despite the expectation of a pullback in profits from the trough in FY12, Maruti's core profits in FY14E will only be 8% higher than FY10 ( its previous peak).


■ Currency-driven profitability swings reduce earnings visibility
For Maruti, costs equivalent to c27% of revenues are denominated in JPY. A 5% appreciation of JPY vs. INR would lead to a 12% fall in EPS. Over the last five years Maruti’s EBITDA margin has declined c1100bps from 15.4% (quarterly peak) in 1Q08 to 4.1% in 3Q12. The entire fall is due to 90% appreciation in the JPY/INR rate over this period. While Maruti has embarked on an aggressive localisation
programme, in the interim, earnings visibility remains low due to the FX impact.


■ Trading at 16x FY14E core P/E and 4% FCF yield
Our target price of Rs1,200 is DCF-based (Rf 6.0%, Rm 8.5%, WACC 13.2% and 4.0% terminal growth rate) and implies 20x FY13E core EPS (Rs49) and 14x FY14E core EPS (Rs67). We define core profit as net profit minus post-tax non-operating other income. Core P/E is (stock price – cash)/ core profit. Risks include better than-expected volume growth and significant depreciation of the JPY.


To read full report: MARUTI SUZUKI
RISH TRADER

>The global race for excellence and skilled labour

The race to boost skill levels and enhance academic excellence is in full swing: expenditures for higher education and for research and development are increasing sharply around the world – and especially in emerging economies.


Higher education is on an uptrend not only in developed countries but also worldwide: the share of the world population with tertiary educational attainment is increasing rapidly. Only sub-Saharan Africa shows relatively disappointing performance; too little has been done there – except in South Africa.


The positions of the individual BRIC nations in the race are mixed: Russia is a ―nation of learning‖ which has had a lead on many developed economies for decades. Russia should step up its pace again, though, since China is rapidly catching up. Brazil and India are also showing improvements.


Industrial countries still hold the lead in the current dash to boost excellence: higher education systems are difficult to compare on account of data availability, yet an analysis of the ―Shanghai rankings‖ shows that the industrial countries dominate the field in terms of the excellence of their higher education systems.


However, the emerging markets have joined the fray: the share of Chinese and Brazilian top universities has simply jumped since 2003.


Excellence via investment in research universities: our analyses show there is a significantly positive correlation between expenditures on education and scores in the Shanghai ranking. Germany poised to catch up: Germany trails comparably developed countries both in terms of spending on tertiary education and the share of tertiary educational attainment in the population. However, Germany produces more excellent universities than is to be expected from a statistical analysis.


A cross-border, project-economy approach to collaboration is a key factor in the dash to boost educational achievement: there is a need for cross-border projects, programmes and partnerships with aspiring institutions in other developed countries and emerging economies and for the creation of new possibilities to finance these initiatives in order to compete in the long-term race to produce more tertiary graduates and spur global progress in knowledge.


To read full report: GLOBAL RACE
RISH TRADER

>INDIA BUDGET PREVIEW 2012: A year of mild consolidation

■ The FY12/13 Union Budget, to be presented on 16th March, comes at a time when economic growth has slowed and inflation, while declining, is facing headwind from a renewed rise in global commodity prices. Additionally, with the FY11/12 fiscal outturn likely to exceed the budgeted target by close to 1% of GDP, there is considerable pressure to get back on the path of fiscal consolidation.


■ Unfortunately, building on the slippages of FY11/12, it is difficult to see much scope for substantial fiscal consolidation in FY12/13. The expenditure side of the budget will likely remain sticky owing to welfare programs such as NREGA and rising subsidy bill on account of food, fertilizer and oil. The revenue side of the budget is likely to be weak despite the slated implementation of the Direct Tax Code, given likely persistence of weak growth in the next few quarters. To support the revenue base, excise duties could be raised on certain items while the services tax net could be broadened, but this could affect economic growth adversely on the margin. We don’t expect major progress toward the implementation of the Goods and
Services Tax (GST), due to opposition from a few states.


■ We think that the government will factor in INR250-300bn proceeds from disinvestment, with an intention of bringing fiscal deficit down to slightly below 5% GDP in FY12/13, from a likely 5¼% of GDP outturn in FY11/12 (as against the budget estimate of 4.6% of GDP). Consistent with past trend, the fiscal deficit will be financed primarily through sizable market borrowings, which will continue to weigh on bond market sentiments.



Focus on fiscal consolidation
The FY12/13 Union Budget is scheduled to be presented on 16th March. Most stakeholders would want to see a strong commitment from the government to return to the path of fiscal consolidation, after having likely breached the current fiscal year’s target by a wide margin. The RBI has repeatedly underscored the importance of fiscal consolidation in making monetary policy transmission more effective; a budget that reverts to fiscal consolidation would give the central bank some flexibility in its monetary policy actions.


Apart from monetary policy considerations, fiscal consolidation is also necessary to prevent crowding out of private investment and reduce the current account deficit. Running high twin deficits not only exposes the economy to macro imbalances but also makes it vulnerable to any possible external shocks. Fiscal consolidation is an imperative to achieve a stable noninflationary rate of growth in the coming years.


We particularly look forward to the government’s plan of action with respect to two key tax reform initiatives—the Direct Tax Code (DTC) and the Goods and Services Tax (GST). The third, equally important area, but perhaps with less suspense, is expenditure management related to various subsidy programs including petroleum, fertilizer and food. There will be some movement toward cash transfers over broad-based price controls, which will be welcome but substantively far from best practice.


Could the government deliver yet another populist budget keeping its electoral considerations in mind? We are cautiously optimistic that this is not going to be a year of fiscal expansion, given that state elections will be behind and the fiscal’s role in fueling inflation is being recognized in Delhi. Of course, there is a risk that like last year, the government would announce an optimistic fiscal deficit target, allowing the RBI to embark on its rate cutting cycle, only to recognize by the middle of the year that the fiscal targets are unlikely to be met. But generally speaking, we expect the FY12/13 budget to aim for less than 5% of GDP in central government deficit. This would constitute about a ½% of GDP improvement in the fiscal position over the previous year.


To read full report: BUDGET PREVIEW
RISH TRADER

>INDIA STRATEGY: Five strategic threads to weave the tapestry of FY13 budget

BUDGET EXPECTATIONS: Bold economic budget after a long gap?


Budget FY13 to be woven around the following five strategic threads (1) fiscal consolidation through subsidy rationalization – through raising diesel, kerosene and LPG prices and partial decontrol of urea prices (these may be the UPA government’s boldest economic decisions). Food subsidy however may be raised as government introduces food security bill (2) withdrawal of fiscal stimulus – through raising excise and service tax rates – across the board – by 200bps and widening service tax net (3) stimulating investments and jumpstarting capital formation (4) accelerating retail investment in equity markets – through lowering of short term capital gains tax on equities and increasing tax allowances for retail investment in equity mutual funds allowing channelization of personal savings from real assets to equities and (5) socialization of personal tax structure – through raising maximum income tax exemption limit and reintroducing personal tax surcharge on high tax bracket assesses and doubling corporate tax surcharge. This may probably be the last opportunity for Finance Minister to present an economic budget in the current term of UPA, as FY14 union budget (being last full-fledged budget before General Elections in 2014) will likely be guided by the imperatives of a popular democracy. Priority shift - from excessive focus on Aam Admi (Common Man) to capital formation… for now


We believe that allocations to welfarist programs like National Rural Employment Guarantee Scheme (NREGS) are unlikely to rise from FY12 levels, allowing the government to keep expenditure under control. However we expect to see government increasing its focus on plan expenditure on projects aimed at reviving capital formation (pertaining particularly to roads, railways and irrigation). With the gross fixed capital formation showing compression in Jul-Sep qtr, we expect several fiscal measures (through budgetary allocations, tax exemptions/benefits, easier financing etc.) to kickstart the capex cycle. As per our infrastructure analysts, the government may adopt following key measures: (i) Sun-set clause on tax incentives for infra projects likely to be extended by one more year; (ii) We expect government to announce fiscal incentives for new capex; (iii) Increased focus on Accelerated Power Development and Reform Program (APDRP); (iv) Setup of National Electricity Fund to provide interest subsidy to SEBs for investments in T&D sector for reducing the losses.


Implications for portfolio construction
Higher taxes & reined in expenditure on populist schemes should result in curtailing domestic consumption modestly. Terms of trade may shift from rural to urban India, albeit temporarily. We cut exposure to both consumer discretionary and staples in our model portfolio. Increased focus on capital formation through incentivizing infrastructure investments will benefit infrastructure stocks. Our Top Picks are: Axis Bank, ICICI Bank, SBI, Coal India, L&T, TCS, Bharti, DLF.


To read full report: INDIA STRATEGY
RISH TRADER

>INDIAN TELECOM SECTOR: Policy is the key risk for Indian telcos

Cashflow cake in sight, but government demands a bigger slice


Indian telcos are forced to contend with significant policy flux in an improving competitive environment. We expect mobile revenues to grow at 15-16% YoY, aided by 3-4% growth in revenue/minute and 12-13% YoY growth in minutes. Higher tariffs should drive 200-400bps margin expansion by FY14E. However, we assume negative impact of policy shifts on incumbents as our base case. Based on strength of balance sheet, cash flows and relative impact of likely regulatory costs, our ladder of preference is Bharti, Idea and RCOM.


■ Bharti – Strong FCF and African operations would temper policy risk
Our Buy rating on Bharti reflects its strong competitive position and relative resilience to global factors. We highlight its improving business momentum in India, driven by tariff increases and 3G rollout, and solid progress in African operations. Our FY12E/13E/14E EPS estimates are Rs14.8/25/34.4. Key metrics to watch: India revenue growth (est: 15% YoY), FCF in African operations (est: $-500m). We maintain Buy (target price Rs420).


■ Idea – Robust performance but burden of regulatory costs could be onerous
Idea’s operating performance has been the strongest among incumbents. It has increased its revenue share and improved its cost position relative to sector leader Bharti. The two concerns on Idea are that compared to its peers it has: a) relatively higher impact of likely regulatory costs and b) a weaker FCF profile over the next three years. Our FY12E/13E/14E EPS estimates are Rs1.5/3.9/5.4. We maintain Hold (target price Rs105).


■ RCOM – Stabilising operations but debt burden constrains valuations
RCOM’s operations have stabilised, but it has been forced to constrain capex to generate cash. It is due to repay around $1.2bn in FCCBs in March 2012. While it is favourably placed with respect to policy issues, RCOM’s key challenge is to build momentum in its wireless business, where its EBITDA has been stagnant for the last seven quarters. Maintaining Hold (target price Rs80).


■ Three key policy issues for the incumbents (Bharti, Idea, Vodafone)
The cost of ‘excess spectrum’ and licence extension and a government decision on intra-circle data roaming are key focus areas. The estimated cost of excess spectrum/licence extension is Rs43/57bn for Bharti and Rs19/46bn for Idea. We factored excess spectrum cost in the EPS estimates but the cost of the licence extension will impact FY15E/16E cashflows. The policy decision on intra-circle roaming will effect the 3G investment case for the incumbents.


■ Incumbents likely to be left out of sector consolidation
It is increasingly clear that the incumbents would not be able to meaningfully participate in an industry consolidation. Rather, consolidation would provide additional strategic options for well-funded players such as Reliance Industries (RIL) to enter the telecom market in a more significant manner. The proposed guidelines on spectrum trading, refarming and auction of new spectrum bands (700Mhz) are also unfavourable to incumbents.


To read the full report: TELECOM SECTOR
RISH TRADER

>EQUITY STRATEGY: Portfolio Musings: Time to look at banks

Portfolio Musings: Continue to remain cautious

We continue to believe equity markets will stay cautious with no credible solution

yet on the European situation. Domestically too, the window of likely policy action

(relaxed FDI, fuel price and fertilizer subsidy reform) is now threatening to close for

the medium term with Uttar Pradesh state elections drawing closer (unless

prescheduled, expected in May 2012). However, while inflation remains elevated,

we believe that policy rates may be approaching a peak with expectations of

slowing global growth and increasing regulatory focus on exchange-traded

commodities. Athough valuations are beginning to look attractive for the Indian

market, investors are now increasingly beginning to look at the outlook for FY13,

where the jury, on economic growth and earnings growth,is still not in. However,

the Indian hinterland - driven by rising prosperity in tier 2 and tier 3 towns, remains

robust doing the heavy lifting for the Indian economy along with services.

Raising O/W on banks, reiterating conviction Buys on tractors & 2-wheelers

Our banking analysts Manish Karwa and Manish Shukla believe that the banking

sector is trading at trough valuations, despite conservative estimates on asset

quality (a legitimate concern, which may already be priced in). Following the high

conviction call from our banking team, we raise our overweight on banks to

179bps with SBI and HDFC Bank the top picks in our model portfolio. We continue

with our high conviction O/W call on 2-wheelers and tractors (M&M and Bajaj

Auto) as we believe that continuing strength in India’s hinterland (aided by strong

monsoon) should drive robust demand for tractors and 2-wheelers. Our key U/Ws

are: (a) Utilities - with power sector continuing to languish from coal-shortage, (b)

Metals - we see further risk to global commodity prices from slowing global

growth plus increased regulatory focus on exchange traded commodities.

Key additions: SBI, cement, NHPC & Exide; Deletions: SunTV, Bharat Forge

New additions to our portfolio: SBI - a top pick with our banking analysts as SBI’s

NIM trajectory has been improving, while its strong liability franchise continues to

help immobilize low-cost deposits. We also add 3 cement stocks (Ultratech, ACC

& Shree Cement); our cement analyst foresees rising capacity utilization and

narrowing price differentials between wholesale and retail prices benefitting key

cement players. We introduce NHPC (regulatory focus for hydro power expected

to turn favorable) and Exide (EBITDA margins to improve). Top Picks: Asian

Paints, Bharti, Bajaj Auto, Coal India, HDFC Bank, ITC, JSPL, L&T, M&M, SBI.

DB India Model Portfolio continues to outperform benchmark MSCI India

Our model portfolio has outperformed MSCI India by 102bps since 5th August

2011 (date of last change to the portfolio) driven chiefly by our O/W stance on 2

wheelers and tractors. Our Model portfolio has outperformed MSCI India byEU

384bps YTD and by 455bps YoY respectively.

To read the full report: EQUITY STRATEGY

>ONGC: 2QFY12 oil realisation to improve significantly; Buy

Rising net realization and production growth on the horizon; reiterating Buy

We expect ONGC’s oil net realization to jump by 60% QoQ to US$78/bbl in

2QFY12 versus the last four years' average of US$52/bbl, driven by duty cuts and

fuel price hikes implemented by the Government of India in June 2011. Moreover,

ONGC’s newly elected Chairman has indicated production growth of 15% in oil

and 58% in natural gas over the next five years. ONGC’s stock price is currently

implying an upstream subsidy sharing of 50% going ahead, as against 31-42%

historically. Reiterating Buy.

Net realization to rise by 60% QoQ, to US$78/bbl, on lower subsidies

We estimate ONGC to report robust INR73.2bn net profit (+36% YoY, +79% QoQ)

for 2QFY12, on higher net realization of US$78/bbl (+24% YoY, +60% QoQ) and

lower royalty payments for the Rajasthan block RJ-ON-90/1. The sharp increase in

net realization is a result of lower estimated gross under-recoveries (INR204bn, -

53% QoQ), driven by fuel price hikes and duty cuts by the Government of India in

June 2011, as well as seasonally weaker diesel sales. ONGC’s average net

realization has been US$52.4/bbl the last 17 quarters. We assume an upstream

subsidy sharing of 38.7% (in line with FY11), vs. 33% in 1QFY12.

Expected production CAGR of 4.3% in oil and 3.6% in gas in the next 4 years

ONGC’s newly elected Chairman Mr Sudhir Vasudeva recently indicated

production growth of 15% in oil, to 28m tonnes, by FY14, and 58% in natural gas,

to 100mmscmd, by FY17. This is likely to come from the development of marginal

fields (G-1, GS-15, G-4-6, etc.), and the Daman Offshore and KG DWN 98/2 blocks.

We believe production start-up from KG DWN 98/2 is likely to be delayed. We

have built in a production CAGR of 4.3% in oil and 3.6% in gas in FY11-15E.

DCF-based value of INR365/sh; uncertain subsidy sharing the key risk

We value ONGC at INR365/sh, based on DCF, assuming a 12.9% WACC, based

on Deutsche Bank’s CoE assumptions for India (rfr 6.7% and risk premium 8.1%),

and a beta of 0.85. Key risks are vagaries in government policy on fuel pricing and

subsidies, a further increase in oil prices and a fall in oil & gas production.

To read the full report: ONGC

>Kotak - Lending biz improves, but all others in a weak spot

Kotak Mahindra Bank - Lending biz improves sharply, but all others in a weakspot [Dipankar Choudhury, Manish Shukla] Q1FY11 results, which were in line with our estimates on a headline basis, continue to reflect the trends visible for the last few quarters and could sustain for some time. The bank reported consolidated loan growth of 42% YoY driven bysecured retail and corporate lending, and a NIM of 5.7% that was down 40bps QoQ. The bank in their earnings call guided for a 30-35% loan growth for FY11E, which they had earlier estimated at mid-twenties, but also indicated that margins could correct to 5-5.5% despite the capital infusion expected soon.

HDFC Bank – Signs of strength in growth, costs stabilising [Dipankar Choudhury, Manish Shukla] We maintain Buy on HDFC Bank after increasing the target price to INR 2,090 from INR 2,050. The bank with its high share of low cost deposits and largely floating rate assets is the best play in a rising interest rate environment. Loan growth from both retail and short-term wholesale loans remains strong. We believe that operating cost ratios could improve further due to productivity improvement from the erstwhile Centurion network.

Yes Bank -Strong asset growth, but CASA remains low [Manish Shukla, Dipankar Choudhury] We maintain Hold on YES Bank with a target price of INR285. The bank continuesto gain good traction in corporate loans, and core fee income growth is also strong. Operating expenses are likely to rise, and the low share of CASA remains aconcern. Trading at 2.8x FY11E P/B, the stock appears fairly priced.

Sector & Company News
** RBI may up capital ratio for banks
** HDFC, Kotak to rework profit forecast for insurance arms
** Yes Bank to raise Rs 15bn tier II capital

To read the full report: INDIAN BANKS

>Stress case suggests moderate downside (DEUTSCHE BANK)

While we are maintaining our baseline view of Indian economic growth moving back to the 8-9% GDP growth trajectory driving corporate earnings growth in India (and hence maintaining our year end Sensex target of 22,000), 3QCY10 should see equity markets being swayed by dramatic waves of risk aversion We have attempted to provide a framework for investors by running a stress test for the BSE Sensex companies and determining the likely downside risk from a moderate global risk event. Our stress tests indicate that there is a ~14% downside risk to our base case Sensex earnings forecast of 1095 for FY11. In case our stress tested scenario pans out, BSE Sensex earnings in FY11 would rise by only 12% relative to our currently estimated Sensex earnings growth of 30%. Based on our stress tested EPS and applying the current market multiple of ~16xFY11 earnings, the fair value of the BSE Sensex would be 15,100. We believe that this provides a reasonable floor value to the Indian market, in a moderate global risk scenario.

■ Declining oil prices – a strong tailwind for India
Our global commodities team expects oil prices to soften in 3QCY10 and remain weak into the end of the year before recovering in 2011. We believe declining oil prices will result in a strong tailwind for India’s domestic economy as well as its balance of payments. A downdraft in global oil prices should help take considerable pressure off an inflation-wary government of India and allow it to
perhaps extend the recent bold deregulation of petroleum products to diesel. The government’s recent decontrol of petroleum prices and the promise of extending this to diesel have been seen as a strong game changer and bring back faith in the Indian government’s commitment to make bold decisions that a popular democracy generally constrains it from implementing.

■ India’s share in regional inflows has ratcheted up sharply
The improving domestic macro situation and India’s unique domestic consumption model has perhaps been the critical factor for the country’s out performance relative to its other large emerging market peers. India’s share of regional inflows in 2010 YTD underscores this thesis. India’s share of regional (Asia ex China/Japan) FII flows (2010 YTD) has ratcheted up sharply to 48%. This compares favorably to 2009, when India received only 29% of regional inflows (with Korea having seen the largest flows then), and 2004/2005 when the share stood at 30%
and 33% respectively.

■ Model Portfolio tilted partially towards defensive plays
Driven by our expectation of a volatile 3QCY10, we have added a more defensive bias to our model portfolio. While we continue to overweight Banks, Industrials and Automotives, we have also shifted Telecom as a non-consensus overweight. Despite strong under performance since May’10, we have gone underweight on Metals as we believe that global headwinds and regulatory concerns will keep investment flows into commodities depressed. Other underweight sectors are: energy, healthcare and Cement. Our Top Buys are: M&M, Maruti, Zee, Axis Bank, HDFC Bank, Lanco, L&T, BHEL, Asian Paints and Tata Steel.

To read the full report: EQUITY STRATEGY

>WORLD WATER MARKETS:High investment requirements mixed with institutional risks (DEUTSCHE BANK)

The world’s water markets are confronted with major challenges. The growth of the global population goes hand in hand with a rise in demand for food, energy and other goods. This means the demand for water will increase accordingly – in the face of a limited supply of this vital resource. Usage conflicts are inevitable, and will become more acute on account of wasteful use and pollution. Scarcity of water is a humanitarian problem and it can curb economic growth. Climate change will amplify many water-related problems and create new ones.

We put the annual investment required in the global water sector at about EUR 400-500 bn. Measured by this yardstick the sector is a picture of underinvestment, especially because water prices in many areas are subsidised and thus too low. As a result, there is a lack of incentives for necessary investments. The prices do not reflect the scarcity of water as a resource; wastage is encouraged. Corruption and the absence of ownership rights compound the problems. To turn the tide, water prices in many countries would have to be boosted. The need to incorporate social considerations in the process greatly reduces the scope for making such increases in practice.

Governments will not be able to raise the funding needed to cope with the upcoming tasks on their own. While there is considerable disquiet about private firms investing in the water sector, the public sector is simply unable to meet all the challenges single-handedly. For this reason, we believe it makes sense for governments and the private sector to cooperate more closely.
Makers of “water technologies” stand to benefit from huge sales potential over the next few decades – despite the risks cited. There is likely to be a particularly sharp increase in the demand for efficient irrigation technologies, seawater desalination and sewage treatment facilities, technical equipment (e.g. pumps, compressors and fittings), filter systems and disinfection procedures.

We have used a scoring model to rank the attractiveness of various countries for investments in the water industry. The Top 20 include many countries from the Middle East that are rich due to their oil deposits, located in very dry regions and relatively stable politically. Two big industrial countries, Germany and the US, and the world’s two most populous nations, India and China, are also among the Top 20 in our ranking. In principle, though, all countries require a substantial amount of investment in the water sector.

To read the full report: WATER MARKETS

>DIRECT FISCAL COST OF THE FINANCIAL CRISIS (DEUTSCHE BANK)

— Final direct cost of the crisis for taxpayers may remain below 1% of GDP in most developed countries. This is only a small fraction of original commitments and also much lower than initial gross expenditures.

— Somewhat surprisingly, in historical comparison the crisis may turn out to be one of the least costly on record. Initial outlays already totalled only half the average seen in previous banking crisis resolution schemes in developed countries, primarily thanks to decisive and bold action taken by public authorities and a speedy recovery of the world economy. Recovery rates, too, have not always been as high as in the recent crisis.

— Among the countries most affected by the crisis, direct fiscal costs are in the end unlikely to exceed 2% in the US and 1% in Germany, while banking-sector rescue programmes in France and the UK might possibly even return a net gain.

— Significant cross-country differences result from the diversity in the designs of the stabilisation programmes, participation rates and the timing of the exit from state support.

■ How do we define fiscal cost?
The fiscal costs of a financial crisis can be broadly divided into two categories: a) direct costs relating to equity injections, debt assumed by the state and asset guarantees as well as (emergency) liquidity support for financial institutions, and b) indirect costs arising from lower tax revenues and higher government spending as a result of a crisis-induced recession, but also including e.g. increased interest costs resulting from higher debt levels (and contingent liabilities). In this briefing, we will mainly focus our analysis on direct costs, excl. support by central banks.

■ Which banking sectors suffered most in the crisis?
Before turning to the actual analysis, it is useful to look at where the crisis played a significant role. Three different types of country can be distinguished as having been hit especially hard by financial sector losses (see chart 1): a) countries such as the US, UK and Ireland that had experienced a credit boom prior to 2007 and where banks had to face declining asset valuations (resulting in securities write-downs and loan losses); b) countries such as Belgium, the Netherlands, Switzerland and Iceland whose home market was not large enough for their ambitious domestic financial institutions which therefore often built up large exposures to structured products originated in other (mostly ―bubble‖) countries; and c) the special case of Germany where a substantial share of the banking sector had no viable (i.e. sufficiently profitable) business model and Landesbanks in particular engaged in ―credit substitute transactions‖, i.e. buying of securitised loans instead of direct lending.

To read the full report: FISCAL COST

>OTC derivatives: A new market infrastructure is taking shape

The global derivatives market has expanded enormously in recent years. Interest rate products (options and futures) have seen a particularly rapid increase over the past eight years. When volumes peaked in 2007, gross notional amounts outstanding of over-the-counter (OTC) derivatives amounted to USD 605 trillion.

A number of structural deficiencies in the market infrastructure of OTC derivatives were revealed during the financial crisis. Inherent counterparty risk and its inadequate management, the intransparency and complexity concerning actual risk exposures, and the danger of contagion, i.e. the risk of a default of one firm spreading through the financial system, are the issues that were brought to the collective consciousness in conjunction with the systemic relevance of these markets.

Traditionally, counterparty risk used to be mitigated between trading partners by means of bilateral collateralisation. While in principle collateral can be an effective insurance against counterparty credit exposure, prevalent market practices such as asynchronous collateral cycles or incomprehensive collateral coverage resulted in uncollateralised exposures in the past.

Central counterparty (CCP) clearing is the most immediate way of addressing these limitations. CCPs also reduce systemic risk, as they reduce the likelihood of contagion. Hence, regulators in the EU and the US are pushing for more OTC business to be cleared via CCPs.

Reform of market infrastructure will alter competitive structures in the industry. Rules on the eligibility of contracts for central clearing, interoperability of CCPs and ownership of the market infrastructure are issues set to shape the industry, but are undetermined at the moment.

Regulators should ensure that legislation drafted is commensurate with the risks faced. While transparency and standardisation are objectives worth of being promoted, the future of the industry will critically hinge not so much on market forces but on the outcome of the regulatory process. Regulation must strike an appropriate balance between greater stability and preserving the benefits of solid, yet dynamic derivatives markets.

To read the full report: OTC DERIVATIVES

>The new world: Emerging markets after the crisis

■ Emerging markets have fared quite well in the crisis
• Particularly against the background of large financial market losses in Sep/08-Mar/09

■ EM economic growth lower than in the “boom“ years but still very robust
• Roughly 4 pp per year higher than in industrial countries in the next 3-5 years

■ Some short-term risks to watch
• Risks of bubbles building in some markets; inflation on the rise in some countries
• Policy risks as governments try to manage “excessive“ capital inflows

■ Medium-term trend: EM position improves but specific risks remain
• Large build-up of public debt in DM has brought issue of sovereign risk to the fore
• Relative risk position of EMs has significantly improved
• Importance of EMs as consumer markets and regarding commodities will rise further
• EM political and policy risks remain important: country-specific knowledge essential

To read the full report: NEW WORLD

>The “Great Risk Shift” – or why it may be time to re-think the developed-/emerging-markets distinction (DEUTSCHE MARKETS)

After defaulting on their external loans during the 1980s, many emerging markets (EM) experienced often severe financial crises during the second half of the 1990s and in the early 2000s. Most top-tier EM have weathered the global crisis much better in terms of public-debt sustainability and the short/medium-term growth outlook than many developed markets (DM). Following what may in the future be remembered as the “great risk shift”, it may be time to re-think old labels and traditional distinctions – and established views of economic and financial risk.

The term “emerging economies” seems to have been coined sometime during the 1980s and became part of standard vocabulary during the 1990s. The term referred to economies that were neither “developing” nor “developed”. In practice, it referred to a group of upper-middle-income countries that attracted private capital following the first oil shock. After defaulting on their external loans during the 1980s, many of the emerging markets (EM), as they were soon called by Wall Street and the City, experienced often severe financial crisis during the second half of the 1990s and in the early 2000s. To be fair, developed economies also experienced various crises during that period (e.g. ERM crises) and a handful of EM reached per income levels comparable with, or even higher than, some of the developed markets (DM), which is why the IMF moved these countries into the “newly industrialised economies” (NIE) category. But the pun about the “submerging” emerging markets, for better or worse, continued to stick.

Following the 2008 crisis, the financial fortunes of DM and EM diverged rapidly. While many DM are witnessing rapidly rising public debt, large fiscal deficits and slower growth, most toptier EM weathered the global crisis much better in terms of public-debt sustainability and the short/medium-term growth outlook. The diverging fortunes have been reflected most strikingly in the concerns about debt sustainability in the so called Eurozone PIIGS. For instance, investment-grade Greece 5Y CDSs are currently trading at 280 bp vs sub-investmentgrade Indonesia and Turkey at 160 bp.

The rating agencies rated Greece A until very recently, while both Indonesia and Turkey carry a sub-investment-grade rating. The rating agencies rationalize this in various ways. Sovereign ratings assess creditworthiness “through” the cycle. Typically, the investor base in the DM is much broader, domestically and internationally. Capital markets are much deeper, and their sovereign debt structures are often (though by no means always) less vulnerable than in the average EM. Finally, DM debt service track records are typically very strong. While some of these arguments have some merit, the rating agencies almost certainly underestimate the improvement in the creditworthiness of EM sovereigns and potentially underestimate the deterioration in DM creditworthiness.

Past (surprise) EM crises seem to have made the agencies cautious about EM upgrades. At the same time, the agencies tend to be reluctant to downgrade a country by more than 1-2 notches a year given that they claim to rate “through” the cycle. Another problem is that by downgrading a sovereign aggressively the agencies may contribute to financing difficulties and thus trigger a sort of “self-fulfilling prophecy”. The reluctance to aggressively downgrade a DM in line with the markets’ assessment of sovereign default risk is therefore understandable, but it hardly justifies the fact that until very recently Greece and China carried pretty much the same long-term foreign currency ratings. It looks odd that Greece with very limited macroeconomic flexibility due to EMU membership and a public debt burden exceeding 100% of GDP should be rated at the same level as China whose public debt amounts to a mere 25% of GDP and whose FX reserves exceed 45% of GDP.

To read the full report: TALKING POINT

>Resumption of second generation reforms? (DEUTSCHE BANK)

■ Budget session agenda signals strong policy intent
The Indian parliament’s agenda for the current budget session (apart from discussing the union budget) seems to signal a strong intent to move ahead on the long outstanding reform agenda. The agenda includes 16 pending bills for consideration and passing (of these 10 to be taken up only in case standing committee reports are presented in time), and introduction of 63 new bills.

■ Pension, Insurance, Mining and Land Acquisition Bills on parliament agenda
Bills listed for consideration and passing include the Mines and Minerals Amendment Bill (for amendments in coal mining, permitting auction of coal blocks and paving way for Coal India’s listing), and Insurance Bill (key objective is to raise FDI cap from 26% to 49%). Bills listed for introduction include Banking Regulation Amendment Bill (to lift 10% limit on voting rights in private sector banks) and State Bank of India Amendment Bill (reducing minimum govt stake in SBI from 55% to 51%), Pension Fund Regulatory and Development Authority Bill (for deepening and improving regulation of pension sector), Land Acquisition Amendment Bill and Rehabilitation and Re-settlement Bill (to facilitate easier land acquisition).

■ Strong on intent, will government deliver?
Since taking power last year, this is the first time; the UPA administration has decisively put many of these long-awaited bills on the business agenda. We believe that politically, the timing is also propitious with the next state election more than six months away, positive coalition dynamics and a government that has firmly signaled the compulsion to return back to the pending reform agenda. Even on the economic front, the near restoration of GDP growth to the 8-9% trajectory has created a compelling platform to resume long pending reform. While we do not see all the proposed bills being taken up/passed, on account of the need for long and arduous debate, even if some of the bills are taken up, the government will send out a very strong message of its intent on moving decisively on the pending reform agenda. This should be very positive for market sentiment.

■ Banking on return to 8-9% GDP growth trajectory
We view the government as growth biased and one of the key premise of our positive outlook on India is the restoration of Indian GDP growth to an 8-9% trajectory over next 12 to 15 months. We maintain our year end target of 22,000. Our top Buys are: Asian Paints, BHEL, HDFC Bank, ICICI Bank, Infosys, Maruti, M&M, SAIL, Sterlite, and TCS.

■ Risks to our positive investment thesis
The return of non-food inflation could bring back the overhang of an ‘inflation wary’ government, a sharp rise in global oil prices raises the risk of an aggressive policy response and a fat pipeline of fresh issuances. A strengthening dollar and weakerthan- expected global growth are key exogenous risks.

To read the full report: EQUITY STRATEGY

>RELIANCE INDUSTRIES (DEUTSCHE BANK)

■ Rebound in refining juxtaposed with recent sell-off augurs well for the stock

We reiterate Buy on RIL with 26% potential upside to our target price. With a 10% fall YTD, the stock trades at 14.0x FY11E PE and 8.4x FY11E EV/E. Key prospective catalysts: i) recent rebound in margins and light-heavy differentials, coupled with plant closures, augurs well for refining outlook; ii) petchem is enjoying near-term tail winds from tight markets and delays in new start-ups; iii) proposed deregulation of auto-fuels could help RIL revive its fuel retailing business; and iv) potential exploration success, acquisitions and gas dispute resolution.

Buy on refining, petchem tail winds and 10% correction

■ Refining bottoming out; US$1/bbl swing implies 3.6% upside to earnings
Our channel checks and the company’s recent results suggest that global refining margins may be at rock bottom. We believe that oil demand revival, spurred by improved economic outlook and ongoing capacity rationalization, could eventually turn around refining margins. The caveat is that the revival is difficult to time and we cannot wish away the volatility in oil prices even under normalized markets.

■ Higher-margin E&P to drive growth, de-risk the portfolio
We expect RIL’s ramp-up in KG D6 gas driving margin expansion and also EPS CAGR of 34.3% for FY10-12. In addition, the increasing share of the E&P (oil&gas) segment should help remove the cyclical risk in refining and petrochemicals.

■ Prospective catalysts: reviving earnings; potential end to KG D6 gas dispute
Our target price of INR1,235/sh uses equal weighting for PE-based and DCF methods. We use 16.1x FY11e PE based on RIL’s five-year average 12m rolling PE. Our DCF uses 10.2% WACC, based on our assumptions of India CoE of 13.4% and terminal growth of 4%. Risks are: i) a worsening global economy along with new capacities hurting refining and petchem outlook; ii) the RIL-RNRL dispute dragging on; iii) production outages; and iv) policy vagaries.

To read the full report: RELIANCE INDUSTRIES

>Stay bullish, raising Sensex target to 22000 (DEUTSCHE BANK)

■ 2010 annual Sensex target of 22,000
We are setting our one year forward target for the BSE Sensex at 22,000, implying an upside of 25% from current levels. Our target implies a PE of 21x on our current FY11 earnings estimates. We believe that the market is underestimating the growth potential since a more convincing, revenue driven, EPS upgrade momentum has just begun.

■ Banking on return to 8-9% GDP growth trajectory
Our 2010 India outlook is premised around two broad themes – a shifting paradigm in the composition of global economic growth and the restoration of Indian GDP growth to a 8- 9% trajectory over next twelve to fifteen months. The key theme for the Indian equity market in 2010 will be the domestic economy and the pace at which economic growth is restored back to the 8-9% growth trajectory. While consensus is still cautious on the restoration of above trend growth, we remain confident that the economy is on course to moving back towards the 8- 9% growth trajectory.

■ Robust consumption to result in return of investment cycle
We believe that the next leg of market re-rating will occur when the investment cycle makes a decisive comeback. We are convinced that strengthening domestic consumption and accelerating momentum in employment generation – across swathes of rural and urban India – is raising business confidence. We expect these factors will lead to an accelerated return of the investment cycle, which should drive the next round of GDP upgrades, upward revision to earnings forecasts and rising conviction in the restoration of the 8-9% GDP growth trajectory.

■ Our investment ideas
DB Investment themes – domestic consumption and consumption derivatives (autos, metals, paints, private sector banks), infrastructure (we prefer power generation equipment suppliers over T&D equipment suppliers) and software ( we are more confident of front ended returns in 1H). Our Top Buys - : Asian Paints, BHEL, HDFC Bank, ICICI Bank, Infosys, Maruti, M&M, SAIL, Sterlite, TCS. Our top mid-cap picks are: Auro Pharma, Bajaj Hindusthan, GVK, Onmobile, and Thermax.

■ Tug of war between inflation and growth, but low risk of sudden policy reversal
We think 2010 will also see the market being swayed by a tug of war between inflation expectations and growth. We sense that the current UPA administration remains biased towards growth, reducing the risk of any knee-jerk policy error. The return of non food inflation could bring back the overhang of an ‘inflation wary government’, which may impact valuations of materials companies. A sharp rise in global oil prices raises risk of aggressive policy response. Global macro factors – strengthening dollar, weaker than expected global growth - are key risks.

To read the full report: INDIA EQUITY STRATEGY

>Revenue growth at an inflection point (DEUTSCHE BANK)

■ Revenue growth driven by robust domestic consumption: We believe that the key highlight of the Dec 09 quarterly results will be the inflection point in revenue growth which is set to turn robustly positive after three quarters of muted growth, primarily driven by robust domestic consumption, which seems to have grown impressively despite concerns of a poor harvest. We estimate revenue growth of 26%/20% yoy for Sensex and DB universe
respectively. Although exaggerated by a base effect, we believe that the robust top-line growth is a reflection of strong recovery in domestic aggregate demand. Indeed, some of the key metrics, such as growth in auto sales, consumer appliance sales, air traffic, etc have posted multi-period highs during the Dec quarter. We strongly believe that private and government consumption expenditure will be the key driver of Indian GDP growth.

■ Revenue growth momentum will propel earnings growth to 26% in Dec 09: Earnings growth, which had already seen an inflection point in Jun-09 quarter, will gain further momentum as we expect Sensex’ earnings to grow by 26% yoy while DB univ’s should also grow by 26%yoy (41% cum-PSU OMCs). This will be due mainly to momentum in topline, unlike preceding quarters when margin expansion (driven by lower raw material prices and cost cutting measures) was the key driver for earnings growth. We view this as a more positive signal of recovery and hence emboldened to expect further improvement going forward.

■ Auto, Oil, and Metals (ex-Corus) to lead while Telecom, Real Estate to lag: We expect the Auto sector to stand out (reflecting strong demand, benign commodity prices and low base), with earnings likely to grow by 261% and EBITDA by 216%. Oil and gas should also show a significant profit jump, but mainly due to lower base in PSU OMCs in the Dec-08 quarter. Ex- OMCs Oil sector earnings should still grow by an impressive 64% yoy due to lower upstream sharing by ONGC. Metals should report EBITDA and PAT growth of ~80% yoy (ex-Corus) on the back of rising volumes, despite lower realizations. The telecom, sector which witnessed an intense tariff battle in the quarter, should unsurprisingly be the biggest laggard with EBITDA and PAT growth at -5%/-28% yoy respectively.

■ We remain convinced that market will overshoot our fair value target in 4Q: We believe that earnings upgrades, which had reversed in past few months, should resume, underpinned by a significant upturn in quarterly results, rising expectations of upward revisions to GDP growth and better-than-expected growth across key global economies. We remain convinced that the market will overshoot our fair value target of 16,500 in 4QFY10.

To read the full report: EQUITY STRATEGY

>2010 US Equity Outlook: The Shape of Things to Come and Seven Trades

Seven questions on the shape of things to come
Our fundamental thesis remains that after a corporate over-contraction, the necessary expansion underway to meet existing demand will maintain pressures for a cyclical recovery into 2010. Enterprise spending and hiring will determine the speed of recovery and its sustainability. Instead of a detailed baseline and alternative scenarios, we discuss seven key questions:

Q1. After cost-cutting, how much upside remains for earnings? Significant.
Q2. How severe will a possible double-dip be? Is it priced in? Modest, a ‘W’ in growth rather than in the level of GDP; market is pricing in flat-to-down earnings.
Q3. Will monetary tightening derail the equity recovery? No. It should have only a temporary impact on US equities.
Q4. Will the dollar turn in 2010? Bad for US equities? We see the dollar rallying with US rates, but not ruling out upside for equities; energy is most vulnerable.
Q5. How are investors positioned after the massive rally? A large asset allocation underweight in equities persists; inflows will come only after rates turn up.
Q6. Will the financials outperform? We think so: current underperformance exceeds that in the Great Depression; they are cheapest on normalized earnings; and employment is a key driver of relative performance.
Q7. Will emerging markets continue to outperform the developed markets? Bulk of outperformance reflected multiple expansion not earnings growth; relative valuations have run up and so we prefer DM stocks with EM exposure over EM.

Revised targets, market & sector strategy
We revise up our EPS estimate for the S&P 500 in 2010 to $80.8 ($77.8) and our S&P 500 target to 1325 (1260). Across asset classes, we see the biggest upside for equities; but our sector allocations make us already overweight in a beta sense and so we stay fully allocated. Across sectors, our largest overweight remains the financials, and the largest underweight energy. We move health care from underweight to neutral as diminishing uncertainty about reform lifts multiples.

Seven trades for 2010
(i) Significant recovery upside but also downside risks: Best of both worlds basket, high-quality stocks cheap on normalized earnings;
(ii) M&A up cycle beginning: Buy acquisition targets;
(iii) Rising rates: Long brokers (XBD) and short REITs (IYR);
(iv) Stronger US dollar: Long retailers (RTH) and short energy (XLE);
(v) Overweight US versus emerging markets: Long US financials (XLF) and short EM financials;
(vi) Flows follow: Stay with value over growth;
(vii) Uncertainty to decline: Short S&P 500 12m forward volatility.

To read the full report: US EQUITY STRATEGY