Indian Markets – Outlook For 2014 Technical, Inter-market & Macro Economic Analysis January, 2014 Tarun Dang and Renu Goel

Abstract

2013 was an year to remember for equities, especially developed markets. As they emerge from the shadows of recession and global demand picks up, emerging markets will follow suit. India has always figured high in the list for investors when it comes to emerging markets as an asset class in itself. India is at the cusp of its next investment cycle. Various leading indicators are signaling a move from contraction to ‘early’ expansion. The Rupee has stabilized, exports & PMI improved marginally & a good monsoons may help cool inflation. Corporate profits have surprised on the positive side; visible on the stock prices of companies from core sectors like capital goods, energy and metals. Sticky inflation has derailed a rate cut cycle that would’ve otherwise stimulated the industry but if the green shoots of expansion are managed well then it is likely to happen soon. But most importantly, 2014 is election year and how it shapes up will decide the fate of Indian economy for some years to come. The industry, markets and investors have pinned their hopes on a decisive electoral mandate for a pro development BJP led by Narendra Modi. Most of the political analysis and projections point towards it happening. Any surprises otherwise will probably be a setback to an economy that is in immediate need of relief from policy paralysis and waning investor sentiment.

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2013 was a marquee year for global equities – trend to continue into 2014

• 2013 has proved to be a significant year for many notable markets across the globe. S&P 500 and DAX, benchmark indices for developed markets like the U.S. and Germany clocked new all-time highs in 2013

• The strong dominant trend in these indices is expected to continue well into 2014 and new highs can be expected

• A country’s equity markets are well known leading indicators of its economic growth trajectory. It reflects the country’s corporate performance and it’s near term expectations. The bottoming out or emergence of US & Germany from the shadows of recession post the Euro zone crisis is well reflected in the performance of their bench-mark indices

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2007 Highs S&P 500

With a parabolic rise since 2012, index has surpassed 2007 highs effectively completing a multi-year double bottom pattern

2007 Highs

DAX

Break-out from continuation triangle helped scale 2007 highs & suggests further upside still remains

History in the making for equity markets – Japan rising!

• While S&P 500 and DAX were posting all time highs, Japan’s Nikkei has risen 52% for the year (its best performance in almost 4 decades)

• UK’s FTSE is retesting its all-time highs with serious intent to surpass it

• However, what makes 2013 and most likely early 2014 significant for these developed market indices is that they have either conquered or are retesting their 2007 highs (which essentially represents the peak before the global markets were plunged into financial meltdown with the subprime crises)

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2007 Highs FTSE

A decade long sideways range if broken (looks highly probable at present) will open significant upsides for the index.

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2007 Highs

Nikkei

Multi-decade downtrend shown with falling channel has been breached. Looks like a new chapter in Japanese equities

Developed markets dominate 2013 as EMs were out of favor

• As developed markets are still in an early recovery phase, the emerging market economies have to contend with muted demand which has trickled down to their economic performance

• The gradual recovery in the Euro zone and the U.S. are reflected in their equity market performance. While they were posting new records there hasn’t been a similar performance by India’s and its peers in the emerging markets like China and Brazil

• India’s Nifty, China’s SSE Composite, Hong Kong’s Hang Seng & Brazil’s IBOVespa have struggled to post any meaningful uptick in 2013. They are still trading way below the highs of 2007 and 2008 (around the time of the financial meltdown) which is a yardstick that we are using to compare global indices

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2007 Highs Hang Seng

Higher lows show rise but resistance at 25000 will be a challenge. Overall, way below the 2007 highs

2008 Highs IBOVespa

A clear underperformer with prevailing long term downtrend marked by the falling channel

Nifty flirting with an important level – Awaiting a decisive breakout

• As investors await positive cues for the economy from the political class, it cannot be more visible than on the benchmark equity index, Nifty!

• The rise from the last long term bottom of 2009 is visible with the higher lows formed. Even though Nifty posted all time highs but it has slipped again and is trading below its 2008 highs

• Nonetheless, compared to its peers Nifty looks better poised and is flirting at a resistance level with what could potentially be a break-out from a 6 year long sideways range

• Even in this tough economic scenario, corporate profits reported in the last quarter have been encouraging

• This chart shows how corporate profits and expectations, represented in a stock market index, precede turning points in the economic progress. Nifty bottomed out in advance before GDP growth rate signaled a turn

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2008 Highs CNX Nifty

A sustained break-out is needed to signal the next phase of the long term uptrend

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-Nifty -India’s GDP Growth Rate (QoQ)

Global recovery will rub on to EMs too – Indian equities better poised

• On a yearly performance report card EMs are easily overshadowed by the galloping performance posted by the developed markets like Japan, Germany and the US. But the contrarian view is that this relative underperformance of the EMs makes them more attractive at this juncture. If the early recovery signs from the US and Euro zone build on then EMs stand to gain & will start showing up moves from the lower base that they are at present

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MSCI Emerging Markets Index

6

26.0%

10.8%

22.8%

52.4%

-0.1%

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-7.1%

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S&P FTSE Dax Nikkei HangSeng Nifty

Stockmarket Indices (Performance 2013)

IBOVespaSSE

Composite

• The MSCI Emerging Markets Index which tracks a wider basket of markets than just the BRICS, has been in a sideways range over the last 2 years while the larger trend since 2007 still remains down. This again confirms the extent of hit that a wider range of emerging nations also took after the subprime crisis

• EM tracking indices have shown positive correlation with developed market indices like S&P 500 over the years. But that correlation has declined in the last 2 years. Our view is that as developed markets & global demand recovers further, the EMs will follow suit again

Taper will be a concern for India though better prepared to absorb it now

• Emerging market currencies bore the brunt when QE taper talks surfaced around mid 2013. Resultantly, equities slumped in initial panic reaction

• Looking at relative performance of both EM currencies and equities it is evident that India is vulnerable to taper triggered outflows, dollar carry trade or otherwise

• Other EM equities were less affected compared to Nifty when taper talk surfaced but eventually by the end of 2013 it was outperforming others

• Credit lies with the rearguard action by the RBI Governor to defend the Rupee. The recovery in the currency and various other steps by the RBI suggest that Rupee is better prepared to absorb shocks in the future. But Indian markets, both debt and equity are heavily dependent on external inflows and hence QE and taper will be expected to have a notable impact

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Relative Performance (%)

Brazil IBOVESPA India Nifty Russia MICEX China - Shanghai Composite

75.00

80.00

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105.006-

Jan-1

3

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USDINR USDRUB USDBRL

7

Equities

Relative Performance (%) Currencies

Initial taper talks surface

Rupee was the worst hit amongst its peers

By the end of 2013 Nifty was an outperformer amongst EM peers

Note: Chinese Yuan not included in analysis since it is not a free float currency

Show Jan 09-Dec10 FII Buy Vs Jan12-Dec13 Buy

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Net FII Buy / Sell (Debt) 10yr Yield

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Net FII Buy / Sell (Equity) Nifty

• 2013 saw a heightened level of FII exit from Indian debt (highest in the last decade). A lot of it has been attributed to taper talk in the US

• In the second half of 2013 FII sell-off in debt was accompanied by a sizable buying in equities in 2013. This shift in asset allocation is suggestive of expectations of higher returns in equities

• At the same time yields have been pushed high (bond prices are down) and one can expect buying interest returning to bonds since they are available at a cheaper price. One of the classic early signs of uptick in an economic cycle is a rally in bond prices. How bond yields perform over the next quarter will provide further clues

8

Money flow analysis shows sizable sell-off in debt & buying in equities

Expect sizable decline in crude & gold – Will ease out pressure on Rupee

• Our analysis suggests that barring some pullback there is high probability that support at 1180 will give way & gold will decline further (1050-950 based on our EW count). Overall view for the long term is bearish

• Based on fractals (similar formations on smaller timeframes) unfolding on the Brent chart we expect a decline towards 100 & then a larger correction once the triangle completes

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Crude Oil (Brent)

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Gold (Int'l Spot)

• These 2 commodities have a significant bearing for India’s current account deficit as they constitute a sizable chunk of its import bill

•With the expected correction in gold and crude oil prices it will ease out some pressure on the hard hit Rupee and help provide further stability to the equity markets

9

2

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1180

Multi-year bull run in Gold seems to be over as it slipped past key support levels & is yet again testing one at 1180

Given the decline before the triangle started forming & the fractals unfolding there is high probability of a correction going forward

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IIP Percentage % IIP

Manufacturing stabilizes but growth challenges remain

• In 2013, IIP has shown feeble signs of recovery. Despite weak headline October numbers, Capital Goods has increased YoY by 2.3%

• PMI, a precursor to manufacturing activity, has been above the critical 50 level during the last two months, showing signs of early expansion . This should reflect in the manufacturing activity in the coming months

• Lack of investment activity and weak consumer demand continues to impact manufacturing in India. Uncertainty about the economy, in light of the May 2014 elections will further limit investment activity

• While global demand seems to be resuming, sustaining it would require the next investment cycle to kick in. This is where India’s challenge lies

A fractional rise in manufacturing activity, driven mostly by export growth

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Repo rate

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Inflation

WPI CPI

Prolonged inflationary pressures hamper rate cuts • CPI is gaining importance for policy purposes since WPI does not capture the services component, which is nearly 65% of the GDP

• The food component in CPI is higher at nearly 50% and only 24% in the WPI. Supply constraints affecting food prices have been temporarily resolved and lower prices will reflect in the CPI in the coming months

• Other factors like a hike in fuel prices, a sudden increase in food prices, and a weakening rupee can potentially keep the inflation rate elevated in 2014

• We are yet to see the start of a rate cut cycle that will effectively usher this new investment cycle. So far the RBI has been forced on the back foot by the rampant inflation in its otherwise progressive measures to promote growth. Going by the Governor’s calculated gamble that food prices aided by the good monsoon will soon start to cool off, he has held status quo of repo rate in the last policy meeting

Moderation in food and vegetable prices in December may provide some respite in the near

future

Inflation continues to impact policy rates. A rate cut is unlikely without inflation reined in

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The rate cut cycle that began in 2012 had to be reversed due to persistent inflation

Resilient global demand support exports

• The Baltic Dry Index, measures the demand to move raw materials and often serves as a proxy for global demand. The Index has gained 228% in 2013. However it is significantly lower than its peak in 2008

• The Index has seen a gradual rise in the last few months, predominantly due to the increase in Chinese demand for imports of Australian iron ore

• Indian exports experienced seasonal high’s during the beginning of the year and exhibited a moderate increase during the year on the back of a weakening rupee and improved global demand. YoY growth continues to be positive

• Import tariff cannot be maintained for lengthy durations and a sustained CAD improvement will depend on export growth

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Baltic Dry Index

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India's Exports

12

Exports need further push to gain from the strong dollar/weak Rupee

We may have seen the bottoming out of the slow-down in demand

-6.4%

6.8%

12.6%11%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

Equities (Nifty) Currency (USD/INR) Fixed Income

% Returns (2013)

Asset class performance & sectoral themes – 2013 and beyond

• MCX gold or ETF like GoldBees (shown in the chart as proxy for Gold prices) have not shown a like to like cut in prices as international spot prices. Nonetheless we are long term bearish on gold at the moment

• Fixed income was the winner in 2013 (11% taken based on higher range of yields offered by certain corporate bonds). There can be a case for bottom fishing going forward as & when signs of bond yields topping out emerge

• Given our money flow analysis we think that equities have the potential to give better returns in 2014 as the growth story takes shape

13

-8.7%

9.4%

0.4%

-7.3%

12.2%

-4.2%

58.0%

-14.3%

6.8%

26.5%

-5.6%

-20%

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CNX Auto CNX Energy

CNX FMCG

CNX IT CNX Nifty CNX Pharma

Sectoral Performance (% gain/loss in 2013)

BANKNifty

CNX Finance

CNX Infra

CNX Metal

BSECapital Goods

Asset Class Performance

• In 2013, there were a few winning sectoral themes like IT and Pharma for stock pickers to play on, even though overall, equities did a meager 6.8%

• While these sectors remain attractive but we expect better moves in Banking, Metals and Capital Goods if the markets break-out in 2014 as we have built a case for. Core sectors like Banking, Energy and Capital Goods are typically expected to lead a bull market rally

Tarun Dang Managing Partner tarun@trend-wise.com Renu Goel Senior Analyst renu@trend-wise.com

www.trend-wise.com @TheTrendWise

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