Indian equity markets have outperformed most Asian markets over the last month, as commodity prices have corrected and the country is though to gain more than others. Optimists also believe that inflation has topped and the RBI may not hike interest rates further. Can this optimism sustain? By Vivek Sharma

A recent report by a large foreign equity research and investment firm adopted an interesting, and what appears to be a very logical argument, favouring investments in Indian stocks now. It is not that interesting theories and arguments are anything new from research firms, considering that they make a living out of such pronouncements and without them, the equity markets wouild be far less interesting and even less amusing.

The report says Indian equities offer a unique hedge against falling commodity prices, because our markets are inversely correlated to what they call 'the commodity complex'.

This inverse correlation is near perfect, going by recent history. When oil prices surged from below $100 per barrel to the record of $147 per barrel, Indian markets slumped and were in fact one of the worst performers globally. Then, when oil started correcting, our markets recovered nearly 20 per cent from the bottom. Again, when oil recovered modestly after slumping close to $110 per barrel, our markets reversed direction and gave up part of the gains from mid-July.

Correlations cannot be more perfect than this. Hedge funds have discovered this inverse relationship only now and are getting ready to increase their investment allocations to India, the report says. There are other positive factors as well. Markets like Russia and Brazil, which were doing very well until mid-July, have lost heavily as commodity prices started correcting.

Russia's invasion of Georgia has made investors nervous and part of the money being pulled out of that country may flow to India. Though inflation in India is still high, the analysts who produced the report are convinced that the economy is past the inflation peak and India remains the best long-term story in Asia, whichever way you look at it --- top-down or bottom-up, it concludes.

Nobody disputes the last part, that India is definitely one of the better long-term stories in Asia. Do the other parts of the argument hold up to closer scrutiny?

The inverse commodity correlation
Like most other economies, commodity prices are the prime driver of inflation in India as well. That is why the government protects us from the ravages of commodity price inflation through subsidies. But, beyond a point, even the all-powerful government cannot afford the subsidies and prices slowly rise.

So, any fall in commodity prices will allow the government to sustain those subsidies. We will all continue to spend as before, inflation will be down, the RBI will stop raising interest rates and industrial investments will continue to grow. That will give the Indian economy added muscle to survive a global slowdown and our equity markets should do well. That in turn makes the Indian economy a safe hedge against the global commodity price correction. Simple enough.

But, there is another side to the commodity story. Take the list of the largest or most valuable Indian companies. How many of them are commodity businesses? Quite a few, starting from the largest of all, Reliance Industries, which will see an erosion in refining margins as oil prices decline. The natural gas Reliance has in reserve in the waters of Bay of Bengal will be less valuable.

Then there are ONGC, Gail India and Cairn India, which will take a direct hit when oil slips. Our large metal companies like Tata Steel, SAIL and Hindalco, all with their huge expansion plans, will suffer if metal prices decline. Standalone refiners like Reliance Petroleum, Essar Oil and MRPL will not attract the same valuations if oil prices moderate. The PSU oil marketers will see their losses coming down,

So it is not just equity markets in Brazil and Russia which are dominated by commodity businesses. India may be far more diversified than either of those markets. But, it is quite another thing to pretend that our market does not have its fair share of commodity businesses. Lower commodity prices will limit the upside potential in all the stocks mentioned earlier, and thereby limit the potential gains for the overall market.

Has inflation peaked?
With the most recent inflation numbers close to 13 per cent, the question most economists are asking themselves is whether we have seen the peak as yet. After all, how high can it go? Besides the positive rub-off from lower commodity prices, the impact of past interest rates hikes by the RBI should kick in now. Then, in several months or latest by early next year, the high base effect should pull down topline inflation figures.

Again, a good, simple and convincing theory. But, real world scenarios are often more complicated than simple theories. Even after the decline in commodity prices, fuel and metal prices in India are still far lower than corresponding international prices. Forget fuel, Indian steel prices are 20 per cent lower than in the west because the government forced the steel companies to hold their price levels. This means, fuel and other commodity prices in India will not come down unless international prices fall much more. That is not impossible, but may take longer and more global economic weakness.

Commodity prices may be the biggest influence on inflation, but they are not the only driver. Domestic demand growth in India has slowed down in recent quarters, but it is not as if demand is declining. Government spending supports domestic demand in a big way and, as we move closer to elections, such spending will only increase in the coming months.

The expansionary effects of the farm debt waiver and the liberal pay hikes to government employees will continue for a while, especially since government employees will get their arrears only next year.

Some believe that the new government that will come to power next year will be harder on inflation and cut down government spending, as it will not have to worry about elections and, therefor, can afford to be less populist. Really? First, it is difficult to foresee the next government that is stronger than the current dispensation, and able to push through policies with ease. Then, in this era of rainbow coalitions, no government can afford to cut down populist spending as the pulls and pressures on it will be far too great.

All in all, hopes of interest rate cuts by the RBI may be premature at this stage, even if the government appoints a populist politician as Dr Reddy's successor at the central bank. 

All depends on the extent of growth slowdown

It is nice, and sometimes even useful, to talk about various theories about market performance. Yes, there are many factors like relative attractiveness when compared to other markets, global trends and so on which define short term market moves. But in the long run, the factor that matters for equity markets the most is the pace of economic growth.

Unfortunately, the outlook for the Indian economy for the next couple of years is at best cloudy. There are not many who expect GDP growth to top 8 per cent this financial year. A few forecasters even predict a growth rate of as low as 7 per cent. Now, 7 per cent would have been very commendable even a few years back, but this is the new India, where expectations often run far ahead of reality. The first quarter GDP data to be released later this week will give us a better idea about what is in store.

Again, markets will recover if the current growth slow down is just a short phase of underperformance and the economy can reaccelerate without much delay. The question is how soon that will happen. There are no easy answers, but majority of the forecasters are not too optimistic.

Though some industry bodies continue to maintain that there is no slowdown in industrial investment growth, the RBI has stated to the contrary. Now this week the CII has finally admitted that some of the investments that are in the early stages of implementation will be affected because of higher interest rates. It is popular wisdom that the effects of interest rate changes trickle down with a lag of one or two years. If that is the case, the rate hikes of the last one year will show up in investment growth and overall economic growth by next financial year or even beyond.

So it is reasonable to expect growth will remain subdued during the next financial year as well. The recovery will depend on how fast inflation will cool down which will help the RBI to bring down interest rates at a faster pace. Of lesser concern is the health of the global economy, but it still matters especially for the effect on investor sentiment.

Given this outlook, markets are more likely to see range-bound movements in the near term. Hopefully, the clouds over the economy will clear over the next few quarters. Even more significant will be the political clouds that may linger after the next general elections.