Cheaper commodities and Indian equities

27 August 2008

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?