Devangshu Datta: The beginning of an India rally?

It is somewhat ironic that, 67 years after the Third Reich collapsed in blood and ruin, Germany is the de facto ruler of Europe. Kanzler Merkel has called the shots as the euro zone has stumbled deeper into crisis. Last week, however, after protracted negotiations, Germany was overruled by an alliance of France, Italy and Spain as the European Union (EU) opted for a new set of rescue measures.

The stabilisation will come through assistance from the European Financial Stability Facility (EFSF). The agreement involves the European Central Bank (ECB) being prepared to open the tap and directly recapitalise banks. It moves the EU closer to a banking union under a single regulator.

Direct assistance to weak banks would keep debt off sovereign balance sheets. In the short-term, this may be enough to shore up the ailing economies of Italy and Spain. But long-term problems remain. Frau Merkel could turn off the tap under domestic pressure. It is also unclear how the Germans will ever be repaid for the burden they are unwillingly shouldering.

Markets all around the world responded to the euro zone news with a relief rally. India saw a massively bullish session on Friday as other good news also filtered through. Softer crude prices were among the factors that brought some cheer and a petrol price cut built on that optimism. If energy prices drop, so will domestic inflation and the trade balance should improve as well.

Apart from global factors, the change of guard at North Block has instilled some confidence. Dr Singh has made some of the right noises. He has moved to clarify the situation with respect to the General Ant-Avoidance Rule (GAAR) and to the retrospective amendments to the Income Tax Act, 1961, sought in the 2012 Budget.

It’s early days yet and it remains to be seen if Dr Singh can revive the animal spirits he referred to. The confusion about whether he’s seen the draft GAAR rules, for instance, suggests that he’s still familiarising himself with key details of his new portfolio. He may well have to inject some animal spirits and a sense of purpose back into the finance ministry, if there is to be any policy movement.

However, foreign investors clearly like the sense of movement. Preliminary estimates suggest that they bought a net Rs 3,000 crore worth of Indian equity on Friday. Without that big session, June would have seen foreign institutional investor (FII) outflows. Domestic institutions remained lukewarm and were net sellers through the month.

Friday was one of those sessions that could define a major trend reversal. Volumes expanded. The market saw its biggest single session rise in 2012 and the rupee zoomed to a closing value of 55.6 against the dollar, up from 56.8 in the morning.

The structural issues with the Indian economy remain, and Dr Singh will have his work cut out if he’s going to even try and tackle them. But if he’s lucky with a good monsoon, there may be a business cycle recovery anyway.

A cyclical recovery could be driven by a trend reversal in inflation. Core inflation is already down, reflecting the stagnation of the Index of Industrial Production. Crude is down, and may stay down unless West Asia and North Africa go into another round of violence. If the monsoon is good, food prices should also ease. That would bring down the two key non-core inflation factors and in tandem, give the Reserve Bank of India enough confidence to start easing liquidity.

While the rating agencies have expressed fears about India’s macro-economic outlook, and those fears remain, lower inflation would definitely help. Petro-subsidies will be reduced, and that should help with the fiscal deficit, as well as on the current account. The 2012 Budget assumed Brent prices in the range of $115 a barrel, so a drop below $95 is very favourable for the government of India, or GoI, accounts despite the rupee’s weakness.

Incidentally, traders will be looking to reverse long dollar-rupee and short euro-rupee positions given what happened on Friday. The euro may harden further, and if FIIs do continue buying through the coming fortnight, the dollar will drop.

The technical position in the equity markets after share prices spurted on Friday suggests that the Nifty may target 5400-5500 levels. If it does move up further, it might spark off a full-fledged bull run. The financial index, the Bank Nifty, is likely to be a major positive influence if this happens.

As a trader, one would expect the next fortnight to be net bullish. However, it would be sensible to keep disciplined stop-losses if one is going long. In terms of valuation, the market is pretty rich. A Nifty P-E of 17.5 is difficult to justify in terms of either earnings projections or by comparison with current interest rates.

It may, therefore, be a little early to bet heavily on a turnaround in the Indian economy. The external situation is still pretty volatile. Three years of policy inaction are unlikely to be reversed within a couple of weeks, if they are reversed at all. A host of companies with Foreign Currency Convertible Bonds and ECB redemptions due in this fiscal year are also going to be scrambling to refinance or redeem, so there will be selective pressure on balance sheets.

The prudent investor might prefer to wait and watch for talk of reform translating into action on the ground before large long-term commitments are made. Dr Singh will have to push for movement on stalled projects. He will also have to try and impose some fiscal discipline at the least. It’s unlikely that he can push the direct tax code or the good and services tax through.

Finally, there are no guarantees where the monsoon is concerned. Indeed, many of the forecasts suggest a deficient monsoon. If the monsoon doesn’t pick up, food prices will remain too high for comfort. That would retard monetary easing, which would be a critical component for an acceleration in growth.