Foundations of rally are suspect

With the BSE100 and MSCI Emerging Markets up 17 per cent and 16 per cent, respectively, year to date, there is excitement in the air after a long time. But can this last? I believe while investors should increase their exposure to cyclical sectors, such as power, infrastructure and financial services, they should focus on well-managed companies with strong balance sheets, because the foundations of the current rally are suspect.

Though the European Central Bank’s (ECB’s) ongoing long-term refinancing operations (LTRO) have given stockbrokers something to smile about, there are three fundamental issues the ECB can do little about.

First, like QE2 a year ago, the latest bout of monetary easing by the ECB is exerting upward pressure on commodity prices in general and oil prices in particular. WTI crude on the Nymex has already crossed $120 per barrel and our economist, Ritika Mankar, says movement in 33 per cent of the WPI basket depends on movements in the global commodity price cycle. Therefore, if this rally in commodities continues, it will make it that much harder for the RBI to cut repo rates significantly. That obviously means banking stocks (which account for nearly a quarter of the benchmark index) will have to shed some of their recent gains.

Second, beyond ECB’s intervention, what has cheered the bulls recently is the nascent economic recovery in the US. This is likely to come under pressure in the coming quarters due to a couple of reasons.

On November 21, 2011, the US Congressional ‘Super committee’ failed to agree on a plan to cut the US deficit by $1.4 trillion. This failure will automatically trigger around $50 billion of fiscal spending cuts. Furthermore, this failure is likely to mean that the cut in payroll taxes ($110 billion per year) and emergency unemployment benefits ($50billion per year), both of which are measures that helped the US in the 2011 calendar year, cannot be extended to 2012 . So, in totality, around $210 billion (1.4 per cent of US GDP) of fiscal spending will be taken off the table by the US government in 2012 vs 2011.

US exports to the EU account for around two per cent of US GDP. With the EU likely to enter a recession in 2012, these exports will be under pressure.

Third, back home in India, the UPA’s ability to deliver reform in Parliament seems suspect. Therefore, if the UP and Punjab election results do not work out in UPA’s favour, we can start discounting the prospects of reform in the Budget session. Put simply, the stock market has made certain assumptions about how the election results will pan out on March 5. If the results behave differently, a pullback is on the cards.

The author is head of equities,

Ambit Capital. The views here are his own and not Ambit Capital’s