India 2011 Research Report

8/7/2019 India 2011 Research Report

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Thema Thematic Focus

India in 2011

Strategic Focus

January 2011

Sustainable Swiss Private Banking since 1841.


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India in 2011

It gives me great pleasure to introduce our publication India in 2011. India is a key market for the Sarasin Group

and we at Sarasin-Alpen are proud to be at the forefront of the Groups expansion in the region.

As the report will demonstrate, the prospects for the Indian equity market remain appealing. The market has per-

formed nicely for many years, reflecting the countrys strong economic growth and remarkable wealth creation over theperiod. Indeed, with a USD return of 19.7% p.a. over the last ten years, India has been one of the strongest equity

markets in the world.

Although this performance is impressive, India is at the beginning of its journey not the end. Income per capita is

estimated to be just USD 1,176 which, according to the International Monetary Fund, ranks India 137th in the world -

just behind the Solomon Islands and Yemen. It is the prospect of further rapid economic development and wealth

creation that makes India such an interesting long-term investment opportunity.

Please feel free to contact your relationship manager in case you require more information on our India offering.

Best regards,

Rohit Walia

Executive Vice Chairman & CEO

Bank Sarasin-Alpen Group


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Contents

Foreword 1India in 2011 1Economic Outlook 3India soft landing for the economy in 2011 3

The global economy will weaken in 2011 3Upswing in India is losing momentum 4Fiscal and monetary policy 6India's role in global rebalancing 8Currency 11Indian rupee for long-term investors 11Equities 13Equities upside potential still exists 13Review: India top in absolute terms, mid-table relatively 13Outlook: earnings the driving factor 13Valuation is expensive, but still not unattractive 15Opportunities outweigh risks in 2011 16Contacts 19


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Foreword

1

Foreword

India in 2011

Dear Client,

According to our cyclical research approach we are firmly

convinced that economic performance is the main driver

of the financial markets. It is not necessarily the absolute

level of growth that is important, but rather the expected

change in the pace of growth. This results namely in posi-

tive and negative surprises for economic growth and cor-porate earnings. As a consequence of the increasing

globalisation, the economic cycles worldwide are syn-

chronised with small deviations.

Our expectations on the global economy and the future

performance of the Indian economy are described in de-

tail in the first part of this publication. In the second part,

we consider the outlook for the Indian rupee. Finally, the

third part contains our outlook for the Indian equity mar-

ket.

In 2010, the Indian economy again grew very strongly. Af-

ter 6% in 2009, growth accelerated to about 9% in 2010.

The Indian central bank tightened monetary policy in re-

sponse to rising inflation. The monetary policy measures

are likely to slow growth in 2011 to some extent. How-

ever, India's long-term potential is undisputed.

If India masters the two main challenges education and

infrastructure in the medium term, the country's econ-

omy can develop into a cornerstone of a new global eco-

nomic equilibrium with strong final demand.

There is growing international pressure on the emerging

markets to allow their currencies to appreciate faster.

The Indian rupee is undervalued and the Indian central

bank will therefore permit a gradual appreciation. How-

ever, the rupee is highly volatile and usually suffers heavy

losses when risk aversion in the financial markets rises.

This raises the risk in a portfolio. The Indian currency is

suitable for long-term investors that are willing to accept

short-term losses.

In terms of valuation, the Indian equity market is by far

the most expensive in Asia. However, the high price is

justified by the best earnings trend. The question is

whether India can maintain the growth momentum of re-

cent years and earnings can therefore continue to grow at

above-average rates in the future. Even if the pace of

growth slows somewhat, it should still remain high com-

pared to the other emerging markets. We see upside po-tential of 15-20% in 2011.

For a more detailed overview of the most important global

economic regions and financial markets, we recommend

our publication Global View. We hope this outlook gives

you a good overview of the opportunities offered by one

of the world's largest countries and the challenges it

faces.

Best regards

Your Sarasin Research Team


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Economic Outlook

3

Economic Outlook

India soft landing for the economy in 2011

India will not escape the global economic downturn that we expect in 2011. Continuing robust domestic growth

can cushion the Indian economy from weaker exports. Consumption and capex will remain the key growth drivers.

We expect growth to fall back from about 8.5% - 9.0% in 2010 to 7.5% - 8% this year. This moderate outlook for

economic growth means the Indian central bank will no longer be able to continue last year's aggressive rate

tightening in 2011. If India masters the two main challenges education and infrastructure in the medium term,

the country's economy can develop into a cornerstone of a new global economic equilibrium with strong final de-

mand.

The global economy will weaken in 2011

Robust global economy in 2010

The global recovery, which picked up pace in the second

half of 2009, continued in the first half of 2010. In the

global recession at the start of 2009, industrial invento-

ries were run down more than the decline in sales. From

the second half of 2009 on, industry- and export-oriented

companies were the main beneficiaries of inventory re-

building. By mid-2010, the gap between inventories and

sales had been closed and confidence in the global

manufacturing sector began to wane again. The OECD's

global leading indicator (which covers all OECD members

and the six most important non-members, namely Brazil,

China, India, Indonesia, Russia and South Africa) had

reached a turning point in mid-2010. For the second half

of 2010, everything seemed to point to a slowdown in the

global economy. However, the US government and the US

central bank helped the upturn in H210 to develop new

momentum. With a huge tax-cutting programme and a fur-

ther easing in US monetary policy, the outlook for the US

economy improved significantly towards the end of the

year. This should also impact positively on the globaleconomy.

but there will be a slowdown in 2011

Thanks to the US measures, the upturn will certainly con-

tinue in the first quarter of this year. However, the global

economy is then likely to cool sharply. The labour mar-

kets in many western economies, especially in the US,

are still in a poor state. Consumers will no longer be able

to maintain the economic upswing once the initial eupho-

ria on fiscal and monetary stimuli has faded. The second

half of 2011 is likely to be marked by a sluggish global

economy. This downturn will probably not give way to a

renewed upturn until 2012. It is only when the labour

markets in the main regions have recovered that con-

sumers can again be potential drivers of the economy.

Powerful upturn in the global economy

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World GDP growth (%)OECD global leading indicator (R.H.SCALE)

Source: Thomson Reuters Datastream

Source: Datastream

Powerful upturn of Asia's export nations

Asia came through the recession far better than the

western industrialised states. In the first place, the bank-ing system in Asia was more robust than in the US and

Europe. Secondly, the region is profiting from the struc-

tural catch-up process in many emerging Asian countries.

However, Asia was not totally immune to the global re-

cession. The highly export-oriented newly industrialised

Asian countries (Hong Kong, Korea, Singapore and Tai-

wan) and the Asean-5 countries (Indonesia, Malaysia,

Philippines and Thailand) were especially hard hit by the

loss of demand from the western industrialised nations.

It was these countries that recovered the most strongly in

2010 on the back of inventory rebuilding. The following


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Economic Outlook

4

chart shows the pronounced cyclical swings in Singapore

and Thailand over the last two years.

Strong downturn and upturn in Singapore and Thailand

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India real GDP growth y oy (%)Singapore real GDP growth y oy (%) (R.H.SCALE)Thailand real GDP growth y oy (%)Source: Thoms on Reuters Datastream

Source: Datastream

Asia is unlikely to escape the global slowdown

However, economic activity in these export-oriented

states is expected to slow in 2011. The trigger is likely to

come from weaker growth in the industrialised states.

China also benefited from a pick-up in export demand in

2010. Domestic demand in China is also strong. The re-

cession in 2009 hardly impaired domestic demand in

China. On the contrary, a huge stimulus package led to

an acceleration in domestic demand. However, China is

now grappling with the fall-out from these measures. The

liquidity available to the economy is far higher than de-

sired and inflation is also clearly in an upward trend. The

Chinese central bank is therefore in the process of rein-

ing in monetary policy. Stricter monetary policy and lower

demand from the industrialised states will result in a

slowdown in Chinese growth at a high level in 2011.

Upswing in India is losing momentum

Domestic supported upturn in 2010

As in China, economic growth in India was supported by

robust domestic demand in the 2009 global recession.

Robust consumption and a major fiscal programme have

been providing the necessary tailwind, as the following

chart reveals. Moreover, in contrast to China and other

Asian economies India is much less export-oriented. The

rate at which Indian GDP grew hardly ever fell below 6%

(yoy), as the left-side chart shows. The resilience of the

Indian economy in the global recession meant that the

upturn in 2010 was less spectacular than in the heavily

export-oriented economies such as Singapore and HongKong. Nevertheless, growth in India returned to the rates

achieved by the economy prior to the global recession.

Economic growth in 2010 should be between 8.5% and

9%.

Strong upturn in Indian investment

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India consumption yoy (%)India investment y oy (%)India government consumption yoy (%)(R.H.SCALE)Source: Thomson

Source: Datastream


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Economic Outlook

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Capital expenditure the most important driver

As in the pre-recession years, investment remained the

key driver for the economy. Historically low interest rates

and a huge need for investment in India's still underde-

veloped infrastructure have ensured buoyant investment

activity. Consumption has not quite managed to regain

the high pre-recession growth rate. As consumption was

relatively robust in the recession, there was simply no

need to catch up. Moreover, the high food prices at the

start of the year probably dampened the consumers

mood. In line with the recovery in the global economy, In-

dian exports also picked up strongly. However, in the

course of 2010 we already saw the first signs of weak-ness. Not surprisingly given the background of strong

domestic demand, import grew at a faster pace than ex-

ports. India's trade balance therefore deteriorated sharply

during the year.

India's imports grow faster than exports

2005 2006 2007 2008 2009 20101500

000

500

000

500

4000

India exportsIndia imports

1500

2000

2500

3000

3500

4000

Source: Thomso n Reuters Datastream

Source: Datastream

Indian growth below eight percent

In 2011, Indian foreign trade should feel effects of the

slowdown in global economic activity that we expect. This

will also have an impact on the domestic economy in In-

dia. Despite the strong domestic sector, the confidence

of Indian companies is based on the global cycle. The fol-

lowing chart shows the close correlation between the In-

dian OECD leading indicator and the US business climate

index for the manufacturing sector (ISM manufacturing).

The ISM manufacturing index can be viewed as the en-

gine for the global economic cycle. Thanks to its domi-

nant financial market, the US economy still exerts a sig-

nificant influence on the global economy.

Slowing in the US points to weaker confidence in India

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45

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65

India leading indicator yoy (%)

US ISM manufacturing(R.H.SCALE)Source: Thomson Reuters Datastream

Source: Datastream

We expect the US ISM manufacturing index to drop to

about 50 during the course of the year. For India, this

also means a further decline in the OECD leading indica-

tor, as the above chart illustrates. The following charts

show how pronounced the slowdown may be. The OECD's

leading indicator is closely correlated with the trend in In-

dian industrial production. A further decline in the leading

indicator points to industrial output growing by 6.0% to

8.0% in 2011. The correlation between industrial produc-

tion and GDP growth in turn points to economic growth of

some 7.5% to 8.0% in 2011. The expected growth in In-

dia is therefore lower than the average rate of about 9%

over the last few years.

Downside potential in India's industrial production

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India leading indicator yoy (%)India industrial production ex construct ion 3m mav (R.H.SCALE)


Source: Datastream


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Economic Outlook

6

Weaker industrial production slows GDP growth

2005 2006 2007 2008 2009 20105.50

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India real GDP growth y oy (%)

India industrial production ex construct ion 3m mav (R.H.SCALE)Source: Thomso n Reuters Datastream

Source: Datastream

Consumption will cushion downturn in 2011

Investment will no longer be able to grow as fast as in

the previous year. There is no longer a need to make up

for inventory losses, as in 2010. In addition, the interest

rate level has now risen. However, given the huge gaps in

Indian infrastructure investment will again make a posi-

tive contribution to growth in 2011. Consumption should

be the main growth driver. The robust and stable growth

numbers in recent years have supported the income of

Indian households. A stabilisation in food prices helps

real income. With stable domestic demand and a weaker

global economy, net exports should again lower Indian

growth in 2011. In view of India's high debt and high fis-

cal deficits in recent years, the state cannot be expected

to contribute very much either.

India a ray of light in 2011, despite slowdown

Given this economic outlook, India should again be one

of the growth engines in 2011 both in Asia and globally.

As most of the Asian economies are more reliant on ex-

ports than India, they are likely to be hit hard by the

global slowdown. We believe that only China can achieve

a stronger economic growth performance in 2011. How-

ever, the growth risks are higher in China. For one thing,

China's economy is more export-oriented. In addition, the

tightening of Chinese monetary policy in 2011 is likely to

be more pronounced than in India.

Fiscal and monetary policy

Debt-to-GDP ratio continues to fall

In the 2009 crisis year, the state deficit increased

sharply following fiscal measures aimed at stabilising theeconomy, which resulted in India's debt rising further. In

2010, the situation improved considerably. Higher growth

and the attendant higher tax revenues led to a significant

reduction in debt. This trend should continue in 2011.

The government deficit will again be below expected eco-

nomic growth, which will lead to a further decline in debt

as a percentage of GDP. However, debt will fall at a far

slower pace.

Debt (as % of GDP) is declining

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India public def icit (%)India debt-to-GDP(%)(R.H.SCALE)


Source: Datastream

Focus will be on debt reduction

Compared to other emerging nations, India's debt is very

high. The massive debt problems in the Euroland have

raised investor awareness regarding sovereign debt. In

the future, investors will demand a higher yield for higher

debt. For this reason, it should also be in India's own in-

terest to reduce its debt significantly. Given the strong

growth, India will also succeed in doing so. Even a gov-

ernment deficit of less than 8-9% leads to lower debt

relative to economic growth. In the medium term, how-

ever, India will be faced with conflicting targets. Building

up the infrastructure requires government funds, which

makes it harder to reduce debt. India will have to achieve

a balance between these goals.

RBI freed itself from low rate policy in 2010

The Indian central bank (Reserve Bank of India, RBI)

manages monetary policy by setting the repo rate and re-

verse repo rate. The repo rate represents the rate at

which the RBI takes liquidity out of the capital market.

The reverse repo rate is the rate at which the RBI pro-

vides liquidity. By setting the rate at which banks can ob-

tain liquidity from the RBI, the reserve bank manages

short-term interest rates. The chart shows that 3-monthLibor (3-month loan without collateral) is generally be-


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Economic Outlook

7

tween the reverse repo and the repo rate. In 2009, the

RBI cut the key rates to a record low to support growth in

India in the global economic crisis and provide the banks

with sufficient liquidity. It continued the low interest rate

phase into the first quarter of 2010. In spring 2010,

however, it became apparent that a powerful upswing

was in progress in the Indian economy. As a conse-

quence, the RBI gradually raised its key rates to 5.25%

(reverse repo rate) respectively to 6.25% (reop rate). The

movement of 3-month Libor interest rates shows that to-

wards the end of the year liquidity became tight and

short-term rates rose above the band defined by the RBI,

which prompted it to inject money into the banking sys-tem with unconventional instruments.

RBI raises key rates considerably in 2010

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India repo rate (%)India reverse repo rate (%)India 3-months Libor (%)

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Source: Datastream

Inflation in an uptrend

Besides the improved economic situation, Indian inflation

was a further reason why the RIBI ended its low rate pol-

icy. Measured by wholesale prices, inflation was well

above the RBI's target of 5% to 5.5%, as is shown by the

following chart. Inflation in India remained at a high level

throughout 2010. The main driver of inflation was the

powerful upward trend in food prices to the middle of the

year. This is also illustrated by the following chart. In In-

dia, food prices are the most important component of

consumer prices. For this reason, changes in food prices

have a big influence on overall inflation. However, to-

wards the end of the year food price inflation and hence

overall inflation subsided. In 2011, inflation is expected

to drop further. Indian growth is below the long-term aver-

age, which should have a damping effect on prices. How-

ever, we expect food prices to remain at a high level in2011, which will slow the decline in inflation.

Food prices drive inflation in 2010

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India wholsale price inf lation (%)

India wholsale price inf lation f ood (%)

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Source: Datastream

Monetary policy only marginally more restrictive

The restrictive monetary policy will probably not be con-

tinued in this form. Economic growth is likely to slow in

2011 and inflation has moved closer the RBI's comfort

zone from its high of more than 10%. In addition, there is

a risk that, as a result of the large interest rate differen-

tials between the short-term interest rates in India and in

the US or Europe (where we expect a continuation of the

zero rate policy), the Indian rupee could appreciate fur-

ther. In a year, in which exports will already suffer from

soft global demand, this is certainly undesirable. Last but

not least, the current tight supply of liquidity available to

the Indian banking sector could deter the RBI from con-

tinuing to raise rates aggressively. This year, we expect

short-term rates to remain unchanged or rise only slightly.

Food prices could become a problem

A further rise in commodity prices represents a risk for

the RBI. This could result in further increases in food

prices, leading in turn to inflation remaining well above

the comfort zone in 2011. For the RBI, this should mean

more rate hikes even though the Indian economy is slow-

ing. This would increase the risk of a hard landing. The

consequences especially for households at or below the

subsistence level could be drastic. On top of rising food

prices (by far the largest item in such households' budg-

ets), there would be a potential loss of income. For this

reason, the Indian authorities are more likely to take ad-

ministrative action than tighten monetary policy again if

food prices continue to move higher. Such administrative

intervention could take the form of subsidies for food

production and price caps on individual products.


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Economic Outlook

8

Virtually no movement in long-term rates

In 2009, long-term rates had already anticipated a rise in

short-term rates. As a consequence, the increase in rates

in 2010 was moderate. Yields on 10-year Indian bonds

moved more or less sideways. Stable long-term interest

rates and rising key rates resulted in the yield curve in

India flattening considerably. This trend should remain in

place in 2011. While short-term rates are hardly likely to

rise any further, yields above all towards the end of

2011 could fall slightly at the long end. A weaker econ-

omy combined with weaker inflation points to lower inter-

est rates.

Yield curve flattened markedly in 2010

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India treasury y ield 1year (%)India treasury y ield 10year (%)

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Source: Datastream

India's role in global rebalancing

Consumption excesses and export boom not sustainable

In the coming years, the dominant theme for the global

economy will be global rebalancing. This means correct-

ing the current imbalances. On the one hand, deficit

countries such as the US, UK and Spain have exces-

sively expanded consumption for years. This was made

possible by huge current account deficits and a sharp in-

crease in lending to households. On the other hand,

there were the surplus countries, which financed the

consumption boom in the deficit countries with their capi-

tal exports and at the same time profited enormously by

exporting to those countries. In Europe, such surplus

states include Germany and Switzerland for example and

in Asia China and the newly industrialised countries of

Asia such as Singapore and Korea. The banking crisis

and the resultant recession have shown that this imbal-

ance will no longer be tenable in the future and that the

global economy will have to return to a more sustainablegrowth path.

India's important role in the new equilibrium

The western deficit countries will have to raise their sav-

ings rates, which also means that consumption in those

countries will decline. However, this means that the sur-

plus nations will lose their most important export markets

and will have to turn increasingly to consumption. This

global rebalancing is not without risks. A situation could

arise in which the deficit countries (have to) reduce their

consumption, while the surplus countries are not pre-

pared to shift from export-driven growth to more con-

sumption. This could lead to a global shortfall in demand.

In this connection, India can play a key role in the new

equilibrium. India is one of the few countries whosegrowth is not based on an export bias and whose con-

sumption is also not excessive. On the contrary, the

strong population and income growth forms the basis for

strong consumption growth in the coming years. The

chart below shows the expected growth in the labour pool

in China, India and the US over the coming 15 years.

Growth is likely to take place solely in India. Accordingly,

India will assume a key role in the global rebalancing

process, as it can offset the lower demand in the tradi-

tionally high consumption western countries.

India's labour market should grow strongly over the

coming 15 years

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India labour f orceChina labour f orceUS labour force

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Source: Datastream, Economist Intelligence Unit

Can India fulfil its potential?

India's potential is not in dispute. The key question in the

medium term is whether India will be able to exploit its

potential. In this regard, two issues will be crucial. 1.

Education - while India is already an international leader

in information technology, there are enormous shortcom-

ings in the education sector. A growing middle classneeds investment in a solid basic education. 2. Infra-


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Economic Outlook

9

structure - to maintain high economic growth in the long

term, the infrastructure must also keep pace. Today,

there are huge shortcomings in India's public infrastruc-

ture; huge efforts are required. If India manages to mas-

ter these two challenges, the country should stand out

not only in terms of high economic growth in the short

term, but should also lay the foundation for sustainable

economic growth in the long term.

Dr. Alessandro Bee, Economist & Fixed Income Strategist


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17/30

Currency

11

Currency

Indian rupee for long-term investors

There is growing international pressure on the emerging economies to allow their currencies to appreciate faster.

The Indian rupee is undervalued and the Indian central bank will therefore permit a gradual appreciation. However,

the rupee is highly volatile and usually suffers heavy losses when risk aversion in the financial markets rises. This

raises the risk in a portfolio. The Indian currency is suitable for long-term investors that are willing to accept short-

term losses.

Emerging market currencies in G20 focusThe last G20 meeting paid a great deal of attention to the

smouldering currency dispute. The US believes the cur-

rency policy of the emerging markets is the main reason

for the global imbalances. The criticism levelled by Wash-

ington at the emerging economies is that they are keep-

ing their currencies undervalued and obtaining an unjusti-

fied competitive edge in international trade. Indeed, in-

ternational currency reserves have grown rapidly in recent

months; more than one half of the worldwide rise in forex

reserves is attributable to the emerging markets. India's

foreign exchange reserves have also risen again. The

emerging market nations appear to be increasingly inter-

vening in the currency markets. In the G20 summit's final

statement, the 20 largest industrialised and emerging

market economies had agreed not to devalue their cur-

rencies to gain competitive advantages. In the future,

therefore, the emerging markets are likely to be less op-

posed to currency appreciation. A trade war would cause

huge damage to all economies. For this reason, the

emerging economies will to some extent bow to interna-

tional pressure and allow their currencies to appreciate.

Currency valuation crucialHow much pressure the G20 exerts on individual coun-

tries will probably depend on the respective valuations of

the currencies. If a central bank attempts to hold a cur-

rency below its fair value, it can hardly defend itself

against criticism that it is manipulating its own currency.

The level of the current account balance is a suitable

measure for assessing whether a currency is undervalued

or overvalued. However, focusing solely on the level of

the current account balance is not enough. This depends

also on the demographics, economic cycle and fiscal pol-

icy of the economy in question. On the basis of these fac-

tors, the International Monetary Fund (IMF) has calculated

a fair current account balance for some emerging mar-kets. Accordingly, in considering whether a currency is

undervalued the relevant point is whether the current ac-

count balance exceeds its fundamentally justified level. If

the surplus is higher than the amount calculated by the

IMF, a currency is undervalued. Conversely, a currency

should trade even lower.

The Indian rupee is undervalued: the current account

balance is higher than the fundamentals warrant

Current account balance minus the "fair" balance

-10.0

-5.0

0.0

5.0

10.0

Korea

Indonesia

Thailand

SouthAfrica

Turkey

Brazil

Chile

Argentina

India

Israel

China

Mexico

Egypt

Malaysia

Source: IMF, Sarasin

India will permit a gradual appreciation

Our calculations show that the Indian rupee is below its

fair value (see upper chart). The G20 will therefore pay

close attention to India's monetary policy. The Indian

Central bank (RBI) will thus probably intervene less in the

future and allow the rupee to appreciate. How quickly it

takes to complete the adjustment is likely to depend

largely on China's currency policy. The Chinese renminbi

is also clearly undervalued and must strengthen in the fu-

ture if the currency dispute with the US is to be defused.

However, China is hardly likely to accede to US demands

for a considerable appreciation. If the adjustment pro-


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Currency

12

ceeded too quickly, this would threaten the existence of

Chinese export industries with low margins. China will

therefore spread the appreciation over several years. In-

dia too is likely to permit the rupee to gain in value only

gradually.

But the Indian rupee is very volatile

From a valuation perspective the Indian rupee offers an

attractive investment opportunity. In the short term, how-

ever, it fluctuates very strongly. Compared to other Asian

currencies, the Indian rupee is more volatile against the

US dollar (see chart below). The Hong Kong dollar is

pegged to the dollar under the currency board system andthe Chinese renminbi is also closely linked to the dollar.

By contrast, the Indonesian and Korean currencies are

even more volatile than the Indian rupee.

Indian rupee is more volatile than other emerging mar-

ket currencies

Implied volatility vs. USD

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HongKong

China

Taiwan

Thailand

Singapur

Israel

Argentina

Malaysia

Philippines

India

Indonesia

Turkey

Mexico

Chile

Korea

Brazil

South

Africa

Source: Datastream, Sarasin

and correlates with equities

The Indian rupee is also a highly risk-sensitive currency.

This is reflected in the high correlation with equity per-

formance (see chart below). The Indian rupee correlates

more closely with equity market trends than other Asian

currencies. Only the Singapore dollar is more dependent

on sentiment in the financial markets.

Indian rupee is highly risk sensitive

Correlation vs. USD & MSCI World

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

China

Argentina

Thailand

Taiwan

Philippines

Chile

Indonesia

Malaysia

Korea

India

Israel

Brazil

South

Africa

SingapurDollar

Mexico

Turkey


The Indian rupee is one of the currencies that profits from

a rise in risk appetite in the financial markets. By con-

trast, if risk aversion grows, international investors with-

draw from India and the rupee suffers severe losses. Dur-

ing the financial crisis in 2008 and 2009 the trade-

weighted external value of the Indian rupee weakened by

some 20 percent. As a consequence, the India rupee

raises a portfolio's risk profile. If the financial markets

correct, investors suffer currency losses on top of equity

losses.

Good environment for the Indian rupee in 2011

Accordingly, for investors with a longer time horizon that

are prepared to accept short-term setbacks, the Indian

rupee is a suitable currency. However, losses should be

limited in 2011. We expect that the recovery in the global

economy will prove to be sustainable in 2011. In recent

months, the economic risks have fallen considerably. We

therefore expect no massive rise in risk aversion and the

environment for the Indian rupee should be good in

2011.

Ursina Kubli, Economist & Forex Strategist


19/30

Equities

13

Equities

Equities upside potential still exists

In terms of valuation, the Indian equity market is by far the most expensive in Asia. However, the high price is justi-

fied by the best earnings trend. The question is whether India can maintain the growth momentum of recent years

and earnings can therefore continue to grow at above-average rates in the future. Even if the pace of growth slows

somewhat, it should still remain high compared to the other emerging markets. We see upside potential of 15-20%

in 2011.

Review: India top in absolute terms, mid-table relativelyIndian equities sharply higher in 2010

In 2010, the Indian equity market developed very posi-

tively and seamlessly continued the good performance of

the previous year. After a subdued first half of the year,

the BSE Sensex index moved out of the tight trading

range in the second half and nearly hit a new record high

at 21,000 points (previous high: 21,200 in January

2008). The full-year performance was 17%. Thanks to the

slight appreciation of the Indian rupee against the US dol-

lar, a dollar investor with exposure to Indian equities even

achieved a return of 22%.

Indian equities: absolute & relative performance 2010

JAN FEBMARAPRMAY JUN JUL AUGSEP OCTNOVDEC

000'S

15

16

17

18

19

20

21

22

96

98

100

102

104

106

108

110

112

India Bombay SE 30 IndexMSCI India relative to MSCI Emerging Markets(R.H.SCALE)


Source: Datastream

No decoupling from emerging markets

In the first half of 2010, the Indian equity market outper-

formed the emerging markets overall (see chart above).

However, in the consolidation in Q4 2010 all of the In-

dian equity market's outperformance was lost again. Lo-

cal factors such as the aggressive monetary tightening of

the central bank (RBI) and corruption cases led to a set-

back. As a result, the Indian equity market achieved only

a mid-table ranking in the 2010 performance table foremerging markets.

Emerging markets performance in 2010

IsraelChina

BrazilWorld

PolandEMRussiaTaiwanTurkeyIndia

KoreaMexico

South AfricaIndonesia

MalaysiaChile

Thailand

0 10 20 30 40 50 60 70

Source: MSCI, Sarasin

Outlook: earnings the driving factor

Global economic momentum in focus

According to our cyclical research approach, we are firmly

convinced that economic performance is the main driver

of equity markets. It is not necessarily the absolute level

of growth that is important, but rather the expectedchange in the pace of growth. This results namely in posi-

tive and negative surprises for economic growth and cor-

porate earnings. As a result of increasing globalisation,

the economic cycles worldwide are synchronised with

small deviations. Our expectations regarding the global

economy and the performance of the Indian economy are

described in detail in the first part of this publication.

Local growth drives earnings

A good growth forecast also enables one to predict the

trend in earnings growth. The chart below shows that


20/30

Equities

14

earnings growth follows growth in industrial production

with a time lag of 6-12 months.

Earnings growth trails industrial production

2004 2005 2006 2007 2008 2009 20100

2

4

6

8

10

12

14

16

18

-30

-20

-10

0

10

20

30

40

50

India industrial production ex construction yoy in %India trailing earnings yoy in %(R.H.SCALE)


Source: Datastream

As we believe that economic growth will slow in H1 2011,

earnings growth is likely to slow further. However, we ex-

pect growth to stabilise at around 6-8%, i.e. there will be

a soft landing and a similar scenario as in 2005. In such

a scenario, earnings growth is likely to stabilise at a level

around 15-20%.

New record earnings in 2010

In recent years, corporate earning growth in India has

been far higher than the average. In the wake of the

global financial crisis, earnings came under strong pres-

sure in 2009. However, they recovered astonishingly fast

after the financial crisis. For example, listed Indian com-

panies already posted new record earnings during the

course of 2010 (see chart).

India: earnings (trailing/forward 12M)

2005 2006 2007 2008 2009 201080

100

120

140

160

180

200

220

240

260

MSCI India trailing earningsMSCI India forward earnings

80

100

120

140

160

180

200

220

240

260


Source: Datastream

Only temporary slowdown in growth

As we expect a renewed global upturn towards the end of

2011, the slowdown in earnings growth over the coming

quarters should merely be temporary. In recent months,

earnings growth momentum has declined markedly. Ac-

cordingly, the consensus of analysts has been reacting to

this trend by revising expectations downward for some

time.

Earnings revisions have been negative for several

months

2006 2007 2008 2009 20100.80

0.60

0.40

0.20

0

0.20

0.40

0.60

0.80

-0.80

-0.60

-0.40

-0.20

0

0.20

0.40

0.60

India EPS revision ratio 1MIndia EPS revision ratio 3M avg(R.H.SCALE)



The above chart reveals that the balance of earnings es-

timates (positive minus negative earnings revisions) has

been in negative territory for some months. To some ex-

tent at least, weaker growth is being anticipated. How-

ever, negative earnings revisions should continue to im-

pact negatively on the Indian equity market in H1 2011.

Earnings expectations high, but not unrealistic

Looking forward, the key question is whether this strong

earnings growth is sustainable. After growth well in ex-

cess of 20% in 2010, the consensus also expects earn-

ings growth of some 20% for the coming two years.


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Equities

15

Expected earnings growth 2010-2012 (%)

0

5

10

15

20

25

30

35

2010 2011 2012

India Emerging Markets


However, if the usual forecast margin of error is deducted

from this 20% (on average earnings are overestimated by

5-10%), we arrive at a quite realistic estimate. The chart

also shows that India has the highest earnings growth

among the emerging economies. This also justifies an

above-average valuation.

Valuation is expensive, but still not unattractive

Indian equity market relatively expensive

In recent years, the valuation of the Indian equity market

has increased considerably. Compared to the industrial-

ised nations, this is mainly due to the fact that the valua-

tions of the equity markets in the industrialised countries

have declined.

Compared to the emerging countries, it is rather the rela-

tive growth momentum that plays a role. Higher earnings

growth is also reflected in the price that investors are will-

ing to pay. The Indian market is currently trading at a

premium of some 30-40% to the MSCI World index and to

the MSCI Emerging Markets index.

Valuation premium relative to MSCI World and EM

98 99 00 01 02 03 04 05 06 07 08 09 100.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

MSCI India forward p/e relative to MSCI WorldMSCI India forward p/e relative to MSCI EM

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80



This premium is about twice as high as the average over

the last 12 years. Both in relative and absolute terms,

i.e. compared to its own past, the Indian equity market is

expensive (see chart below). Such a valuation is justified

only as long as growth remains at an above-average level.


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Equities

16

Valuation expensive historically and relatively

0%

10%

20%

30%

40%

50%

Forward PE Trailing PE

India current valuation relative to 12y average

India current valuation relative to Emerging Markets

India vs. Emerging Markets (12y average relative valuation)


We believe India will be able to maintain above-average

earnings growth in the coming years thanks to the posi-

tive growth momentum. The premium therefore also ap-

pears justified. However, as expectations are already

high, there is only limited scope for positive surprises. On

the other hand, there is considerable potential for disap-

pointment if growth expectations are not fulfilled.

Higher valuation unlikely

Given the already high valuation and premium over other

equity markets, the valuation is unlikely to rise further.

This means that equity market performance is limited to

the level of earnings growth. Accordingly, we expect the

Indian equity market to move in line with expected earn-

ings growth of 15-20% in 2011.

Opportunities outweigh risks in 2011

Global risk aversion the biggest risk

As the significance of foreign money flows is relatively

high, we believe an increase in global risk aversion repre-

sents the biggest risk for the Indian equity market. While

we expect global risk aversion to continue to trend down-

wards in 2011, the Indian equity market remains vulner-

able. The money flows that India has attracted in recent

years are highly volatile and can quickly dry up. If many

investors wanted to exit at the same time, there could be

a major setback.

High correlation between India and emerging markets

2008 2009 20100.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

0.90

0.95

MSCI India / MSCI Emerging Markets, weekly correlationMSCI India / MSCI World, weekly correlation

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

0.90

0.95



The Indian equity market's close correlation with the

MSCI World and the MSCI Emerging Markets index shows

that global factors are more important than local ones for

the performance of the equity market. In view of the In-

dian equity market's especially high correlation with the

emerging markets, China in particular is extremely signifi-

cant for the performance of the Indian market.

Positive surprise in China an opportunity

We believe that concerns of a sharp slowdown in growth

in China are overdone and expect positive surprises.

While growth should slow to about 9% in 2011, the Chi-

nese economy appears unlikely to suffer a hard landing.

The Chinese equity market, which investors are currently

steering clear of, is our top recommendation among the

emerging markets for 2011 from a contrarian standpoint.

Good news from China and a good performance on the

part of the Chinese equity market should also be positive

for Indian equities.

Double-digit return expected in 2011

We are optimistic for the Indian equity market in 2011

and again expect a double-digit return. However, given the

high valuation the upside potential is limited and the In-

dian stock market is therefore hardly likely to outperform

the emerging markets overall. But investors that are able

to ride out strong fluctuations should profit from exposure

to Indian equities.

Philipp Brtschi, CFA, Chief Strategist


23/30

Abbreviations

17

A actual value

abs.ch absolute change

ASW asset swap spread

avg. average

bn billion

bp basis points

corp. corporate

CPI Consumer Price Index

Div. yield or DY dividend yield

E estimate

EBIT earnings before interest and taxes

EPS earnings per shareEV/EBITDA enterprise value to earnings before interest, taxes,

depreciation and amortisation

excl. excluding

FY financial year

GAAP Generally Accepted Accounting Principles

GDP gross domestic product

GNP gross national product

gov. government

m million

M&A Mergers & Acquisitions

mavg moving average

N.A. not available

p.a. per annum

P/B price-to-book ratio

P/E price-to-earnings ratio

P/NAV price/net asset value

R&D Research & Development

R.H. Scale right hand scale

ROE return on equity

SAA Strategic Asset Allocation, long term strategy based on investment profiles

TAA Tactical Asset Allocation; short term strategy based on return/risk expectations

vs. versus

yoy year over year


24/30


25/30

Contacts

19

Contacts

Research

Dr. Jan Amrit Poser Tel. +41 44 213 92 81

Head of Research [email protected]

Economic Research

Dr. Jan Amrit Poser Tel. +41 44 213 92 81

Chief Economist [email protected]

Dr. Alessandro Bee Tel. +41 44 213 92 83

Fixed Income Strategist [email protected]

Ursina Kubli Tel. +41 44 213 92 80

Forex Strategist [email protected]

Benot Robaux Tel. +41 44 213 97 91

Corporate Bond Analyst [email protected]

Strategy Research

Philipp Brtschi, CFA Tel. +41 44 213 95 72

Chief Strategist [email protected]

Peter Bezak Tel. +41 44 213 90 80

Portfolio Strategist [email protected]

Eliane Tanner Tel. +41 44 213 92 54

Commodity Strategist [email protected]

Dr. Jianyong Wen Tel. +41 44 213 97 40

Quantitative Analyst [email protected]

Fund Research

Irene Huber, CFA Tel. +41 44 213 93 13

Fund Research [email protected]

Equity ResearchRainer Mnnle, CFA Tel. +41 44 213 94 99

Head of Equity Research

Sector Strategist, Industrials

[email protected]

Patrick Hasenbhler Tel. +41 44 213 94 81

Head Swiss Equity Research

Consumer Goods, Media, Misc. Services

[email protected]

Daniel Bischof Tel. +41 44 213 94 83

Financials (International) [email protected]

Dr. Philipp Gamper Tel. +41 44 213 94 97

Capital Goods, Chemicals, Construction, Automotive [email protected]

Ute Haibach Tel. +41 44 213 96 76Metals & Mining [email protected]

Dr. David Kgi Tel. +41 44 213 94 82

Health Care [email protected]

Michael Romer Tel. +41 44 213 94 84

Energy, Utilities, Consumer Goods [email protected]

Oskar Schenker Tel. +41 44 213 94 88

Chemicals, Construction, Technology, Industrials [email protected]

Rainer Skierka Tel. +41 44 213 94 98

Financials (Swiss) [email protected]


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20

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India 2011 Research Report