Economy
Commodity prices can be fickle, but the weak growth-cloud has its own silver lining, says Nomura

Nomura notes that a regime of stable and range-bound commodity prices could go a long way in addressing India’s inflation and twin-deficit problem, says Nomura Equity Research

Given how leveraged India’s external account is to global commodity prices, the close to $19 per barrel fall in crude oil prices and the 20% fall in gold prices from mid-February to mid-April were surely a distinct positive for the market, according to Nomura Equity Research in its India Equity Strategy report. However, commodity prices have somewhat rebounded from their mid-April lows. Uncertainty regarding the global growth and inflation outlook remains high and shifts in investor expectations continue to be volatile, driven in equal measure by global risk-on/risk-off rallies.

 

Given this backdrop, the brokerage recognizes that the rise and fall in global commodity prices could be temporary and an improvement in the market’s macro ecosystem from a fall in commodity prices could be small should price moves reverse. Amidst this volatility, terms-of-trade shocks—negative or positive depending on commodity price moves—are hard to call and tough to extrapolate over meaningful periods so as to significantly affect key underlying macro variables, Nomura says. With that caveat in place, the brokerage notes that a regime of stable and range-bound commodity prices could go a long way in addressing India’s inflation and twin-deficit problem.

 

However, while commodity prices can be fickle, the weak-growth-cloud has its own silver lining. The domestic growth slowdown appears to be bailing the country out of its high trade deficit problem and is manifesting itself as flattening imports across non-oil and non-gold import categories.

 

Nomura expects the process of economic adjustment to a smaller trade deficit to be driven by the income effect as slowing output growth translates to weaker income growth. Nomura noted this in our recent report, which marked a turn in our cautious view on the market to a more constructive one.

 

In the present report, Nomura’s analysts look at corroborating evidence across key import and export categories. Following conclusions emerge: 1) the sequential momentum of imports has peaked and has been on the decline for four months now; 2) the sequential momentum of exports, which was largely flat since October last year, has rebounded reasonably over the past two months; 3) trade data in India display strong seasonality, but Nomura’s findings in the above two points were based on de-seasonalised data; this suggests that the reduction in the trade deficit in the March quarter is more than just a result of favourable seasonality; 4) on a cumulative FY basis (to avoid inference errors based on volatile monthly data), total imports have been flat in FY13 after rising by $120 billion in FY12. Within imports, a rise in oil imports has been almost entirely offset by an equal fall in non-oil imports; 5) importantly, there is strong evidence of a normalisation in import categories relevant for investments—chemicals, capital goods, coal and iron & steel, for example—and consumption (electronic goods and transport equipment, for example); the growth in nominal imports and export growth are highly correlated over time.

 

It then follows that should the nascent rebound in exports continue, a pick-up in imports cannot be far behind, potentially nipping the turnaround in the trade deficit in the bud.

However, a revival of global growth (the reason for a turnaround in exports) will have a significantly positive read-across for domestic growth as well, Nomura believes. A rebound in domestic growth by itself will warrant a re-rating of the market, boosted by strong capital inflows, in our view. After all, high growth and an expanding trade deficit happily co-existed in the pre-crisis period since 2004.

 

CAD matters to the market. India’s current account problem—joined at the hip with a high fiscal deficit that emerged post-crisis—has been the key overhang for the market performance for three reasons: 1) high CAD puts pressure on the rupee, thereby stoking imported inflation and making the central bank’s task of easing rates that much more difficult. Any forex intervention by the RBI then further crunches systemic liquidity and keeps interest rates under pressure; 2) a weak rupee negatively impacts common currency market returns. This gets compounded when a persistently high current account deficit leads to an entrenchment of expectations of further rupee weakness; 3) financing the CAD becomes an additional policy concern and a rate-cutting cycle is that much more difficult to embark upon when debt-arbitrage and yield-seeking funds are at stake. In this regard, potentially diminishing headwinds to CAD augurs well for the monetary easing cycle, in our view.

 

Nomura’s base case view on the market’s macro ecosystem this year has been one in which growth remains weak, thereby keeping inflation in check and keeping the rate and liquidity environment benign. Our Mar-end 2014 Sensex target remains at 21700. Nomura remains overweight on rate cyclicals and defensive growth plays and is underweight on domestic growth cyclicals. The brokerage’s top five stock picks for the year are ICICI Bank, ITC, M&M, DrReddy’s and Zee Entertainment.

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Domestic demand to weaken further: Nomura

Citing weaker demand and lower inflation, Nomura expects the RBI to cut policy rates further. Power problems have been blamed for manufacturing woes

In a recent note to its clients, Nomura expects domestic demand to weaken further with a downward bias in prices. Manufacturing has taken a big hit, thanks to power problems. It also expects that this would be the reason for the Reserve Bank of India (RBI) to cut interest rates. The report states: “The PMI data suggests that domestic demand continued to lose momentum in April and is likely to remain weak in the near term. Nonetheless, weak demand and stable input costs should help reduce inflationary pressures which should increase the space available for the Reserve Bank of India to cut policy rates.” PMI fell to 51 in April from 52 in March.
 

It is pertinent to note that many investors were bullish as gold as well as crude oil prices plummeted, which kept bulls’ hopes high. But there’s a flip side to falling commodity prices: lower demand. And it is the low demand that caused the downward pressure. The report states: “The new orders index (52.3 from 52.8) fell further in April while the new export orders index (51.1 from 50.4) rose, suggesting a further slowdown in domestic demand and some pick up in external demand.”
 

The lower demand has led to contraction of output and supply. Manufacturers are cutting down on production to save cost, and to match prevailing lower demand. It was also mentioned that power problems were a big cause, something that has been affected by government policy paralysis. The note states: “The output index fell to 50.2 from 51.6, as manufacturers likely cut production on weak demand and persistent power shortages. The finished goods inventory index rose back above the contraction/expansion threshold of 50 (to 50.7 from 48.5) and the new orders/inventory ratio fell for the sixth straight month to 1.03 from 1.09, which indicates manufacturing activity is unlikely to pick up in the near term.”

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