hEDGE April 07

April view: ‘Sell’ now ‘Buy’ later
> Cement – Continuous government intervention to shy investors away
> Telecom – High earnings visibility to support valuations

March retrospective:
• Huge unwinding witnessed in stock futures
Although the overall rollover activity in the March expiry picked up quite sharply on the last day, the rollovers in stock futures were much lower than the previous expiry. Total stock futures’ open interest in the fresh series is INR 56 bn (24%), lower than the previous expiry. Lower rollovers imply that market players are uncertain about the market direction and would not like to take big directional bets. The futures position is very light in the April series, which would be big month not only due to the beginning of the earnings season but also because many domestic and global cues have stacked up.
• FIIs cover most of the shorts at lower levels; MFs continue to sell
Almost all the short positions created by the FIIs over the last three months have been covered in March 2007, at lower levels. FIIs were net buyers of USD 1.74 bn in March, after selling USD 1.69 bn in the December 2006 – February 2007 period. FIIs have been selling in the Indian equity markets since December 2006, largely on the back of uncertainty over the budget outcome and valuation concerns. Mutual funds continued the selling spree with sale of USD 0.42 bn in March 2007. This is the highest sale in any month since June 2006.

Pharma and capital goods stocks remain firm; auto and FMCG stocks most hit
Unlike the large cap indices, the BSE small cap and mid cap indices failed to recover after hitting their near term low on March 7, 2007. Among the sectoral indices, Auto and FMCG were most adversely affected, while pharma and capital goods index remained firm.


RBI plays party spoiler
The RBI surprised markets by raising the short term lending rate by 25bps (to 7.75%) and the CRR by 50bps (to 6.5%). The repo rate has been hiked for the fifth time (from 6.50% to 7.75%) and CRR for the third time (from 5% to 6.5%) in FY06-07. The consistent tightening by the RBI is aimed at containing credit growth rate (currently at 29%, above the RBI comfort level of 25%). This, in turn, keeps inflation fears alive; as it is, headline inflation is at a high of 6.46% due to a low base effect and rising prices of food articles.
The central government is also doing its bit to keep potential economic overheating in check. Ceiling on cement prices, export ban on wheat, ban on trading in pulses, petrol and diesel price cuts, cut in custom duties across manufactured products categories are a few policy measures undertaken so far. This is particularly so, since state elections are due in Uttar Pradesh. Congress has already lost two elections and inflation has been cited as one of the major reasons for it.
The above-mentioned measures taken by the government clearly indicate that curbing inflation is its top priority at present. The latest RBI statement also states that the stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability.
With continued strong growth in the Indian economy, RBI is willing to take some harsh measures to contain inflation. Hence we may see further fiscal moves by the government and monetary tightening by RBI in FY08. However, tightening is unlikely in the April 24 annual policy meeting, since the second stage of the CRR hike will be effective only since April 28. Till then, we believe, RBI has already taken the necessary action. On the whole, we believe that markets are headed for some more corrections in the short term.
All’s not bad though
Despite the monetary tightening, there are a few positives that can provide good support to the market. First, area under rabi crop coverage has been strong this year, with total area sown at 112.9% (as on March 23, 2007), 2.3% Y-o-Y above area sown previous year. This could provide a fillip to the rural consumption and even help in containing inflation. Second, a come off in inflation numbers is likely to start reflecting in the releases from mid-April due to the base effect. Moreover, inflation rate is expected to fall below 6% and we expect it to cool down further to RBI comfort level of below 5% by Q1FY08 end. Government spending will resume in Q1 FY08 (typically, spending is strong in Q1 of any financial year), which could further boost growth numbers. The US Fed could hint at rate cuts in the May 2007 FOMC meeting, which is likely to boost global equity markets, impacting India favourably.

Cement – Continuous government intervention to shy investors away
In a bid to make the imported material cheaper, the government has abolished the 16% countervailing duty and 4% special additional customs duty on Portland cement (after completely abolishing the basic import duty on cement in January this year). We expect this government move to make imports cheaper by up to INR 40/bag and remove the price differential between domestic and imported cements. This will be another
sentiment dampener for the cement stocks that were already reeling under selling pressure by investors over the past few months. Despite the fact that valuations of many cement stocks have started looking compelling and demand for cements continues to remain strong, the fear of further government announcements (to contain cement prices) would keep investors away from the sector. We expect the sector to remain an underperformer over the next few months.

Auto – Firming interest rates to impact volumes
The sales numbers for the previous month have come in for all the Auto majors. The numbers were below expectations across the board, with differences only in the degree of disappointment. These numbers have to be evaluated in the context of the fact that Automobile sales traditionally received a boost in the month of March, as firms and CV operators make purchases, so as to claim depreciation benefits on the vehicle. Tata motors reported a modest 11.3% increase Y-o-Y (for the month of March, 07) in total vehicle sales. Ashok Leyland was particularly disappointing, with the company actually witnessing de-growth of 3.2% Y-o-Y. In the passenger vehicle segment, M&M was the best of the lot, with total auto sales growing by 19.8% Y-o-Y, buoyed by a good performance by the Scorpio. Maruti’s sales were tepid, registering a 13.6% increase on a Y-OY basis. Two-wheelers were even worse off. Bajaj Auto’s woes continue, with sales declining by 10% Y-OY, while TVS saw sales dip marginally by 0.5% Y-OY. Hero Honda managed to stay in positive territory, logging a growth of 11.4%. The slowdown in volumes seen during this month can be attributed to the lagged effect of firming interest rates. RBI’s recent move to increase the CRR to 6.5% and the repo rate to 7.75% has further queered the pitch for the Auto sector.
Despite the fact that stocks have corrected to a fair extent, we think that near term concerns on volumes would remain a drag on the sector as a whole. We believe that the sector will under perform the broader market.

FMCG – Defensive play
There has been some let up on the input cost front, with prices of crude palm oil (CPO) easing slightly. Going forward, we expect further softening in CPO prices, given the “El-Nino” weather conditions have receded, likely ramp up in output in key producing nations of Indonesia and Malaysia, and the decline in the relative attractiveness of CPO as a bio-fuel feedstock. This would provide some succor to the likes of HLL and Godrej Consumer. Moreover, HLL might announce price hikes in the detergents segment during the next month.
Overall, valuations for the sector seem fairly undemanding. We opine that the FMCG sector, as a whole, will be a market out-performer. We say this in the context of rising interest rates (FMCG demand is fairly insensitive to interest rate movements) and the sector’s appeal as a “safe haven” during times of market uncertainty. Banking – Unabated monetary tightening to adversely impact profits RBI made its strongest monetary policy tightening move by raising the repo and CRR rates, to tighten its liquidity position. A hike in the repo rate makes it difficult for banks to borrow from the RBI, indirectly impacting their ability to lend. A hike in the CRR is supposedly aimed at sucking out excess liquidity generated through RBI’s intervention in the foreign exchange market. This was an unexpected tightening – more in terms of extent than timing (as the market is becoming used to RBI’s surprise). This tightening would exacerbate the market’s concerns over macro environment, interest rates, and banking asset quality. While we do not expect tightening to continue for long (with likelihood of inflation reducing to RBI’s tolerable range of 5-5.5% by April-May and deceleration in credit growth during April-June period, to comfort RBI), we see risk reward ratio negatively skewed. We extend our negative view on the sector from near term perspective (three months), as we believe the short term concerns would dominate investors’ expectations. Even though current valuations appear to be attractive, the near-term headwinds would keep stock prices depressed.

Telecom – High earnings visibility to support valuations
The subscriber additions figures for March are expected over the next couple of days. We expect these numbers to be largely in line with expectations. Telecom remains one of the few sectors, in which, there is earnings visibility. Also, the pace of subscriber additions is not going to be impacted by hardening interest rates. Other than that, there are potential stock specific triggers. Spectrum allocation would be the major trigger for RCOM. Both Bharti and RCOM have announced that they would be de-merging their telecom infrastructure into separate entities. While both stocks (more so RCOM) have already reacted to the same, any further news flow in this direction would support stock prices. In light of these factors, we expect the telecom space to outperform the market.