December 31, 2008

What's in store for 2009?

2008 was a disastrous year for all asset classes, except bonds for the last few months of the year. Gold managed to do well too. Most of us in the market saw a different face of the markets relative to the last few years. Even the seasoned players have learnt a lesson or two from the events in the global markets. Risks got re-defined and 10% per annum seemed astronomical returns. The rate at which entities went belly-up was shocking. 50%-90% fall in stock prices were still digestable, but banks and financial powerhouses turning into hollow structures was the most shocking event of the year for me. Short-term US bills trading with negative yields was a revelation too!

One of the key drivers behind the mega-bull rally that the Indian markets witnessed during the period 2004 to 2007 was global liquidity. With global interest rates at significantly low levels, a glut of liquidity found its way into attractive avenues, including Indian equity markets owing to extremely robust economic shape of the country and sustained corporate earnings growth.

As we entered 2008, global interest rates had almost peaked with commodity and oil driven inflation being the primary reason pushing up rates. Also, the sub-prime crisis dried up otherwise liquid corporate bonds and MBS/ABS markets. Liquidity starved and risk averse investors resorted to 'flight to safety' by shifting their investors from equities to gold and US treasuries. The music had stopped! The selling pressure intensified with each episode of bankruptcy in the financial industry in US, UK and other major economies.

Within the domestic economy too, growth momentum clearly had started to slow down significantly. Indicators like IIP, GDP and credit growth had peaked in 2007 and investors started pricing in a slowdown in corporate earnings also. Resultantly, equity markets, with PEs at historically high levels, started to contract taking down the prices. Sentiment related factors also played its part as investors went from an extreme of greed to fear between the beginning and end of the year.

So what should we expect heading into 2009? Here are my thoughts:

1. Barring the first few months (till April/May 2009), volatility will die down significantly. One of the most important features that marked 2008 was high vols. 2009 will be a stark difference to 2008, at least in this respect.
2. Corporate earnings will shock us on the negative side. A large section of the market believes that most of the bad news is already in the price. I beg to differ. With interest rate cuts not yet passed on to the real system, the light at the end of the tunnel is still far-off. Q4CY08 to Q3CY09 will throw up results that will make Sensex at 9000-levels look rich.
3. Globally too, data releases and sentiment has a reasonably long way to keep falling before it picks up for the better. I do not expect the global investor community to consider India very seriously again before mid-2009. Fresh selling might halt soon, but buying might not resume soon.
4. Expect RBI to continue dropping interest rates even lower. From the current level of 5% for the benchmark Reverse Repo rate, I see room for atleast 100bps easing. With industrial production and exports looking to fall in the negative territory soon and inflation to fall into the sub-5% zone, RBI can focus completely on supporting the ailing growth. The interest rate differential between India and US in the growth cycle has been about 3%. I see no reason why it cannot be at similar levels in the slowdown phase. Growth in both the economies look to correct by about 4%-5%, which is not starkly different. So with US officially adopting Zero Interest Rate Policy (ZIRP), India's benchmark rate will possible settle at 3.5%-4% levels and that should happen before April 2009.

What are the implications from an investment perpective, if the above holds true? Firstly, one can afford to stay away from equities for few more months. By that I mean you might not miss a mega rally by not investing now and investing after April 2009. I would want to put money into gilts. Gilts, not corporate bonds-linked income funds, mind you. I do not see any major value in corporate bonds irrespective of what the AAA and AA spread indicates. Gilts looks good to deliver an absolute 5%-8% returns over the next few months. Post that, money can move into equities. An aggressive investor could look to allocate 75% to gilts and 25% to equities. Within equities, banking, FMCG, pharma and capital goods segments are the sectors that looks good to me for the next couple of years.

Wish you and your loved ones a rocking New Year.

Happy investing.