May 2012 : Rupee Weakness?

The Indian stock market displayed significant weakness in the month, down 6.2% for the month, and this time around our stocks also participated in the decline. The weakness in the stock market seems be due to both global and local factors – while the world continues to fret about the Greek election due in mid-June and the possible Greek exit from the Euro and its contagion to Spain and Italy, India continued to be bogged down by growth fears with the fourth quarter GDP growth at 5.3% – the last time Indian GDP growth was this low was in the Oct-Dec 2008 quarter. Also, adding to the nervousness was the rapid depreciation in the Indian rupee which is touching life time lows.

The worries on the rupee front stem from the large current account deficit that India has – in the year ending March 2012, the trade deficit (which does not include IT exports and other services exports) was roughly $180 billion, a large chunk of which is due to oil imports. However, when we add what are called invisibles (IT exports, net service exports and transfer payments) the current account deficit comes to about $75bn which is about 4.5% of GDP. However, one big item of import which escapes attention is about $45 bn of gold imports which is really more of a capital item (being a form of money). If we exclude gold imports, the picture does not look so dire. India’s forex reserves dipped from $275 bn to $260 bn over the financial year which does not seem to warrant a 22% depreciation in the currency. With Indian gold demand beginning to decline and the recent fall in global oil prices, there are positives on the horizon on the currency front.

On the whole it seems that the depreciation of the rupee seems more driven by the poor sentiment on India, thanks to the perceived policy paralysis, as well as a general appreciation of the dollar against most currencies during the period. The latter is also somewhat reminiscent of what happened in the global crisis of 2008. There are many similarities between the current economic environment and 2008 – dollar strength, very low long term government bond yields (both the US and Germany 10 year bond yields are at life time low – this signifies a great amount of fear in the market and hence the crowding into what are viewed as extremely safe assets), negative IIP in India and a general air of pessimism. The only difference is that the last time this happened post the Lehman bankruptcy while this time this seems to be happening even before the Greek exit is a finality. The level of fear in the market seems to be reaching an extreme.

Whether these fears will ultimately be realized is difficult to predict, but we do know that past episodes of such fear such as Sep-01 or Oct-08 have generally resulted in very strong equity performance in subsequent years, because high levels of fear usually create the low valuations from which long term investors can profit. We have also observed in the past that in this phase of the market, high quality companies also fall sharply. Some of our high confidence bets are today trading at valuations similar to those in March, 2009. This has got us quite excited as we are fairly confident that these companies will deliver over the long term. The discount sale on right now is a great opportunity to invest.