India 2012: State of the Subcontinent

Last year, emerging markets suffered one of their weakest years of the past decade. Emerging market equities declined a little over 20 percent, underperforming their peers from developed economies by a wide margin. On the other hand, emerging market bonds produced solid gains: Both corporate and sovereign debt gained around 6 percent each.

India was particularly hard hit, dropping close to 40 percent in US dollar terms, a far cry from its spectacular performance in 2010. India’s market was stymied by stubbornly high inflation, a weak currency, and a political establishment unable to take the necessary steps to shore up the country’s long-term economic growth.

India’s domestic economy will be the paramount issue for the Subcontinent’s policymakers in 2012. Politicians in New Delhi will likely try to blame the European sovereign-debt crisis for the Indian economy’s woes. But their mismanagement of the economy, overblown populist rhetoric and interparty fighting have prevented them from enacting the necessary measures to ensure sustainable economic growth.

India’s political gridlock is evidenced by the government’s backtracking in early December on foreign direct investment in the country’s retail sector, as well as its inability to pass the anti-corruption bill in the upper house of parliament later that month. Although companies like Wal-Mart (NYSE: WMT) will have to wait to enter the Indian retail market, the larger issue is that such political inefficiency has slowed the growth prospects for crucial sectors of India’s economy.

In particular, companies in India’s infrastructure sector continue to face issues such as limited regulatory transparency, high inflation and interest rates, and global economic uncertainty. And the majority of the Indian companies in the sector also have substantial debt burdens, which have not been helpful in a slow growth environment with a weak Indian currency. Beyond that, a decline in foreign direct investment has stalled numerous projects.

Source: Bloomberg

As such, our position in Indian infrastructure companies via the Emerging Global Shares INDXX India Infrastructure Index (NYSE: INXX) has not performed well since our initial recommendation in October 2010. Consequently, as we position the Model Portfolio for 2012, we are selling the position to take advantage of the recent rebound in the market.

Sell Emerging Global Shares INDXX India Infrastructure Index.

The political situation in India remains murky, and elections will be held in key states early this year. Uttar Pradesh, the country’s most populous state, will hold elections in seven phases, which will unfold during most of February. Punjab, a significantly smaller state in terms of population, will also hold elections in January and March.

In these and other states, the Indian National Congress, India’s ruling party, faces serious opposition, and further dramatic developments cannot be ruled out if it does not perform well.

On the economic front, inflation, which is around 8 percent, remains a serious issue for India, persisting in a manner that few of its policymakers had anticipated. While food inflation has fallen to levels below 8 percent from its recent high of 20 percent, inflation in non-food manufacturing has risen 8 percent from 3 percent.

Early last year, food inflation was a major concern, so inflation’s shift in momentum toward non-food manufacturing has surprised policymakers. Some analysts attribute this development to the government’s pursuit of initiatives to support rural employment and guarantee prices for certain agricultural products.

One example of these policies is the Mahatma Gandhi National Rural Employment Guarantee Act, which aims to enhance “the livelihood security of people in rural areas by guaranteeing a hundred days of wage-employment in a financial year to a rural household whose adult members volunteer to do unskilled manual work.” Another policy is the Minimum Support Price which requires government to purchase agricultural produce from farmers at a fixed price regardless of market conditions.

These efforts to affect a redistribution of income have had an inflationary outcome. That forced the Reserve Bank of India, the country’s central bank, to tighten monetary policy last year in an effort to curtail the problem.

Source: Bloomberg

At the moment, economists do not expect India to exceed gross domestic product (GDP) growth of 7 percent this year. If the country’s chaotic electoral politics continue to dominate the headlines for much longer, the resulting uncertainty could cause economic growth to come in closer to 6 percent. And if investors begin to worry that economic growth is at risk, the Indian stock market could rapidly decline by 20 percent to 30 percent.

But before that happens, India’s central bank will likely take steps to support the economy by lowering interest rates. Such action should be beneficial to the economy by spurring new loan activity. Annual growth in loan demand has fallen to 16 percent from more than 30 percent a few years ago.

If inflation continues to dampen and growth remains weak, the central bank could cut rates by the end of the first quarter. In the short term, India’s stock market should react positively to such an action.

Regardless of the present headwinds, India’s strong domestic demand story means that it remains an attractive investment destination for the long-term investor.

Furthermore, the Bombay Stock Exchange Sensex trades at around 2 times book value, which is significantly lower than its long-term average of 3.2. That offers fundamental support at current levels.

For now, our Model Portfolio’s main exposure to India will occur via iShares MSCI BRIC Index (NYSE: BKF), whose portfolio also covers Brazil, Russia and China. iShares MSCI BRIC Index is up around 6 percent so far in 2012, but it could rise quickly if the broad market remains strong.

Buy iShares MSCI BRIC Index up to 50.

The Global ETF Profits Way

As a reminder, the Global ETF Profits Model Portfolio is divided into three sections: Growth, Income & Hedges (I&H) and Short-Term Opportunities.

The Model Portfolio provides the full spectrum of strategic approaches to investing by recommending growth, income, and hedging strategies, as well as shorter-term tactical opportunities. Additionally, the use of exchange-traded funds (ETF) can capitalize on trends in specific sectors without incurring the risk of selecting the wrong stocks in those sectors.

The Growth and I&H Portfolios are appropriate starting points for investors seeking to establish positions for the long term. The Short-Term Opportunities Portfolio is best suited for those investors who have a greater tolerance for risk. We’ll adjust the ETFs in the overall Model Portfolio on an ongoing basis to reflect investment objectives. Our recommendations are sorted in descending order of preference, starting with our favorite pick at the top of each section.

It’s important to buy a cross-section of recommendations–taking into account, of course, your objectives and risk tolerance–in order to gain broad exposure to the investment themes we’ve highlighted, as well as to maintain proper diversification.

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