Important disclosures can be found in the Disclosures Appendix
All rights reserved. Standard Chartered Bank 2014 research.standardchartered.com Samiran Chakraborty +91 22 6115 8820 Samiran.Chakraborty@sc.com Regional Research Standard Chartered Bank, India
Nagaraj Kulkarni +65 6596 6738 Nagaraj.Kulkarni@sc.com FICC Research Standard Chartered Bank, Singapore Branch
Bharat Shettigar +65 6596 8251 Bharat.Shettigar@sc.com FICC Research Standard Chartered Bank, Singapore Branch
Robert Minikin +852 3983 8567 Robert.Minikin@sc.com FICC Research Standard Chartered Bank (HK) Limited
FICC Alert | 22 April 2014 India Election scenarios and market impact
We present three scenarios and likely market responses to the outcome of the ongoing general elections Equities, FX and credit markets have partially priced in a positive election outcome; IGBs are laggards Stay Positive on IGBs; buy 5Y IGBs (7.28% 2019), current: 8.82%, target: 8.65%, stop-loss: 9.10% Real-money funds should remain Overweight the INR in both the short and medium term
Summary As a sequel to our report On the Ground, 8 April 2014, India Hope builds, but delivery will be key, we present below three possible scenarios of election outcomes and the implications for the Indian government bond (IGB), FX and credit markets in each scenario.
The three scenarios we envisage are as follows: (1) the Bharatiya Janata Party (BJP)-led National Democratic Alliance (NDA) getting 240+ seats and forming a stable government, (2) the BJP-led NDA getting between 220 and 240 seats, which could open up several possibilities of government formation, and (3) the BJP-led NDA getting less than 220 seats. We assign subjective probabilities of occurrence of 60% for scenario 1, 30% for scenario 2, and 10% for scenario 3.
In scenario 1, we expect unhedged total returns of c.7.3% over a three-month period (for a foreign investor long 5Y IGBs) and credit spread compression of 15-20bps. In the least likely scenario, we project unhedged total returns of -3.7% and a credit spread widening of 50-60bps. We recommend that investors remain Positive on IGBs. We stay long 5Y IGBs (7.28% 2019); entry: 8.95%, target: 8.65%, stop-loss: 9.10%, current: 8.82% on attractive valuations and favourable supply dynamics in the <5Y segment. Real-money funds should remain short- and medium-term Overweight the Indian rupee (INR). The risk-adjusted return for long INR versus the US dollar (USD) is not attractive enough to recommend INR longs right now.
We think the primary impact of an election outcome on total returns will be driven by FX rather than duration. An election outcome resembling scenario 1 could be a strong trigger for near-term INR gains as growth expectations strengthen and inflows to equities pick up. However, we predict a potential downward shift in the USD-INR trading range of only 2-3% from current levels, as the Reserve Bank of India (RBI) is likely to intervene and rebuild its FX reserves. Likewise, IGB gains could be accelerated in this scenario as markets price in continued fiscal consolidation, better supply-side management of inflation, and sentiment improvement in other asset markets. Such expectations should also tighten Indian credit spreads by about 15-20bps. Figure 1: Possible election outcome scenarios and expected market responses Scenario Subjective probability USD-INR in 3 months (Reference spot: 60.30) 10Y IGB yield in 3 months (Reference yield: 8.85%) 5Y IGB yield in 3 months (Reference yield: 8.82%) Unhedged 3M total returns from long 5Y IGB Average Z-spread on Indian credits 1 BJP-led NDA getting 240+ seats 60% 58.0 8.65% 8.55% 7.3% (FX: 6.2%, IGB: 1.1%) -20bps 2 BJP-led NDA getting between 220 and 240 seats 30% 61.0 8.95% 8.85% 0.9% (FX: 1.0%, IGB: -0.1%) +10-15bps 3 BJP-led NDA getting less than 220 seats 10% 63.5 9.10% 9.00% -3.7% (FX: -3.0%, IGB: -0.7%) +50-60bps
Source: Bloomberg, Standard Chartered Research
FICC Alert
22 April 2014 2 In scenario 2, FX and IGB gains would be limited because of the uncertainty surrounding the composition of the new government. We may also witness moderate outflows from equities and debt markets, leading to a rebound in USD-INR. Although there may not be an immediate sell-off in IGBs, we do not expect substantial gains either. In the least likely scenario 3, we expect a sell-off in both the FX and IGB markets. The focus could shift to the risk of sustained foreign outflows from both local equities and debt markets, which could exert pressure on the INR. We believe the rates market will price in an increased likelihood of fiscal slippage, and sentiment in other asset markets will worsen.
In SCout, 11 April 2014, India: Reviving growth, brick by brick, we presented our outlook for the equities market (and foreign inflows) in three post-election scenarios relating to GDP growth.
Elections outlook India the worlds largest democracy, with more than 814mn voters has embarked on a month-long national election process. Predicting the election outcome is a hazardous task in such a large and heterogeneous democracy. The presence of multiple political parties (370 parties contested the 2009 general elections) increases the complexity further. We use recent opinion poll results to create a few scenarios of election outcomes and try to assess different combinations that may push a coalition above the majority mark of 272 seats. However, we place a caveat that opinion polls were not accurate predictors of Indias previous two elections (see On the Ground, 8 April 2014, India Hope builds, but delivery will be key). In fact, most opinion polls survey only an average of 60-100 persons in a constituency (the average number of voters per constituency is close to 1.5mn).
Scenario 1: The BJP-led NDA getting 240+ seats Most of the opinion polls are now predicting this outcome, if we include the recently announced coalition between the BJP and the Telegu Desam Party (TDP). In such a situation, the NDA can garner support from independents and very small parties with less than two seats (in 2009, they got more than 25 seats) and may not require support from any large regional party. With a stable and cohesive government, the chances of the NDA following its growth-oriented economic programme will be higher. Hopes of economic recovery and reduced uncertainty should encourage investor flows to India. The asset markets should respond positively, and over- Figure 2: The main opposition party has gained in importance Various opinion polls over a period of time
Agency Publication date INC UPA BJP NDA Others ABP Nielsen 7 Apr 73 92 217 236 215 CNN-IBN-Lokniti-CSDS 7 Apr 94-106 111-123 206-218 234-246 174-198 CNN-IBN-Lokniti-CSDS 7 Mar 94-110 119-139 193-213 212-232 172-212 ABP News-Nielsen 22 Feb 73 92 217 236 215 Times Now-CVoter 13 Feb 89 101 202 227 215 ABP News-Nielsen 25 Jan 81 101 210 226 216 CNN-IBN-Lokniti-CSDS 24 Jan 92-108 107-127 192-210 211-231 206-222 India Today Group-CVoter 22 Jan 91 102 188 212 229 CNN-IBN-Lokniti-CSDS 28 Oct 116-124 134-142 171-179 187-195 206-222 CNN-IBN-Lokniti-CSDS 26 Jul 131-139 149-157 156-164 172-180 206-222 Source: Media reports, Standard Chartered Research We use recent opinion poll results to create a few scenarios of election outcomes We think the probability of the BJ P- led NDA getting 240+seats is 60%
FICC Alert
22 April 2014 3 leveraged companies should be able to reduce their leverage by raising equity or selling non-core assets. This could be the stepping stone towards a gradual investment recovery. If this is followed by easing supply-side bottlenecks and other structural reforms, the growth recovery could become more robust and sustainable. A majority in parliament will likely give the NDA the power to legislate on economic reforms (tax, labour, foreign investment) in addition to more decisive executive actions (on expediting project approvals and framing more business-friendly regulation) that may not even need parliamentary approval.
Scenario 2: The BJP-led NDA getting between 220 and 240 seats If the NDA gets seats in this range, several possibilities are likely. One, the NDA could enter into negotiations with one or two relatively large regional parties to form a post-poll alliance that would still be led by Narendra Modi. Two, the NDA could form a minority government, with some of the regional parties abstaining from voting against it. Three, the BJP may look for a different PM candidate who is more accepting of other regional parties that are not part of the NDA coalition at present. Until there is more clarity on which one of these possibilities will play out, the markets are likely to remain extremely nervous. We think that a government will finally be formed in scenario 2, but it might not have the political cohesion to push through difficult reforms. Some regional parties might force the BJP to dilute its economic agenda, and some others might bargain for favours. The pace of decision making and economic reforms is likely to be slow. Sentiment in the asset markets could also remain depressed as uncertainty prevails. If after a few months the government can demonstrate its ability to turn around the economy through executive decisions, sentiment could improve.
Scenario 3: The BJP-led NDA getting less than 220 seats In this case, the NDA may not get enough new coalition partners to cross the 272- seat mark. With no coalition securing a majority, the chances of a hung parliament will increase. Theoretically, there is a possibility that the regional parties will come together and form a government with support from the United Progressive Alliance (UPA). However, we do not see this as a realistic possibility, because regional parties are often strong competitors within particular states like the All India Anna Dravida Munnetra Kazhagam (AIADMK) and the Dravida Munnetra Kazhagam (DMK) in Tamil Nadu and the Samajwadi Party (SP) and the Bahujan Samaj Party (BSP) in Uttar Pradesh. Thus, it becomes difficult for them to form an alliance at the centre. A hung parliament will be an unexpected outcome, with sharp negative reactions in Figure 3: INR seems to have responded positively to the increasing popularity of the BJP Figure 4: FII inflows to Indian equities and debt have picked up since October 2013
Source: Media reports, Bloomberg, Standard Chartered Research Source: Media reports, Bloomberg, Standard Chartered Research CNN-IBN- Lokniti- CSDS survey Times Now- India Today- Cvoter USD-INR (RHS-inverted scale) 59 60 61 62 63 64 100 140 180 220 260 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 P r e d i c t e d
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CNN-IBN- Lokniti- CSDS survey Total FII inflows to Indian equities and debt in the month (USD bn, RHS) 0 1 2 3 4 5 6 150 160 170 180 190 200 210 220 230 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 P r e d i c t e d
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We think the probability of the BJ P- led NDA getting less than 220 seats is 10% The probability of the BJ P-led NDA getting between 220 and 240 seats is 30%, in our view
FICC Alert
22 April 2014 4 financial markets. Even if the NDA is somehow able to form a minority government with less than 220 seats, markets are likely to question its stability and its ability to make decisions.
Based on opinion poll results and factoring in the possibility of errors in the surveys, we assign subjective probabilities of 60% for scenario 1, followed by 30% for scenario 2 and 10% for scenario 3. It will not be possible for us to update these subjective probabilities, because no more opinion/exit polls will be allowed until the election process is over on 12 May. While at present, markets are focused on 16 May when the election results will be announced, the political process after the elections is likely to have a more prolonged impact on the markets. They will likely keenly watch for the composition of the ruling coalition (i.e., which regional parties decide to join it and under what conditions); the choice of ministers for critical ministries; decisions of the new government in the first few days of coming to power, particularly budget proposals; and the speed at which the economy responds to those decisions.
Market outlook Rates market The impact of an election outcome on the IGB market has been limited in the past. The medium-term trend in IGB yields after the elections depends more on the macroeconomic backdrop at the time of elections. Interestingly, the last two elections (2004 and 2009) were held at the trough of the policy rate cycle (May 2004) and the inflation cycle (May 2009). In 2004, IGB yields increased by 150bps within three months after the elections in anticipation of policy-rate hikes that started in October. In 2009, WPI inflation spiked to 7.15% in December from 1.45% in May, leading to yields increasing by c.70bps in the three months after the election results were announced.
We think the current macroeconomic backdrop is different from that in 2004 and 2009. In March 2014, CPI inflation was at 8.3% y/y very close to the RBIs end- December 2014 target. We expect only a moderate uptick in CPI inflation in Q2-2014 on the back of adverse base effects and weather-related disturbances. However, inflation will likely trend downwards in H2-2014 as the base effect turns favourable. In our view, the RBI is likely to ignore these transitory factors and keep policy rates steady for some time. Thus, unlike during the previous elections, we may already be close to the peak of the policy rate cycle this time. With the benchmark 10Y IGB yield Figure 5: Credit markets have also rallied, partly due to the government meeting its FY14 headline fiscal target Figure 6: IGBs have remained range-bound and not responded to the improvement in election sentiment
Source: Media reports, Bloomberg, Standard Chartered Research Source: Media reports, Bloomberg, Standard Chartered Research CNN-IBN- Lokniti- CSDS survey SBI 5Y CDS spread (bps, RHS-inverted scale) 200 250 300 350 100 140 180 220 260 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 P r e d i c t e d
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Times Now-India Today-Cvoter CNN-IBN- Lokniti- CSDS survey 10Y IGB yield (%, RHS- inverted scale) 8.25 8.50 8.75 9.00 9.25 100 140 180 220 260 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 P r e d i c t e d
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Times Now-India Today-Cvoter The 2004 elections were held at the trough of the policy rate cycle, and the 2009 elections at the trough of the inflation cycle Markets will watch for the composition of the ruling coalition, the choice of individuals for critical ministries, and budget proposals after the elections are over We think the current macroeconomic backdrop is different from that in 2004 and 2009
FICC Alert
22 April 2014 5 c.100bps higher than the policy rate, we think the IGB markets are adequately pricing in the likelihood that the central banks tight monetary policy stance will continue. The daily average of this spread when the repo rate was operative has only been about 35bps from January 2005 to date. In a more recent period from January 2011 to December 2013 it averaged about 55bps. Thus, our base-case view is for 10Y IGB yields to decline amid a stable policy rate environment with improving external-sector dynamics.
If the outcome of the elections resembles scenario 1, IGB gains may accelerate. The markets would likely price in continued fiscal consolidation and better supply-side management of inflation, with sentiment improvement in other asset markets also potentially benefiting the IGB market. Overall macro stability could bring in foreign demand, partly reversing the fall in demand from the RBI. The bond market will keenly watch the first budget of the newly elected government to assess its fiscal stance. If the budget does not announce any additional borrowing, the bond market will likely be relieved. The BJPs manifesto for the 2014 election emphasises fiscal discipline; indeed, during 1999-2004 (when the BJP-led NDA was in power), it managed the fiscal deficit well.
The disinvestment process started during the NDA regime, and it may become an essential component of bridging the revenue expenditure gap if the BJP-led NDA is elected. However, the urge to fulfil election promises could increase expenditure in the new governments first year. The manifesto also lists several specific measures to address supply-side issues plaguing inflation. The RBI would be more comfortable about relaxing its tight monetary policy stance if these supply-side measures are successful. Finally, we expect sentiment in other asset markets, particularly FX, to improve substantially, which will have a spillover impact on IGBs.
Scenario 2 could make the bond markets nervous until there is more clarity on the formation of the new government. Although there may not be an immediate sell-off; we do not expect substantial gains either.
In a less likely scenario 3 (a high chance of a hung parliament), IGBs may sell off. The rates market would price in an increased likelihood of fiscal slippage and worsening sentiment in other asset markets. The focus could shift to possible foreign outflows from both local equities and debt markets, which could exert pressure on the INR. Figure 7: Monetary policy backdrop for 2014 elections is different from that in the past two elections Figure 8: FII inflows to equities stronger than to debt Cumulative flows since 1 February 2014, USD bn
Source: Bloomberg, Standard Chartered Research Source: Bloomberg, Standard Chartered Research 2004 Elections 2009 Elections 10Y IGB yield Repo rate Reverse repo rate 3 4 5 6 7 8 9 10 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Equities LCY debt (IGBs + T-bills + Corporate debt) -1 0 1 2 3 4 5 6 2-Feb-14 17-Feb-14 4-Mar-14 19-Mar-14 3-Apr-14 If the outcome of the elections resembles scenario 1, IGB gains may accelerate Scenario 2 could make the bond markets nervous until there is more clarity on the formation of the new government
FICC Alert
22 April 2014 6 FX market Since September 2013, the INR has benefited from policy response to last years currency depreciation, and improving macros have reinforced the stabilisation process. However, India will need to return to a high growth path and see more sustainable improvements to its current account deficit for the INR rebound to be extended. We believe that amid such a backdrop, FX markets will keenly watch the election outcome to assess any change in policy framework adopted by the new government. However, until the election results are clear, USD-INR is likely to trade between 59.50 and 61.50. This is very close to the level that RBI Governor Rajan characterised as fair value for the INR, and it seems likely the RBI will be successful in fostering INR stability around this level in the very near term. The governor recently opined that USD-INR of 55.0 would leave the INR at too strong a level (although this conclusion is very dependent on the measure of Indian inflation used in assessing INR valuations).
An election outcome resembling scenario 1 could trigger near-term INR gains, as markets may not have completely priced in such an outcome. This could potentially shift the USD-INR trading range lower by 2-3% from current levels. A cohesive and decisive BJP-led coalition government will lead to expectations of a growth recovery by focusing on infrastructure and manufacturing. In our view, the key propositions of the BJPs manifesto that have a high probability of implementation are accelerated and time-bound (including environmental) clearances in the manufacturing sector, its strong emphasis on infrastructure development, and its proposal to rationalise the tax regime (see On the Ground, 8 April 2014, India Hope builds, but delivery will be key). As highlighted in SCout, 11 April 2014, India: Reviving growth, brick by brick, in a scenario where the likelihood of growth bouncing back to 7.0-7.5% increases (possibly in conjunction with a strong and stable government in FY15, year starting 1 April 2014), FII inflows could be USD 10-15bn per annum.
We think the FX markets have only partially priced in the likelihood of scenario 1, as uncertainty about the accuracy of opinion polls persist. If the election results indicate a stable government, the INR may gain further from increased capital inflows. YTD, the INR has gained only 2.5% against the USD, while comparable emerging-market (EM) currencies like the Indonesian rupiah (IDR) and the Brazilian real (BRL) have gained c.5-7%. The INR therefore has scope to appreciate on a favourable election outcome. Moreover, domestic exporters have hedge ratios of c.30-35%, which are Figure 9: Growth recovery is key for INR appreciation
Figure 10: INR has underperformed its peers YTD spot returns versus the USD, %
Source: Bloomberg, Standard Chartered Research Source: Bloomberg, Standard Chartered Research 39 44 49 54 59 64 4 5 6 7 8 9 10 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 USD-INR (RHS, inverted) Consensus GDP forecast (% y/y) -2 0 2 4 6 8 IDR BRL INR THB MYR PHP ZAR FX markets will likely keenly watch the election outcome to assess the change in policy framework adopted by the new government In scenario 1, the INR trading range could shift to 58-60 The INR has gained only 2.5% against the USD YTD, while comparable EM currencies like the IDR and the BRL have gained c.5- 7%
FICC Alert
22 April 2014 7 likely to increase as the INR gains momentum. This should also propel the INRs advance. However, the RBI is likely to moderate such appreciation pressures to rebuild its FX reserve cover.
In the scenario of a BJP-led coalition government getting between 220 to 240 seats, we expect a knee-jerk mild sell-off in the INR as markets brace for an uncertain period of political negotiations to form a government.
As a result, we may also witness moderate outflows from both the equity and debt markets. Foreign investors were overweight Indian equities in the MSCI as of end- December 2013; we think this may reduce if scenario 2 materialises (see SCout, 11 April 2014, India: Reviving growth, brick by brick). Investor confidence is unlikely to return to FX markets till the new governments policy framework becomes clear.
In a less likely scenario 3 outcome (a high chance of a hung parliament), investors would be disappointed, and we expect the INR to retrace its gains since its low of 63.11 in January 2014. The RBIs support may be required to stabilise the INR, as USD-INR could trade beyond the RBIs comfort level.
Credit markets To assess the impact of the election results on Indian credit spreads, we need to analyse two factors Indias credit rating trajectory and where Indian credit spreads are in the context of broader Asian and EM markets.
Indias ratings came under pressure in mid-2013 due to a low growth rate, currency depreciation and capital flight. However, since then, the authorities have used a variety of policy tools to narrow the current account deficit, while monetary policy has been more assertive in addressing inflation concerns. Importantly, the government managed to contain the FY14 fiscal deficit at 4.6% of GDP, versus initial estimates of 4.8%. While the quality of fiscal consolidation is somewhat questionable (due to significant cuts in planned expenditure, a rollover of subsidy payments, one-off revenue from telecom spectrum auctions and dividend payments from state-owned companies), ratings pressure has clearly abated. The budget to be announced by the new government will determine the FY15 fiscal outcome and longer-term trends that could affect the sovereign credit profile.
Figure 11: Average Indian credit spreads against peers Z-spread, bps Figure 12: Benchmark Indian bonds against peers Duration, Z-spread, bps
Source: Standard Chartered Research
Source: Standard Chartered Research China Thailand India Indonesia 150 200 250 300 350 400 450 Jul-13 Oct-13 Jan-14 Apr-14 ONGCIN 18 RILIN 20 BHARTI 23 NTPCIN 22 PTTEPT 18 TOPTB 23 PCCW 23 NANFUN 22 CHCONS 18 CHINAM 22 BRTFOD 18 SBIIN 18 EXIMBK 23 ICICI 20 IDBI 19 BBLTB 18 BBLTB 23 AGSBB 23 BCHINA 23 BBRIIJ 18 BBNIIJ 17 130 175 220 265 310 2.6 3.1 3.6 4.1 4.6 5.1 5.6 6.1 6.6 7.1 7.6 Increased chances of a hung parliament would disappoint equity investors; the INR may sell off, too Indian credit spreads have tightened recently on a gradual improvement in macro fundamentals
FICC Alert
22 April 2014 8 Indian credit spreads have tightened sharply in the past six months due to the gradual improvement in the macro picture. Since September 2013, Indian credit spreads have come in by about 140bps (Figure 1) and are currently trading broadly in line with the low-BBB credit space in Asia. We believe markets are currently pricing in a negligible possibility of a rating downgrade, which we believe is fair. Hence, we have an overall Neutral recommendation on Indian credits, with a preference for corporates over bank senior paper.
The possibility of a sovereign downgrade is the biggest concern for credit investors. They will likely be looking at election results to get further clarity on this. As highlighted in the previous paragraph, the pressure of a rating downgrade has reduced significantly given the improvement in the fiscal and current account positions. Thus, if the election outcome resembles scenario 1, Indian credit spreads could tighten further by about 20bps in three months. While a strong showing by the BJP-led NDA would not, by itself, translate into an immediate improvement in economic growth and fiscal consolidation, the markets would likely price in the potential for longer-term structural improvements, which has been a big concern for the rating agencies. Also, if the new government sticks close to the 4.1% fiscal deficit target announced for FY15 by the current government and takes some initial steps towards this, S&P will likely revert Indias sovereign rating outlook back to stable in H2-2014. Such a scenario would be more beneficial for the bonds issued by quasi- sovereign corporates and senior financials in particular, as the rating of these entities is directly linked to sovereign ratings. Bonds issued by private corporates like Reliance Industries Ltd., Bharti Ltd. and Vedanta Resources are unlikely to benefit directly, but they will likely benefit indirectly from improved sentiment.
If the election outcome resembles scenario 2, Indian spreads could see a mild sell-off (of about 10-15bps), as investors would prefer to take profits and wait for more clarity on the new governments composition and policy stance. In this scenario, private corporates could outperform marginally given the lack of direct linkage to sovereign ratings.
However, if scenario 3 plays out, Indian credit spreads will likely see a much sharper sell-off (of at least 50-60bps). Investors will likely believe that the lack of a common economic agenda would make it difficult for the new government to implement contentious reforms or undertake meaningful fiscal correction. This in turn could lead to capital flight, currency pressure and a negative feedback loop for credit markets. In case of scenario 3, we also see an increased probability of S&P downgrading the ratings and/or Moodys changing the outlook to negative over a 6- to 12-month period. In such a scenario, we would expect spread widening across all sectors. However, downstream oil and gas names like Indian Oil and Bharat Petroleum that bear the brunt of the oil-subsidy burden could be exposed more. Fragmented polity under scenario 3 and the related economic uncertainty would impact the banking sector as well in terms of slower credit growth and further asset-quality pressure. This could lead the banking-sector credits to underperform. The smaller state-owned banks with weaker credit fundamentals would be affected more from a fundamental perspective. That said, the sell-off in bonds could in fact be led by the larger and relatively strong banks as they are much more widely held by international investors and thus would attract larger selling pressure. In such a scenario, privately owned corporates, especially names with large international/export operations (such as Reliance, Bharti and Vedanta) would be less affected fundamentally and are likely to outperform substantially. A positive election outcome could tighten Indian credit spreads by about 15-20bps In scenario 3, the credit spread will likely see a sharper sell-off of c.50- 60bps
In scenario 1, credit spreads could tighten further by 20bps
FICC Alert
22 April 2014 9 Local markets strategy We recommend that investors remain Positive on both the INR and IGBs. Specifically, we recommend buying 5Y IGBs (7.28% 2019) at the current yield of 8.82% (entry: 8.95%, target: 8.65%, and stop-loss: 9.10%). In the most likely scenario (1), where the BJP-led NDA gets 240+ seats, we expect unhedged total returns of c.7.3% for a foreign investor long 5Y IGBs (c.6.2% from FX and c.1.1% from IGBs).
An election outcome resembling scenario 1 could be a strong trigger for near-term INR gains and could potentially shift the USD-INR trading band lower by 2-3% from current levels. A cohesive and decisive BJP-led coalition government will lead to expectations of a growth recovery by focusing on infrastructure and manufacturing. We think scenario 1 is only partially priced in by the FX markets, as uncertainty about the accuracy of opinion polls persist. Moreover, we think domestic exporters have hedge ratios of c.30-35%, which are likely to increase as the INR gains momentum. This should also help INR gains. Likewise, IGB gains could accelerate in this scenario as markets price in continued fiscal consolidation, better supply-side management of inflation, and sentiment improvement in other asset markets.
In scenario 2, FX gains would be limited by the uncertainty surrounding the composition of the new government. We may also witness moderate outflows from the equity and debt markets, leading to a rebound in USD-INR. But adjusted for carry, FX returns would still be positive. The IGB market could be nervous, too. Although there may not be an immediate sell-off, we do not expect substantial gains either.
In the least likely scenario 3, we expect a sell-off in both the FX and the IGB markets, resulting in unhedged total returns of -3.7% (-3.0% from FX and -0.7% from IGBs) in a long 5Y IGB position. The focus could shift to possible foreign outflows from both the local equity and debt markets, which could exert pressure on the INR. The rates market will likely price in an increased likelihood of fiscal slippage and worsening sentiment in other asset markets.
Based on the analysis of a marginal impact of the elections on the local markets, our recommendation of long 5Y IGBs is based on the most likely outcome of the elections (scenario 1). However, there are several other supporting factors that make the pay-off from this trade asymmetric. As highlighted in Rates Alert, 16 April 2014, IGB valuations are attractive; buy 5Y IGBs, we think the 5Y IGB valuations are attractive in a stable policy-rate environment. Despite a moderate uptick in near-term CPI inflation prints, a strong base effect has the potential to reduce CPI inflation to the 6.5-7.0% range in H2-2014. Supply dynamics (in the <5Y segment) and local market positioning are also favourable. With the rationalisation of the IGB quota for FIIs (i.e., no incremental investment allowed in T-bills), future FII inflows will likely be to 1Y-5Y IGBs. We think a positive election outcome could accelerate inflows to this segment. However, the risk-adjusted return for the long INR versus USD position is not attractive enough to recommend a long INR trade right now. Our estimates of Sharpe ratios for such a trade are in the range of 0.6 to 1.0.
We recommend that investors remain Positive on both the INR and IGBs Unhedged total returns for foreign investors long 5Y IGBs are as follows: scenario 1: +7.3%, scenario 2: +0.9%, scenario 3: -3.7% We recommend buying 5Y IGBs (7.28% 2019) at the current yield of 8.82% (entry: 8.95%, target: 8.65%, and stop-loss: 9.10%)
FICC Alert
22 April 2014 10 Figure 13: Estimates of total returns in the three scenarios of election outcomes
Scenario (A) Probability of occurrence of scenario (B) 3M returns on long 5Y IGB position (C) 3M returns on long INR vs. USD position (D) 3M total returns from unhedged long 5Y IGB position (E=C+D) 1 60% 1.10% 6.20% 7.30% 2 30% -0.10% 1.00% 0.90% 3 10% -0.70% -3.00% -3.70% Expected returns 0.61% 3.70% 4.31%
Note: INR returns are based on onshore forwards; Source: Standard Chartered Research
Figure 14: Key dates and events that may affect the markets
Date Event 12-May-14 Announcement of various exit-poll results 16-May-14 Announcement of election results 30-May-14 Formation of the new government Mid/End June 2014 Announcement of FY15 union budget
Source: Standard Chartered Research
FICC Alert
22 April 2014 11 Disclosures Appendix
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Document approved by Will Oswald Global Head of FICC Research Document is released at 01:01 GMT 22 April 2014