'Rupee depreciation is a key risk to FII flows'

At a time when global equity markets are paving way for a phase of correction, moderation and development, India-specific concerns might lead to underperformance by Indian markets in this phase.

Jayesh Gandhi, executive director, Morgan Stanley Investment Management in an interview with Business Standard, says Indian equities continue to remain a long-term bull story based on the growth prospect for the country and, hence, in a way cannot be ignored by global investors.

Edited excerpts:

Given the macroeconomic headwinds, how are you now approaching the Indian equity markets?

Equity markets globally are in a risk-off mode.

The liquidity-driven rally witnessed since the beginning of the year, now appears to be giving way to a correction as economic data shows moderation, and developments, particularly in the euro area, fell short of expectations.

Indian equities have also followed a similar pattern.

The recent correction could also be seen in-line with the global trend.

However, India-specific concerns are large and many.

Hence, the probability of our equity markets underperforming during the correction is high.

The macroeconomic concerns raised by Standard & Poor's and the International Monetary Fund regarding India are real, alarming and, if unattended, could lead the country into a crisis similar to that witnessed two decades ago.

The need of the hour is bold policy measures and strong reforms.

The silver lining here is that global commodity prices have seen a meaningful correction.

Hence, the hope is that a softer commodity basket could provide the much needed relief on inflation and an opportunity for the government to undertake pricing reforms in petroleum products.

What is your interpretation of the latest economic updates coming from the US and China? How high is the probability of a third round of quantitative easing in the US?

The economic data in the US was surprisingly strong in the first quarter, and hence, the equity markets there have rallied hard.

However, going into the second quarter, the economic data has begun to disappoint and could be one of the causes for the correction.

Economic growth is stable and the recent commentary from the US Federal Reserve also suggests low probability of further large policy easing.

However, in an election year, it is indeed difficult to make a call on policy action.

Recent economic data from China suggests slowdown in economic growth rates but no hard-landing.

Importantly, softer growth environment globally has taken the shine off commodity prices, particularly metals and oil, which are witnessing meaningful correction and more could follow.

Do you think problems in the euro zone/PIIGS nations could aggravate further and pave the way for a correction in H2FY13?

After the ECB's policy initiative in the form of LTRO-1 and 2, there was a widespread view of stability and hope that ECB would be able to avoid a large tail-risk event in the European banking sector.

However, the recent political turmoil has brought forth the key impending issue

in the euro area, which is the lack of fiscal union and fiscal discipline amongst the countries, particularly smaller peripheral states.

The situation is fluid and hope is that the change in political leadership in key nations would not impede the agreed on austerity measures and fiscal prudence would prevail.

How will foreign institutional investors allocate their funds in the Indian market over the next few quarters?

Does India still figure as one of the top preferences or has it dropped a few notches?

Indian equities continue to remain a long-term bull story based on the growth prospect of the country and, hence, in a way cannot be ignored by global investors.

However, recent data suggest that most FIIs are underweight on India.

The concerns for India come on growth slowdown, lack of reforms, policy paralysis, etc.

For a foreign equity investor, another principal concern today is the weak currency.

The recent clarification on the controversial GAAR provisions would help.

However, a lot needs to be done to improve the investment climate.

FII investments have been positive YTD, but maintaining this trend is going to be tough without some major policy initiatives and reforms.

In the Indian context, FMCG and pharmaceutical stocks have done quite well since the past few months. Do you expect this trend to continue or is it time to switch loyalties?

Indian equities have been in a declining mode for the last 12 months.

Thus, defensive sectors such as FMCG and pharmaceuticals have been performing relatively better.

The outlook for the sectors could largely depend on the direction of the equity markets.

Corporate commentary during the current earnings season, so far, has been encouraging and estimates suggest earnings growth trajectory is coming back to reflect the nominal GDP growth of around 12-15 per cent.

This is a positive change, since the last few quarters' earnings growth was stalled on account of increase in cost, as both material and interest costs increased significantly.

Going forward, the soft inflation and commodity prices coupled with some moderation in interest rates could provide the much-needed fillip to corporate earnings.

The way to play the positive earnings movement could be through domestic cyclical sectors, such as banking and consumer discretionary stocks.

Our portfolio continues to focus towards growth at reasonable price, in companies with strong balance sheets and earnings growth visibility for the next few years.

What is the outlook on the rupee?

The view on the rupee remains negative, primarily because of the large current account deficit and balance of payments deficit that India has in its external account.

In order to support the rupee, RBI might have to sell more dollars, which in turn will reduce domestic liquidity and require further OMOs.

However, these actions may, at best, smoothen the decline in the rupee, but currency depreciation continues to be one of the key risks to FII flows in the equity markets today.

To reverse the declining trend, we need to boost the investment environment in the country, which is dependent on government policy and reforms.