Monetary easing during election fever in India

• We are intensely mindful of how poorly the “markets” have done projecting election and referendum outcomes in the last five years. That said, our expectations remain centred around a Modi victory, albeit with a smaller majority than in 2014.
• A Modi “loss” would, no question, be a market dampener. However, as in previous election cycles, we would expect the markets to absorb the “disappointment” and devolve to a fundamental assessment of (i) the stability and the strength of the institutions, (ii) underlying reform momentum, and (iii) the outlook/sustainability for growth.
• The bottom line is, irrespective of the election outcome, we believe that Modi’s structural reforms have been well-institutionalised and will sustain a new investment cycle and our growth outlook.

Counter-cyclical easing by RBI

We now expect another 75bps to 100bps of policy easing over the next 12 months.

• Fact: At a broad level, growth in M3 (broad measure of money supply) has been lagging nominal GDP growth since December 2016. Modi has remained fiscally disciplined, allowing the Reserve Bank of India (RBI) the flexibility to now start to ease counter-cyclically.
• India’s growth soft-spot in 4Q2018 was triggered by tight systemic liquidity and risk aversion following the Infrastructure Leasing & Financial Services default last October. We would specifically highlight RBI’s recent announcement of a USD swap window to address domestic liquidity concerns, strengthen the deposit base for the domestic banks, reduce hedging costs and incentivise foreign portfolio investments in domestic debt instruments.
• With inflation now trending below RBI’s inflation-targeting framework, and bolstered by central banks globally signalling a collective “pause”, RBI delivered its second successive interest rate cut, reducing the benchmark repo rate by 25bps to 6%. We believe that RBI will continue to be “accommodative”.

The Monsoon watch resumes

Seventy-five per cent of India’s annual rainfall occurs during the Southwest Monsoon (June to September) season, and given India’s historically poor irrigation infrastructure, the monsoons remain crucial to the agrarian economy. With the Australian Meteorological Bureau recently signalling a 70% probability of an El Niño event, concerns have started to build over the likelihood of a poor monsoon season in India.

• Seventy-five per cent of India’s agrarian output is monsoon dependent. So, a poor monsoon season will weigh on sentiment and, importantly, on inflationary expectations — assuming the risk of a spike in agri-commodity prices. In contrast, we believe that proactive policy intervention to prevent “hoarding” of agri-commodities and the judicious use of the country’s surplus store of grains will significantly moderate the risk of spiking agri-commodity prices.
• The economic drag (agriculture accounts for 15% of the country’s GDP) is only seen in the year subsequent to a poor monsoon season when agricultural output/rural cash flow/rural purchasing power/rural demand actually declines. Specifically, a poor monsoon would be negative for agro-chemicals, seeds/agri inputs companies, autos and rural demand-focused consumer companies.

The bottom line is, we are much more sanguine than the markets at this point — not because we have a specific view on the distribution and/or the extent of the rainfall expected in the current monsoon season, but because we believe that the economic impact of a potentially poor monsoon season is likely to be minimal over the next 12 to 18 months.

Key risks to assess:

• Domestically, (i) continuity to Modi’s reforms and anti-corruption platform, (ii) fiscal constraints in an election year limiting government spending, and (iii) delayed/impaired transmission of RBI’s monetary easing.
• Externally, higher energy prices (which remain our major concern) and increasingly unpredictable geopolitics and trade conflicts negatively impacting global growth/risk appetite/flows, creating a potential drag for Indian risk assets and, in particular, for the rupee.

Time to look at developers

The stock we would like to highlight this month is DLF, India’s largest property developer. Having painfully restructured its business into two distinct verticals — rental income-focused commercial properties and pure development (both residential and commercial) assets — management has finally succeeded in consolidating the family’s stake into the listed entity (eliminating any potential conflicts with minority investors), while deleveraging the balance sheet of the listed entity (allowing for the effective monetisation of a valuable landbank).

DLF is a prime beneficiary of the new Real Estate Regulatory Act (RERA), which enforces explicit restrictions on the marketing/sale of new property projects in order to protect consumers and strict guidelines on revenue/cash flow recognition on customer deposits in escrow accounts.

• RERA has effectively eliminated the highly disruptive unorganised sector as well as balance sheet-constrained developers that lack the capital to invest FUNDS & ETFS upfront in land acquisition and infrastructure development.
• Importantly, too, shrinking supply and a limited pipeline of new product launches have allowed real estate prices to stabilise after almost five years of declines.

We expect DLF to deliver on robust positive free cash flows compounding at close to 30% annually over the next three to five years (versus the market’s more muted expectations of about 15% growth).

• Having delivered on a quarterly sales run rate of about INR6 billion ($117 million) per quarter (despite the overall weakness in residential property markets), as sentiment/pricing improves, we expect DLF’s sales run rate to rise to about INR8 billion per quarter, while maintaining operating margins in excess of 35%.
• We expect the commercial rental portfolio (which has currently leased out 28 million sq ft) to deliver on INR18 billion of post-tax cash flows, compounding at about 12% annually on the back of both rental rate increases and increased leasing of space.
• The deleveraging of the balance sheet will yield significant interest savings.
• What we are not yet “building in” is management’s “roadmap” to selling down INR130 billion in unsold inventory in completed, prime location projects, and its ability to selectively monetise the landbank through strategic asset sales.

Conclusion

We do expect the markets to remain volatile as India goes to the polls over the next six weeks. On the ground, strong rural consumption trends, a nascent capex cycle and our expectations of policy reform continuity/momentum would suggest that India’s idiosyncratic growth opportunity is intact. We would urge investors to take the long view and continue to increase their allocation to Indian equities.

We are on the cusp of a new investment/consumption upcycle. Irrespective of the election outcome, India’s structural reforms and domestic economy stand poised to deliver on sustained real GDP growth compounding at 7%+ annually over the next three to five years.

We see credit growth and profit margins inflecting higher. We expect our portfolio companies to deliver on earnings and cash flows compounding at 15%+ annually over the next three years.

We find valuations and the risk/reward compelling — especially in the smalland mid-cap space — given the prospects of sustained revenue and earnings growth and the likelihood of further easing by RBI.

The Tantallon India Fund is a fundamental, long-biased, India-focused, total return opportunity fund registered in the Cayman Islands and Mauritius. The Fund invests with a three- to five-year horizon, in a concentrated portfolio (25 to 30 unlevered positions), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models, and in management’s ability to execute. Tantallon Capital Advisors, an advisory company, is a Singapore-based entity, set up in 2003, holding a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore