Will 'Buy China' mean 'Sell India' for FIIs?

Dec 9, 2014

In this issue:
» Falling commodity prices a mixed bag for Indian steel
» Brent falls below US$ 66 a barrel
» What lower oil prices mean for the US energy sector...
» ...and more!

 Chart of the day
In an era where the developed world is still battling inflation and the central banks are only combating this through loose monetary policies, global investors are looking at opportunities outside of these countries. Naturally, emerging economies such as India and China among others are finding considerable favour.

Foreign institutional investors (FIIs) have been pouring money into the Indian stockmarkets on the back of the Modi wave. After 2 years of considerable slowdown under the reign of the largely ineffective UPA government, considerable hopes have been pinned on the Modi government to unleash reforms and kick start economic growth in the country.

Since Indian stock markets have always been influenced by foreign money, the surge of liquidity has led to considerable run up in stock prices. Therefore, will this rally last or are Indian markets ripe for correction? Further, how does the performance of the Indian indices compare with that of China?

Let us examine the second question first. As reported in the Economic Times, the past month has seen a huge jump in the Chinese stock markets. Indeed, Chinese markets have gained around 25% in the period, while Indian indices have gained a mere 1%. It has also been estimated that China's valuations are cheaper as compared to India based on one year forward earnings. In such a scenario, it is quite possible that FIIs may prefer to invest in Chinese equities as compared to Indian stock markets in the coming months. And the kind of money that has been pouring into India will see some sort of a pause.

Having said that, the notion of valuations in China being cheaper does not necessarily make it an attractive destination. We have highlighted in one of our recent editions of the 5 Minute Wrapup how China is a front running candidate for a potential major crash. And given its sheer size and the impact that it has on the global markets, a crisis here is bound to have repercussions on the global markets. Commodity prices crashing, wasteful investments and a possible debt bubble are all problems that make China a ticking time bomb.

The rise in stock prices has also been quite unprecedented in China. As reported on Bloomberg, the value of shares changing hands on China's two biggest exchanges exceeded 1 trillion Yuan (around US$ 162 bn) for the first time last week. This is more than five times the average daily turnover during the past three years. In Shanghai, trading values have increased threefold when compared to the market's peak in 2007. Thus, the idea that China's valuations are cheaper based on forward earnings should be taken with a pinch of salt we believe.

India, in the meanwhile, has seen valuations become rich even though on the ground level economic activity is yet to significantly pick up. We are not saying this will not happen. The growth story very much remains intact. But the stock prices do seem to have run ahead of fundamentals somewhat. And we will not be surprised if some sort of a correction does take place.

Do FIIs prefer investing in Chinese stocks?

History has shown that many a time FII investors have known to be a tad fickle. And so there is the possibility that new money will find its way into China simply because it looks cheaper to India. But should China stutter, this money will once again find its way into India should the Indian economy begin to recover around the same time. Which is why taking a call purely on the basis of FII behavior hardly makes much sense.

What we do know is that if a correction does take place in the Indian stock markets, it becomes the perfect opportunity for the smart investor to put in money in some high quality companies which could then be trading at cheaper valuations.

Do you agree that the Chinese stock market is currently a better investment option as compared to India? Let us know your comments or share your views in the Equitymaster Club.

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To continue on China, a slowdown in the economy has led to a considerable fall in commodity prices. Take the case of iron ore for instance. As reported in the Mint, iron ore imports into China fell by 13.4% from a year ago and by 15.1% sequentially. Little wonder that lower demand has translated into iron ore prices crashing. Indeed, prices have been down by around 47% in the year so far.

For India, a slowdown in China and the consequent impact on commodity prices has been both a boon and a curse. Since mining has been banned in certain states, Indian companies have been grappling with poor iron ore availability for a while now. Cheaper prices have made the case stronger for iron ore imports.

However, falling prices do not bode well for steel producers in India. This is because steel imports have also been surging. In the period from April to October this year, steel imports rose by around 21% and in October alone, imports jumped 33%. In an environment where steel realizations have weakened, cheaper raw material costs (in the form of lower prices of iron ore) do offer some comfort to Indian steel companies. But the real growth will come once the Indian economy picks up and the domestic demand for steel rises.

The pressure on oil price continues with the same falling to a 5-year low of US$ 66 a barrel today. The concerns broadly remain the same - that of oversupply situation arising. And with the oil producers from the Middle East looking to gain market share, the probability of oil prices continuing their downward movement for some more time seems to be on the higher side.

How long will this continue? Well... from the looks of it, as long as oil producers in the Middle East continue making money or till the time some of the US oil producers go bust. However, with news of US oil producers looking to cut jobs as well as capital expenditure on future expansion over longer periods, the overall supply situation could turn out to be quite different from what was expected. Conoco, for instance, has announced a 20% or US$ 3 bn reduction in shale spending - the biggest reduction announced so far by US drillers. As was reported by the FT a few days ago, investments to the tune of US$ 100 bn may be at risk due to falling prices. Not to mention the trickledown effect of the same - job losses and lower businesses to related businesses such as fracking, which is believed to contribute to about US$ 300 to 400 bn of the US' economic activity.

No doubt, there are some benefits of lower oil prices, which provide more spending power to consumers. As per estimates, lower oil prices are likely to provide additional US$ 75 bn to the consumer purchasing power. However, as per an article on Moneynews, these effects are expected to be negated when it comes to the overall picture.

Apart from the obvious impacts to GDP and its effect on employment, what seems to be hurting the sector in the US is the restriction on pipeline development which is making oil transportation to refineries quite expensive. And with this, the exploration projects are expected to become vulnerable to oil prices at levels around which they are hovering at the moment. And that by ignoring this fact the government is making a big mistake; the latter argues that the payoffs on such projects are not significant.

Not to mention the overall effect of the strengthening US currency versus other global currencies, thereby making US' exports more expensive and imports cheaper. This would only widen the nation's trade deficit.

Well... from what we can see, the situation is likely to be quite messy in the short term. Given the possibility of rising supplies and lower prices, it would be interesting to see how things play out. While lower oil prices are beneficial for net oil importers such as India, the fact of the matter is that an energy war can hurt the global economy in the long run.

In the meanwhile, the Indian markets were under pressure with the BSE-Sensex trading lower by about 314 points or 1.1% at the time of writing. Stocks across the board were trading weak with those from the power and metal spaces leading the losses. Mid and smallcap stocks were under pressure as well with their representative indices trading lower by about 1.7% each. As for markets in Asia, they ended the day on a weak note; sentiments in Europe were dull at the time of writing.

 Today's investing mantra
"If you don't feel comfortable owning something for 10 years, then don't own it for 10 minutes." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit and Devanshu Sampat.

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