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After a great '06, 2007 will be a tricky year for investors

2006 was a great year for almost all asset classes, except maybe debt. Will we see an encore in 2007? Highly unlikely.

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Extent of rise in interest rates will be a key determinant of  returns in various asset classes.

MUMBAI: 2006 was a great year for almost all asset classes, except maybe debt. Will we see an encore in 2007? Highly unlikely. The returns in the New Year will be much less, maybe even negative in some cases, experts told DNA Money.

The refrain on the street is, 2007 will be a year of modest returns and volatility.

Obviously, the returns will differ for each asset class. And factors like timing and selectiveness when investing will play a major role in determining profits and losses.

In other words, it will be a tricky year for investors.

Among the key factors to watch out for are interest rates and domestic inflation, corporate profitability, valuations, swings in the global economy and foreign institutional investor (FII) flows.

Says Raamdeo Agrawal, joint managing director, Motilal Oswal Securities, “Corporate profits will grow by at least 20% in 2007. But how the markets perform will also depend on the global scenario. In the worst case, returns could be 15% and in the best case 20%. While valuations currently are fair at around 22 times earnings, they are a bit stretched.”

Janish Shah, head of research, Networth Stock Broking, adds: “Valuations may fall and comfort levels will deteriorate as corporate profit growth decelerates, although it will still remain in the high double digits. In equities, being selective may bring in returns of 20-30%, but one has to be really selective.”

One factor that may play spoilsport is rising interest rates. Says Agrawal: “Rising rates can hurt equity. But it all depends on how much it will rise by. Any significant rise from current levels will be detrimental.”
Over the long term, interest rates and equity markets share an inverse relationship. That is, when interest rates rise beyond a point, it becomes attractive to invest in debt.

But rising interest rates also lead to high cost of borrowings, which impact corporate profitability and consumption, leading to lower growth rates. But thankfully, the Indian equity markets are nowhere near such a situation.
But given the upward bias in interest rates, investment in debt instruments will seem more attractive at some point of time in 2007.

Another important element that will determine market direction is the foreign institutional investor (FII). Says a fund manager: “The rally here has happened because of FII money. So, any change in the outlook for emerging markets will impact us too. We got to get $10 billion a year, which looks difficult at current levels of valuation.” 

Also, although the global, and especially the US, economy is expected to slow down, the US stockmarket is expected to deliver positive returns in 2007. If that happens, initially, some money could also flow out of emerging markets, including India.

The trend in the dollar will be crucial to the process. Its continuing weakness could be an advantage to emerging market equities, experts say.

On the positive side, India is an economy driven by internal consumption. Says the fund manager: “Inflows will happen once you continue to reassure the India growth story, which should not be an issue. On the other hand, with regards to the US slowdown, a hard-landing will have serious emerging market repercussions. But, a soft landing should bring more money into India.”

In which case, US companies could increase outsourcing from India to reduce costs, which would prop up local earnings growth. Earnings growth of 20-25% would be sufficient to bring valuations lower to attractive levels. Currently, the BSE Sensex is trading at a price-earnings multiple of 22.76.

Lastly, if the government cuts corporate taxes and rationalises excise and other duties in the forthcoming budget, it should also lead to a positive impact on equities.

The good news is that the rise in interest rates may be held back, though not very soon. It could be a few months before this happens.

Says Sandeep Bagla, head, fixed income, Principal PNB Asset Management Company: “In 2007, the markets will be range-bound. You may not see much action from central bankers because they have already increased rates. We are reaching an inflection point on rates. Depending on how the economy performs over the next three to six months, the next interest rate decisions will be made.”

The RBI will continue to target inflation. And if it is unable to do so effectively, expect further rate hikes till prices come under control.

For investors, given that interest rates are showing an upward bias currently and liquidity remains tight, investing in floating rate and money market instruments will make sense. At least, till there are signs of interest rates peaking. Thereafter, investors can lock themselves in high-yielding fixed income funds.

On the flip side, says Bagla, if the Indian economy surprises on the upside and growth momentum sustains much beyond the expectations of the regulator, thereby raising inflationary fears, “the RBI may decide to move to a systematically higher interest rate environment”.

Commodities: Among other asset classes, commodities are expected to be a mixed bag. While copper, zinc, other industrial metals and crude will correct downwards, precious metals would do well.

Says Janish Shah of Networth: “We are not bullish on commodities. Prices are likely to consolidate or decline in the latter part of year because of an increase in incremental production. Secondly, demand growth may not be there.”

For instance, China is taking steps to bring down commodity prices, while the US economy is heading towards a slowdown. Pankil Shah, head of commodities, Motilal Oswal Commodities, says: “2007 could be the year of consolidation for base metals (copper, zinc, tin) because the overall world economy is on a downturn.”

Says Avinash Raheja, senior vice-president, Commtrendz Risk Management Services: “Commodities that have seen huge speculative flows may also be affected, though to a lesser extent. Copper, zinc, silver, gold and other industrial metals come to my mind.”

However, going by this argument, speculative money needs to be flushed out before the cycle picks up again and this may take quite some time. Says Raheja: “Although we are in a long-term commodity bull market, history has taught us that even in 15-year bull cycles, you can have consolidations that may last for 1-2 years and we’re most probably in the midst of one right now.”

All of them see gold as a good long-term investment, though now may not be the right time to buy as a correction is expected.

Says Ranjini Panicker, chief of research, Man Financial: “We remain bullish on gold and are looking at the possibility of it retesting its high — as it did in 2006, of around $730-750 levels.” A longer term investment horizon, of about 5 years, may also see gold surpass its all-time high of $850.

Raheja adds: “Most agricultural commodities have limited downsides. In fact, some of them like coffee, wheat, corn and soyabeans (oilseeds) still look attractive.”

Pankil Shah believes this year would not be good for pulses excepting tur.

Real estate: What about real estate? Investment returns from this asset class are a function of interest rates, growth in size of high-income middle class, foreign flows and, of course, a buoyant economy.

With interest rates rising and property prices ruling firm “it is becoming difficult for the middle-class, in terms of affordability. However, demand will be relatively better because of an overall buoyant economy,” says Janish Shah.
Additionally, the last few years have seen big-time appreciation in property prices and hence, from here on, to expect significant gains would be foolhardy.

Speculative money has led to sharp rise in prices in Tier-2 towns (excluding the top 8), but this is not a big issue in Tier-1 cities because most of the demand is real (rising income levels, demand from service industry individuals, etc). Therefore, prices are likely to go up realistically in Tier-1 cities.

Additionally, among key positive influences here are the increasing demand from foreign investors and the domestic retail industry.

With regards to investment in listed real estate companies, a real estate consultant says: “Some stocks may see a correction, because fundamentally the demand is very strong and it may be very difficult to implement the projects. And hence, profit projections may go haywire. Investors should hence, concurrently keep a watch on the company’s progress in scaling up its capacity to build and deliver projects as per plans-an important element that will decide future valuations.”

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