GLOBAL INVESTING: Why the Indian rupee and Nifty are overvalued

Dubai - Dalal Street again the darling of emerging-market fund managers

The indian rupee's rise to a 16-month high against the US dollar at 65.40 is not surprising given the smoke signals that emerged from the momentary conclaves of Big Daddy (as the Reserve Bank of India is known in the money markets) in Mumbai and the Federal Reserve Board in Washington. Dr Yellen indicated that the Fed was willing to tolerate a temporary rise in US wage inflation above its dual mandate level of two per cent. This is the reason the US Dollar Index tanked from its 102 high to below 100 and the yield on the US Treasury note fell from 2.61 per cent to 2.40 per cent. This was a green light to own the Indian rupee as one of the world's most attractive high-yield currencies. The RBI made the trade a no-brainer once Dr Urjit Patel decided not to cut the repo rate and keep monetary policy neutral to hedge inflation risk. A hawkish RBI in Mumbai, a dovish Fed in Washington. How could the Indian rupee not appreciate against the US dollar?
Two, the Uttar Pradesh polls were a game-changer in Indian politics. The BJP's landslide win reinforces the relative collapse of the Samajwadi Party and its Congress ally in India's most-populous state. The UP win means Modi will probably win reelection as prime minister in the 2019 general election and remain at the helm until 2024. This is hugely reassuring for foreign investors who have staked untold billions of dollars on Modi's pro-market, reformist agenda, despite his selection of the odious Yogi Adityanath as UP chief minister.
Three, contrary to prognostications of macroeconomic doom after Modi's shock rupee banknote reform, India delivered seven per cent GDP growth in the December quarter, the highest in the emerging markets. Three, the Union Budget also demonstrated that the BJP government is willing to commit to fiscal discipline, with a 3.2 per cent budget deficit target.
Four, the fall in oil prices in the past two weeks is positive for the Indian current account deficit, as is the fall in the price of gold since 2011.
Five, Modi's reforms to boost foreign investment in aviation, insurance, banking etc. reinforced India's balance of payments and reduced Dalal Street's reliance on offshore hot money portfolio flows. The surge in FDI in 2016 is unquestionably rupee bullish, as is the implementation of the Goods and Services Tax.
Six, India's equities market is once again the consensus darling for Wall Street's emerging market fund managers. The rupee has been positively correlated to a Nifty that has now risen above 9,000 and is the most expensive stock market index in Asia. For now, the Indian rupee is on a roll. Yet strong US data a hawkish Federal Reserve could again resurrect King Dollar and the Indian rupee could well depreciate to 67. At Nifty 9,000, MSCI India trades at 17.8 times forward earnings, at least two full points above its historic average of 15 times. Indian equities are also now two sigma (standard deviations) above their mean valuations in the last decade. India also trades at a 34 per cent premium to the Morgan Stanley emerging markets index. I cannot forget that Nifty 9,000 proved to be a short term market top in the both March 2015 and September 2016.
While Indian equities deserve to trade at a valuation premium to the emerging markets indices, the scale of the premium makes the Sensex/Nifty too expensive for new money at this time. I am programmed to exit India at 18 times earnings given my analysis of market cycles on Dalal Street since the debacles of 2008. Foreign positioning risk could also prove a sword of Damocles for the Sensex/Nifty indices once Federal Reserve continues to raise interest rates this summer and autumn. However, the "equity culture" among India's life insurers and mutual funds will broaden domestic participation. It is surely significant that Indian mutual funds own 12 per cent of the float on Dalal Street, below the 20 per cent owned by offshore fund managers. Modi's rupee banknote reform will boost bank CASA deposits by at least $250 billion - and provide high-octane fuel for the stock market. This could explain the stellar 18 per cent performance of the MSCI India country index fund in the first three months of 2017. The ghost of E.M. Forster will applaud our financial passage to India!
The writer is a global equities strategist and fund manager.