In this incisive and though-provoking piece, Satish Ramanathan addresses the big question : is the debt driven global recovery sustainable? What will be the key growth drivers for the developed world and how are they different from the developing world? What is the outlook for Indian markets? What are likely to be the key drivers for the Indian market, going forward?

After the party and the subsequent crisis, now is the time for all of us to count the bills and search for the dough to pay back. This is now leading to several questions and theories about whether or not there will be a subsequent slowdown after this. To understand this issue, we need to break this into two clear blocks - the developed world and the developing world.

Developed world - coping with more debt but low growth

The developed world has been extending its growth curve through more and more debt, until the banking crisis led to the government taking over a lot of the toxic debt from the private sector. This alone, is not a bad thing and such counter-cyclical measures work when the economies are bad and governments spend or provide support to the financial system, but today there are several issues that confront the developed world:

Growth

We think that over the next year or so, growth may surprise positively, given the level of pessimism built into the system. We think companies will begin to spend more to replenish their stock and consumers spend on purchases put off by a year. The culmination of these two trends will be a positive bump up which is not yet anticipated. The US savings rate has moved up to around 3%, and is likely to increase. But, the average fleet of cars and trucks are old by historical standards and are likely to get replaced gradually resulting in a surprise in demand indicators. We think we can see this trend playing out in H2 of 2010 in the US and we could see the Euro zone play out later by around 6-9 months.

Demographics

An aging population has put a heavy burden on the developed world which has guaranteed pension and health care benefits casting a long shadow of debt as we go along, with lower contributions to taxes from the current generation and the future generations as well. This begs the question: Will governments honour their commitments? Several countries have continually increased their retirement age to delay the eventual costs, at the expense of a younger population further exacerbating the problem.

Lack of revenue growth for government

High government debt is by itself not a worry, provided there is some modest inflation and growth to increase revenues. This does not seem possible as the developed world does not face expanding populations and hence need to build further physical infrastructure. Growth, through increased consumption, capital expenditure, therefore seems limited. Will they increase taxes to offset the higher burden? That is increasingly becoming the only alternative facing governments, and one would therefore anticipate this in the future. Can this change the behaviour of investors, and will more money rush to offshore tax free havens? This is going to become a contentious issue in the future.

Inflation

Governments usually try to overcome high debt by having a higher inflation rate, which reduces the real interest rate and increases taxes in nominal terms. But that will not be possible in the developed world, which has higher capacities and slow demand growth. Hence inflation may not be that helpful as before. Further, governments are also watchful of inflation as this is enshrined in their political mandates and there may be a tendency to raise interest rates exacerbating the current slowdown

Devaluation

Whether desired or not, this may be a natural outcome of the developed world economies' poor fiscal health which can set the foundation for the trade imbalance to correct marginally; as for the present many goods and service capacities have permanently shifted East and it is unlikely that they will return to the west in a hurry.

How about the developing economies (emerging economies) then?

Developing economies have for long depended on the developed world to boost their economic growth by exporting low value items and high savings to modernize their economies and cities. These countries have limited social commitments on health care or pension benefits apart from the commitment to collect taxes. Many of these countries have used high real estate prices to lower tax rates and create a virtuous cycle of low taxes, low interest rates and high real estate prices to fund growth. However, the demographics in many of these countries are also becoming an issue and growth would eventually become a problem, spare the low government debt and trade surpluses. This leaves China and India as the long term growth stories but with problems of their own.

India's growth story India has seen an unprecedented level of government intervention to avert any sharp crisis. Debt levels as a proportion of the GDP is now close to 82%; a life time high, but not alarming as we have been close to 8% between 2002-2006. Fears of a rating downgrade and the Greek debt crisis have prompted the Government to become more conscious of its borrowing, which is a positive. Bond markets continue to be nervous on account of a high front ended borrowing program and liquidity drying up in long tenure bonds. Banks, who contribute almost 50% of government borrowing have limited appetite on the long end of the curve, which may force the yield curve up. Hence, we expect interest rates to remain volatile for the next six months. On an international front, bond markets are now increasing pricing in risk for government paper, and CDS rates for government paper is increasing. If the developed world is faced with increasing debt, then sharp volatility in bond markets cannot be ruled out, which would impact India much more than other Asian countries as it has the highest amount of debt. Inflation has remained doggedly high initially on account of food prices and then on account of the government reducing its subsidies on fuels. We think that this is going to lead to lower consumption growth than what many expect, as lower government borrowing and subsidies, has the impact of actually pulling out money from the hands of the public and lowering consumption. Inflation could continue to remain higher on account of volatility in commodity prices and government intent to reduce subsidies.

Currency

The Indian rupee is again caught in the circle of the twin deficits - fiscal deficit and trade deficit that could potentially make the currency volatile.

Market Outlook

Under the current uncertain circumstances of inflation and commodity prices, defensives continue to outperform. The pharmaceutical sector has seen a significant appreciation on the back of potential outsourcing from US on back of the recently announced healthcare reforms. Further, there has been some aversion to highly leveraged companies, or companies that would further equity. We think Indian markets will continue to be range bound on account of the following:

o Domestic allocation to equity is still low and is not likely to increase in a hurry

o Large equity overhang from domestic companies, as many companies look to raise capital to fund infrastructure projects

o Disinvestment of over 5-6 billion dollars would significantly remove excess liquidity in the markets

o Valuations relative to growth no longer very attractive in the large cap space

o Margin compression over the medium term on account of increased capacity addition, higher input costs and marketing expenses as the pent up demand eases.

Defensives have performed well till date, but we remain concerned on valuations. The street is expecting a linear growth for a long period of time, but we remain worried as inflation begins to bite and reduces consumption. The wildcard is foreign flows, which has been chasing Asia. The flows could reverse when there are signs of a stronger than expected US recovery, impacting markets. We need to recognize that top US companies have strong free cash flows unlike Indian companies and would be preferred in a scenario of US recovery. China's growth will also be keenly watched and any signs of a slowdown would further move money away from Asia.

In such an environment, mid-caps and small-caps tend to do better and the breadth of the market indicates that there is a fizzy environment being built there. We caution investors from getting deeply entrenched in the small-cap space, even as they remain attractively valued. Volumes have declined in the large caps even as markets trend higher. This could indicate scepticism in the market, and absence of speculative activity. Corporate earnings are picking up on account of input costs easing and borrowing heading lower, but we remain cautious. We think there could be negative surprises in the commodity space and this could impact earnings, as many of the large companies are still linked to the fortunes in the commodity space.

In the short term, we remain optimistic on the earnings cycle on account of higher growth, especially in the US centric businesses. Based on the earnings, liquidity and interest rate outlook, we should brace ourselves for a longer period of a range bound market.