Benchmark equity indices are about 23% off their record peaks seen in January, but it is not yet time to turn bullish on India, feels Adrian Mowat, managing director and chief Asian and emerging markets equity strategist, JP Morgan Securities Asia Pacific.

Deteriorating economic fundamentals, in the form of high inflation, weak rupee and widening fiscal and current account deficits, could further choke foreign portfolio flows into India, he warns. Already, foreign institutional investors have net sold $3.1 billion worth of shares since the beginning of 2008.

Inflation is the issue whether you are in US, Europe, China or India, says Mr Mowat, adding that a key problem everywhere was the decline in real income growth as a result of rising costs.

Contrary to popular fears, Mr Mowat does not expect the RBI to hike interest rates anytime soon. It (an interest rate hike) is less likely now because if the RBI is using up its forex reserves to buy rupees, it is contracting domestic money to grow.

What we think is that real income is under pressure, which will slow growth. The other thing that will slow growth is that infrastructure projects will cost much more than that was budgeted, he says. According to Mr Mowat, the weakness in the rupee is a major cause of worry.

Through 2007, investors wanted to own infrastructure, financials, commodities, etc, and didnt want pharmaceuticals and technology. That was a good trade when the rupee was strong. Now, you see the rupee weakening.

People are selling what they own and rotating it to what they don't own and benefit from a weaker rupee. The rupee situation is quite unnerving. The pace at which the rupee fell in the past fortnight is very unusual among Asian currencies, he says. A weak rupee makes foreign investors apprehensive as their return on investments will have to be higher in order to make up for currency depreciation.

Nevertheless, Mr Mowat is bullish on the IT and pharma sectors, despite concerns of a recession in the US, a key market for both sectors.

Investors are very aware of the problems in US economy and interestingly, I dont think that US will go in for a full blown recession. The problems in the US are the same as elsewhere. The real income growth has tuned negative in the last two months in the US as inflation has been rising, he says.

In October 2007, the Securities and Exchange Board of India tightened norms relating to the issuance of participatory notes by FIIs. Since April this year, transactions by FIIs too, are subject to margin requirements, as is the case for local investors. Are these factors contributing to outflow of foreign money from the stock markets? No, feels Mr Mowat.

He points out that in the past, foreign investors have tended to shrug off tightening regulations because the fundamental story was still very good.

The fundamentals are deteriorating now and thats what is affecting inflows, he says.
In the emerging market space, China, Mexico and Taiwan rank high on Mr Mowats list of favourites, as these economies have better fiscal flexibility and planned growth. In comparison to India, countries like China have the fiscal flexibility and their government plans for growth. In that sense their core inflation is quite low.

So China looks good. We like Mexico. Underlying growth in Mexico is quite strong in terms of consumption, investment. We like Taiwan because it is inexpensive, has a credible macroeconomic policy and its political situation looks good with improving relations with China, he says.

What could possibly save the day for Indian equities? We had a tech bubble in the 90s and in 2008 we are having a commodities bubble. But, a downturn in commodity prices may well prove to be the savings grace for the second half of the year. In the event of a commodities rollover you get a whole series of positive events.

This would take the fear out of inflation. This would be particularly beneficial to countries like India with their current account deficit. You would also see a portfolio effect, which is that money comes out of Brazil and Russia and goes into Asia. This could also make us revisit our forecast on India, says Mr Mowat.