Which way to go?

The key macro themes and concerns for 2007 are now fairly clear. At the global level, the main theme is a slowdown in the US economy and the consensus, so far borne out by the data, is for a soft landing. At the other end of the world, the Chinese central bank has raised the reserve ratio for banks, yet another attempt to cool the economy.

The implications of these twin slowdowns are obvious — slower growth in all export-oriented economies and lower commodity prices, including lower crude oil prices. These lower prices will act as a buffer, cushioning growth from too steep a dip. It’s also worth noting that growth in the EU and Japan is expected to offset some of the anticipated weakness in US growth. Moreover, any serious weakness in the US economy is likely to be immediately met with interest rate cuts.

What about liquidity? There are two concerns on that front. One of them is of interest rates being raised further in the EU and Japan. Tightening by central banks there is a distinct possibility. The latest data show that Japan’s monetary base continues to contract.

The second worry is that a slowdown in the US may lead to a deceleration in the flow of funds from US investors into the market, including to overseas assets and markets. So far, however, nothing of the sort has happened.

The domestic scenario at present is a continuation of very high credit growth and a build up of inflationary demand pressures. A global slowdown, which leads to lower crude oil and commodity prices, may well lead to lower inflation. But at the moment, the RBI seems to be bent on slowing down the economy. Several banks have revised their lending rates upwards. This may lead to some deceleration in the growth of consumer credit. That should, however, be more than offset by higher growth in corporate investment and investment in infrastructure. As far as liquidity is concerned, higher interest rates are not really a hurdle, given the many other avenues that corporates have of raising money both at home and abroad.

What is the investment stance that follows from these tentative conclusions? First, given the fact that the investment cycle in India has just taken off, betting on investment demand and on infrastructure may be better than betting on sectors that depend on consumer credit. In other words, avoid sectors such as automobiles while increasing the weightage of the construction and cement sectors. Even a sector such as power utilities, where profits are entirely dependent on capacity expansion, is relatively more attractive. Naturally, in view of the weakness in commodities, it may be best to stay away from that space. On the other hand, sectors such as airlines should gain because of the lower crude prices.

Lower crude oil prices should also be positive for the rupee, which will also be boosted by dollar weakness if the US slowdown story plays out according to the script. That will benefit importers and hurt exporters — the margins of IT service companies could be impacted.

And finally, one theme that is increasingly becoming important is that of consolidation. As companies become targets for acquirers and a premium is paid for them, some of those high valuations may rub off on other companies in that sector — consider the price being quoted for Hutch, the fancy price paid by Holcim, the rise in valuations of small banks. Private equity deals will have the same effect, and as research from Venture Intelligence shows, the value of these deals may go up to $10 billion this year.