Wealthy Nations Daily Update - India, Monsoon and Relative Value

After two years of El Nino drought, the India Meteorological Department (IMD) has predicted that this year’s monsoon will be fruitful, saying last week that precipitation between June and September will be ~106% of the long-term average. However, over the last 20 years, the IMD have only successfully predicted the chance of rainfall on 5 occasions. With over half of the labour force employed within the the agriculture sector and around 60% of the nation’s farmland reliant on rainfall, these predictions are hugely important. Poor rainfall and extended drought have devastating effects on agricultural production and thus a disproportionate effect on the poor.

India's economy has more recently been described as the “bright spot” amongst the global gloom and doom as the government looks to “Reform to Transform India”.  In fact the country’s Finance Minister, Arun Jaitley said earlier this week that the the Indian economy could beat market estimates (7-7.5% in 2016-17) and grow by as much as 8.5% this year; if monsoon predictions are correct. We wonder whether this level of growth is sustainable. As much as the country has taken steps to shield itself from global headwinds, this remains a risk, especially on India’s exports. As does the recent “rally” in oil; although Jaitley does not think that $50pb is an issue. India also struggles with high levels of government debt, social and structural issues and the lowest income per capita amongst the BRIC nations; in fact one of the lowest in the world.

Stratton Street’s Net Foreign Asset model views India as a 3 star country, having net foreign liabilities less than 50% of GDP and is therefore within our parameters to invest. We have not looked to add a position in India simply because we cannot find value within the region. The country is rated one notch above “junk” at Baa3 by the three major rating agencies thus most bonds also share the same rating, apart from Reliance Industries, for example.

Reliances’ activities span hydrocarbon exploration and production, petroleum refining and marketing, petrochemicals, retail and telecommunications, and is rated Baa2/BBB+. If we take the 5.4% issue maturing in 2022, our Relative Value Model (RVM) calculates that the fair value spread should be around 217bps over Treasuries; the bond trades at +269bps currently. Although the bond has a very attractive yield of over 5%, the expected return of less than 1% and ~1 notch credit uplift do not look attractive to us. We would rather hold China's state-owned CNOOC, also involved in the exploration and production in the oil and gas sector. Due to its high rating of Aa3/A+, the 3.875% 2022 issue trades at a lower spread of +162bps, which is well above the fair value spread of +71bps. The bond offers a lower yield of 3%, however, it has an attractive expected return of ~5% with ~4 credit notch cushion.

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