>DEFLATION VERSUS INFLATION (MERRILL LYNCH)

Deflation vs. Inflation: The Battle Rages On

US TIPS: We remain positive on longer maturity TIPS BE’s for longer horizon investors. The recent narrowing in BE's provides an opportunity to re-add to long BE positions that we had recommended scaling back on last week.

European IL: We remain short Euro breakevens but see short term risk from oil prices and therefore prefer to sell inflation forward. We analyse cross-country breakeven spreads and recommend selling BTPei35 breakevens against OATei32. The real German government curve looks too flat in the 5-8 year sector compared to France.

JGBi: The rally in JGB inflation linkers has stalled since April. We believe further weakness should provide a selective buying opportunity.

EM IL: the only long duration left
Exposure to inflation-linked instruments remains important in our overall exposure in EM local debt markets. What we have seen in recent weeks is that exposure to real rates is now the best way to express a long duration view. This is because most central banks have now come close to the end of the easing cycle, which means there is little upside at this stage for a plain long duration position. On this basis, we continue to hold recommendations of a long Turkey Feb. 2012 CPIlinker bond and a long Brazil NTN-B 2015 IPCA-linked bond in our portfolio.

Commodities: A very fast increase in oil prices in the coming months could put the embryonic economic recovery at risk. How high could oil go near-term? In OECD economies, our economists believe that $70-80/bbl oil could start to pose a risk to the recovery, while the risks to EM growth would come in at $90-100/bbl.

US economics: Headline CPI came in significantly below expectations with a 0.1% M/M increase in May. Most forecasters missed the tepid rise in energy which benefited from an aggressive seasonal factor to the downside. Core prices were in-line with a 0.1% M/M gain taking the annual rate to 1.8% versus 1.9% in April. Euro area economics: Inflation hit a record low of 0.0% in May. While downside risks dominate in the summer, positive headlines rates are seen before year-end.

UK economics: CPI inflation fell a little further in May, and is expected to continue falling to a trough in September.

To see full report: INFLATION

>TATA MOTORS (MERRILL LYNCH)

Gaining traction; upgrade to Buy

■ Ride domestic growth, 30% potential upside We upgrade our rating to Buy from Underperform as we expect valuations to mirror market share gain led recovery in domestic business (67% FY11E EBITDA), and we think this will more than offset the known weakness in JLR operations. We reflect this by raising our standalone EBITDA forecasts by 65% in FY10 and 62% in FY11. Our sum-of-the-parts PO of Rs420 factors in NIL contribution from JLR.

■ Buoyed by domestic operations We expect standalone business to register 54% EBITDA CAGR, on: (1) higher CV volumes due to cyclical rebound in trucks, and a spate of bus orders, and (2) stronger margins, on better vehicle realizations and soft commodity prices. Our EPS estimates of Rs18 in FY10 and Rs30 in FY11 are ahead of consensus.

■ Financial health on the mend Tata Motors’ debt of ~Rs320bn (debt/equity 1.3x), includes Rs70bn from vehicle financing and Rs25bn customer advances. We however expect leverage ratios to improve on stronger cash flows and likely equity issuance, failing which we expect further monetization of investments. By FY11, we estimate consolidated net debt/EBITDA at 2.3x, net debt/equity at 0.8x and interest cover at 2x.

■ Sum-of–the-parts value at Rs420 Our PO is based on FY11E EV/EBITDA, and driven by: (1) standalone business valued at 8x, which is a slight premium to mid-cycle sector valuations on market share gains, and (2) JLR at nil value, equivalent to 4.6x, in line with global peers.

To see full report: TATA MOTORS

>RELIANCE INDUSTRIES LIMITED (MERRILL LYNCH)

Still factoring too much potential upside

■ Revised PO implies 9% downside; cut to Underperform
The Mumbai High Court on June 15 ruled against Reliance Industries (RIL) in its litigation with RNRL, the consequent hit to PO being Rs173/share. A stronger rupee means hit of another Rs68/share. We have cut PO by 5% to Rs1,837/share even after factoring in upside of Rs137/share for upgrade in prospective resources in KG D9 and D3 blocks. After a 70% rally over 5 months RIL looks over-valued on our PO and on fair value in most other scenarios (Table 2). It is not cheap at 15.5x FY10E and 11.8x FY11E. Our earnings and PO do not factor all potential downsides (no tax holiday on gas output and weaker than assumed refining margins). We are therefore downgrading RIL to Underperform from Buy.

■ Share price factors lot of potential upside, not all downside
RIL has large reserve accretion potential. Our PO amply factors the reserve upside - 4bn boe valued at Rs427/share (US$13bn). We estimate RIL’s share price values reserve upside at Rs614/share (US$20bn) implying 6.2bn boe of future reserve accretion. It effectively values 10.9bn boe of reserves (PO values 9bn boe) vis-à-vis 4-5 year reserve target of 10bn boe set by RIL in October 2007. All potential downsides are not factored in. 7-year income tax holiday may be disallowed for gas production. We think the probability of it being disallowed is very low but downside to our PO if disallowed is significant at Rs300/share (16%).

■ Refining margins may be weaker for longer than assumed
Singapore refining margins are down to US$3/bbl in Jun’09 (US$5.1/bbl in Apr’09) and light-heavy crude spread has collapsed to below US$1/bbl. US refiner Valero warned of loss in 2Q. IEA forecasts 2.5m b/d decline in global oil demand in 2009E. This could keep refining margins weaker for longer than assumed by us.

To see full report: RIL

>FUND MANAGER SURVEY GLOBAL (MERRILL LYNCH)

SAVOUR THE DIPS

■ Bond yield back-up causing no macro panic
The June FMS shows no signs that investors are spooked by the recent rise in US bond yields and oil prices. The investor mood is pro-growth and fears of a growth "double-dip" or an imminent crash in U.S. Treasuries and the US$ are currently absent. On the contrary, the consensus is overweight assets that usually benefit from rising bond yields such as commodities and Emerging Markets.

■ Optimism is back in fashion
Global growth expectations continue to surge (+78%, a 6-year high); a net 7% of investors believe global recession is likely in the next year versus 70% just two months ago. Investor expectations have shifted decisively from recession to recovery: one-third of our panel believe corporate profit growth will exceed 10% in the next 12 months; cash balances fell to 4.2% (in-line with historical average); hedge fund net exposure surged from 25% to 35%.

■ Asset allocators finally back overweight equities
Expectations shifted from deflation to inflation in June: a net 19% of investors see higher inflation in 12 mths time versus -1% last month. Asset allocators reduced bond exposure (to -15% from -3% in May) and finally moved overweight equities (+9% from -6% in May). But optimism remains measured. Back in March the FMS showed extreme pessimism making us very constructive on equities. June levels of optimism on equities or risk cannot yet be described as dangerously high.

■ All bulls in the China shop
Global positioning remains pro-China. The survey shows the biggest OW of commodities as an asset class in the past 3 years. A net 49% of fund managers want to be OW Emerging Markets, versus just 8% who wish to be long European equities. Investors are OW technology, energy & materials, as the link to Chinese growth supersedes traditional notions of early cyclicals such as consumer discretionary. And investors are U/W every single defensive sector (pharma, staples, telecoms & utilities) for the first time since Nov 2003; a point at which the S&P had seen a similar 30% rally and presaged a further 10% run into year end.

■ There will be dips...buy them
Markets and optimism may have rebounded so quickly that both need to pause for breath. But "buy the dip" is the equity message coming from the survey with Q2 reporting season set to be the next major hurdle for re-setting expectations. The contrarian trades are as follows: directional bulls would buy consumer discretionary, industrials, Europe and Japan. Directional bears would go short the relative euphoria on Emerging Markets, energy and materials. Note that panellist's feedback on oil price valuations implies the consensus thinks $65/b is fair value.

To see full report: SURVEY GLOBAL

>BANKS-RETAIL (MERRILL LYNCH)

Higher loan growth, lower NPL’s to sustain re-rating

■ Sector re-rating to sustain on growth, reforms
We expect the banking sector re-rating, already underway, to sustain owing to a) higher than estimated loan growth at 16.5% in FY10 and +20% in FY11 driven by our GDP upgrade (by Indranil Sen Gupta, our India economist) to 6.3%, greater focus on infra spend; b) easing rates and less likelihood of spike in bond yields as govt. pursues divestment (making it easier to fund the fiscal deficit); c) easing concerns on asset quality with NPL formation levels peaking at a lower level (though NPL’s will rise and remain the key challenge); and d) progress on reforms incl. insurance, with higher visibility on banks’ monetizing their stakes.

■ Raising PO’s on higher ROEs; Upgrading Axis, Fed to Neutral
We are raising our PO’s across banks to capture i) the sector re-rating due to the expected improvement in macro; ii) roll forward of our estimates to FY11; iii) capturing higher RoE’s due to higher growth and lower credit costs; and iv) rerating of equity related biz. like insurance and asset management for banks that have stakes in these biz. Re-rating accounts for 40-60% of the PO upgrade. We are also upgrading Axis and Federal Bank to Neutral owing to easing of NPL
concerns. But given the sharp run up, we refrain from taking them to a Buy.

■ ICICI Bank, HDFC – Preferred picks in large caps
ICICI Bank remains our top pick in the sector as it remains a key beneficiary of easing rates, less vulnerable to rising NPL’s (even though concerns are easing), benefits from re-rating of its equity related biz. (insurance and asset management) and positive risk return trade off. HDFC is the other stock we like (despite being expensive) as it is a key beneficiary of the likely uptick in mortgage lending, good asset quality and also offers a play on HDFC Bank and insurance and asset mgmt. SBI, while offering a positive risk return (1.2x FY11 book for subs; 17% ROE) is behind ICICI and HDFC owing to near term margin and NPL issues.

■ Govt. banks (like PNB, BOI) can provide +30% upside
The bigger upside, may, however, come from some of the govt. banks (ex-SBI) that could offer much better value, trading at 1.1-1.3x FY11 adj. book with RoE’s of +20%. The key triggers would be higher growth and rising comfort on asset quality. Key risks remain the rise in bond yields (that we hope will not spike). In particular, we like PNB and BOI (+30-35% upside) followed by UBI. Indian BK is our preferred small cap pick (+40% upside). These banks are also better placed
on asset quality, amongst govt. banks.

To see full report: BANKS-RETAIL

>MACRO DRIVERS AND EM EQUITIES (MERRILL LYNCH)

■ Macro framework for EM equities
We focus on oil, the EMBI spread and USD as our major barometers for growth, risk and flow in emerging markets. We test the sensitivity of EM equity markets to the three macro drivers (table 1). When combined into a simple regression equation, they together explain 86% of the movement in the MSCI EM index. A “fitted” macro framework for MXEF based on the three macro drivers closely tracks the actual index (see chart 1 in report).

■ Comfortable with 500-850 trading range for EM
Our macro framework can quantify the risk to the current level of MXEF. Plugging in the current values of oil, USD and EMBI, the macro framework says MXEF “should be” 8% lower than current actual level. So MXEF is hardly stretched. Using our strategists’ forecasts for oil, USD and EMBI for end-09, the framework says MXEF should end this year 13% down on the current level. We are comfortable with a 500-850 trading range for MXEF in 2009.

■ Stress-testing EM equities
Can MXEF break through the 1000 level? The framework says we would need oil up to $84 & DXY down to 65 & EMBI spread down to 300 - this bullish combo seems unlikely in our view. What needs to happen for MXEF to break below 550? Oil down to $55 & DXY up to 90 & EMBI spread up to 500 - this bearish combo seems unlikely in our view.

To see full report: MACRO DRIVERS

>THE ASIAN MACRO NAVIGATOR (MERRILL LYNCH)

Hong Kong—dumping ground for global liquidity

Hot topic
■ Hong Kong’s monetary base doubled after September 2008. Along with China, it is one of two Asian economies that has matched the quantum leap in global monetary policy.

■ Why is narrow money exploding? We think Hong Kong sits at the confluence of three key trends in global liquidity: (1) loose Fed policy; (2) China’s appetite for non-USD foreign assets; and (3) the world’s desire for China-linked assets.

■ Hong Kong is a small, open economy. We expect a sharp upturn in the second of the year; but global demand will remain a long-term headwind.

■ Still, the liquidity boom has already proved inflationary for asset prices. We expect it to help reflate the economy and eventually inflate goods prices.

■ So we’re raising our 2010 growth forecast to 3.8%, from 2.9% previously. (No change to 2009.) We’re also raising our 2009-10 inflation forecasts. — TJ Bond

Asian snapshot: Asia—on track for the yo-yo recovery
Despite one or two months of mixed trade data, Asia is on track for the yo-yo recovery. The next two quarters may favor the small, open economies of Asia. The principle is very simple: as confidence returns and financing conditions ease, pent-up demand for inventories and final expenditure can boost exports very rapidly. What goes down will most likely come back up (the yo-yo). As this happens, the countries that have experienced the deepest contractions could well
post the steepest rebounds.

What to watch: China’s monthly data
Next week is all about the China data. Overall, we expect May to deliver a mixed message, due to China’s position in the cycle (exports to the G3 are still weak) as well as seasonality.

Money: total new bank loans in May should be similar to the level in April, while M2 growth should pick up slightly. Foreign trade: export growth should slow further in year-on-year terms, while import growth should be flat, leading to a slight narrowing of the trade surplus. Industrial output could ease slightly in May from April; however, trends in power usage point to a pick up in industrial momentum. Fixed investment should continue to accelerate in May, underpinned by residential construction as well as fiscal spending.

Finally, Taiwan’s exports should post a sequential increase in May after the disappointing April outturn.

To see full report: ASIAN NAVIGATOR

>OIL & GAS (MERRILL LYNCH)

Auto fuel marketing margins set to plunge deeply in the red

■ R&M companies outlook worsening; retain underperform
Refining margins continue to remain weak. Auto fuel marketing margins, which are minus Rs0.2/l in June 1-15, are expected to slump to minus Rs2.5/l from June 16. A 12-18% price hike would be required to bring auto fuel margins to normal levels. There may be no price hike for 5-7 weeks as the government mulls freeing prices. R&M companies FY10E earnings outlook has deteriorated even as investors are enthused by hopes of reforms. We retain underperform on
R&M companies.

■ Auto fuel marketing margin deeply in the red (-Rs2.5/l)
Gasoline and diesel prices are up 8-15% in June 1-5 to US$74.2-76.2/bbl from levels in May 16-31. This steep price rise is expected to plunge auto fuel margins steeply in to the red at minus Rs2.5/l. Diesel margins are set to slump in to the red at Rs1.9/l from June 16. Gasoline margins have been in the red since April 2009 but they are likely to slump deep in to the red to Rs4.9/l from June 16.

■ FY10E margin may slip 18% to Rs0.9/l even if prices freed
We are assuming FY10E auto fuel margin to be Rs1.1/l. Average auto fuel margin up to June 15 is Rs0.65/l. 1Q margin will slip to just Rs0.1/l if auto fuel margin for June 16-30 is indeed minus Rs2.5/l. FY10E average will decline to Rs0.9/l even if auto fuel prices are freed and auto fuel margins rise to Rs1.2/l from 2Q.

■ 12-18% price hike required in auto fuels for normal margins
At current prices 12-18% (Rs4.0-8.0/l) price hike is required in diesel and gasoline to eliminate losses and ensure normal level of marketing margins of Rs1.2/l. A 10% hike in gasoline and diesel prices would take inflation to 6% by March 2010. Thus a steeper hike would mean risk of higher inflation than 6%.

■ No hike before decision on pricing freedom in 5-7 weeks?
The petroleum minister had indicated on May 29 that government approval for freeing of auto fuel prices would be sought in 6-8 weeks. One wonders whether this means no price hikes for another 5-7 weeks until government decides. If regional prices sustain at current levels pricing freedom would mean 12-18% price hikes, which may be difficult to implement, given inflation concerns.

■ Singapore refining margin US$4.6/bbl in 2Q09
Reuters’ Singapore refining margins average to date in 2Q 09 is US$4.6/bbl vis-àvis US$5.5/bbl in 1Q09. US refiner Valero, which made a profit of US$309m in 1Q09, on June 2 guided that it would incur loss of US$261m in 2Q09.

To see full report: OIL & GAS

>VOLTAS (MERRILL LYNCH)

COOLEST ONE; NEW BUY

■ Initiating with Buy and Rs185 PO based on 16xFY11E
We initiate on Voltas, the second largest air-conditioning & engg co in India (70% of sales) and Middle East (30% of sales), with a Buy. We expect it to be a key gainer of (1) thrust on infra in India; & (2) rise in oil price that could drive up capex in Middle East. Voltas FY10E PE has doubled to 16x since 15 May09 led by (1) new govt (2) 20% oil price rise & (3) new orders. We expect the 16xPE to be sustained due to expected 30%+ ROE and 25%+ EPS growth, hence have based
our PO at 16xFY11E.

■ Market size attractive; lead indicators showing uptrend
We expect market size for MEP (air-conditioning, electrification, plumbing etc), engg equipment and room AC in India to double in next five years, driven by India’s thrust on infra and 7%+GDP growth. We expect Middle East MEP market, which is US$5bn+ in size to grow 10% pa driven by US$60/bbl+ oil price. Uptrend is evident from new order wins, rising order execution and declining inventory.

■ FY09-12E EPS CAGR at 26%; 31% higher than consensus
We expect profit to grow 22% in FY10E and 38% in FY11E. Order backlog of 1.9x FY09 sales for MEP key for FY10E. Expect stronger growth in FY11 to be driven by (1) 56% rise in new orders; and (2) 80bp increase in EBITDA margin driven by change in sales mix to favor more profitable mining and construction equipmenT sales. MEP, room AC and engg equipment contributed 60%, 21% and 19% of Voltas FY09 operating profit, respectively.

■ New initiatives + acquisitions could yield further upside
Recent initiatives could yield further upside. These are (1) expansion of presence in MEP work in industrial units like power plants following acquisition of 51% stake in Rs2bn Rohini Electrical last year and (2) entry into water treatment biz where it recently won order worth Rs500mn in India. It has surplus for acquisitions.

To see full report: VOLTAS

>HINDUSTAN PETROLEUM CORPORATION LIMITED (MERRILL LYNCH)

■ PO implies 19% potential downside; cut to Underperform
HPCL’s share price is up 40% since the election results on 16 May on hopes that auto fuel pricing may be freed up. Even as investors turn bullish, the FY10E earnings outlook has deteriorated, in our view. Auto fuel marketing margins were at supernormal levels until March 2009, but have collapsed and turned negative. Even if auto fuel prices are freed up, only a normal auto fuel margin is likely in FY10E. In this scenario, we only expect a healthy FY10E EPS if oil bonds are issued. HPCL’s new PO of Rs291.4, based on base-case FY10E EPS, implies 19% potential downside. Thus we downgrade HPCL from Buy to Underperform.

■ Cut FY10E EPS 20% on drop in auto fuel marketing margins
We already assumed weak refining margins and significant LPG and kerosene subsidies in FY10E. We were earlier assuming a supernormal auto fuel margin of Rs2/l (US$7/bbl) in FY10E. Auto fuel margins have collapsed since March 2009 and are now negative. Margins to date in 1Q FY10 are Rs0.7/l. Assuming auto fuel pricing is freed up, FY10E margins would be Rs1.1/l. A lower auto fuel margin would have meant EPS of just Rs1.3. Assuming Rs13.6bn of oil bonds limits our FY10E EPS cut to 20% to Rs29.

■ Base- and worst-case PO implies 19-81% potential downside
We calculate HPCL’s PO on three FY10E EPS scenarios. PO based on base and worst-case EPS implies 19-81% potential downside. PO based on best-case EPS implies 18% potential upside. However, the best-case EPS, which assumes a supernormal auto fuel margin of Rs2/l and Brent at US$50/bbl, is improbable, in our view.

■ HPCL to be in red in FY09E
In 9M FY09, HPCL booked a pretax loss of Rs133/share. Although we expect a.4Q pretax profit of Rs114/share, this still means red for HPCL in FY09E.

To see full report: HPCL

>COMING SEPTEMBER: HIKING GDP/BOP FORECASTS (MERRILL LYNCH)

■ Bottom line: India bottoming out to ~7% growth end-09…
We grow more and more comfortable with our January call of India bottoming out end-09 to ~7% growth. This leads us to hike our growth forecast to 6.3% in FY10 (from 5.3%) and 7.3% in FY11 (from 7.1%), assuming the 2H09 G-3 bottom out our global economics team expects. We have also grown more confident of our long-held twin view of BoP risks overdone/ medium-term constructive INR outlook: read Christy and me here. This, in turn, has led us to push our FY10 BoP
outlook up by US$14bn. Risks: monsoon, US$100+/bbl oil.

■ …although 4QFY09 ‘upside’ bit of statistical ‘construct’
We do not set much store by the fact that India’s 5.8% 4QFY09 GDP growth beat our (/consensus) 5% expectation. 40bp of the ‘upside’, after all, emanated from a concentrated higher-than-expected growth in construction (7% of GDP), due to an ever so convenient downward revision in its 4QFY08 growth to 6.9% from 12.6%.

■ Political stability allows pump priming by PSU divestment…
At the heart of our upgrade is a likely fiscal stimulus of 0.5-1% of GDP in the July budget. The convincing re-election of the Congress-led UPA, after all, has opened the door for ~0.5% of GDP of PSU divestment. Our estimates also suggest that the government can borrow an additional Rs500bn/US$10bn, in case the RBI steps in with our expected OMO purchases of Rs1200bn/US$25bn.

■ … and softer lending rates should support loan demand
There is also greater visibility of our expected 50-100bp bank prime lending rate (PLR) cut by September. A much more politically stable Delhi should be able to muster the comfort to cut PSU bank deposit rates, if CPI inflation softens as we forecast. This, in turn, should fructify our expected bottoming out of credit demand around 15.5% (14%, earlier) by September to fund end-09 recovery.

■ With 550bp PLR-10y spread muting fiscal/inflation risks…
Won’t a high fiscal deficit/inflation prevent softer lending rates? Not really. True, we ourselves expect a reversal of the easy money policy by April 10, with WPI inflation crossing 5% by March. Yet, even if yields react – as we expect - the ~550bp spread between bank PLR and the 10y is too high to sustain. This should protect our soft lending rate regime until 2HFY11.

■ …improved BoP outlook easing funding constraints
We have upgraded our FY10 capital inflow projections by US$14bn on a mix of receding international risk aversion as well as domestic political risks. This, in turn, should ease funding constraints given India’s dependence on foreign capital inflows for long-tenor funding. Could appreciation damage recovery? We think not. The RBI will persist, in our view, with its policy preference for a relatively weak INR to support exports. At the same time, the need to block imported inflation from rising oil prices should prevent policy-driven depreciation.

To see full report: ECONOMICS

>FUND MANAGER SURVEY GLOBAL (MERRILL LYNCH)

No “Sell in May”

■ The bulls are back
Investors are now positioned for global economic recovery according to the May FMS. The unrelenting gloom of a mere three months ago has been replaced by fairly typical early-cyclical sentiment, with the only hint of potential irrational-exuberance in Emerging Markets. Real economic data now needs to satisfy consensus expectations but the May FMS does not say “Sell in May”.

■ Surging optimism on macro outlook and corporate profits
Optimism on global economic growth surged with a net 57% of panellists expecting a stronger economy- the highest reading since early-2004. And for the first time since March 2005, investors expect corporate profits to improve in the next 12 months, with over a quarter of respondents forecasting EPS growth to exceed 10%.

■ All regions seeing optimism (even Europe. . .)
Global growth optimism remains founded on China with two-thirds of investors expecting strength. However, even the final recessionary holdout has turned pro-growth with a net 35% of fund managers expecting Europe’s economy to improve, compared to a negative 26% last month.

■ Rising risk appetite but asset allocators hedge bets
The BAS-ML Risk & Liquidity composite jumped to the highest level since Nov 2007, with investors cutting cash balances to 4.3% (from 4.9% last month and a recent peak of 5.5%). However, asset allocators are still hedging their bets: they remain U/W equities (-6%) and have only marginally lowered cash O/W (+21% from +24%). A brief 9-month sojourn into bonds ended with allocators cutting to a net 3% U/W. They stay U/W Europe & Japan, but a record net 40% of investors see GEM as the region to O/W for the next 12 mths.

■ Defensives hacked back
Investors’ top 3 global sectors are now technology, energy and materials as May saw a rout in defensive sectors: pharma fell to -2% from +21%, staples -1% from +9%, and utilities -19% from -15% (now the most U/W global sector). The stubborn bank U/W was further reduced to its lowest level since June 2007.

■ What happens next?
Markets in H1 were all about extreme positioning & policy. With positioning now more balanced, markets in H2 will be driven by the economy & earnings. The FMS says the market grinds higher via asset allocation moves and pressure from the ongoing U/W in global banks. The grind lower risks revolve around weaker Chinese/EM data. Contrarian trades to mull over are long Europe/Japan, short EM/China; long pharma/utilities, short technology/materials.

To see full report: FUND MANAGER SURVEY

>MARKET ANALYSIS COMMENT (MERRILL LYNCH)

A spring haircut but only a trim

■ Market in a confirmed correction - should be limited to 10%
The market remains in a base- building process, now going into its eighth month. In the process, the S&P 500 has rallied nearly 40% from the March 6 low (666) and is currently down 5.5% off the May 8 high of 930. It still appears to us the S&P 500 is forming a right shoulder of a head and shoulders bottom (see chart in report). To anticipate a directional change in the market we have overlaid a 40- day moving average and 150-day moving average, and the 40-day is just approaching the 150-day. A sustainable cross of the 40-day above the 150-day would be a positive sign that this correction should remain limited. Additionally, cash levels remain elevated, and AMG inflows into domestic equities are not excessive, and levels are supportive of additional recovery highs.

■ Short levels remain elevated in mega caps and financials
Short levels did fall in late-April by 5% for the first time since December, but levels remain elevated in mega cap stocks and financials. We have adjusted for hedging (selling short) against recent financial equity offerings and short levels are still elevated.

■ Commodities spring back to life
Energy, grains and soft commodities are positioned to continue their rally. Crude oil is in a confirmed rally and natural gas is just breaking to the upside from a Vbottom. A rally is under way in sugar, soybeans and coffee - and wheat and corn could be next. The correction in the US dollar confirms the commodity rally.

■ Levels to watch:
First support on the S&P 500 is 845-825 and this range is within a 10% correction. First support on the DJIA is 7900-7750. Should this be a more sizable correction the second level of support on the S&P is 815-780 and on the DJIA 7435-7260. Our upside targets remain intact with S&P at 1055-1065.

To see full report: MARKET ANALYSIS COMMENT

>HEDGE FUND MONITOR (MERRILL LYNCH)

HFs’ sharply reduce net long in NDX; HF’s selling $ buying €

■ Large Specs buy gold, oil & 2Y-T’s; sell NDX & US$
Note: Commitment of Traders data reflects positions as of last’s Tues close

Equities: Large specs held steady their net long position in the S&P 500 futures last week while continuing to reduce their longs in the NDX. In recent weeks readings in the NDX had reached their highest levels since Oct 07- when the NDX subsequently fell 6.7% 1month on. Large specs also added to their shorts in the Russell 2000. HFs are still a source of liquidity for the markets but less so with a potential buying power of ~10b, consisting of $6b in the SPX, $1b in the NDX and $3b in the R2000.

Metals: Large specs added to their gold longs last week, while also buying silver and platinum. Additionally they held steady their net shorts in copper.

Energy: HFs covered crude oil last week, while adding to their deep shorts in natural gas. Additionally, they increased their longs in heating oil.

Forex: Large specs bought the Euro last week, while modestly selling the USD. They also covered their net shorts in the Yen.

Interest Rates: HFs increased their longs in the 2-Yr Ts, while covering more of their significant shorts in the 10-Yr Ts. They added to their shorts in the 30-Yr T-Bonds.

■ M/N and L/S hedge funds’ market exposure continue to improve
Our models indicate both M/N and L/S funds’ market exposure continuing to improve reversing the rapid fall in beta from late March and early April; both are now only moderately underweight equities (pp 3-4). It is potentially bullish for equities if HFs, with substantial cash on the sidelines and facing significantly lower outflows in Q2, return to the markets. M/N HFs were big losers in April because of their sharp drop in beta during much of the rally (see Hedge Fund Monitor, 13 April 2009). We also note a significant shift by funds away from High Quality to Low and from Growth to Value.

■ Macros sell the SPX, commodities; buy the US$, Emerging Mkts
Our models suggest Macro HFs added to their crowded net short in the S&P 500 last week, while holding steady the NDX. Additionally, they continued to buy the US$ index and modestly added to their shorts in the 10-Yr Ts, while continuing to sell commodities. They also continued to increase their small caps tilt relative to the large caps. We also estimate Macro HFs bought the Emerging markets and the EAFE markets last week.

To see full report: HEDGE FUND MONITOR

>GEM STRATEGY (MERRILL LYNCH)

India Re-rating & EM One Year On

India Re-Rating
420 million Indians just voted for deregulation, supply-side reform and less government intervention, a marked contrast with voters in the G7 and unambiguously equity-bullish. But investors are only modestly UW India and India now trades at roughly a 40% premium to EM (versus 10-year average premium of 24%) so we expect only modest reallocation to India. (Note India’s forward PE has today jumped from 14.4x to roughly 17.4x - see table 1).

Emerging Markets One Year On…
May 21st marks the one-year anniversary of the cyclical high of Emerging Market equities versus Developed Market equities (chart 1). A dramatic comeback in EM is being lagged by other correlated growth & risk assets: if EM is a faithful lead indicator then we can expect more to come from global Material stocks and the Euro for example (see Charts 2 & 3). The summer risks to relative performance of EM, in our view: Emerging Markets are overbought short-term; US dollar strength due a new risk-aversion event; weak Chinese economic data. Absolute direction of global equity markets will likely be dictated by US consumption.

To see full report: GEM STRATEGY

>ASHOK LEYLAND (MERRILL LYNCH)

Expensive on muted prospects

Raise forecasts, but retain rating
Q4 results were ahead of expectations, thanks to control over key expense items. Still, operational EBITDA, declined 70% to Rs908mn (BAS-MLe Rs648mn), and high interest outgo restricted recurring net profit to Rs269mn (Rs476mn). As a result, FY09 EBITDA declined 40% to Rs4.69bn (BAS-MLe Rs3.90bn), and net profit Rs2.02bn (Rs1.50bn). We raise forecasts to reflect this surprise. However, re-iterate Underperform on weak prospects, and expensive valuations.

Margin surprise
Q4 margins at 7.5% (down 450bps yoy) was driven by strict control over staff (down 26%), and overheads (down 32%, after adjusting for forex gains included under this item). As a result, the company ended the year with margins at 7.8% (down 240bps). We believe margins will hold up as commodity prices remain soft.

We raise forecasts to reflect the surprise
We raise margin expectations by 180bps to 8.1% for FY10 and 110bps to 8.5% in FY11, and thereby EBITDA forecasts by 33% and 17% in FY10 & FY11 resp. We retain truck volume assumptions of 5% decline in FY10, and 10% growth in FY11.

Business outlook muted
Our CV outlook is muted, on slowing economy and infrastructure related investments. We however are positive on buses (~39% of volumes), as well as light vehicles (Nissan JV operational only in CY11). By FY11, we expect new entrants in CVs. We therefore expect company to lose share in CVs.

Reiterate Underperform with higher PO
Our revised PO of Rs13.4 (earlier Rs11.2), is based on 5x FY10E EV/EBITDA, in line with mid-cycle valuations.

To see full report: ASHOK LEYLAND

>ENGINEERING & CONSTRUCTION (MERRILL LYNCH)

Stable Govt. to drive re-rating

■ Good governance in AP & Delhi voted; Buy Infra Builders
A stable Govt. in UPA alliance & voting back of Andhra (AP) & Delhi Govt. is great news for pick-up in Infra spends. Budget deficit will encourage divestment of PSUs such as NTPC, NHPC, Power Grid and more PPP projects, that should necessitate progressive policies in sectors such as power & roads. These coupled with Infra deficits creates a macro framework for robust sustainable growth & that has potential to drive E&C cos re-rating as they move into a higher orbit, in our view. We raise PO to factor-in re-rating across BAS-ML universe with top picks – E&C - BHEL (Rs2000 v/s 1700) & IVRC (255 v/s 215); Reliance Infra, JPA (developers).

■ Vote for incumbent Govt. in AP/Delhi = vote for governance
We attribute the voting back of incumbent Congress Govt. (see table 2) in the state of Andhra Pradesh (AP) led by land mark US$10bn Irrigation spends and Delhi – fixed water, power and transportation (metro rail + roads) problems. While this will not only encourage in-coming Govt. to accelerate Infra spends, but it will also act as role model other Govt. Loss of election by Mr. Balu, ex-transport minister despite win by his party in TN, may be a vote v/s ineffective governance.

■ Buy builders - stocks to re-rate before EPS become visible
Likely improving visibility of Infra capex, potential falling-in place of Industrial capex on return of business confidence coupled with the global liquidity makes for a potent combination to re-rate the sector till the order inflows / earnings becomes visible in the next few quarters. We think that once the earnings catch-up, rich multiples will start to look reasonable.

■ Top Picks: BHEL, R. Infra, IVRC, L&T & JPA

1. BHEL: We raise PO to Rs2000 (1700) as it will be the main beneficiary for the liquidity driven sector re-rating given its visibility of 23% CAGR in earnings, potential for PE expansion to 17.5x (15x) FY11E at 20% premium to Sensex and thrust on power capex incl. the ‘bulk’ ordering by its customers’ – NTPC/DVC.

2. Reliance Infra with surplus equity (~US$1.5bn) may benefit from likely auction of three more UMPP by Govt. in FY10E leading to higher E&C value and value of R. Power investment. Stock is inexpensive at 1.1x consolidated FY09A P/BV.

3. IVRC: We see IVRC to benefit from return of pro-Irrigation capex (70% of its backlog) Govt. in AP. Potential pick-up in roads / real estate capex is +ve.

4. L&T: PO Rs1235 (1110) on benefit from thermal & Nuke power capex, potential pick-up in roads & industrial capex from improving business confidence.

5. JPA: Markets does associate JPA being close to BSP and hence, it runs the risk of not participating fully in the ensuing rally. However, we think that eventually a 40% discount to NAV and strengthening new project pipeline will drive stock.

■ Minister is key catalyst to watch
We think that personalities do matter in polity. We look for change in Industry, and transport ministry, while hope better performing Aviation & Power minister (Jairam Ramesh) to return. Return of aviation minister should secure ADF funding deals.


To see full report: ENGINEERING & CONSTRUCTION

>DR REDDY'S LABS (MERRILL LYNCH)

In good health; Rate Buy......

■ Reinstate coverage with Buy rating; 25% upside potential
We reinitiate coverage of Dr Reddy’s Laboratories (DRL) with a Buy rating and PO of Rs714. We forecast 20% EPS CAGR over FY09-11, and core EPS CAGR of 49%. At PO, stock would trade at 15x FY11E core EPS, which is a slight premium to peers. Near-term triggers include possible surprise on management guidance later this week, and likely launch of Omeprazole OTC in H2 FY10.

■ Forecast revenue to grow 11% annually
We expect growth in global generics (~70% of DRL) driven by new products and market share gains, and revamp of supply-chain (in India), even as our forecasts factor continuing pressure in EU (~13%). Based on management indication, we see upside risk to Para IV exclusivities/niche opportunities. In the PSAI segment (~30%), we expect API (ingredients to formulators) to maintain ~13% annual growth on DRL’s sizeable portfolio of filings, and focus on customs manufacturing (rather than slowing customs synthesis), to drive recovery towards 2H FY10.

■ Stable margin estimates, but may be conservative
Following an expected spike to 18.5% in FY09, we estimate margins at around 18%, restricted by our conservative revenue assumptions for high contribution opportunities with limited competition. However, we expect base margins to rebound around 30% (or 400bps) on improved revenue and mix to higher contributing markets, ie, Russia, US and India.

■ Valuations attractive in our view
Despite a 27% YTD stock rally, we believe valuations are attractive, given strong 49% core EPS CAGR, compared with domestic peers at 21% CAGR (consensus), as well as global counterparts (14% CAGR). On 2-year price to earnings growth (PEG), DRL trades at 0.3x, which is 60% discount to domestic peers.

To see full report: DR REDDY'S LABS

>INDIA WEEK AHEAD (MERRILL LYNCH)

Thank Goodness!

■ Political stability strengthens end-09 bottom out…
Markets should welcome the return of political stability Monday. The Congress-led UPA, after all, convincingly returned to office belying all fears of a hung assembly. Political stability strengthens our end-09 bottom out hypothesis, assuming the G-3 stabilize 2H09 as we expect.

We expect a politically more confident Delhi to allow PSU banks to pare deposit rates - as CPI inflation comes off here - to cut lending rates to support growth.

Besides, the Congress could fund an additional 0.5-1% of GDP fiscal stimulus (~1% of GDP so far) in the July budget by divesting PSU stock. This poses some upside risk to our FY10-11 growth estimates: we estimate Re1 of public spend generates Rs1.5 of GDP. Finally, this defuses the possibility of political risks eroding investor confidence.

■ … eye ministry for policy cues
We would scan the new ministry to be sworn in on Friday for policy cues. The Congress has already announced that it will retain defense, finance, foreign and home affairs. PM Manmohan Singh is apparently ‘persuading’ Rahul, Congress president Sonia Gandhi’s son, to join his cabinet to spearhead rural development.

■ Stable Delhi likely to soften rate expectations…
A 25bp RBI rate cut (by July) to oblige the new finance minister should support gilts: read Ashish and me here. Second, gilts should also take comfort from the potential of divestment to moderate fiscal pressures. Third, PSU banks will likely follow the SBI into post-poll deposit rate cuts. Finally, this should culminate in a 50-100bp prime lending rate (PLR) cut by 1HFY10. Do read our rates roadmap here.


■… and comfort fx flows
Fx inflows should improve with the political risks over the INR dissolving. Besides FII interest, the DLF stake sell should fetch US$750mn. Anyways, capital inflows have been recently healthy here. This, in turn, supports our twin view of BoP risks overdone/constructive medium-term INR outlook. Do read Christy and me here.

■ RBI, like investors, positioning for end-09 U in inflation
We are not surprised that RBI Gov Subbarao again flagged the need to ‘think’ about “reversing” his easy money policy, with commodity prices bottoming out. Inflation – likely 0.7% this week – should likely U by September to rebound to ~5% by March 10 (Chart 1). On our part, we expect the RBI to pause with a final by-July rate cut. Reversal should begin by April 10, assuming bottom out end-09
(Chart 2). Even if yields harden, the ~600bp spread between bank PLR and 10y offers sufficient cushion for soft lending rates to persist till 2HFY11 (Chart 3).

To see full report: INDIA WEEK AHEAD

>Hedge Fund Monitor (MERRILL LYNCH)

HFs short 10-year T-note to levels not seen since April ‘05

Large Specs buy gold, 2Y-Ts; sell NDX, oil, US$ and 10Y-Ts
Note: Commitment of Traders data reflects positions as of last’s Tues close
Equities: Large specs decreased their net long position in the S&P 500 futures last week while also continuing to pullback on their crowded longs in the NDX. In recent weeks readings in the NDX reached their highest levels since Oct 07- when the NDX subsequently fell 6.7% 1month on. Large specs also added to their shorts in the Russell 2000. HFs are still a source of liquidity for the markets but less so with a potential buying power of ~$9b, consisting of $6b in the SPX and $3b in the R2000.
Metals: Large specs marginally added to their gold longs last week, while aggressively buying silver. Additionally they modestly added to their net shorts in copper.
Energy: HFs sold crude oil last week to go net short, while adding to their deep short position in natural gas. Additionally, they marginally increased their longs in heating oil and moved sharply back into a crowded long in gasoline.
Forex: Large specs covered the Euro last week, while modestly selling the USD. They also added to their net shorts in the Yen.
Interest Rates: HFs increased their longs in the 2-Yr Ts, while increasing their significant shorts in the 10-Yr Ts. They also added to their shorts in the 30-Yr T-Bonds.

M/N and L/S hedge funds’ market exposure continue to improve
Our models indicate both M/N and L/S funds’ market exposure continuing to improve after falling rapidly in late March and early April; both still remain underweight equities though (pp 3-4). It is potentially bullish for equities if HFs, with substantial cash on the sidelines and facing significantly lower outflows in Q2, return to the markets. M/N HFs were big losers in April because of their sharp drop in beta during much of the current rally (for reference see Hedge Fund Monitor, 13 April 2009). We also note a significant shift by M/N and L/S funds towards Low quality from High. Low quality has significantly outperformed in this rally, but that may be changing.

Macros sell the SPX, commodities; buy the NDX, US$, 10 Yr-Ts
Our models suggest Macro HFs added to their crowded net short in the S&P 500 last week, while buying the NDX. Additionally, they continued to buy the US$ index and modestly covered their shorts in the 10-Yr Ts, while selling commodities. We also estimate Macro HFs were flat the Emerging markets and bought the EAFE markets.

To see full report: HEDGE FUND MONITOR