India ETFs In Freefall As Inflation Concerns Rise

by on January 18, 2011 | ETFs Mentioned:

The start of 2011 has been a very rough one for most of the world’s major emerging markets as they have seen their share prices fall across the board. Moderating fears over the economic situation in a number of developed markets have pushed many investors back into industrialized nations while concerns over rate hikes have spooked others from putting excess cash into emerging countries. Arguably, the worst hit by this recent trend is the nation of India, a country that many were looking to lead the emerging world this year. Yet, India’s leadership in the market has not come to fruition so far in 2011; of the ten worst performers in the Emerging Market Equities ETFdb Category seven are funds tracking the Indian market including two of the three worst performers, a situation that has left many to wonder if India is not yet ready for the emerging markets spotlight.

This recent and severe downturn is largely due to the extremely high level of inflation that is hitting food prices all across the nation. The country’s wholesale price index rose 8.4% in December of 2010 which was a roughly 100 basis point increase from November’s inflation reading. “In the short term, managing inflationary risk, particularly, food price inflation is the biggest challenge to be faced by our policy makers… An appropriate policy response to contain food inflation must draw from multiple sources,” said Dr C. Rangarajan, the Chairman of the Prime Minister’s Economic Advisory Council, suggesting that in order to stop food price inflation a combination of fiscal and monetary measures must be taken [see India ETFs: Warning Signs In GDP Report?].

Many believe that the growing inflation could spark unrest if not dealt with quickly, forcing the central bank to raise rates in order to curb inflationary trends. Protests are already starting to crop up in a number of areas across the nation including demonstrations against the recent increase in fuel prices. “The oil price hike for the seventh time in six months will hit the public hard. We will not tolerate this anti-people decision of the UPA and launch a statewide agitation if the government fails to withdraw the hike,” said BJD legislator and state convener of the Biju Yuva Janata Dal (BYJD). These words and protests come after a four rupee hike in prices of gas per liter which translates into roughly a nine cent increase per liter suggesting that the current situation is precarious to say the least and that any further increases– even extremely small ones– could lead to more widespread unrest.

This tense situation is likely due to India’s status as a low-income country. Despite growing at an impressive clip for much of the past decade, India remains one of the world’s poorest countries with the average GDP per capita coming in at just $3,200. Thanks to this extremely low income, any increase in food prices has a devastating impact on the vast majority of the country, which is now being reflected in the nation’s plunging equity markets [see 11 Rapid Fire ETF Ideas For 2011].

However, any attempt to deal with food price inflation is likely to curb growth putting the Indian economy in an awkward situation in which they will have to sacrifice growth for price stability, which has also weighed on markets over the early part of January. Averaged out, the seven funds tracking the Indian market have produced losses of over 5% in the first two weeks of the year, potentially calling into question the nation’s status as a top destination for emerging market capital.

Given the wide variety of other problems facing the Indian market, such as relatively high budget deficits, widespread corruption, and a terrible infrastructure, these inflation fears may be just enough to push investors away from Indian securities until the current situation becomes a little clearer [also Seven Most Corrupt Country ETFs].  Below, we profile three of the hardest hit areas of the in-focus Indian market that are accessible via ETPs that investors should keep an eye on as this crisis continues:

Infrastructure

Lower growth looks likely to negatively impact the infrastructure sector especially severely as investments in the capital intensive sector plunges, forcing the nation to stall any plans to boost the decrepit infrastructure. Currently, there is one ETF that tracks the Indian infrastructure market, EG Shares‘ India Infrastructure Fund (INXX). The fund has declined by 5.2% on the year thanks to poor prospects for some of the fund’s top holdings across a variety of industry segments. Tata Motors, the fund’s top component, has fallen by 9.7% since the beginning of the year thanks to fears over declining car demand, while Sterlite Industries, a major mining firm based in Mumbai which makes up 5.6% of INXX, has declined by 9.1% in just the past two weeks as well, underscoring the widespread pessimism in this corner of the market for 2011 [also see India Infrastructure ETF In A Pickle: What's Next?]

Small Caps

Many consider small cap funds to be more of a ‘pure play’ on a local economy since multinational companies– which often have operations in a variety of nations– are largely absent. This allows companies that focus on the national economy to take the spotlight, which can be both good and bad for investors. Currently, there are two ETFs available to investors seeking exposure to the Indian small cap market; the Market Vectors India Small-Cap Fund (SCIF) and the EG Shares India Small Cap Fund (SCIN). The two funds have, respectively, dropped by 6.7% and 5.6% in the first half January suggesting that the local market has been hit significantly hard by the recent turn of events. Both funds are heavily concentrated in three sectors; industrial materials, financials, and software while charging expense ratios of 85 basis points. Thanks to their focus on industrial materials and financial firms, which are likely to be among the most impacted by a rate hike, these funds have been among the weakest performers and could continue to underperform the broad market going forward if inflation fears persist.

Broad Market

The worst performer so far in 2011– both in the emerging markets category and for India specifically, is the iPath MSCI India Index ETN (INP) which has plunged by almost 7% in just ten trading days. The fund tracks the MSCI India Total Return Index which provides exposure to approximately 85% of the free-float-adjusted market capitalization of equity securities by industry group within India. The billion dollar fund offers heavy exposure to financials (25%), industrial materials (22.1%), and energy companies (17%), while offering minimal exposure to media, telecom, and consumer service firms. Both of the fund’s top components, Reliance Industries and Infosys Technologies, have declined by more than 5% on the year while the rest of the fund’s top five has seen losses approaching– or even exceeding– double digits, helping to drag down this popular ETN to start the year and leave a cloud of pessimism hanging over this once-loved emerging market [read ETN Investing: Facts And Fallacies].

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Disclosure: No positions at time of writing.