Citigroup Prefers India Stocks as Inflation Cuts Bond Gains

India’s stocks are a better bet than bonds as the fastest inflation in Asia erodes fixed-income returns and deters interest-rate cuts, Citigroup Inc. says.

“If you’re talking about the next six to 12 months, yes, the preference would be for equities over bonds,” Pankaj Vaish, Mumbai-based head of markets for South Asia at the third-biggest U.S. bank, said in an Aug. 22 phone interview from New York. “It’s hard to expect a huge return out of bonds immediately because we have to wait for this whole disinflation process to yield results.”

Equities would be the better performers should Prime Minister Narendra Modi deliver on a pledge to revive India’s $1.88 trillion economy, he said. Debt gains are seen limited as the central bank will probably hold borrowing costs until mid-2015 to quell price pressures, according to Vaish, who said that prior to an Aug. 5 policy meeting he’d been expecting a reduction as early as the coming quarter.

Reserve Bank of India Governor Raghuram Rajan flagged risks to his goal to slow consumer-price gains this month, as a weak monsoon threatened to boost food costs in a nation where more than 800 million people live on less than $2 a day. Local stocks rallied 25 percent this year, the best performance among the world’s 10 largest markets, as Modi unveiled plans to allow more foreign investment and to improve public finances.

International investors have pumped $12.6 billion into Indian equities this year through Aug. 20 and the S&P BSE Sensex climbed to a record today. The nation’s government bonds returned 8.4 percent, the biggest gain in Asia’s local-currency debt markets, as global funds boosted their holdings by $16.5 billion, according to exchange data compiled by Bloomberg.

Rising Yields

The yield on 10-year sovereign notes has climbed 12 basis points since sinking to 8.44 percent in July, the lowest level since September 2013. The spread over similar-maturity U.S. Treasuries widened to 618 basis points, or 6.18 percentage points, from this year’s low of 571 in January.

The RBI’s target to rein in gains in the consumer-price index to 6 percent by 2016, from almost 8 percent last month, “looks difficult” to achieve, according to Vaish. Local interest rates may even rise as policy makers step up the fight against inflation, fueling bond declines, he said.

“We had hoped that we would wait only another six months but I think we have to wait another 12 months” to see the results of steps to temper CPI increases, said Vaish. “Before that, it may become hard for the bond market to get too excited.”

‘Break Glass’

The 10-year yield will be at 8.45 percent by year-end, compared with 8.56 percent today, according to the median estimate in a Bloomberg survey of five banks and mutual funds. The 30-stock Sensex may climb to 28,143, or 6.5 percent, by then, a separate survey of seven strategists showed last month.

Stocks advanced this year as Modi’s government eased the foreign-investment cap in the defense industry and announced plans to build more highways, coal-fired power plants, airports and ports. Economic growth slid to below 5 percent in the last two years from 9.6 percent in 2006-2007.

“Equities have rallied a lot on expectations and I think what will be important now is that the pace of reforms has to be maintained,” Vaish said. “Given the bold promises that Mr. Modi laid out, there is an agreement with voters that you will break glass, take some bold decisions. There are a couple of things they have done well. My view is if you have political capital, you use it. If you don’t, it actually disintegrates.”

Bond Inflows

Even as stocks rallied to an all-time high, foreigners plowed more money into Indian bonds than shares this year for the first time since 2011. Investments quickened as optimism about an economic recovery buoyed the rupee, adding to the appeal of Asia’s highest investment-grade yields. The currency gained 2 percent this year to 60.5650 per dollar.

India’s 10-year bond yield compares with 2.38 percent in the U.S., 0.93 percent in Germany and is more than double China’s 4.20 percent, according to data compiled by Bloomberg.

Last month, India eased foreign-investment rules for government debt, raising a cap on overseas ownership by $5 billion to $25 billion. While that allowed global asset managers to buy more bonds, quotas for sovereign wealth funds were simultaneously cut to $5 billion from $10 billion, keeping the ceiling for total foreign holdings unchanged at $30 billion.

India should consider gradually raising the limits for foreign institutional investors, or FIIs, said Vaish.

“We tend to be very skeptical of debt inflows,” he said. “FIIs actually are friends and well-wishers of India. They are not necessarily fair-weather friends who will run out.”

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