(Downgrade to Underweight: With Earnings Normalizing, Valuations Are Expensive; Market Is Vulnerable to Global Tightening.)

Year-to-date, the Bombay Sensex Index has returned less than the IFC/S&P regional benchmark. Foreign investors over the past twelve months purchased US$5.5 billion (net) in local equities, just 0.7% of market capitalization and down by half from the previous twelve months’ US$10.9 billion. Indian domestic equity mutual funds have also reduced their net purchases. Diminished investor appetite and poor relative performance presumably reflects Indian stocks’ “overowned” status and high valuations. We believe that over the next 1-2 quarters, poor relative performance will persist, given that the Indian stock aggregate in our GEM database is still the most aggressively priced in both price-to-book terms and forward P/E terms despite the likelihood of a longerterm corporate earnings and ROE normalization. Indeed, the bottom-up EPS growth consensus for the 23 Indian companies in our GEM database is projected to fall by more than half from 2006’s actual 24% (and 35% for broader Indian corporate earnings beyond our sample) to “only” 11% in 2008, below the Asia regional mean for 13% EPS growth that year.

We do acknowledge that India’s expensive multiples have reflected certain long-term fundamental positives – such as (1) higher Indian trend GDP growth over the past four years to roughly 8%-9%, from the previous so-called “Hindu growth rate” of roughly 4%-6%, and (2) consequently improving fiscal revenues, as well as (3) very encouraging age-distribution demographics and (4) the gradual penetration of consumer finance. But Indian fundamentals are not without their own risks and disappointments, such as (1) elevated inflation, (2) a balance of payments (BoP) vulnerability to portfolio flows that sustains local interest rate upside risks, and (3) growing political fragility that retards the pace of (increasingly market-critical) structural reform. The BoP issue is

salient in light of our belief in the risk of global monetary tightening (including from the Fed and Bank of Japan) over the next two quarters, which would present a headwind to cross-border capital flows. India outperformed China during the late-February-early March EM correction -- in large measure because that correction was induced by fears of a U.S. growth shock (and by extension, imports slowdown), to which China would be much more exposed than India. But the next EM challenge, in our view, will be a U.S. inflation shock (and monetary tightening), to which portfolio inflow-dependent India is more vulnerable. In light of the above, we recently downgraded India to Underweight for the second-quarter of 2007 from our previous cautious Market Weight allocation.