Market Update
Macro Economic Review
India’s macro-economic parameters, which have held stable since long, are seeing some interim disruptions. While the fears of the government missing out on the fiscal deficit target this year are gaining steam on one hand, the rise in inflation is sounding concerns on the other.
The November Consumer Price Inflation (CPI) surprised on the upside at 4.9% due to high food and fuel inflation. While food inflation spike was led by higher vegetable prices, the higher LPG prices drove the fuel inflation. Core inflation rose to 4.5% yoy after ranging between 3.9% - 4.1% for past 6 months while the Wholesale Price Index (WPI) also inched up in tandem to 3.93% because of food and fuel inflation.
Having said that, India’s monthly economic activity index (EAI) grew at a 10% YoY in November 2017, marking the highest growth in 17 months, supported by a favourable base and very high growth in fiscal spending.
Meanwhile, the RBI continued to maintain its status quo on the policy rates at 6% (voted 5-1) and its neutral policy stance. The Monetary Policy Committee (MPC) statement has however struck a vigilant tone on inflation, revising marginally upward its 2HFY18 CPI forecast to 4.3-4.7% from 4.2-4.6%.
The Index of Industrial Production (IIP) for the month of October ‘17 slowed to 2.2% vs 3.8% in September ‘17 as manufacturing sector activity slowed to 2.4% vs 3.4% last month. Capital goods output was in the green for the 3rd straight month at 6.4% vs 7.8% in Sept 2017. Meanwhile the Manufacturing Purchasing Manager’s Index (PMI) rose to a multi-year high of 54.7 in December ’17 vs. 52.6 in November ’17, exuding confidence on economic recovery.
November trade deficit narrowed to $13.8bn vs $14bn in the previous month as exports picked pace. Exports were up 30.6% in November led by gems & jewellery and engineering goods. Imports posted 19.6% growth led by higher crude imports. Gold imports declined to $3.26bn and non-oil imports also slowed down to $30.47bn.
The government’s recent announcement regarding additional borrowing of Rs 500 billion (0.3% of GDP) through government bonds over and above the budgeted net borrowing of Rs 3,482 billion for FY ’18 once again kindled the market concerns over fiscal slippage, which we have been highlighting since quite a while now.
The last time government resorted to additional borrowings was in FY12 when fiscal deficit was revised from budgeted level of 4.6% to 5.9% of GDP. In the current circumstances, we believe that the fiscal deficit could surpass the 3.5% of GDP in FY18 and hover at around 3.3% in FY19 as probability of rural stimulus in the pre-election year budget seems high, especially in wake of the Gujarat election results where the ruling party has had a tight race for the rural seats. This also brings us to assume and expect more rural centric policies from the government hereon as we move closer to the 2019 general elections.
Meanwhile the Labour Bureau data has revealed that the total employment increased from 20.52m at the end of FY16 to 20.94m at FY17-end, implying a 2.03% growth in FY17. The quarterly economic survey does not include people engaged in crop production and plantation as well as those employed in the public administration and defence (PAD). Employment growth of 2% against real GVA growth (non-farm, non-PAD sector) of ~6%, implies an employment elasticity of ~0.33x which is much lower than 30-year average of 0.54x and 10-year average of 0.46x. More and more people moving out of jobs in the farming sector signifies the need for them to be absorbed in the non-farm sector, will add significant burden to the non-farm sector and this could well be a key challenge for the policy makers going forward.
Equity Market
The markets are volatile and the hardening of yields continued even last month. Post the 25-bps repo rate hike in the August’18 bimonthly monetary policy review meeting to 6.5%, the bond yields had begun to soften in anticipation that this would be last of the rate hikes for now. However, the expectation was short lived with crude oil prices moving north, fueling fears of further widening of the Current Account Deficit (CAD) and its adverse impact on the value of domestic currency (INR).
The Indian equity markets continued to grow stronger during the month of December 2017, with the benchmark Nifty index gaining another 3% over the previous month, largely reflecting the strength in global equity markets. However, market activity was, once again, heavily centred around the midcap space with the Midcap index outperforming the large cap index by over 3% during the month.
Market strength this month can be said to be largely reflecting the expectations building around the anticipated strengthening of the earnings growth during the quarter, as the residual impact of GST and demonetisation begins to wane. This was despite the rise in commodity prices including oil and the stress witnessed in the debt markets due to the sharp rise in benchmark yields, both of which, at the margin, can prove discomforting for equities. This concern was somewhat assuaged towards the end of the month with the government indicating no significant slippage on the fiscal deficit front for the current year and, at the same time, accelerating its efforts towards raising resources through disinvestments and PSU dividends.
Additionally, the flow of funds in the market was also upbeat with FIIs returning as net buyers for the third consecutive month, and the Domestic Institutional Investors (DIIs) emerging as net buyers for 9th straight month led by Domestic Mutual Funds.
Concurrently, the Government’s reform agenda continues to gather steam. First, it was the modification to the GST regulations for small businesses and exporters, followed by the crucial announcements to boost investments and fuel economic growth i.e. the Bharatmala Pariyojna, an ambitious cross-country highway development program inviting massive investments of close to Rs. 7 lakh crore and the large-scale recapitalization of ~Rs. 2.11 lakh crore to boost public sector banks.
These developments strengthen our base case of a back-ended recovery in earnings for 2HFY18 and will likely enable investors position themselves for a full-blown earnings growth in FY19 and beyond.
In the current environment, while our portfolio approach continues to remain balanced, reflecting the bottom-up conviction on specific companies rather than mere sector considerations, we believe that there is now an increasing evidence strengthening our pro-cyclical stance.
Our portfolios have seen some shifts to capture opportunities for a potential industrial recovery. We do back cyclical companies but only where valuations are reasonable. On a bottom up basis, we are willing to invest in companies across sectors that are experiencing near-term headwinds, if the valuations are attractive. However, we remain wary of balance sheet risks.
Our approach has been incrementally more constructive towards large cap equities vis-à-vis the smaller companies and that stays unchanged based on current valuation differentials.
Fixed Income Market
The bond market has been adversely affected due to lower than anticipated growth in the tax revenue vis-à-vis the budgeted estimates. This gap between the actual and the target revenue is being met through additional borrowings, which is expected to result in potential slippage in the fiscal deficit target for the FY18. The uncertainty in the attainment of the fiscal target, has somewhat weakened the market sentiments and the bond yields have moved higher in the wake of lower demand from the domestic investors.
The 10-year benchmark yield has thus moved from 7.09% to 7.39% last month, in the wake of
- Fiscal slippage
- Negative market sentiment
- Anticipations about the potential fiscal slippage
- Steady firming up of oil prices
While the market has always looked up to the Finance Minister (FM) for a final say on the fiscal position, the potential slippage on the fiscal front so far has not been taken kindly by the market. While the negatives have been steadily being priced in, the bond prices have been dropping consistently over the past 4-5 months, so much so that the 10-year bond yield is almost 100bps higher vis-à-vis last year. Further, recently, there has been drop in the surplus liquidity position, after almost a year, resulting in an upswing in the yields of shorter maturity bonds as well.
The recent uptick in the headline inflation is also adding to the negative market sentiment and has pushed bond prices lower. RBI’s persistence in maintaining its neutral monetary policy stance despite there being a benign inflationary trend for the better part of 2017 has also been negative for the bond market. Further, slowdown in the credit growth and its ensuing impact on the broad money supply is also expected to result in subdued economic activity leading to delays in pick-up in the real GDP growth in a sustained manner.
Continuous Open Market Operations (OMO) for government securities (gsec) by the RBI and lower money multiplier effect due to low credit growth has reduced the liquidity position within the banking system. The domestic currency (Indian rupee) has been holding steady, with an appreciating bias, for the last few months. Steady foreign inflows into portfolio investments and Foreign Direct Investments (FDI) have led to appreciation in the INR. The forex reserves have thus gone past $404bn, lending stability to the currency.
As bond yields move north due to weaker market sentiment and higher fiscal and higher market borrowing, we do not expect the real rates to contract unless led by some policy action from the RBI or the government. While the market is not pricing in any moderation in repo rates and fears of higher inflation support RBI’s cause in maintaining its hawkish stance on inflation, we hold on to a slim probability of some accommodative stance, amid growth slowdown and higher real rates. Meanwhile, the expectations that rose following the credit rating upgrade by the Moody’s have been short-lived. Though the upgrade enables credit worthy borrowers to borrow cheaper from the overseas investors, we are not expecting any spread contraction in the wake of the ongoing weak sentiments.
The fundamentals point at the need to drop rates amidst slowdown in economic activity, address liquidity concerns and the concerns pertaining to slowdown in money growth. The benign inflation situation is expected to continue till the credit demand picks up, which is largely delayed due to tight monetary conditions and hawkish stance of the RBI.
In the current market conditions, we urge investors to be tread cautiously and choose funds with duration is aligned to their investment horizons. We do not expect any rate reductions soon due to potential threat of fiscal slippage, but maintain our argument for a need to have tighter real rates and push for efficient allocation of capital to savings/investment.
The market, in due course, is expected to move in line with the Monetary Policy Committee (MPC’s) rate decision, which is expected to take cognizance of developing inflation and growth dynamics.
Last Updated: 15th January 2018
Next Update On: 15th February 2018
Update Frequency: Once Every Month
