Market Update
Macro Economic Review
The recent updates to the Indian macroeconomic parameters have thrown in mixed results. While the high frequency (lead) indicators such as vehicle sales, credit growth etc. and the GDP, exhibit improvement at the ground-level; rising inflation and high twin deficits continue to pose risk to the overall economic health. This could pose policy challenges for the RBI and the Government going ahead.
As per the revised updates, India’s 3Q GDP for FY 18 rebounded to 7.2%, implying that the economy is beginning to overcome the impact of twin disruptions caused by demonetization and GST. Similarly, the investment growth surged to double digits to 13% in 3QFY18 from 8.9% in the last quarter. The GDP growth for the full year FY’18 has also been revised upwards by 10 bps to 6.6%, implying that the fourth quarter FY ’18 GDP is estimated to grow at 7.1%. Incidentally, the third quarter real GDP growth has improved despite net exports continuing drag the overall economic activity (negative impact of ~140 bps on GDP) and the GDP deflator (i.e. the economic measure of inflation) rising by 100 bps in 3Q FY ’18 to 4.4% due to higher WPI and CPI inflation.
Further, the manufacturing output growth (Index of Industrial Production-manufacturing) accelerated to 7.1% in 3Q from 2.5% in the previous quarter, taking the industrial production growth to 6% from 3.3% previously. Notable uptick was visible in the sale of commercial vehicles (up 34% YoY vs 21% in Q2) as well as 2-wheelers (up 16% vs 12%). The credit growth too rose to 9% from 6% during the period. The Consumer Price Index (CPI) inflation too moderated marginally to 5.1% from 5.2% in the previous month, though the Core CPI at 5.1% continues to remain sticky.
The Current Account Deficit (CAD), on the other hand, has risen to 1.8% of GDP during first half of FY ’18 vs. 0.4% of GDP in the corresponding period of the previous year. Trade deficit for the month of January ‘18 too widened to $16.3bn, which is well above the recent average of $13.4bn – driven by acceleration in imports to $40.7bn (+26%) together with slowdown in exports to $24.4bn (+9%), particularly pronounced in textiles and gems & jewelry.
The headline fiscal deficit has remained unchanged at 3.9% of GDP in January ‘18 (on a 12-month trailing basis); for April ’17 – January ’18 period, the fiscal deficit stood at 113.7% of the revised budget estimates (excluding divestment proceeds). Once the year-end adjustments are made, the fiscal deficit could close-in to ~3.5% of GDP, as announced in Feb 2018 budget.
While the revised GDP numbers are drawing much attention, a catalyst to this upward revision also comes from the Gross Fixed Capital Formation (GFCF), which has seen a sharp upward revision, entailing a detailed analysis. But having said that, an analysis of GDP trend over past 7 quarters reveals that the consumption growth, after having peaked in Q4 FY17 (10.2) %, has slowed down relatively to 5.7% in Q3FY18, while, investments, after holding at negative 2.2% post Q4FY17 have inched upwards to 13% in Q3FY18. This lends cushion to the RBI against raising rates since expansion on the demand side has moderated and the contribution presently is being led by the supply side.
Equity Market
Indian equities, in the month of February ’17, ceded most of its previous month’s gains, ending lower by ~4.9% vs. the previous month. The markets were largely dragged by the Banking and Infrastructure companies even as Information Technology, Metals and FMCG led the overall relative performance. The sell-off is largely attributed to the heightened levels of global volatility that weighed down investment sentiments as Foreign Portfolio Investments (FPIs) turned out to be major net sellers after nearly four consecutive months of being net buyers in Indian Equities.
Besides, re-introduction of the Long-term Capital Gains Tax (LTCG) on equity investments in the Union Budget 2018-19 and the unsuspected unravelling of the massive ~$2bn scam involving the country’s 2nd largest public sector bank i.e. Punjab National Bank (PNB) have also, to some extent, dampened investment sentiments. Additional headwinds in the form of hardening US G-Sec yields to a 4-year high of 2.95% in the wake of developments in the global macroeconomy, with a cascading effect on Indian yields that rose to a 2-year high of 7.88%, also impinged the markets.
Having said that, domestic corporate earnings and macro-economic data continue to point at fundamental recovery in the economy. Moreover, the recent political successes in the North-Eastern Region, by the party whose Government currently rules the Centre, lends further credence to the political stability in the country.
Markets currently seem to be in the mood to price-in some of the recent fundamental risks which have started to pose a challenge to the continued contraction of equity risk premium seen in the past couple of years; key among them being the return of inflation, albeit modestly. We reckon that the markets will likely stay rangebound for a while till it rebalances its assessment of improving economic and corporate earnings growth at one end and inflation on the other.
Meanwhile, from a domestic standpoint, we continue to believe that the government’s reform agenda supported by tailwinds in the global growth scenario strengthen our base case for a back-ended recovery in the earnings for 2HFY18 and will, likely, enable investors position themselves for a full-blown earnings growth in FY19 and beyond.
In this backdrop, 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 to strengthen our pro-cyclical stance. Meanwhile, our portfolios have seen some desirable shifts to capture the opportunities for a potential industrial recovery. We do back cyclical companies but only where valuations are reasonable and where balance sheets can withstand operational stress. On a bottom up basis, we are willing to invest in companies across sectors that are experiencing near-term headwinds, provided 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 is unchanged based on current valuation differentials.
Fixed Income Market
The negative sentiments in the bond market continues amidst additional government borrowing and higher headline Consumer Price Index (CPI) inflation. While there has been a modest drop in the CPI last month, it continues to hover above 5%. The rising bond yields over last 1 year have driven away quite a few investors from the market leading to sporadic investments. This, together with uncertainty with regards to the future trajectory of the CPI and the lingering fear of rate hikes by the RBI, has pushed the bond yields even higher over the last few quarters. Besides, Government ‘s acknowledgement of slippages in the fiscal deficit target have added further fuel to the persisting negative sentiments in the bond market.
The 10-year benchmark (the new issue) yield has moved from 7.43% to 7.73% last month in wake of the.
- Additional borrowing due to fiscal slippage
- Relaxed fiscal target for FY19
- Negative market sentiment
- Risks of higher CPI highlighted by RBI in the Feb
- policy Persistent volatility in the oil prices
- The new cost plus formula (1.5x of cost) of calculating Minimum Support Price (MSP) for agricul-ture commodities, which threatens to further aggravate the already rising CPI inflation.
The negatives in the market and the jitteriness about the future rate actions by RBI have led to the selloff in the bond market. The yields are almost 150 bps higher compared to the same period last year. The foreign investors have also been net sellers in the market in the last month, which in turn has put the rupee under pressure.
With bond yields moving north due to weaker market sentiments, a higher fiscal and higher market borrowings, we do not expect the real rates to contract unless triggered by some policy action by the RBI or the government. The ongoing fears of higher inflation support RBI’s cause to maintain its hawkish stance on inflation and we feel that the market has started to price-in a few rate hikes given that the 10-year benchmark is trading at a spread of 175 bps over the repo rate
So far the rise in inflation has been led by food price inflation, the effect of HRA to central government employees and the effect of GST on the services sector. The entire effect of the HRA and GST on CPI will be felt till June 2018 and has the potential to push inflation towards 5.80% - 6.00% band. While the food price inflation is transient in nature, the new cost plus formula (1.5x the cost) of calculating MSP could trigger secondary inflationary tendencies and give rise to wage inflation in the rural economy with spill over as generalized inflation.
Since RBI has not already hiked the repo rate despite highlighting the risks to inflation in its latest policy, we do not expect a rate hike from RBI unless the headline CPI goes beyond the forecast 5.60% in the first 6 months of FY19.
Further, to reduce volatility in the given market conditions, we urge investors to be cautious and pick fund duration aligned to their investment horizons. We do not expect any rate reductions soon due to fiscal slippages but hold on to our stance for a need for tighter real rates and endorse efficient allocation of capital and savings/investment.
The market, in due course, is expected to move in alignment with the Monetary Policy Committee (MPC’s) rate decision, which is expected to take cognizance of developing inflation and growth dynamics.
Last Updated: 15th March 2018
Next Update On: 15th April 2018
Update Frequency: Once Every Month
