Market Update
Macro Economic Review
The Indian economy maintained steady performance despite the near-term headwinds in form of higher commodity prices, rising fiscal deficit and depreciating currency.
RBI kept the key policy rate unchanged, while maintaining its stance of ‘calibrated tightening’. The tightening stance looks perplexing as the RBI slashed its H2FY19 inflation forecast by 130bps to 2.9%, implying full-year FY19 inflation under 4%, which will undershoot its earlier guidance of 4% (second year in row).
RBI remained quite upbeat on growth, highlighting improving capacity utilisation, rise in PMI (purchase Manager’s Index), expansion of bank credit and closing output gap. It retained FY19 growth forecasts at 7.4% and H1 FY20 is seen at 7.5%. The central bank expects corporate profitability and disposable incomes to improve due to fall in commodity prices thus holding up growth. We see a risk to these numbers and expect the numbers to be revised downwards going ahead.
Real GDP growth moderated to 7.1% in Q2FY19 compared to 8.2% in Q1FY19. GDP growth for H1FY19 now stands at 7.6% compared to 6% in the same period last year. Real GVA growth softened to 6.9% for Q2 FY19 from 8% in Q1FY19 due to a slowdown in agriculture (3.8% from 5.3% in Q1FY19) and in industry (6.8% from 10.3% in Q1FY19). On the demand side, private consumption slowed to 7% (likely reflection of weak rural demand scenario which may persist going ahead) from 8.6% in Q1FY19, government consumption expenditure grew 12.7% (7.6% in Q2FY19) and gross fixed capital formation grew 12.5% (10% in Q1FY19).
The trade deficit continued to expand despite strong growth in exports (17.9% YoY) and lower gold imports (US$1.7bn vs US$2.6bn last month) as higher oil (US$14.2bn vs US$10.9bn) and capital goods imports (16.3% YoY) pushed up the trade deficit. The impact of the recent decline in oil prices would be crucial towards reducing the Current Account Deficit going ahead. The fiscal deficit for April-October FY19 was 103.9% of the FY2019 budget estimates. Gross tax collections grew 6.7% with indirect tax collections (including GST) growth of just 1.2% and while direct taxes grew 13.3%.
The industrial production grew 4.5% in September compared with the upward revised 4.7% for August 2018. The IIP (Index of industrial production) for first six months grew at a reasonable rate of 5.1% compared with 2.6% in the same period last year.
Retail inflation as measured by the consumer price index (CPI) eased to 3.31% in October from 3.7% in September 2018. The core inflation however, continues to remain elevated at 5.8%. WPI also hit 4-month high of 5.28% reflecting the impact of pass-through of higher commodity prices and rupee depreciation.
The RBI announced Rs. 400 bn of Open Market Operation (OMO) purchase for the month of December though the quantum of each tranche and timing will be notified later. This was on back of Rs. 400 bn purchases in month on November 2018. In FYTD19, the RBI has injected durable liquidity to the tune of Rs. 1,360 bn through OMO purchases and tried to ease liquidity tightness in the market. We expect liquidity to ease a bit further as the RBI has taken numerous general and NBFC specific measures. We believe a potential slowdown in growth and reduction of commodity and currency led inflation could likely trigger a change in stance from the RBI to neutral going ahead.
Equity Market
Indian equities recovered from October lows (Nifty +4.7%) as crude falling ~22% over the month boosted sentiments, parallelly driving the INR up. The recently concluded 2QFY19 earnings for BSE200 companies suggests that while sales growth momentum has been healthy at ~26% YoY, profit growth (2% YoY decline) has been significantly weak due to higher input and interest costs. Aggregate PAT, even excluding PSU banks, has grown by just 7% YoY, compared to ~27% YoY last quarter (which was on a lower base). So overall, after a brief pause during Q1FY19, post Q2, there were more earnings downgrades and these were more broad-based during this quarter suggesting softness in earnings growth in the near term. RBI board met during the month followed by announcements on ECB hedging requirements, relaxation of NBFC norms.
In terms of sector level performances, the best performing sectors were BSE Consumer Durables (+7.2%), BSE Realty (+6.7%), BSE Capital goods (+6.6%) BSE Bankex (+5.6%), while the sectors which were major laggards were BSE Metals (-5.5%), BSE Healthcare (-2.4%) and BSE Tech (-1.6%). FIIs turned buyers after 3 months of selling albeit of a smaller quantum, while DII buying slowed significantly with Insurance companies turning net sellers. State assembly polls went underway in MP and Mizoram with reported record voter turnout of 75% with results to be declared on Dec 11. Rajasthan, Chattisgarh and Telagana will also head into election in early Dec, tracking the LS polls later next year. Near-term, markets will try to derive cues from this, along with developments surrounding liquidity/refinancing conditions in the fixed income market (which appear to be normalizing) and the December RBI monetary policy. Recent fall in Crude oil and INR appreciation, if they were to sustain, are likely to act as tailwinds.
While concerns on some of the global and local events (US elections, progress on US-China trade standoff, and concerns on geo-politics relating to oil have abated, Indian markets will likely tread cautiously until the election outcomes in 4 key states scheduled in December. Recent improvement in macro factors will however support overall market valuations and protect downside. Incrementally, we do turn constructive on the market from an opportunity standpoint; particularly in the mid and small cap segment given steep valuation corrections in several good quality businesses.
Our portfolio approach continues to remain balanced with bottom-up stock selection and sector selection playing an equal role. We believe evidence is emerging on strengthening a pro-cyclical stance and some portfolio shifts to capture a potential industrial/manufacturing recovery are being undertaken. Cyclicals with comfortable balance sheets and attractive valuations or companies with strong franchise value but presently facing growth headwinds do attract our attention.
Fixed Income Market
The decline in longer tenor bond yields, which started in mid-October, continued further in ovember’18. The reasons for the fall in bond yields broadly remained unchanged, viz. (not in the order of rank), with last factor coming into play in November.
- Drop in the international oil prices, led by buildup of inventory and increased supply
- Sustained decline in headline inflation in India
- Stabilization of INR vs USD and EUR
- Monthly calendar of OMO announced by RBI for Oct, Nov and now Dec
- Contraction in trade deficit
- Reversal in portfolio outflows from overseas investors
There was a 20bps decline in 10-year sovereign bond yields over the last month, closing at 7.60% in November, compared to 7.80% in previous month. The 10-year benchmark sovereign yield came off from an intra-day high of 8.22% in October.
The drop in international oil prices by over 30% from the peak has been the biggest trigger for this rally in the bond market. While majority of the investors were wary of the credit market post the default of IL&FS and its group companies, a strong rally in the gilts was underway and mostly went unnoticed. The rally in sovereign bonds also led to some contraction in the spreads of PSU bonds.
Besides, the additional round of rate hikes which were priced in following the steep rise in oil prices in previous months and stance change from Monetary Policy Committee (MPC), has started to neutralize and further contributed to the rally in bond yields. MPC in its October policy review had changed the stance of the policy from neutral to ‘calibrated tightening’ (which was later explained by Urjit Patel as meaning ‘rate reductions are off the table’). Now it remains to be seen if the MPC members change the stance of the monetary policy again and so soon.
The headline inflation data has moved lower over the last 3 months despite the rise in oil prices due to sharp drop in the food price inflation component. This inflation trend prompted the MPC members to refrain from a rate hike in early October, which was till then widely priced in. Unfortunately, RBI has been overestimating inflation for the last 2 years. This has led to incorrect setting of the policy rates. In October’18 MPC estimated that headline CPI will be in the range of 3.9%-4.5% for the period October’18 till March’19. The current headline CPI is 3.31%. It seems unlikely that inflation will rise anytime soon to move outside the upper band of the forecast.
The money market at the shorter end was under huge liquidity stress post the default of IL&FS and its group companies in September’18 and downgrade of its credit rating to D from AAA in a matter of weeks. Ever since the default, government had desired that RBI would infuse liquidity into the markets in a targeted manner for the NBFCs and HFCs. However, so far RBI has not relented and only infused liquidity through the OMO route by buying gilts. So far, RBI has undertaken OMOs of Rs. 36,000 crores in October’18, Rs. 40,000 crores in November’18 and Rs. 40,000 crores in December’18. The net effect is that total demand is outstripping supply for November and December’18.
This has increased the liquidity in the hands of the banks. It is expected that the excess liquidity in the hands of the banks will get onward lent to the corporates including NBFCs and HFCs. However, in the absence of commensurate risk appetite the flow of liquidity into the affected sector is ebbing and the credit spreads have widened by over 100bps in the last couple of months. Of late, RBI has modified the policy around sell down of assets by HFCs & NBFCs. These measures have opened up lines of liquidity for such entities and have led to some drop in their borrowing cost.
In the given market conditions, we urge investors to remain cautious and pick fund duration aligned to their investment horizons. While we do not expect any rate hikes in the next few months, we feel the change in stance to ‘calibrated tightening’ by RBI ties their hand while CPI remains benign. We do 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 sync with the MPC’s rate decision, which is expected to take cognizance of developing inflation and growth dynamics.
Last Updated: 15th November 2018
Next Update On: 15th December 2018
Update Frequency: Once Every Month
