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April 2011

Globally, markets continued to shrug off negative news and volatility touched a multi-year low reflecting huge complacency among investors. Rating agency Standards and Poor (S &P) threw a surprise by revising its outlook on sovereign rating of US from ‘stable’ to ‘negative’ indicating a one-third probability of a rating downgrade over a 2-year period. Logically, it should have been negative news for US equities, bonds and Dollar. However, the markets didn’t pay much attention to the fact that there are serious concerns about the state of public finance in developed world. Problems in the Euro Zone have just been deferred, not resolved. There are signs of moderation in economic growth; inflation is rearing its ugly head and geo-political risks persist, however, a liquidity driven rally in risk assets didn’t show any signs of cooling off. Close to zero interest rates and massive liquidity injections by central banks in developed world are surely helping but there are some other factors at work as well. Corporate profitability and cash flow generation continues to surprise on upside supporting equity valuations. However, one needs to be cautious given the low level of margin of safety in most of the asset classes today. Markets have taken the excessive liquidity in financial system for granted. Inflation has been running higher than the tolerance level of central banks in most of the economies. Risk appetite may shrink as quantitative Easing by Federal Reserve gets over by End-June and other central banks shifts their attention to deal with inflation. 

The US dollar has been on a declining trend for almost a year. The DXY index reflecting dollar’s value against 6 major currencies has fallen from a high of 88 in June 2010 to 73 now. The weakness in Dollar has been one of the main drivers behind surge in prices of several commodities. Record fund flows into commodities have pushed up prices to unprecedented levels. Undoubtedly, in the longer run, resources are going to be under pressure due to huge demand from emerging economies which are witnessing strong economic growth while incremental supplies are dwindling. In case of agricultural commodities, there is a structural case for higher prices as demand is growing much faster than supply can keep pace with. Having said that, we believe that commodity prices in general could witness correction in near term as dollar is likely to see a technical rebound and demand is likely to soften in the wake of moderation in global growth. Unwinding of speculative positions could lead to sharp volatility. 

In India, higher commodity prices, supply constrains and strong demand dynamics have led to inflation staying way beyond Reserve bank’s comfort level and the central bank had to bite the bullet and do a 50 bps hike in repo rate in monetary policy on May 3rd instead of continuing with its calibrated approach. Given that inflation has consistently been above their target and the tolerance level while inflationary expectations are becoming quite entrenched with a serious risk of persistent wage-price spiral, a strong action even at the cost of sacrificing growth became inevitable. The policy actions recognized the importance of price stability to maintain long term economic growth trajectory. The RBI has guided for a higher inflation in the first half while indicating that the yearend inflation for March 2012 would likely to be 6% with an upwards bias. The government is yet to pass on the impact of higher crude oil prices and we expect a rise in administered prices of motor fuel after the announcement of state election results in middle of May. The policy actions are expected to reinforce the RBI’s inflation fighting credibility and ensure that the monetary policy objectives are realized in a non disruptive manner considering the current inflation- growth dynamics.

Among other significant steps, the RBI has changed the operating procedure of monetary policy by making the weighted average overnight rate as the operating target and moving to a single operating rate i.e. the Repo rate. Moving towards a single operative rate would enhance the effectiveness of policy transmission. The savings rate too has been increased by 50 bps and investment restrictions have been imposed on Bank investment in debt oriented Mutual funds. We believe that the lagged effect of monetary tightening coupled with uncertainties on global front would increase the downward risk for growth prospects in FY 2012. Given the stance of central bank and a large government borrowing program, bond yields are likely to have an upside bias in the near term. 

There has been a significant shift in liquidity situation in the banking system. The government cash balances have moved from a surplus of close to Rs 90,000 crores kept with RBI to borrowings of Rs 37,000 crores. under the Ways and Means Advances from RBI. The huge government spending in the month of April has resulted in the LAF borrowings coming down from an average of Rs 80,000 crores in the month of March to Rs 35000 crores at end April. The improvement in the liquidity situation has resulted in short term money market rates in the 3 month tenure coming down by around 170 bps over the levels in March. We expect that the liquidity situation would start tightening going forward driven by monetary tightening, higher supply of T- bills and Cash management bills and the scheduled G sec auctions. We have been running extremely low duration across our fixed income funds. 

Indian equities were almost flat in the month of April after witnessing a strong upturn in March. Foreign investors pumped in $ 1.5 billion dollars. Markets ignored the macro data of rising WPI inflation and softness in Industrial production numbers. Corporate performance for the quarter ending March 2011 has been a mixed bag. Though at an aggregate level they have broadly been in line with expectations, there was couple of surprises at individual company level within each sector. As expected there are pressures on margins due to rise in wages, interest cost and raw material prices.

The markets would keenly be watching progress of Monsoon which probably has never been as critical as it is this year. Poor monsoon could not only make the inflationary situation worse and complicate problems for the RBI; it would put tremendous pressure on government finances as subsidy bill mounts. So far, the indications are that monsoon is likely to be normal this year. 

Higher inflation has not been able to dent consumer spending as combined effect of rising wages and wealth effect from increase in equity, real estate and bullion prices have offset the impact. There is a structural shift in economy as GDP is likely to cross $ 2 trillion mark with per capital GDP likely to touch a level of $ 1700. Given the low base and under-penetration levels, there are several categories like packaged food and beverages, food chains, modern retail, telecom, media, healthcare and hospitality which could witness massive growth as the classic J-curve theory plays out. Similarly, there would be opportunities in the infrastructure sector as well. Presently, there are multiple headwinds for the sector. The execution of existing planned projects as well as incremental order intake has been slow. They have been dealing with issues such as delay in environmental clearances, allocation of land and mining licenses, labour shortage apart from rise in interest and material costs. However, one needs to assess how much of it is captured in the valuation. Broadly speaking, in an inflationary environment, preference would be for those companies which have visibility on growth and higher ability to pass on increased costs. Over the next few months, as markets deal with uncertainties on the global as well as domestic front, investors should take advantage of the volatility and increase allocation to equities in a gradual manner. 

Navneet Munot