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August 2013

The ‘assurance” that unwinding of quantitative easing (QE) by the US Federal reserve would be data dependent and monetary policy stance would remain extremely accommodative has brought some cheers back to global markets. Developed markets also got support from better-than-expected economic indicators. Pumping of easy money or the fears of withdrawal of it instead of economic fundamentals have been the main drivers of global financial markets for quite sometime. Our view on the whole “tapering of quantitative easing” talk is that, if central banks withdraw liquidity based on expectations of real economy turning around, then it should actually be good for investors in the longer run. Emerging markets are facing their own set of challenges and investors are becoming choosy in placing their sector and stock bets within these markets instead of treating it as a single ‘basket’.

 Rupee continues to weaken despite a series of policy announcements by RBI and Government. The logic behind increasing interest rates has not worked in stabilizing the currency. Currency is at an all time low, while both bond and equity markets have suffered losses. Economy is likely to suffer collateral damage with investor sentiments touching a nadir. While the currency is showing a weak momentum with no relief in sight, we strongly believe the consensus has turned unipolar in its outlook. The other extreme was seen in 2007 when copious flows made consensus bet on rupee strengthening as a one-way street. We expect current account deficit to shrink substantially due to slowing domestic demand, improved import substitution and export prospects and lower global commodity prices. Policy measures will help as well. Government measures FII flows should turn positive in both equity and bond market given the relative attractiveness of India compared to other emerging markets.

 Fears of a sovereign rating downgrade, deteriorating macro environment and pressure of financial markets have ensured government continuing with its resolve to push the reforms envelope further. Whether its liberalizing the FDI limits, sops for the export sector or continuing with oil sector reforms, the steps have all been in the right direction. Of course, the challenges are manifold, undoing a long spell of inaction and mistakes is not easy, political capital and window of opportunity are limited. Alas, markets are not in a forgiving mood.

The suitability of Sen vs Bhagwati model for our society is an extremely critical debate. The arguments in the Media and parliament are interesting but let's wait for the battle of ballots for the final judgment. If the verdict in state elections over the last couple of years are any indication, the new class of voters may prove pundits wrong. The subtle transformation is still under-appreciated by markets.

While most of the economic data series and forecasts portray significant moderation in growth prospects, a silver lining in the form of good monsoon is missed by the markets. Monsoon in the current year is 16% above normal till July end.

Whether it is due to the color of money coming in or the reflection of macro reality and investors perception but the fact is markets have rarely been so polarised in terms of valuation. On the face of it, the Sensex has been moving in a very narrow range this year so far, but beneath, the dispersion of returns is at record. The fancy and sheer magnitude of valuation premium for so called ‘defensives’ has led to what some people call the biggest 'fad' seen in the stock market in recent history. Markets have rarely differentiated so much between the haves (stronger balance sheet and visible cash flows) and have-nots. Surely, lots of boats get sunk or permanently damaged in upheaval created by any major cyclical downturn. One needs to be ultra cautious about them to survive in the market. Having said that, staying at the shore and not seeing beyond the current trends will lead to missing on opportunities which come rarely in the life of markets.

India’s core story has certainly hit a pause button, and the duration of this pause is uncertain at the moment. Cyclical challenges have led to questioning of the structural story itself. However, we believe that the structural strengths and institutional pillars will get us back to our true potential. There are no prompt remedies though a sense of urgency among all stakeholders is certainly needed. This phase would also work as a baptism for India Inc. to revisit and reconstruct its business model for emerging realities. This phase where domestic growth might be strained for sometime, can fast forward some components of the story, like export competitiveness (with recent currency depreciation), improved governance and supply side investments.

Equity market is throwing incredible opportunities for those investors who have ability to look through and have patience. This too shall pass! As Buffet says, look at the market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

The RBI monetary policy stance in the recent past has been guided by the evolution of risks impacting the external sector. The central bank has guided that shifts in global market sentiments can trigger sudden stops and reversals in capital flows, thereby impacting the monetary stance. The possibility of the US Fed reducing the extent of quantitative easing and the associated withdrawal of funds from emerging markets starting led to the concerns on the external sector account getting amplified. FII outflows from the Indian debt markets have been over USD 7 Billion in June-July 13. In an attempt to address the sharp substantial weakness, possibly accentuated by speculative positions funded by easy onshore liquidity, the RBI announced a slew of liquidity tightening measures intended to increase short-term interest rates. Yields backed up significantly on the back of these tightening measures with the 10yr benchmark bond yield moving higher by 70 bps to 8.17% while 1 yr gilt gapped higher by 225 bps to 9.9%. AAA corporate bond spreads widened by around 25 bps during the month with 5-10yr corporate bond yields moving higher by 95-125 bps.

While keeping the benchmark policy rates unchanged in July review, the RBI guided for a rollback of recent liquidity tightening measures once the currency stabilizes. The central bank also highlighted downside risks to growth and a softening trajectory of inflation. The guidance stressed on external sector stability as a key variable guiding further monetary policy actions. With a largely open capital account and requirement of maintaining currency stability, despite having no explicit fixed targets, the RBI has admitted that the ‘Impossible Trinity’ trilemma has constrained monetary policy responses.

Bond yields have already corrected significantly, in spite of the favorable growth inflation dynamics as far as policy rate trajectory is concerned. The RBI policy guidance reflects the same, with the central bank commenting that the policy easing would have continued in the absence of external sector driven concerns. Soft macro data and reduced pricing power provide leeway for additional policy rate cuts. However, the extent and sequencing of the same will depend on global market conditions and the external sector stability. Based on these considerations, we have been looking to deploy cash and increase duration in our long term bond funds. Short term fixed income products have got hit due to sharp increase in short term yields as a reaction to RBI measures but investors staying in the fund should logically be able to make it up through higher accrual from hereon and possibility of capital gains when RBI measures are unwound. Given the current growth-inflation dynamics, bond yields should not sustain at higher levels for too long.


Navneet Munot

(Mutual funds investments are subject to market risks, read all scheme related documents carefully.)