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December 2011

A swift move to “risk-off” trade globally negated most of the October gains. The persistent fears of European contagion and weak economic data continued to drag the markets through the month. Crisis in the Euro zone didn’t show any signs of improvement with policy makers failing to come up with a credible plan. Credit markets remained strained and bond yields in the entire Euro zone kept inching up. Markets remained on a roller coaster reacting to news flow with sharp daily swings. 

Towards the end of the month, 6 large central banks led by US Federal Reserve made a coordinated effort to lower US Dollar swap rates by 50 bps. This helped in alleviating concerns about freezing of liquidity in inter-bank markets and led to a smart rally on the last day of the month. The non-US banks have been struggling with shortage of dollar funding and this effort by central banks threw a lifeline at them. The move is unlikely to solve the solvency crisis; however, is a directional response of the developed economies to display their commitment and intent towards normalizing market conditions. The forthcoming meeting of the Euro constituents on December 9th is critical to the future of European Union, not to mention an important trigger for the financial markets. 

China cut its Reserve ratio for banks by 50bps signifying that it is officially done with monetary tightening cycle. China is preparing itself for a soft landing. While most of the other central banks in both developed as well as emerging countries have softened their stance, India has been one of the exceptions. We expect RBI to acknowledge the economic slowdown and change its monetary stance shortly. 

In India, economic data continued to display elevated anxiety: 
  • GDP grew at 6.9% in the second quarter of 2011-12. During the first half of the fiscal year, GDP growth averaged 7.3% compared with 8.6% a year ago. The contraction in Fixed Capital Formation is a reason to worry. 
  • Headline Inflation remained sticky with October number printing at 9.73%, a bit higher than expectations. 
  • IIP figures for September 2011 too were lower than expected at 1.9%, with August data revised down to 3.6%. A contraction in mining and capital goods production continued to weigh on growth. 

The rupee continued to weaken as trade deficit widened and capital flows have dried. Rupee lost 7.5% in November, its steepest decline in one single month and touched an all-time low of 52.50 against the dollar. Currency traders exploited the elbow room offered by reluctance of RBI to intervene in currency markets and the concurrent negatives of slowing growth, global risk aversion, inflation and India’s twin deficit. Weak rupee will add pressure on inflation and the subsidy bill of the government. It has also added a layer of uncertainty in the minds of investors at a time when macro environment has not been conducive. From a positive perspective, it will increase export competitiveness and make valuations look more attractive for foreign investors. 

The 2QFY12 results did provide a reality check with the cash flows showing more strain in this economic environment. While sales momentum was sustained (to be viewed in light of YoY inflation and the stock-in for the Festive season), the earnings for broader market have slowed down to high single digit on the back of higher input costs, increased overheads and higher interest costs. There was also some stress on account of fluctuations in the Forex market, though it will be more evident in the current quarter given sharp drop in rupee last month. The decibel on default worries by corporates and state run utilities also gathered momentum. The concomitant developments of falling rupee, FII’s adjustments in India exposure in MSCI index rebalancing and the negative global undercurrents added further pressure to the fall in markets. 

While we write this piece, the Indian parliament is on debate of the key legislations that would enable the future growth roadmap with as much as 31 critical bills under consideration. Some of the critical reforms related to mining, aviation and financial services sector, introduction of goods and services tax (GST), FDI in multi-brand retailing and electricity distribution reforms have long been awaited. Uproar over decision on FDI in multi-brand retail leading to government back tracking on its decision shows the grim political reality. 

Government’s response to a slowing economy amidst mounting macro challenges and tough external environment is quite critical and we hope that political class will rise to the occasion and not derail the structural India story. We believe that directional reversal in policy making to be subject to test of political will on the backdrop of impending state elections is critical for change in the market sentiments. The other important driver for the market would be the trajectory of inflation and interest rates. One can expect RBI to soften its stance on interest rate as India Inc struggles on account of simultaneous occurrence of slower growth, higher costs and weaker currency. 

Investing world is very fascinating – events and perceptions do change. In an uncertain global environment, India stands out due to its relative position in terms of attractiveness of opportunity. The underlying promise of the structural India story with a compulsive balance on investments (supply constraints), consumption (demographics, low penetration and under leverage) and export competitiveness remains unquestionable in a world dealing with deflation and anemic growth. In coming months, the India story would be subject to further scrutiny in terms of its character, depth, policy commitment and longevity. 

In Today’s pain lies tomorrow’s gain. We expect this period to offer a good opportunity to investors to participate in the long term India story. Our focus has been on bottom up stock picking and our selection bias towards quality, competitive edge and emerging high growth businesses does offer our investors a strong moat to ride these times. 

The Q2 GDP data and the core sector data reinforce the view that the rate hiking cycle has topped out. RBI monetary stance is likely to be on a pause mode with more active liquidity support considering the downside risk to growth and expected inflation trajectory. We continue to maintain a positive bias on interest rates over the medium term. The continuing stress on systemic liquidity has resulted in RBI announcing Open Market Operations (OMOs). The announcement of OMO and the enhanced limits for FII’s participation in local bonds have resulted in yields falling by around 30bps from the intra month highs in November. The recent RBI actions after the October policy review provides comfort in maintaining a high duration bias in portfolios. 

We expect RBI to be more proactive in ensuring that systemic liquidity deficit does not impact the real economy. OMOs could continue for a while as the first line of liquidity support. The possibility of CRR relaxation would also keep markets supported. CRR actions could only come in as a second resort or in case of extreme stress in liquidity driven by possible higher Forex interventions in the coming weeks. The possibility of additional borrowings due to weak fiscal position continues to be a source of worry. We believe that in the near term the possibility of OMO support could probably absorb some of the additional net supply and also some part of the deficit financing could be done through Tbills or Cash Management Bills. 

Short term rates have been at elevated levels on account of the tight liquidity conditions. Money market yields have remained in a range of 9.30% to 9.50% in the 3 month space. We continue to witness higher incremental deposit growth vis-a-vis the incremental credit growth in this fiscal. Banks have been less dependent on wholesale funds thus capping any significant upside in short term rates. In spite of tightness persisting on account of the advance tax outflows, we may not see too much upside in short term yields from current levels due to a change in monetary stance and also the possibility of additional OMOs. We have been recommending investors with risk appetite and investment horizon of over a year to consider the dynamic bond fund which is well positioned to take advantage of the opportunities in the bond market. With the short term corporate bond rates at elevated levels, we recommend short term funds to investors with a moderate risk appetite and an investment horizon of up to 6 months. 

Navneet Munot