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February 2011

The markets were in a depressing mood at the beginning of the month of February due to concerns about macro economy, and political situation. Events in Middle-east and North Arica (MENA) leading to sharp spurt in prices of crude oil added to negative sentiments. The centre of conflict, Libya accounts for just 2% of the crude oil production, however, markets are worried about the contagion effect. High crude oil prices increases the pressure on inflation and current account deficit as India imports bulk of the crude oil requirement. It also adds to fiscal burden given the administered prices of retail fuel products. 

Governance deficit and declining moral standards have been  the topics of intense debate over the last few months as a series of scams and scandals got unearthed. In fact, media uproar, public outcry, role played by institutions like Supreme court have at least led to rolling of some heads this time and could act as restraint for people indulging in such practices in future. While these events have led to a halt in executive functioning and could hamper the pace of reforms for some time, we believe that it would ultimately lead to better transparency and improved governance standards in future. The Right to Information Act (RTI) was one of the big legislative reform that is manifesting itself in improving transparency standards. If one analyses results of the state government elections over the last few years, it is quite visible that governments which focused on growth and better governance have got re-elected. This gives us a reason to be optimistic about growing maturity of our democracy leading to better quality polity and good governance in times to come. 

The  Finance minister presented the union budget on February 28 amidst a situation of political gridlock and macro backdrop of high inflation, current account deficit and fears of slowing growth momentum. The approach of budget could be termed as incremental and growth-oriented. Budget deficit for fiscal year 2011-12 at 4.6% of GDP was lower than market expectations. The budget assumes a 14% nominal GDP growth and projects a 3.4% increase in expenditure and 18.5% growth in revenues. While revenue growth numbers look achievable, there could be risk of overshooting on the expenditure side particularly on the subsidy front. Despite higher food, fertilizers and crude oil prices, subsidy provisions for these three items for the next financial year are lower than the revised estimate for FY 2010-11. High nominal GDP growth leading to buoyant tax flows and higher receipts on account of auction of 3G telecom licenses led to fiscal deficit coming in at 5.1% of GDP compared to budgeted number of 5.5% of GDP for FY 2010-11. Finance minister re-iterated its commitment and indicated time lines for roll out of unified Goods and Service Tax (GST), Direct Taxes code (DTC), issuance of new bank licenses and move towards cash subsidies for kerosene, LPG and Fertilizers for poor section. While there were selective changes in custom and excise duties to bring them in line with proposed GST regime, services tax was kept at 10% with its scope getting widened by bringing more services  into the tax net. The budget measures on taxation would be broadly neutral for most of the sectors barring few like cement and aviation which would have marginally negative impact. Auto and tobacco companies were beneficiaries as markets were expecting a hike in tax rates. The budget stayed away from any populist largesse and has taken incremental measures to boost investment into housing, infrastructure and social sector. Quantum increase in limit for FII investment in infrastructure bonds and allowing foreign investors to invest in domestic mutual funds are bold moves towards liberalizing the capital account. The budget measures would help in increasing the availability of finance for the infrastructure sector, however, the key issue is pace of execution which has lagged expectations. The finance minister took incremental measures to address the problem of food inflation, however, we believe the issue needs a far more innovative approach and urgent action from the government. 

The markets typically show higher volatility around the budget time and this time was no exception. Foreign investors continued to remain net sellers in the market while there are signs of increased flows from the domestic  investors. As the budget event is behind us, the market would now focus on cues from global markets and incremental economic data and corporate earnings. Given the backdrop of macro concerns, outlook on corporate earnings growth has weakened. Margins could be under pressure due to increase in raw material prices, wages and interest rates. Higher inflation, rising rates and tight liquidity could also impact discretionary spending. For these reasons, investors have preferred sectors and stocks with higher visibility  of earnings like technology. While events in middle-east and domestic economy and political sphere could keep sentiments depressed for some time, we recommend investors to take advantage of volatility by gradually increasing exposure to equity markets as long term fundamentals remain intact and valuations are becoming attractive.  

Given the inflation trajectory, we expect RBI to increase policy rates by 25 bps in its mid-term review  of monetary policy this month. Incremental policy actions are unlikely to have much impact as RBI is behind the curve as reflected in bond yields and deposit and lending rates. G-sec yields eased towards the month end as budgeted government borrowing for next year came in at lower than market expectations and no additional borrowing was announced for the remainder of current financial year. The pressure on money market rates continued as the huge supply combined with tight liquidity resulted in funding costs moving up in the short term money markets. The 3 month bank CD rates moved up close to 60 bps over the month and traded at close to 10.10%, whereas the 1 year CDs traded at close to 10.20%. Investor sentiment in the money market remained cautious on account of tightness expected during the month of March on the back of Tax related outflows and quarter end redemptions in mutual funds. We expect the money market rates to peak out over the next few days and correct substantially as we move into April. Short term yields are at record highs and investors should take advantage by investing in accrual products like ultra short, short term funds and fixed maturity plans. 

Navneet Munot