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February 2014

Sensex corrected 3% last month on the back of global uncertainty on account of QE tapering by US Fed and emerging market’s currency slide.

The announcements on continued QE tapering and increased risk aversion resulted in a sell- off in Emerging market equities and currencies. The global capital markets are since dithering between a possible growth revival in developed markets, against corresponding monetary adjustments in emerging markets. Simultaneously, growth data from China disappointed with a concurrent overhang of challenges in its financial system.

At home, the government has demonstrated a healthy response to a stressed macro environment where the policy machinery has responded with initiatives such as Project Management Group (PMG), a framework that can evolve as an enabling template for delivering fast track infrastructure project. It has also extended its commitments to sustenance of measured and time determined soft increases in retail fuel prices.

November IIP numbers disappointed with a 2.1% y-o-y decline. Growth momentum moderated substantially in consumer durables. Inflation prints were significantly lower-than-consensus. Vegetable prices have corrected sharply even as core inflation remains sticky. In response, RBI surprised markets with a 25bps rate hike. The RBI also highlighted that the need for further tightening over the near-term is unlikely if inflation tracks its expected downward path.

FIIs remained net buyers to the tune of USD 123 million in January while DIIs sold equities worth USD 430 million. Lack of plausible options make Indian equities a compulsive choice for global funds particularly those who allocate money into emerging markets. The intense participation of FIIs in large liquid quality names has created a valuation divergence between large-cap and mid and small-cap that is fairly large relative to history. We believe the entire mid and small cap space offers tremendous opportunity for long term investors. Most of the corporates in this space have witnessed an extremely challenging period. This has initiated a phase of strategic reorganization and rationalizations. Some of these are trimming down their cost structure; others are hiving off non-core businesses. The higher interest cost regime has also forced a measured look at leverage. We feel most of the companies which have been able to protect the balance sheet in this environment have enabled their businesses to participate in the next cycle growth.

The 3Q FY earnings reported so-far have been a mixed bag – global sectors / companies have fared well, while domestic sectors have disappointed. The valuations are reasonable with the markets trading at a 15-year mean of around 16.5x earnings. While cost of capital has marginally gone up, India is certainly offering trough-cycle RoEs, which can recover in the medium term.

Political developments would dominate the sentiments and market performance in the coming months. The recent election mandates in favour of growth and governance form cornerstones of things to follow. One also has to respect the reality that the two decade fragmented politics has retained the commitment to reforms continuum albeit with varied intensity.

Concerns about poor governance, slowing growth, possible stagflation, worsening twin deficits and to top them all a weakening currency have subsided to a large extent. We feel the market is poised for a good long run with the bottoming out of the macro data, improving corporate profitability, committed policy regime, reasonable valuation and sustained commitment from long term foreign investors. Return of the domestic investors back into the equity market would be critical for a sustained bull run. A favourable political outcome, if any, might provide an added windfall, in the interim. We remain encoded for participation in both the strategic as well as tactical opportunities in this scenario.

The RBI December Mid quarter review had guided that future policy actions would be contingent on the direction of both headline and core inflation. Even though the headline inflation numbers had eased according to expectation, the core inflation numbers showed a moderate increase. The 25 bps hike in repo rate may also have to be seen in the context of the Urjit Patel committee report which recommended a CPI inflation anchor for policy purposes and a CPI inflation target of 8% within a year. The rate hike reflects RBI’s assessment of the required policy stance to achieve the desired inflation trajectory.

The RBI guidance makes further rate actions data dependent. Overall a fair bit of uncertainty surrounds the medium term direction of CPI inflation considering the unaddressed supply side constraints though the lagged effect of tight monetary and fiscal policy, soft global commodity prices and high base effect in food prices should lead to softening of CPI gradually. In the very near term, CPI inflation could trend downwards on account of easing in primary articles, which would most likely result in a phase of status quo on policy rates. Even though the formal adoption of the Urjit Patel Committee recommendations would depend on consultations with the government, we expect that incrementally monetary policy actions and operating procedure could evolve based on the broad guidelines of the report. This would entail that the RBI focuses more on headline CPI inflation, with active liquidity management through term repo auctions. Recent RBI measures continue to stress on ensuring positive real return for incentivizing savings and to ensure that revival of growth happens in a non inflationary manner, which hints at a largely anti inflation bias in Monetary policy for the near term.

Yields ended the month broadly unchanged with the current 10-year gilt yield rallying by 4 bps to 8.78% and 1-year gilt yield selling off by around 5 bps to 8.82%. Long end yields initially rallied sharply by more than 30 bps on the back of lower inflation data and strong FII debt purchases. However, with the surprise RBI policy hike and increased volatility in external currency markets, yields subsequently retraced the entire rally.

Considering the higher expected gross borrowings over the next few years, on account of high repayments, a significant directional easing in long end rates is unlikely over the next few months especially in the context of the current policy stance of the RBI. We expect RBI to focus more on headline CPI inflation going forward. Considering the recent moderation in food and vegetable prices, RBI might pause for the next few months.

In the interim, with the supply schedule for the current fiscal year drawing to a close, bond yields may remain largely supported in range. The RBI is likely to be more proactive in addressing liquidity shortages which may recur over the coming months driven by government cash balances. OMO as a tactical liquidity or subtle yield management tool cannot be completely ruled out, with the choice of securities likely to be more at the short –medium end. The front end of the curve looks relatively attractive in the current situation on a risk – reward framework. Inspite of anticipated seasonal liquidity pressures, we expect overnight rates to be well anchored in the near term. Money market and short term funds apart from long dated FMPs are expected to provide attractive investment opportunities in the current market conditions.

Navneet Munot

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