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July 2012

Favorable outcome from the European Union (EU) Summit against very low expectations and accommodative stance of most of the central banks led to a rally in risk assets towards end-June. Economic data continued to disappoint and commodity prices remained under pressure on concerns about demand destruction. Despite rally in risk assets, bond yields in developed world remained close to historic low levels. Equity markets in Spain, Greece and Italy bounced back sharply while Turkey and India were among the best performers within emerging markets.

Rupee continued to remain under pressure and touched an all time low of 57.35 against the Dollar. However, reversal in sentiments towards the month-end brought it to 55.50 levels. The central bank did play its own part through measures such as increasing the ECB limit for companies, raising the ceiling for FII investment in G-Secs apart from its regular intervention in the Forex market. India’s trade deficit touched a record level of $16.2bn in May due to slowdown in exports. We think that currency weakness will help in boosting exports and import substitution over the medium term while lower commodity prices and decline in gold imports should lead to improvement in the current account. The currency has not only weakened but has witnessed heightened volatility as well and we expect RBI to contain this volatility going forward. 

Equity markets rallied despite poor headline economic data. Index of Industrial Production (IIP) for April came in at 0.1% (consensus of 1.8%), third successive month of lower than estimated number on the back of contraction in Capital Goods and Intermediate Goods. Output of eight core industries remained subdued at 3.8% in May vs. 3.1% growth in the previous month. WPI inflation for May rose to 7.6% vs. 7.2% in April. The markets remained wary with upward revisions of prior month numbers. Core inflation also increased to 5% from 4.8% m-o-m. CPI print of 10.4% consolidated the rising trend. Massive increase in government consumption over the years without commensurate augmentation of the supply side is the geneisis of most of our macro challenges today. 

The RBI left interest rates and the CRR for banks unchanged in the monetary policy review. It also adopted a hawkish stance and made mention of the supply-side pressures that need to be addressed in order to reign in inflationary pressures. The presidential nomination hogged majority of political limelight. Prime Minister taking up charge of finance ministry has rekindled the hope for a policy revival. The renewed optimism did overshadow continuation of the extended policy paralysis (postponement of telecom EGOM decisions) and a negative remark from Fitch. We expect a reversal in policy inertia with focus on execution post the Presidential election. The Prime minister and bureaucrats have made right noises over the last few days to improve sentiments, though ground level action is awaited. India retains its core position in the emerging markets universe through is size, structure (social, economic, legal) and longevity. Given the state of world economy and political situation, India may again emerge as relatively attractive investing destination. Domestic investors have been staying underweight equities and we expect the trend to reverse in sometime as sentiment improves and relative attractiveness of physical assets (real estate and gold) decrease. While global risk appetite will determine the fund flows, monsoon and policy actions would be key factors to watch out for in the near term. We have a positive bias on economy and markets from a longer term perspective.

In our equity portfolios, we continue our emphasis on bottom-up stock picking with essentiality of quality (business franchise, earnings, cash flow and management) and valuation to the ultimate delivery of long term sustainable returns. We remain strategically alert to act on the value trades that emerge in such environment. We continue to recommend that investors should use the downturn to increase allocation to equities as long term fundamentals remain intact. Valuations are reasonable and pricing in most of the risks on the horizon. Patient investors would be suitably rewarded for risks. 

Bond yields, especially on the government securities segment traded in a very contrasting manner during the first and second half of the previous month while closing flat on a m-o-m basis. During the first half of the month, leading up to the monetary policy review on 18th June, market expectations had been built in for at least a 25 bps policy rate reduction. Weak incoming macro economic data, the decline in crude oil prices and stable core inflation data had resulted in market anticipation of monetary easing. The newly issued 10 yr benchmark government security traded at 8.04% before the policy as against the issuance yield of 8.15%. The RBI moved against market consensus and kept rates on hold, citing elevated headline and retail inflation indices and lack of supply side responses from the government. The status quo on policy rates and the rather hawkish statement led to yields retracing all the gains made in the first half. The new benchmark 10yr yield closed the month at 8.18%. In line with the RBI policy stance, the systemic liquidity deficit has been improving leading to an easing in money market rates across the curve. Corporate bond spreads in the short end have remained stable while the 10yr segment witnessed an uptick on account of the change in the underlying 10yr sovereign paper. 

The RBI OMO purchases amounting to about Rs 545 billion in the last 2 months has kept government bond yields supported in spite of the supply pressure. Gradual improvement in systemic liquidity could result in the OMO’s being conducted more sparingly. Considering the higher net supply during the coming months, in the absence of RBI support, yields can potentially inch upwards marginally. The RBI stance is likely to be more aggressive on providing liquidity considering the requirement of efficient monetary policy transmission. This would be positive for investments in the short to medium term corporate bonds. During the previous quarter, money market yields have moved down driven by lesser supply and anticipation of improvement in liquidity. This trend is likely to persist in the coming months leading to a more steep curve. The long end of the curve may witness continuing volatility, with the RBI OMO schedule likely to govern near term direction. We anticipate accrual funds to gradually shrink maturities given the new valuation norms being implemented. We re-iterate our positive views on interest rates and recommend that any spike in long term yields should be used as an entry opportunity into duration funds. 

Navneet Munot