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March 2011

March turned out to be very volatile as series of negative news flow gripped the market at the start of the month, however, investors mounted the wall of worry and Sensex gained 9% at close. Natural disaster in Japan, continued unrest in middle‐east and North Africa region (MENA) pushing crude oil prices higher and worries over domestic macro‐economic and political situation kept the markets under pressure, however, the trend reversed in the second half the month. Foreign investors turned net buyers and poured over a billion dollar in last few sessions as risk aversion receded and valuation started looking attractive. The legendary investor, Warren Buffet made his first visit to India and his remarks over the long term prospects of Indian economy helped in reversing the negative sentiments prevailing here. As the market views were getting polarized towards a bearish trend and positions were light, large buying by foreign investors amidst thin liquidity led to a swift rally. Dramatic turnaround in the equity markets matched the performance of Indian cricket team in the ICC world cup 2011.

Geo‐political situation in the middle‐east remained fluid and crude oil prices climbed 10% during the month. We believe that monetary tightening in emerging world should put downward pressure on global commodities, however, a significant component of rise in crude oil price stems from the geo‐political risk. This remains the single biggest cause of concern as higher crude oil prices will push up inflation and put pressure on current account as well as fiscal situation.

Higher energy and food prices have created a policy dilemma for the central bank. To check the risk of potential spillover from higher food and energy prices into more generalized inflation, RBI has been pursuing a tight policy with a combination of liquidity measures and interest rate increases. The underlying assumption was that economic recovery remained robust and policy actions had to focus on the goal of price stability. The economy is projected to grow at 8.6% for FY2010‐11, there are signs that growth momentum is slowing down. There has been sharp decline in monthly Index of Industrial Production (IIP) data over the last few months. While the consumption component continues to show resilience, the slowdown in capital investment shows weakness in the investment climate. There has been an environment of uncertainty on the global as well as domestic front and a tighter policy with lagged effect could pose threat to the growth outlook going forward. The RBI Mid‐quarter policy review in March continued to maintain the fine balancing act between the objectives of maintaining price stability by reining in demand side pressures while seeking to minimize downside risks to the growth momentum. RBI increased the policy rates by 25 bps and highlighted the risks emanating on both the policy objectives i.e. price stability and containing inflationary expectations and maintaining growth.

The medium term economic growth trajectory would be guided by the progress on the reforms front and the supply side responses on the agricultural sector. The union budget announcement on increasing the share of manufacturing to GDP to 25% from the current 16% and the rollout of the GST and Direct Taxes Code are also expected to provide a structural impetus to maintaining the growth momentum. The finance minister has announced that a spate of legislative reforms pertaining to financial sector would be undertaken in the near term. The government has indicated steps towards addressing the critical issue of fuel, fertilizers and food subsidies which would go a long way in ensuring fiscal consolidation. The need of the hour is to focus on giving a significant push towards building physical and social infrastructure to maintain the growth trajectory. While there are some dark clouds on the horizon, we believe that given the multiple growth drivers, structural factors and low base, Indian economy would continue to post one of the highest growth rates and throw several opportunities for patient long term investors.

Having witnessed a sharp rally in March, the equity market is likely to move in narrow range over the next few months and trend would depend on the cues from global markets, 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. Market would also be watching the progress of Monsoon and outcome of several state elections due in this quarter. We have been recommending investors to take advantage of the downturn in equity market as long term outlook remained positive. It is always difficult to time the market and best way is to build exposure to equities through a systematic investment plan. The recent rally highlights the importance of maintaining discipline of asset allocation.

Short term rates have moved up over the last quarter as tight systemic liquidity coupled with large supply from banks resulted in money market rates moving up to near 10.20% in the 3 month segment towards the March‐end. The one year CD rates remained supported near 10.15%‐10.20% levels on account of demand from Mutual funds for Fixed maturity Plans. Market has witnessed tight liquidity since the beginning of June 2011 when 3G/ BWA auction payment outflows to the Government of India hit the banking system. The frictional source of liquidity deficit has been the large government balances being built up with the RBI. This has got accentuated during the times of Advance tax outflows. On a more structural side, the huge imbalance between the credit and deposit growth of the banking sector and the increased currency in circulation with the public has pressurized the banking system liquidity.

Going forward, the overall liquidity situation is expected to move close to the comfort level of the Reserve Bank at +/‐ 1% of NDTL as the frictional factor unwinds. Short term money market rates are expected to ease substantially going forward, especially in the first half of April. However, the structural factors would take time to unwind and the rollover of bank CD’s towards May‐June could again put an upward pressure on rates, even as the peaks witnessed in the Jan‐Mar 2011 quarter are unlikely to be retested. The Government’s fiscal position has been better than market expectations which led to a rally in Government bonds after the Union Budget. In view of the under budgeting of subsidies the eventual evolution of the borrowing program would still be challenging, especially in a stubbornly inflationary scenario. The first half borrowings of Rs 2.5 lakh crores have been in line with the market estimates. Maintaining the FY 2011‐12 deficit target of 4.6% and net borrowing of Rs. 3.58 lakh crores (including T‐bills of Rs. 15,000 crores) look challenging to achieve as subsidies are seriously under‐estimated. Revenue growth targets look achievable but expenditure containment would be challenging. However, continued global uncertainty, recent growth in Bank NDTL and bleak prospects of growth in the developed economies along with RBI’s current significant moves to tackle inflation would keep a check on rising bond yields. On balance, it is expected that long term interest rates would see an upward bias and could peak out in this quarter. 

Navneet Munot