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March 2012

After a splendid January, equity markets continued their climb against the wall of worries right through February. Despite the persistent “Yes”/“No” toggle on the European solution on Greece’s bailout and across-the-board demotion of Euro-credits by the rating agencies,  the markets  supported risky assets as the European Central Bank (ECB) and Bank of Japan (BoJ) signaled continued easing and economic data from the US sustained its positive momentum. ECB pumped in €529 billion through second round of Long term Repurchase Operations (LTRO) on top of €489bn it dispensed in December 2011. The US equities are now at a 10-year high and the emerging markets too are witnessing their own share of global money commitments. The ‘risk-on’ trade was also evident across commodities including precious metals that rallied smartly during the month. While the deluge of liquidity has ignited a rally in risk assets, the concerns about solvency crisis and impact of deleveraging process on the real economy and financial markets remain. 

Economic indicators in India displayed continuation of moderation in the growth momentum: 

  • GDP growth for quarter ending December 2011 at 6.1% y-o-y was lower-than-expected.
  • Weak manufacturing sector growth (0.4% y-o-y) was the key drag. Much of the moderation was underpinned by a plunge in capital goods segment, which remains the most volatile component of Industrial Production (IP).
  • January inflation fell below 7% for the first time in last two years - much of this was on account of a very favorable base effect but some of this was also on account of moderation in the sequential momentum.
  • The rupee remained stable after a sharp rally in January. Foreign inflows helped in negating the impact of rising Brent crude prices (up 10% in Feb). 
  • Liquidity in banking system remained extremely tight despite the cut in CRR. We fear a sharp drop in savings rate in the current financial year given the state of government finances, drop in corporate profitability and trends in household investments. 

At the same time, one witnessed incremental positive news on the policy front:– 

  • RBI guided on easing monetary policy subject to a favorable inflation scenario and fiscal consolidation. RBI intervention has helped in rupee stabilizing below 50 against the dollar. 
  • PMO addressing the issues faced by the power and infrastructure sector: 
  • Withdrawal of ‘Go – No Go’ restrictions pertaining to environmental clearances for large projects 
  • Coal India assigned the responsibility of ensuring coal supplies to power projects that have entered into long term PPAs
  • Favorable verdicts on Vodafone tax issue and cancellation of 2G telecom license allocations (all the 122 of them - a development that removes any further possibility of ambiguous processes of allocations of national resources).
  • Several measures to attract foreign flows through equity and debt route
  • Initiatives to garner money through PSU divestment  

 These initiatives concurred with recently opened investment windows for global money (through Individual exposure directly in Indian debt/ equity markets), and persistence of global “risk-on” trade. As a result, FIIs were net buyers with net inflow of USD 5.1bn as compared to an inflow of USD 2bn in the previous month.

The investment mood, witnessed reversal from a denial-to-disbelief-to-acceptance of the “risk-on” continuum. India’s performance ranking fell to 14th position from 3rd in the previous month. Year to date, India is now the 4th-best performing market. For the second consecutive month, the broad market indices outperformed the narrow market. The small and mid-cap indices outperformed the BSE Sensex by 5.3% (y-o-y) and 2.8% (y-o-y), respectively.

The earnings season for 3QFY12E has been through. Most of the results have been either in line or better than expectations. This has to be also seen in the backdrop of the then-persistent slower investment cycle and the interest rate cycle that was at its peak. One can expect some of this weak momentum to continue for one more quarter. However, the positive reflexivity in the policy cycle should start reflecting sooner in earnings revisions which seem to have progressively bottomed since.

Going forward, apart from global risk appetite that drives flows and sentiments, the market would critically hinge on four crucial developments – State Election Results (which undermine political equations at the Centre going forward), RBI Policy (to initiate the formal rate reversal cycle), FY13E Union Budget (where the market has begun to positively build-in expectations) and Crude oil (a critical lever in India’s fiscal arithmetic). One can expect the current momentum on the policy, and interest rate to continue till there is no adverse development on fiscal situation and core inflation.

While one enters a month that has such multiple critical developments – we remain well balanced to capture positive developments through tactical allocation to sectors sensitive towards interest rate and investment cycle, while retaining our quality bias when it comes to business, managements, and cash flows.

Money market rates remained under pressure during the month on account of continuing stress in the system liquidity with LAF borrowings averaging around Rs. 1,40,000 crs. The new SEBI regulations on fair valuation of money market securities which resulted in reduced incremental purchases from Mutual Funds and market expectations of liquidity deficit aggravating further led to short term rates moving up by more than 100bps during the month. The cumulative impact of Forex intervention, currency in circulation, movement of government cash balances and the mismatch between the incremental growth in credit and deposit numbers have overshadowed the liquidity impact of CRR reductions and the Open Markets Operations (OMO) by RBI. The 10yr benchmark government bond yields remained in a narrow range due to the continuation of the OMO program and on account of the fag end of the fiscal year borrowing schedule. The macro data announced during the month broadly reinforced the deceleration in growth and the slowdown in inflation momentum. The near term market direction would be determined by the trends in the crude oil prices and the Union Budget stance on the fiscal position. The incremental RBI stance on rates would be governed by these two variables. Short term rates may remain elevated given the tight liquidity and typical March end phenomenon. We expect liquidity situation to improve and short term rates to correct in the next quarter. We recommend investors with risk appetite to invest in Short term fund which are well positioned to take advantage of opportunities at the short end of the curve.

Navneet Munot