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May 2011

Most of the equity indices globally were in red in May and India was no exception. Foreign Institutional Investors (FIIs) were sellers to the tune of $ 1.5 billion and Sensex lost 3.31% to close at 18503. Midcaps outperformed large caps during the month. The macro environment has been a cause of concern given the stickiness in inflation and deceleration in growth momentum. Quarter IV FY2011 (March 31, 2011) GDP growth slowed to 7.8% primarily due to a deceleration in fixed investments. For the financial year FY 2010-11, the GDP growth was revised downward to 8.5% from 8.6%. The deceleration in fixed investments, which commenced in 2QFY2011 due to policy uncertainty, continued in quarter four with growth slowing to 0.4%. The situation on the inflation front remains worrisome as the increase in global crude oil prices is yet to be passed on to consumers (with the exception of petrol). Inflation is expected to remain elevated over the near term, particularly as local fuel prices are raised, and global commodity prices (especially oil) remain high. In the near term, headwinds from higher commodity prices, tight monetary stance and uncertainties on the policy front could have a dampening effect on the growth trajectory. However other indicators such as tax collections, corporate sales, credit off take and exports growth indicate positive momentum. 

Corporate earnings season for quarter ending March 2011 was concluded in the month of May. Aggregate adjusted earnings growth for the benchmark BSE Sensex companies at 3% yoy was significantly lower than expectations. The weak performance could largely be attributed to a substantial miss by some of the key index heavyweights. Excluding these, growth was relatively healthy at 12% (and more in line with consensus expectations). While revenue growth remained robust, the margins disappointed. Revenues rose a robust 25% yoy (ex Energy). But rising input costs took a toll on profit margins across sectors. The consensus earnings growth estimates for FY2012 are at 20%. We firmly believe that for an emerging economy like India where penetration levels, across sectors, remain very low the parameter to focus on may not necessarily be margins alone but earnings growth as well. As long as strong revenue growth feeds through higher net profits, we would not be overly concerned. Considering that India has just started to reap the benefit of demographic dividend, we think domestic consumption including consumer staples and consumer discretionary are long term winners in the game. We are quite positive on healthcare sector which has opportunities both in global as well as domestic markets. FY2011 trade data peg exports touching US$246bn up 38% YoY – significantly higher than the government target of US$200bn. Going forward, a combination of external factors might temper export growth, however, we believe that a renewed thrust on exports is positive for the economy as a whole and particularly for plays in the engineering, automobiles, pharmaceuticals and refining space.

Indian investors have been staying largely away from the equity markets for almost three years. While both wealth and income effect suggests that higher allocation towards equities is just a matter of time. Higher interest rates and volatility in the markets have been a dampener for flows into equity funds. However, we expect the trend to change in second half of this year. The positive triggers that the market has been waiting for is primarily big push from the government on the reforms front and softening of global commodity prices and consequently inflation in India. After the state elections results in which left parties have been voted out in their strongholds like Bengal and Kerala, expectations have increased that the government would now step up on the reforms agenda. The upcoming Monsoon session of the Parliament could see more bills being tabled, including the key GST, Land acquisition, mining and FDI in Insurance and Retail. The Government has also showed some strong intent in addressing the scam allegations, with several high profile arrests in the last month. Markets would also be watching progress of Monsoon closely. Poor monsoon could not only make the inflationary situation worse and complicate problems for the RBI; it would put tremendous pressure on government finances as subsidy bill mounts So far, the indications are that monsoon is likely to be normal this year. While the volatility in equity markets is likely to continue for some more time, valuations of companies have corrected sufficiently and there is value emerging at lower levels. Over the next few months, as markets deal with uncertainties on the global as well as domestic front, investors should take advantage of the volatility and increase allocation to equities in a gradual manner. 

The RBI monetary policy actions which focused on an inflationary stance delivered a larger than expected rate action of 50bps as compared to the market consensus of 25bps. The latest hike was the ninth increase since the RBI began hiking rates in early 2010 and has effectively raised policy rates by a total of 400bp. The 50bp is the first of that magnitude in the current tightening cycle and the tone of the policy statement remains hawkish.  The RBI acknowledged that the monetary tightening so far has being effective in checking aggregate demand, but rightly appears ready to sacrifice some near-term growth for stronger sustainable medium-term growth in a lower inflation setting.

The monetary stance and the weekly supply of bonds in an environment of resurgence of inflationary concerns led to an up move in bond yields over the month. The movement of short term rates has charted the liquidity scenario. The government cash balances with the RBI have moved from large surplus positions till March 2011 to huge borrowings under Ways and Mean advances (WMA) in the current financial year so far. Huge tax refunds and the draw down by states have resulted in Government borrowings under WMA staying above the limits. This has resulted in government resorting to issuance of Cash Management Bills, and higher issuances of regular Treasury bills. We expect that the liquidity situation could remain tight on the basis of higher issue of T-bills and the regular Gilt auctions. This could result in short term yields remaining elevated and having an upside bias in the near term. Our Fixed Income schemes had maintained a lower duration leading into the monetary policy. Subsequent to the up move in yields, we have been incrementally adding duration, primarily with a trading view in the long term funds. The elevated short term rates provide a good investment opportunity in accrual based products such as liquid, ultra short and Fixed maturity plans.

The near term outlook for Debt Mutual Funds would also be shaped by the regulatory guidelines which could impact flows into the funds. The RBI has recently capped the investments overall by a bank in Debt Oriented Mutual Funds at 10% of the Net Worth. The dividend distribution rate for corporate investors in Debt funds would also be aligned to that in Liquid Funds from 01st June 2011.

Navneet Munot