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November 2011

After a series of stress months, October provided a refreshing relief with a tactical bounce in equities. The optimism was guided more by the perceived proximity to a probable resolution of the crisis in Eurozone.

The month witnessed a well-spread ‘risk-on’ trade across equities – driven more by sentiments. The flip-flop in EU did provide further stability to dollar which retained most of its smart gains of the previous month. The Dow Jones index rallied almost 10% in October, and the S&P 500 and NASDAQ surged about 11%. The gains helped the Dow clock its best monthly performance since October 2002, while the S&P 500's climb was its best since December 1991. The emerging markets too joined the party. The euphoria though has given up for higher caution with the distressed economies struggle to arrive at internal consensus to toe the line of required restrain in their respective finances. 

Large part of the equity gains for the month can be attributed to the perceived solution by the eco-political leadership of EU that was high on intent and did provide some clarity on the extent of damage that the system needs to take to accommodate Greece. The solution though failed to detail the path of advancement. The proposed initiative forces private banks and insurers to accept a 50% haircut on their Greek government bonds holdings under a plan to lower Greece's debt burden by 100 billion euros. The deal also simultaneously offers "credit enhancements" or sweeteners to the private sector totaling 30 bn euros. The aim of the package is to have an orderly restructuring of Greece debt, ring fence other large economies from contagion effect and recapitalize the banking system. 

We expect markets to continue to gyrate to the tunes coming from Euro zone. The end-solution is a double edged sword – an economically correct system runs a risk of strong political/social fallout while any confrontation on the economic solution runs the risk of dragging the global financial ecosystem into a deep freeze. The fiscal policy gridlock in US could be another source of uncertainty at least through the November 2012 elections. The impending spending cuts (if any) suggests the consumer to be tapped out, the US economy stands at a risk of weaker outlook without any liquidity assistance from the Fed. The Fed has already committed to near zero rates continuing through 2013, however, may have to embark on another round of quantitative easing if economy shows signs of weakening in next quarter.

The Indian markets did benefit from the global ‘risk on’ trade, the RBI’s indication towards a pause on rising interest rates going forward and sustenance of good results from some of the market heavyweights in technology (on the back of currency depreciation) and Consumer (on the back of continued consumption growth). FIIs pumped nearly half a billion dollar last month and have turned net buyer for the calendar year 2011. Domestic investors remained net sellers of equities. 

The macro data continued to disappoint with Index of Industrial production (IIP) for August coming in at 4.1% against expectations of 5% while headline inflation printed at an elevated level of 9.7% for the month of September. The markets have also been concerned about the policy paralysis for over a year now. There were announcements on some of the peripheral reforms (Cable digitisation, Pharma Pricing, telecom policy to name a few), we are facing the impasse on some of the critical inputs such as Coal which, if not addressed in time, has serious serial ramifications on sectors such as power, manufacturing and banking. The need for speed, might, and intensity of reforms is paramount than ever before.

The corporate results for the 2QFY12 have been a mixed bag. While the revenue growth at 18-19% was decent, higher input costs have dragged the bottom line growth to single digit numbers. Infrastructure due to higher interest costs and slow execution and banks with continuance of slippages and rising concerns on the asset quality outlook have been party poopers thus far.

Most of the management interactions do suggest that the latent consumer buoyancy in the rural India is still a bankable draft for corporate India to sail through when it comes to managing sales growth. The investment cycle in the economy though has almost close to standstill with marginal new commitments to Greenfield exposures.

Markets are driven by fundamentals, sentiments and liquidity. India has been a laggard by a huge margin this year to its emerging market peers. Almost each of the three variables has been adverse for a sufficient period of time and hence, institutional participation has been lackluster. The persistent selling by domestic players and a lower than expected FII trickle have not helped the cause either. Though, underlying promise of India story (with a compulsive balance on investment, consumption and export competitiveness), driven thus far by higher quartile RoEs and transparent operative systems does offer an interesting alternative in an otherwise opaque growth-less world.

Given the global macro environment, markets are likely to remain volatile. In such environment, our endeavor has been to retain a defensive bias in the portfolios while focusing on bottom-up ideas with strong businesses, managements that respect cash flows at good valuations. 

Government bonds continued to witness selling pressure after the government increased the borrowing amount for the 2nd half last month. The 10-year government bond moved up 45 bps during the month to close at 8.88%. The Reserve Bank of India hiked policy rates by another 25 bps but sounded dovish in its tone citing downside risk to growth. Markets reacted positively with the 10 year government bond yield falling by 10 bps, but yields inched up later on profit booking and supply concerns. Also, no indication of Open Market Operations (OMO) by the RBI dampened sentiments. Though inflation remains above RBI’s comfort zone, it is expected to moderate starting December 2011. The RBI has acknowledged the fact that growth has been moderating on account of the cumulative impact of past monetary actions. The Reserve Bank has revised downwards the baseline projection of GDP growth for 2011-12 to 7.6% from 8% earlier. The expected outcome on inflation provides room to the RBI to address growth concerns in the short run and thus the likelihood of a rate hike in the December review is very low. Considering further fiscal slippages on account of rising subsidy bill and lower revenue growth, bond markets are expected to remain jittery in the short term. Markets would find support on any news of relaxation of FII limits for government bonds or an announcement of OMO by RBI.

Bank deposits continue to show healthy growth (17.40% YoY), thus reducing the reliance of banks on the wholesale market. The deposit growth in the current fiscal year at 8.00% (Apr- Oct 7th 2011) continues to outpace the credit growth of 5.2%. Money market rates were under pressure on account of usual tightness due to the festive season as indicated by the LAF figures which crossed Rs. one lakh crores during the end of the month. Liquidity is expected to remain tight for the next few months but improvement in structural liquidity as reflected by the lower incremental credit deposit ratio, demand for wholesale funds by banks could be limited. 

Corporate bond spreads narrowed on lack of supply with issuers raising money through medium term borrowing suiting the FII investor. Also, demand from Insurance companies and Provident funds assisted in narrowing the spreads to 65 bps for the 10 year AAA PSU credit. In the near term, demand supply would continue to drive corporate bond spreads.

We believe interest rate cycle is nearing its peak. It is ironical to see bond yields touching record highs in the backdrop of possibility of a severe slowdown staring at us. Spike in yields due to supply concern should be used an opportunity by investors to invest in duration funds. Investors with risk appetite and investment horizon of over a year should consider the dynamic bond fund which is well positioned to take advantage of the volatility in the markets. With the short term corporate bond rates at elevated levels, we recommend short term funds to investors with a moderate risk appetite and an investment horizon of up to 6 months.

Navneet Munot