Amidst the prevailing skepticism on global economy and markets, September turned out to be one of the best months for equities globally. On the back of massive liquidity flows, Indian markets had a decent move up with Sensex posting a gain of 11.67% during the month and closed above the psychologically important level of 20,000. Equity Indices are very close to the all time peak witnessed in January 2008. Foreign investors chasing higher growth poured $ 6 billion in a month and their year to date investment in equities is now at $ 19 billion. Domestic investors remained net sellers.
One of the noteworthy features of the rally over the last 18 months has been high premium for quality stocks. Companies with better quality earnings, balance sheet profile and good corporate governance are trading at significant premium to rest of the market. If liquidity flows continue at the current pace and the momentum leads to wider participation then we might see this premium shrinking as investors chase higher beta.
Robust capital flows led to sharp appreciation of Rupee against the dollar. It gained 4.5% during the month and closed below 45 levels against the dollar. Rupee had been under pressure on concerns about record Current Account Deficit, however, the trend got reversed last month with massive FII flows in equity market. Sentiments about rupee got a boost from government’s decision to hike the FII ceiling in bonds by $ 5 billion each for investment in corporate and government bonds. Given the interest rate differential and positive view on currency, we may expect higher flows in fixed income markets over the next couple of quarters.
While higher risk appetite has led to a rally in global equities and commodities, bond yields remained depressed. The 10-year US treasury yield is trading around 2.5% on demand for safe haven assets. Bond yields in developed countries are at levels last seen in Dec 08 when fears of a depression like 1930s were looming large. The financial crisis had its genesis in excessive credit risk and high leverage so reaction of investors of all herds could be termed as natural to flock towards something that is ‘risk-free’ as far credit risk is concerned. Investors have been overweight equities and having burnt their fingers so badly (over the last 1, 3, 5, 10 and 20-years, ‘risk-free’ treasuries have delivered better returns than US equities) are now trying to correct the asset allocation in favor of a performing asset. However, those paying excessive price for a predictable cash-flow and buying insurance against deflationary threats must also keep in mind the state of public finances and ultimate burden of unfunded pension and Medicare liabilities on the sovereign. Given the nature of debt deflation cycle, overnight rates at close to zero and current thinking of monetary policy makers, bond investors are justified in their super bullish views, however, one must keep a watch on valuation as margin of safety against ‘price risk’ is diminishing. Betting on mean reversion may not pay off always; ask anyone who shorted Japanese bonds anytime in last 20-years. So don’t get tempted to go against the tide early, still it could be long way to go. We may be long way off, but it is almost certain that a few years later, we would look back at some great bubbles of this decade including the ones in government and high grade bonds, precious metals and some of the currencies like Japanese Yen.
Inflation and growth expectations as priced by equity investors look quite optimistic when compared with their counterparts in the bond market. However, one must remember, that economic growth at macro level alone doesn’t drive the equity market performance. One needs to watch valuations, liquidity and sentiment indicators. While we have an extremely cautious outlook on growth prospects in the developed world particularly the US, blue chip equities have so far shown a huge resilience for a variety of reasons. Corporates have been accumulating cash through this decade and balance sheets are quite healthy. Blue-chip multinationals have also been a beneficiary of robust growth in emerging countries. PE multiples are in line with historic average and in fact, lower than several emerging markets. Last year, companies witnessed massive jump in profits driven by cost cutting and aided by low base, however, sustaining this growth in the backdrop of cautious outlook on macro economy and fears of higher government intervention would be tough. As the incremental data continue to show deteriorating picture on the macro side, stock markets could see a decline with higher volatility, however, pushing it sharply down would require a major negative shock in view of negative real interest rates and PE multiples at historic mean. While a possibility of severe ‘double dip’ recession in near future is somewhat unlikely, given the excess housing inventory, high unemployment, tight credit conditions, impending tax increases and wearing effect of stimulus should lead to growth faltering in quarters ahead. As the maneuverability on fiscal front is quite constrained, monetary policy will have to show extra ordinary courage and creativity in leading a combat against deflation induced by forces of deleveraging. The concerns are that policy makers are running out of ammunition and also, the fact, that long term implications of the remedies suggested could be quite dangerous. Now, what could be the fall out of the extra ordinary measures like massive quantitative easing, if any, taken by US FED.? Either the market loses confidence in ability of policy makers to ignite animal spirits; hence, risk assets get sold off. The other possibility is that this massive liquidity overhang chase growth and yield and find its way into assets like equities and bonds of emerging markets. While looking at domestic interest rates, we may find our equity markets fairly valued but a global investor pricing it with risk-free rate of developed world will find it quite attractive. Investors also need to keep in mind the solid long term fundamentals of Indian economy and corporate sector and coupled with the small possibility of left-tail risk of a global liquidity driven rally, trying to time the market may not be appropriate. Investing with a long term horizon within an appropriate asset allocation framework would be the best way. We continue to focus on bottom up stock picking while keeping a lid on macro environment and valuations.
In its mid-term policy review on September 16, RBI raised interest rates for the fifth time this year in a bid to move closer to a neutral monetary policy rate. It raised repo rate by 25 basis points to 6 per cent and the reverse repo rate by 50 bps to 5 per cent. The corridor between repo and reverse repo rate has now shrunk to 100 bps from a high of 300 bps. RBI mentioned that inflation and inflation expectation need to be anchored and negative real interest rates need to come to an end. The process towards normalization of policy rates is nearing end and incremental data flow would dictate further action. The repo rate as tool for transmission of monetary policy would remain an effective rate for some more time. However, in view of recent surge in capital flows, liquidity situation might improve sooner than we expected earlier.
We expect bond yields to soften in next quarter in view of global environment, further improvements in government balance sheet, drop in inflationary readings aided by base effect and expected pick up in Banks’ NDTL growth due to good inflow of overseas liquidity in to our economy.
We have been able to take advantage of tight liquidity and higher short term rates by re-pricing the portfolios at higher levels in case of our liquid, ultra short term and short term bond funds. We would look to increase duration in long term bond, gilt funds and MIPs in line with our view on interest rates. We reiterate our positive stance on bond yields, particularly the government bond segment and recommend investors with risk appetite to invest in duration funds which are positioned to take advantage of opportunities in fixed income markets.