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October 2011

September was a painful month as equity, commodity and credit markets took beating on Euro land woes and faltering global growth. Gold that has been acting as a safe haven for a long time saw its price falling by 11.5% during the month. In a world gripped by fear and short on trust, US treasury yields touched record lows. 

The US Fed announced ‘Operations twist’ aimed at flattening of the yield curve by selling short term securities and buying long dated securities to the extent of $ 400 billion. The 10 year US treasury yield fell 30 bps to a record low of 1.90% while 30-year treasury yield eased by 70 bps to 2.91%. Given the credit conditions in financial markets and deleveraging by households, lower interest rates alone are unlikely to spur growth. Fed’s earlier move of quantitative easing resulted in rally in risk assets like emerging markets and commodities instead of helping in revival of growth momentum in US. The economic growth will remain depressed as the Fiscal maneuverability is quite limited while monetary policy is running out of ammunition. President Obama’s announcements on strategy for jobs creation didn’t meet market expectations. Leading indicators are pointing towards a flat growth with possibility of mild recession going forward. 

Investors were more focused on happenings in the other side of the Atlantic. Sovereign bonds of peripheral European economies and banking stocks tumbled as investors feared a Lehman moment like 2008. In terms of magnitude and complexity, this is surely a bigger solvency crisis, however, signs are emerging that policy makers are getting close to some resolution. There is realization that bold and timely steps are needed to avoid a Lehman point in Europe which could tip the whole world into a deep recession. An orderly restructuring of Greece’s debt should happen soon as default is inevitable. The challenge would be to stem the spread of crisis to bigger debtor nations like Italy and Spain while recapitalizing the banking system impacted by haircuts on sovereign exposure. Europe’s rescue fund, the European Financial Stability Facility (EFSF) would be enlarged significantly along with support from the ECB and IMF. All this should help in averting the crisis in near term; however, the structural issues persist. The correction in debt ratios through austerity measures amidst a slowing economy would create a negative spiral. Europe, or for that matter a large part of the developed world including US, will have to undergo a painful period of deleveraging and low growth for a long time. One of the silver linings is healthy shape of corporate balance sheets. Markets have been in disarray for sometime but at least quality blue chips there should bounce back smartly once the fear factor recedes. 

Risk aversion led to US dollar emerging as safe haven again and this time Asian currencies were not spared. Rupee weakened sharply as current account deteriorated and sell off in equities shrunk FII flows into India. Current account deficit widened to 3.1% of GDP in Q1FY12 due to increase in imports bill. From a higher base, export growth is likely to moderate further due to poor growth outlook of the global economy. Though we expect the Rupee to resume its upward trend as risk aversion recedes and lower commodity prices help the trade account. We also expect the international community particularly the US to increase the pressure on China for revaluation of its currency. This would be positive for all Asian currencies including the Rupee over the medium term. 

The contagion effect from global markets resulted in Indian markets showing heightened volatility during the month. Fall in rupee and weak economic data further impacted sentiments. FIIs were net sellers due to global risk aversion. Indian markets get impacted due to strong capital flow linkages and global risk appetite still continues to remain one of the biggest drivers for our markets. Markets ended the month flat with Sensex closing a percent lower compared to previous month. 

Though there could be a temporary bounce back, commodity prices are likely to remain soft given the global economic slowdown. We expect growth rates to moderate in China and that should put additional downward pressure on commodity prices going forward. Inflation has been one of the big negative factors from macro as well as corporate profitability perspective and we expect the pressure to recede. There are widespread signs of deceleration in economic activity. Fixed investment as well as consumption growth have been showing weaker trend. Higher interest rates, global uncertainties and policy impasse are taking a toll on the growth prospects.

We expect that RBI would acknowledge the growth deceleration and peaking of inflationary pressures and take a pause in monetary tightening soon. The lagged effect of policy tightening so far is yet to fully play out. There has been a policy impasse with most of the reforms getting stalled and execution being very slow for almost 2 years. Given the global environment, we expect the government to realize the need for urgent action on several fronts. This time we are also severely constrained on the fiscal side and growth push has to come from structural reforms and better execution than pump priming through deficit financing. We expect things to improve from hereon on these fronts. Mining bill, land acquisition bill, banking and pension sector related bills apart from taxation reforms are some of the areas where government is likely to focus. On infrastructure side, our sense is that activity levels in some areas like Road construction are picking up while a strong government intervention is required to sort out issues on sectors like power. 

Given the macro backdrop, over riding theme in our portfolios have been to stick to quality and defensive stocks. We have also been underweight on global cyclicals and sectors adeversely affected by policy paralysis and higher inflation. Our portfolios have positive stance on sectors like Healthcare, Telecom and Consumers while remaining underweight on metals, infrastructure and financials. As valuations are turning favorable, incrementally the bias is towards adding on to domestic cyclical like financials and industrial names. We remain focused on bottom up stock picking which we believe is the best way to generate alpha in the long run and the volatility induced by global factors is giving us a good opportunity.

Equity markets have been going through challenging times and given the global situation, it could be a while before we see a sustained upturn. But the global upheaval is giving an excellent opportunity to domestic investors to increase allocation to equities in a gradual manner. It is time to follow the famous dictum of Mr. Warren Buffet, “Be greedy when others are fearful, be fearful when others are greedy.” 

Bond yields came under pressure after the government announced an increase in the 2nd half borrowing calendar by Rs.52,800 crores, which would take the total FY12 gross borrowings to Rs 4,70,000 crores. Additional borrowings have been announced on account of slippages in the original estimated cash draw down from the previous financial year by around Rs 16000 crores and shortfall in estimated net collections from the small savings schemes. Markets could remain concerned on further slippages especially on the revenue side and the likelihood of the divestment target of Rs 40,000 crores being missed. In view of the additional announced supply and the fear of further slippages in the deficit numbers, Gsec yields in the near term could retain an upward bias. The 10 year benchmark traded in a range of 8.31% – 8.36% for most part of the month but the increased borrowing for the 2nd half of the financial year caused a sell off with the benchmark 10-year yield closing at 8.44%. Any significant change in policy stance and/ or a large scale OMO support from RBI could provide support to yield movements. 

The growth in bank deposits, especially time deposits continues to reduce the reliance of banks on the wholesale markets. The deposit growth in the current fiscal year at 6.00% (Apr- Sep 09th 2011) continues to outpace the credit growth of 3.4%. The money market segment witnessed its usual quarter end tightness with the 3 month CD yields touching a high of 9.40%. With the festive season starting and usually witnessing increased currency in circulation, money market rates could be under pressure but improvement in structural liquidity as reflected by the lower incremental credit deposit ratio, demand for wholesale funds by banks could be limited. 

Reliance on onshore funding markets is likely to increase as global bout of risk aversion leads to higher spreads on emerging market debt and also higher liquidity premium. Further modifications in the FII debt investments limits in the Infrastructural sector have been announced. These measures could lead to increased FII participation over a longer term. In the near term, the restricted issuer set, global risk aversion and pressure on Forex markets apart from withholding tax and minimum holding period could deter large scale flows. 

We continue to maintain a positive outlook on interest rates from a medium term perspective, but have tactically reduced duration on account of the excess borrowing which could pressure on rates in the short term. With the dynamic bond fund well positioned to take advantage of the volatility in the markers, we recommend investment in the fund to investors with a risk appetite and an investment horizon of at least up to a year. 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