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September 2011

The global economic outlook has deteriorated considerably with weak data emanating from all parts of the world. The world was coming out of a severe balance sheet recession and expecting a sustainable robust recovery was asking for too much. Balance sheets of households and governments got way too stretched and re-balancing process would be long and painful. Policy rates are almost at zero levels and there is limited ammunition left on the monetary side. The quantitative easing in US and Japan didn't help much in reviving the economies there and rather the money found its way into assets like precious metals.

Concerns about the health of public finance in US and Europe combined with low rates have led to investors chasing safe haven or relatively higher yielding currencies such as Swiss Franc, Australian Dollar, NewZealand Dollar, Canadian dollar and Brazilian Real etc. Several of these currencies have become extremely overvalued and pose acute threat to their economies with the risk of a deflationary development. Their governments and central banks would be fighting tooth and nail to combat further appreciation. Japan is facing a similar situation and an overvalued Yen would be one of the biggest hurdles in economic recovery after being hit by a Tsunami earlier this year. Though China should logically be opting for a more aggressive Renminbi appreciation given the high domestic inflation, it doesn't want to sacrifice on exports competitiveness. US and Europe actually need weaker currencies to get them out of deep debt problems and fears of recession, however, the problem is nobody else wants appreciation in its currency. One of our major worry has been threat of a looming currency war with every country adopting “beggar thy neighbor” policy. This should ultimately in the longer run lead to a higher inflationary environment. Having said that, we maintain our bearish outlook on commodity prices in the near term in view of deteriorating economic outlook.
 
Post the downgrade of US sovereign rating, equity markets have taken severe beating while treasury yields have touched record lows. Gold has rallied strongly while other commodities have declined in a typical ‘risk-off’ trade. Situation in peripheral Europe is not showing any signs of improvements. Bond yields, credit spreads and banks stock prices are indicating rising fear factor. This is not only a liquidity crisis but also a solvency crisis and no quick fix solutions can bring confidence back. Unfortunately the political leadership and cohesive approach that is required to deal with monumental challenges that the anglo-saxon world is faced with seem to be lacking.

In this backdrop, Indian markets have also shown greater volatility. We believe that a growth moderation in rest of world augurs well for India as it leads to lower commodity prices and increases relative attractiveness of India from growth differential point of view. We expect RBI to soften its hawkish stance in view of global uncertainties and slowing down of growth momentum. We don’t expect big bang reforms, however, there are evident signs that government is recognizing the challenges and incremental actions are positive. While the crisis in Euro zone and rest of the world would impact India as well through trade and capital flow channels, we believe that India is relatively better placed. External balance sheet is strong with adequate Forex reserves, financial sector is well capitalized and economic growth has higher resilience due to domestic demand driven growth model. Household and corporate balance sheets are less leveraged and even sovereign debt to GDP ratio has declined over the last couple of years due to strong growth in denominator (nominal GDP).     

A historic anti-corruption movement led by social activist Mr. Anna Hazare caught the attention of whole country and political class had to take cognizance of that and parliament adopted a resolution to bring anti-corruption law as proposed by the civil society. It has been an eventful year with unearthing of so many scams, hyper-active judiciary and media, arrest of ministers and business leaders; all of this have led to policy and execution impasse. But we strongly believe that these events in the longer run are positive as it would lead to structural reforms, improved governance standards and bring more transparency in the system.

We have been maintaing a cautious stance in portfolios given the macro backdrop while focussing on bottom up stock picking. We have been underweight sectors that are leveraged on global growth prospects and also those that are adversely impacted by high inflation. Prefernce has beeen for companies with stronger balance sheets, pricing power and higher visibility of growth. Our portfolios have positive stance on sectors like Healthcare, Telecom and Consumers while underweight on Metals, Infrastructure and Financials. We haven’t really changed our stance very aggressively but are definitely looking into go lighter on Consumers. While consumption remains a secular long term story we are worried about near term upside risks on alternate sectors. We are looking to add quality names in the Industrials space as valuations are turning attractive.

It has been been a challenging period for investors in the equity markets while all other assets classes (fixed income, gold, real estate) have done well. We believe, domestic investors seems to have turned seriously underweight on equities as an asset class and there is potential for significant flows from them in the long run.  We continue to recommend that investors should take advantage of the volatility induced by global factors and increase allocation to equities in a gradual manner as long term prospects remain intact and valuations are favorable. 

Renewed concerns regarding the fragile macro economic situation both in the US and the Euro Zone and the higher risk aversion sentiment post the US sovereign rating downgrade dominated the trajectory of bond yields. The easing in UST yields and the downward movement in global crude prices supported market sentiments, resulting in the benchmark 10 year G-sec yield trading as low as 8.20% during the month. In spite of the recent volatility witnessed in Index of Industrial Production (IIP) and weekly inflation numbers, we anticipate that the monetary policy tightening phase is closer to peak. The weak near term growth prospects in the developed world and the impact of recent aggressive monetary tightening in the emerging markets would restrain further build up in commodity prices in a sustained manner. This apart the lagged impact of previous aggressive monetary tightening in a scenario of deficit systemic liquidity has substantially improved the monetary transmission mechanism. The money market segment continues to reflect the improving systemic liquidity scenario with the short end CD’s trading in a range of 9-9.20% during the month. The structural improvement in liquidity situation reflected in higher deposit growth vis a vis the credit growth is likely to keep the money market rates stable in a range.

We have increased duration across all medium to long term duration schemes in line with our view on the near term trajectory of rates. We continue to recommend dynamic bond fund for investors with a risk appetite and an investment horizon of at least up to an year. This fund is well positioned to take advantage of volatility in market movements which is likely to be the norm in the near term as market takes cues increasingly from both global moves and domestic inflation prints. The money market funds have been actively looking to re-price the portfolios with a focus on highest credit quality and ensuring sufficient scheme liquidity and diversification.

Regards,
Navneet Munot

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