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April 2015

While progress on the nuclear deal between Iran and western powers is a distinct positive, one gets nervous watching developments in neighbouring Yemen. Experience over the last couple of decades has made investors complacent about geo-political risks. Potential geo-political risks alongwith uncertainties created by extra-ordinary monetary experiment in the developed world present a left-tail risk that is difficult to hedge. This could be the reason that even in an environment of strong dollar and soft commodities, precious metals have been steady. The other safe haven, sovereign bonds in developed world are yielding extremely low returns both in absolute as well as real terms.

The government managed to get some of the important bills cleared from the legislatives, like - Insurance Bill which hikes FDI limit from 26% to 49%, Coal mining Bill which allowed government to auction coal mines under e-auction, and MMDR Bill which allows grants of mineral concessions through auctions, thereby bringing in greater transparency and removing discretion. The successful completion of auctions for telecom and mining resources is set to generate sizeable pool of annuity cash flows for the coming years. There was also an effort to provide relief to some of the gas-based power projects. As things stand, the critical bill pending legislation is pertaining to land acquisition where building the political consensus has been a big challenge for the government.

The management interactions and the ground level undertones have been bearish despite lot of action from the government side. Wealth effect is wearing off with declining activity in real estate, MSPs are stagnant and the recent hailstorms have not helped the cause either. The government’s efforts to rein in fiscal deficit by cutting expenditure, lagged effect of tight monetary policy and slowdown in exports are the other reasons for the slowdown witnessed ‘on the ground’. However, we have certainly moved from inaction to proactive action by the government while making assets on ground financially viable. The new regime has focused systemically on a policy reset with efforts on reducing leakages, increased financial penetration and market linked resource allocation – creating bedrock for transparency, accountability, and efficiency driven economy. Similarly, transmission of monetary easing done last quarter and benefits from fall in commodity prices will reflect in improved consumer and business sentiments in the coming quarters.

We expect government (both Centre and State) to push forth investments in the core infrastructure segments like road, railways, power transmission and distribution (T&D) and defense (localization), urban development almost immediately. We expect the government spending on infrastructure to lead to a virtuous cycle in coming 12-18 months.

On valuations, markets are trading at an above-average forward PE of 17.3x FY16E. The earnings for the quarter ending March 2015 are likely to disappoint but we believe positive momentum will start from the next quarter given the overall economic environment, softer rate cycle and improving sentiments. The reflexivity in earnings surprises and hence stock performance in the mid cap space should be even better given its deeper sensitivity to economic cycle.

Markets have been consolidating at the current levels for some time now and our view has been that incremental returns are likely to track earnings growth. FII investments at USD 7 billion YTD (in equities) indicate relative preference India enjoys globally. The trend should continue as India stands out in current uncertain global environment on multiple counts. There has been a recent trend where domestic investors have been more than contributing to positive market momentum than foreigners. As domestic household investments in capital markets increase, we expect this trend getting more established.

In line with market expectations, the RBI maintained policy rates after having delivered a cumulative 50bps repo rate reduction in Q1CY2015. The central bank has emphasized that the monetary stance remains accommodative with policy rate reductions contingent on incoming data. After the 50 bps reduction so far, based on CPI inflation consistently undershooting the glide path targets and considering the muted demand side pressures, the central bank has in this review focused towards ensuring policy rate transmission. Towards this, the RBI has proposed to encourage banks to migrate towards a uniform policy for setting base rates based on the marginal cost of funds. The RBI has also proposed to explore bank products pricing based on external market based indices. These measures and the Governor’s post policy briefing underscores the intention to align bank lending rate movements with the policy rate changes and thereby facilitate better monetary policy transmission. The timing of future policy rate reductions is contingent on transmission by banks of RBI’s front-loaded rate reductions, food inflation scenario (over and above transitory factors) and policy efforts by government to augment supply and hence growth. The expected normalization of the US Fed’s monetary policy stance would also have a bearing on the RBI policy stance.

The RBI has been sounding cautiously optimistic on the growth numbers. However, as highlighted by all market studies and RBI as well, a sustained pick-up in investment is the need of the hour to gain confidence in growth trajectory. On the CPI inflation trend, the central bank reflects increased confidence in inflation trajectory, even while flagging off upside risks. Based on current estimates, the upside risks appear to be offset with factors such as softness in global commodity prices and global deflation risks, lowering of household inflation expectations, weak domestic demand and government taking committed steps to address supply side constraints. CPI is estimated to remain at current levels in the first quarter, before moderating to around 4% in August and firming up to about 5.80% by the year end. On monetary policy stance, the revised framework agreed recently with the Government would shape the stance for the coming years.

A rigid adherence to the medium term CPI target of 4% +/-2% would probably preclude aggressive near term monetary policy rate reductions. However, as emphasized by the Governor, the RBI prefers real policy rates in the range of 1.5% to 2.0%.This would enable sufficient judgmental call on the trajectory of policy rates, considering the current business cycle and its likely evolution. Over the near term, CPI inflation is expected to average closer to 5.25% and with demand side pressures subdued, the RBI could have leeway to reduce policy rates further by about 25-50 bps, consistent with a real rate of 1.50 to 2.00%.

We would expect that with interbank liquidity improving in the current quarter after the March seasonality and also the maturing Forex forwards, liquidity conditions should remain surplus thereby prompting banks to pare lending rates.

The recent Monetary Policy framework agreed by the government and RBI , measures announced to revive investments, better targeting of subsidies and more active supply side management along with fiscal consolidation would enable a gradual and durable lower inflationary environment. This would enable policy rates and thereby market interest rates to move lower further and also avoid sharp course corrections in a short span of time, thereby rewarding medium to long term investments in bonds.

Regards,
Navneet Munot

(Mutual funds investments are subject to market risks, read all scheme related documents carefully.)

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