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August 2011

We were surprised by the resilience shown by global markets and have been highlighting that the developed world is mired in a deep public debt crisis which would continue to hound markets for a very long time. US Federal Budget impasse has temporarily been averted with government avoiding possibility of a technical default on August 2 but growth deceleration fears will keep sentiments depressed. Fiscal austerity is now forced upon at a time when economic growth is moderating and monetary maneuverability is quite limited.

Unemployment situation is likely to worsen with economic as well as political repercussions in years to come. European Central bank has turned hawkish and increasing rates when peripheral Europe is going through a deep crisis and needs lower funding cost. US Federal Reserve has no room to cut rates and the two massive quantitative easing programs have not helped in reviving the economy. Rather the liquidity injection found its way into various risk assets overseas like emerging markets and commodities. We believe given the fiscal tightening expected in US, the Federal Reserve may have to embark on another round of quantitative easing though it may not help the economy much given the powerful forces of deleveraging. The Fed will mention higher tolerance for inflation in the medium term and use rhetoric to convince the markets about continuance of extra ordinary loose policy and zero rates for a very long time. Policy makers around the world reacted to the credit crisis in a most synchronized manner ever seen in history. But since the middle of 2009, it became ‘A tale of two cities’ with developed world continuing to deal with deflationary risk while emerging economies fighting a battle against inflation. We believe that in a hyper‐ connected, finance‐driven, globalised world, there would be some convergence again. We have been bearish on commodity prices in view of expectations of moderating growth, shrinkage in global liquidity, and technical rebound in US Dollar and speculative unwinding. This should take the pressure off from inflation leading to softening in stance by central banks of emerging countries. The upward risk to commodity prices could be from expectations of another round of quantitative easing and more investment flows due to rush towards hard assets, however, we believe demand destruction would play a bigger role in taking the speculative froth away.

Indian equity market has been one of the worst perfoming markets this year with Sensex losing 11.27% year‐to‐date. Domestic macro situation has deterioarted with sticky inflation and slowing growth momentum. Corporate profitability has been under pressure due to increase in interest rates, raw material costs and wages. There has been concerns about the political situation where policy impasse and a series of scams and scandals have taken their toll on business confidence, infrastructure spending and capital flows.

Though resilience of private consumption and huge growth in exports have been the silver lining. Foreign Direct Investment (FDI) flows have shown some improvement over the last few months. Foreign Institutional Investors have turned net buyers with $ 2 billion of net flows year‐to‐date. Though domestic investors have largely stayed away from the market. Of late, there has been visible improvement on the reforms front with clearance of Reliance‐BP deal, fuel price increase and duty rationalisation, cabinet re‐shuffle, committee of Secretaries recommending 51% FDI in multi‐brand retail and announcement about government’s intention for direct subsidy transfer through UID. There are a number of legislative bills including the Lokpal Bill, Land acquisition, The Mining bill and prevention of Money Laundering amendment bill that are likely to be introduced in the winter session of Parliament. The other positive factor for the market would be signs of rate cycle peaking out which has been one of the biggest concerns for last one‐year. Market would be keenly watching progress of Monsoon and sowing season as any shock on food prices could aggravate the situation on inflation and fiscal front.

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.

Given the global situation, our markets are likely to exhibit higher volatility with a downward bias in weeks ahead. As ‘risk‐off’ trade gains momentum, Indian markets could also see a sell‐off. However, we believe that despite the concerns on domestic macro, on a relative basis, Indian economy would do well in a global context. Sluggish global economy putting downward pressure on commodity prices is actually a good news from India’s perspective. Commodity price decline augurs well for our economy and corporate profitability.

Markets are reasonably valued in line with historical average and there is potentail for around 15‐18% returns over a one‐year period as markets start pricing in earnings growth for FY 2012‐13. 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. It has been a challenging period for investors in the equity markets, however, as history has shown dark clouds are always followed by shining sun and this time would be no different.

Reserve Bank announced a larger than expected 50 Bps hike in the Repo rate in quarterly monetary policy review. Persistent elevated inflation and the lack of supply side responses along with a largely accommodative fiscal policy have increasingly resulted in stronger monetary actions to restrain aggregate demand. Controlling inflation has emerged as the predominant concern for maintaining the medium term

growth trajectory. The policy stance is dominated by the imperative to maintain an anti inflationary bias. The policy actions largely followed the script of the annual policy review in May, where the stance of the policy had decisively shifted to controlling inflation and anchoring inflationary expectations. RBI has maintained its baseline growth projection for the fiscal year at 8% and simultaneously increased the inflation estimate to 7%. RBI has also highlighted that the overall buoyancy in consumption on account of increase in real wages could restrain significant growth moderation. With the RBI having increased rates by 125 bps in the last 3 months, the additional policy actions are likely to be spaced out and in response to incremental data points. We believe that RBI would soften its stance soon in view of evolving global situation and signs of growth moderation becoming more evident. The lagged effect of policy tightening is yet to play out fully and further tightening could choke the growth momentum more than desired. We think that we are at the peak of rate cycle and bond yields are attractively priced.

The larger than anticipated action resulted in market rates moving up by around 10bps across the curve especially in the 10‐year segment. The benchmark 10‐year G‐sec yield inched up to close at 8.45% against 8.33% in end‐June. We believe that global environment has turned very favorable for bonds. Given that central bank action in developed world and risk off trade will keep yields in those markets at suppressed levels, we will attract capital flows in some form as money finds it ways when there is an arbitrage. We also expect bank deposit growth to surprise on upside with further moderation in credit growth which would bring down money market yields and also lead to banks turning bigger buyers of bonds. Our biggest concern has been fiscal situation where possibility of higher than budgeted borrowings has been keeping G‐sec yields under pressure. However, our view is that Reserve bank could absorb a part of incremental supply in the second half and global factors would be a bigger driver for the bond market in next few months. We recommend exposure to our Short term fund and Dynamic bond fund to investors with risk appetite and long term horizon given our positive view on direction of bond yields. Dynamic bond fund would be in a position to take advantage of opportunities across market segments and yield curve spectrum.

Navneet Munot
CIO – SBI Funds Management Private Limited

(Mutual funds investments are subject to market risks, please read the scheme Information document carefully before investing.)