July marked completion of 2-months of the new government at the centre. The markets continued to give thumbs up to the new policy regime. The benchmark index closed nearly 2% higher over the month. Year-to- date, India remains one of the best performing markets in the emerging markets peer set.
The new government’s first budget rightly focused on the four pillars of the future India strategy – fiscal prudence, ease of doing business, attract financial savings to asset creation and give escape velocity to infrastructure development. Local macro indicators were mostly constructive. The monthly economic
indicators reflected an improvement, both in industrial production as well as inflation. The monsoon picked up after a weak June, though still being below average.
Thus far, government has sent right messages in terms of its intents and priorities. Decisions pertaining to controlling inflation, expedite decision making by abolishing all EGoM, bringing special focus on creating manufacturing competencies and steps to ensure steady flow of credit to infrastructure and housing sector are positive. Tough decisions like raising railway fares and continuing with fuel price hikes have been taken.
The prime minister continues to work towards creating a more cohesive and co-operative climate within the SAARC region with a long term objective of making it a strong economic union. Also rather than talking big, the focus is to set the ball rolling on execution and further fuel the economic positive reflexivity.
The external backdrop remained mixed. Policy developments in China were encouraging. Geo-political developments in the Middle East adversely impacted investor risk appetite. The US Federal reserve continues to taper the quantitative easing (QE) while guiding for an extended period of near-zero interest rates. We believe that if the current trend of improvement in the labour market and uptick in CPI continue then expectations on US interest rates may undergo a change.
The FII flows continue to be positive, with domestic investors turning buyers in the last couple of months. With the recent run up, the market is now trading at about 17x FY15E, which is marginally above the 10-year historic average. The consensus estimates continue to witness marginal upgrades. The 2-year forward earnings growth remains at around 15% CAGR.
Mid-cap valuations too have improved and are now trading above the 10-year average. The recent catch up in this segment has brought the mid cap valuations at premium to large caps. The market is certainly factoring a higher growth expectations from the mid cap space now. We expect this gap to continue given that mid cap corporates would remain a larger beneficiaries of the positive reflexivity in the economy. We also expect earnings upgrades to follow across the spectrum, with a larger dispersion in mid-caps as we go forward.
Going forward, we need to watch out for progress of 1Q FY15 earnings season, progress of monsoon and Government’s action on the ground. We expect Prime minister to announce his vision and blueprint on the economy as part of his Independence Day address on August 15th. The risk factors to watch out are – shift in global liquidity and interest rate expectations, surge of equity supply on-shore and geo-political developments. Emerging market investors have been substantially overweight on India given the relative attractiveness but any signs of improvement in outlook on China may lead to shift in incremental flows as a tactical trade given the valuation gap.
We re-iterate that India is in a sustained long term bull run on the back of slow but stabilizing macro, revival in corporate earnings growth, reasonable valuations and improving liquidity both from the foreign as well as domestic investors. Having said that, we expect the market to consolidate its recent gains in the near term as it absorb the current earning season and management commentary and concurrent large equity issuances. We expect the market to reward patient and disciplined investing. To capture the emerging opportunities, we have enhanced breadth of our investible universe to benefit from the opportunity that exists down the cap curve for the similar quality. We maintain our focus on bottom up stock picking for generating alpha.
Even as the RBI maintained status quo on policy rates which was widely anticipated, the accompanying statement has been perceived to be more hawkish as against a somewhat neutral/dovish undertone perceived in the June review. The reduction in SLR and the accompanying cut in HTM holdings are part of the gradual measures designed to reduce the regulatory pre-emptions on banking system to provide space for credit growth as the economy starts to recover. With credit demand remaining weaker and the government maintaining its fiscal consolidation targets, the timing of the same cannot be disputed. The RBI, while acknowledging the recent deceleration in inflation momentum, has provided a more cautious guidance on the 6% CPI target by January 2016 citing upside risks to the same. The near term negative market reaction can be attributed to the lack of any additional liquidity enhancing measures or a relaxation in daily CRR maintenance as also the higher stress given on the 6% CPI target, even as the RBI went ahead with an SLR cut.
Overall the policy indicates that the RBI is firmly focused on containing inflation expectations as per their medium term glide path. This reinforces expectations of an elongated pause in policy rates, while firmly ruling out any near term monetary easing driven by recent CPI moderation. The RBI’s cautious guidance also reflects the central bank’s assessment of a more lower output gap which could result in near term price pressures as demand and business confidence picks up, with supply side responses likely to act with a lag.
Overall the RBI is likely to adopt a more cautious stance as the economy transits from a high inflation, supply constrained, low growth trajectory to an environment where growth impulses revive with gradual inflation deceleration and execution of supply side measures by the government. On the liquidity front, recent buildup of government cash balances has been cited as the reason for volatility in overnight rates. The RBI is likely to consider additional term repo auctions, with modulation in both the tenor and timing to consistently maintain the rates in alignment with the policy rates stance.
We have been maintaining a moderately higher duration with a more medium term view on rates. At the same time, we would continue to tactically keep higher cash allocations to take advantage of market volatility. A steady moderation in CPI driven by both government actions and a vigilant monetary stance, would also provide more confidence of an eventual policy easing sometime over the next year.
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