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December 2013

The benchmark Sensex touched a new high in early November and markets have since been consolidating the gains. The equity market rally is becoming broad based with mid and small caps outperforming the large caps. Global environment was largely supportive through the month as better-than-expected growth indicators in key developed markets and policy tone remaining dovish helped investor sentiments. The investing world is now adjusting to the possibilities of tapering of QE by the Federal Reserve in the next calendar year.

At home, the government continued with commitment towards reforms with gradual increase in retail fuel prices remaining on track and also going ahead with immediate priorities on resource-raising like the PSU stake sale exercise. It has also reviewed the template for investments in telecom, refining and roads sector.

The current period is dominated by the election fever through four major states. Markets are taking these elections as the dress rehearsals towards the final showdown in mid-CY14 and hence their outcome would hold key to the interim sentiments, and also govern the direction of policy actions of the ruling coalition in the short term.

Macro economic data points released over the last month were mixed with growth potentially bottoming out at current levels while inflation data was higher on account of food inflation and currency depreciation. Unlike the trend over the past one year, core inflation has recently started moving higher in tandem with headline inflation and this is something that needs to be monitored closely. Balance of payment data for the period July-Sep 13 showed the Current Account Deficit (CAD) contracting to 1.2% of GDP as against 4.90% during Apr-June 13. We have been arguing that current account would surprise on the positive side and we are now seeing policy makers and street expectations moving towards a CAD of $ 50 billion in FY 2014 against $ 88 billion in FY13.

The earnings season was a respite to the overpowering nervousness that prevailed at the beginning. For the broad market, revenue growth accelerated. The market now estimates earnings growth of 9% and 18% for FY14 and FY15 respectively.

As things stand, markets have been getting over worries about the policy paralysis, twin deficit, and slower GDP growth. We seem to be successfully withering the crisis of confidence one witnessed in early part of the year. Most of the issues on economic parameters, governance and corporate profitability seem to have bottomed out.

The recent move of the market has also demonstrated its bias towards a favorable outcome from the impending elections. One expects to get a healthy infrastructure template ready to roll out post elections. Concurrently, lack of credible, investible opportunities in the emerging market peerset also makes it a destination for long term return seekers globally. The market momentum may gather pace if the domestic investors return in the near future.

While maintaining a quality bias, our portfolios are increasingly shifting the tilt from defensive to cyclicals as growth and corporate profitability are close to bottoming out. While remaining vigilant on value opportunities due to volatility induced by global events, our focus continues on bottom up stock picking.

RBI policy stance in the recent past has been guided by two major overlaying factors: volatility in Rupee and and inflation expectations. RBI introduced a subsidized currency swap facility that incentivized capital flows into the country via FCNR deposits and overseas bank borrowings. The swap facility has significantly surpassed expectations by attracting more than USD34 billion in inflows over the last 3 months. In response to the inflows and delay in US Fed QE tapering, the rupee recovered sharply from its record lows in August. Amidst stability in the currency, RBI in September gradually started the process of normalizing the conduct

of monetary policy. In its latest policy meeting in end-October, RBI further reduced the MSF rate by 75 bps from 9.5% to 8.75% thus bringing it close to its pre-tightening level.

In the near term, the trade balance trend that has swung in favor of rupee is expected to continue leaving the currency well-supported. Meanwhile, sentiments around the US Dollar had recently reached extreme negative levels. Furthermore, the Fed is likely to announce the beginning of QE tapering within the next 6 months. This is likely to provide a bid to the dollar. Considering the above mentioned factors, we expect rupee to remain relatively range bound in the near term. Government commitment towards maintaining the Fiscal deficit targets have been an added positive, even as the quality of adjustment continues to be debatable. Broadly, we expect external events to have more of a bearing on the near term direction of rupee.

Even as currency related pressures have substantially receded in the last couple of months, RBI has had to particularly focus on inflation of late as both core and headline inflation have significantly taken a turn for the worse. The food component of inflation indices is becoming extremely unpredictable with fruits and vegetables, dairy and meat products etc showing lot of volatility. Going forward, the evolution of inflation trajectory is likely to influence additional moves on the repo rate. To the extent we expect inflation to remain at elevated levels in the near term, RBI is likely to hike the policy rate at least one more time in the next few months. RBI also would like that real rates remain attractive for some time in order to boost savings and restrain consumption.

Yields were higher on the month with the current 10-year gilt yield selling off by 11bps to 8.74% Note that new benchmark 10 year gilt (8.83% coupon) was issued in the month and the old 10 year benchmark bond (7.16% coupon) is currently trading at a roughly 30 bps higher yield. Towards, the end of the month, systemic liquidity conditions have eased significantly on account of large scale mobilization of NRI deposits by banks.

In the near term, the RBI is less likely to use OMO as a liquidity infusion tool, since the recent flows under the subsidized FCNR and bank borrowings have led to reserve money accretion through the Net Foreign Asset route. The recent easing in liquidity conditions, if sustained may lead to a tactical pull back in yields, given the fact that the borrowing schedule is relatively light in the coming quarter. On a more directional basis, the RBI policy stance and the fiscal deficit trends would determine the medium term direction. The trajectory of inflation, especially the Consumer Price Index may determine further moves in the Repo rate. Overall, in view of the renewed focus on inflation, further policy hikes cannot be ruled out, with the extent and sequencing likely to be moderate and gradual in view of the disinflationary impact of below potential growth. The front end of the curve looks relatively attractive in the current situation on a risk – reward framework while long bond yields are likely to remain range-bound.

Navneet Munot,
CIO, SBI Funds Management Pvt Ltd.

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