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February 2011

Equity markets fell with Sensex losing 10.6% in January as investors got jittery about the macro situation and political gridlock after unearthing of a spate of corruption scandals. The government seems to be besieged by scams and scandals and the legislative business is in complete halt. The geopolitical situation in Egypt and Tunisia led to fears of a contagion risk impacting all emerging markets. Investors which poured record flows into emerging markets are taking some money off the table while developed markets saw net inflows. Developed market equities have got some tailwinds from a strong cyclical recovery, robust earnings and financial profile of corporate sector and relatively attractive valuation while sentiments about emerging countries are spooked by fears of rising inflation and interest rates. This trade was long due and tactical in nature as over the longer period, a larger share of global pool of investible money would continue to shift towards emerging markets on a structural basis. The cyclical recovery in developed world has largely been driven by the policy stimulus and deleveraging by households and stretched public finance would hamper the growth prospects for an extended period.

Whole world is facing inflation in food prices driven by a spate of climatic problems and constant increase in demand. There are already instances of food riots in some parts of the world similar to the ones witnessed in 2008. The world needs another green revolution to meet with rising demand for food as the problem is structural and not a cyclical one. Investors are turning bearish on growth outlook for emerging countries, however, there seems to be a consensus on the direction of global resources prices and speculative interest in a wide range of commodities is at record high. Indeed, the rising industrialization and consumption levels in emerging world would put upward pressure on resource prices over the long run, however, the trend has got over-extended as far as near term is concerned. We would not be surprised to see softening in several commodities in the months ahead.

The macro outlook for India has deteriorated over the last few months. The inflation has been sticky and now the trajectory is upwards. Higher inflation can be attributed to a variety of factors including robust demand conditions in India created through loose fiscal and monetary policy post Lehman crisis, number of government initiatives to boost farm and rural incomes and rise in global commodity prices due to a strong cyclical recovery and quantitative easing by central banks. There are signs that the inflation in primary articles can seep into broader level inflation in view of limited supply response in manufacturing sector and labour market. There is a serious risk of a wage-price spiral unless decisive steps are taken on demand containment as well as supply augmentation. RBI’s policy action clearly indicates its helplessness in containing the damage. Inflation, particularly in primary articles has become very sticky. In India, unfortunately, RBI has always borne the brunt of dealing with high inflation through monetary measures whereas augmenting supply side through reforms and reducing fiscal deficit are critical in containing inflation and inflationary expectations.

The other concerns on macro front are high levels of current account deficit and budget deficit. RBI has also sounded caution on current account deficit and the financing pattern as it leads to vulnerability on account of volatility in global risk appetite and flows. The very recent trend in trade data shows improvement, however, one needs to keep a closer watch. Given the political situation, stickiness in expenditure pattern, pressure from high subsidy bill on food, fertilizers and fuel, lack of one-off receipts like telecom licenses and big ticket disinvestment, the finance minister would find it tough to meet even the FRBM target of achieving fiscal deficit target of 4.8% of GDP for FY 2011-12. Given the impending move towards unified Good and Services Tax (GST) and Direct Taxes Code (DTC), there is unlikely to be much tinkering with the tax rates in this budget. The need of the hour for the government is to break the political gridlock and move fast on implementing the reform agenda. High fiscal deficit along with tight monetary policy which works with lag could seriously impact the growth prospects in FY 12 and beyond. Looking at the monetary and banking statistics, the government could crowd out private investment next year when reviving the investment cycle is so critical. There are early signs of a slowdown in growth momentum as witnessed in declining imports, industrial activity and crawling pace of execution on the infrastructure front. Given the backdrop of macro concerns, outlook on corporate earnings growth has weakened. As we have been cautioning that margins could be under pressure due to increase in raw material prices, wages and interest rates. Higher inflation, rising rates and tight liquidity could also impact discretionary spending. For these reasons, investors have preferred global cyclical sectors like technology and metal stocks.

Looking at the sentiments in equity market, there is a sense of gloom which is in stark contrast to the exuberance witnessed in early November. Undoubtedly, the macro picture has deteriorated and there are dark clouds looming on political and economic front. Of late, watching and reading media reports are quite depressing, but as history has shown, our politicians may not deliver out of conviction but have never failed in delivering out of compulsion. And there are compulsions today. Recent clearance of POSCO project after being held up for a very long time by the environment ministry is one such sign. We also believe that events in Egypt or hyper-noise in India about the corruption issues would lead to structural changes in governance standards. Apart from these events, politicians would be taking note of the verdict in recent state elections and importance of growth and governance in our electoral democracy. There is extremely limited maneuverability on the fiscal front; however, we expect the government to use this as an opportunity to re-iterate its commitment on the reform agenda. Foreign investors poured in $ 29 billion last year and we highlighted the risk of some of the money moving out. However, we believe that domestic investors would return to equity markets at lower levels as relative attraction of real estate and gold fades. Indeed, higher interest rates would lure investors towards safe deposits; one must not forget that timing the investment in equity market is easier said than done. The long term fundamentals of Indian economy remain absolutely intact. Favorable demographics and changing social and cultural fabric, potentially large investment in infrastructure, opportunities in manufacturing, rising disposable income and consumption levels have been some of the key themes driving markets over the last decade. Most of these ‘stories’ are very much intact. Till few months back, markets were pricing in all the possible positives with the economy and individual companies while ignoring any risk. But over the next few months, fear is likely to overtake greed as markets would price in every possible bad news. Surely, corporate earnings growth will take a hit but what we need to assess is how much of it is already in the price. Most important thing for investors is valuations and we believe that large part of froth has been taken away and as markets focus more on near term macro, great long term opportunities are emerging for a patient investor.

The RBI increased policy rates by 25 bps while sounding hawkish on inflationary outlook. The effective policy rate (operative rate changed from reverse repo which touched a low of 3.25% to repo rate now at 6.50%) has moved up by 325 bps while systemic liquidity has moved from an excess of over a lakh crore to a deficit of similar amount. Bond yields are likely to remain range-bound with slightly downward potential and could resume the upward trend post the announcement of Union Budget. Money market rates would be driven by systemic liquidity and demandsupply factors. Though liquidity conditions could improve a bit as government spends over the remainder of financial year, rates are likely to remain elevated due to constant supply from banks. On the positive side, we believe that deposit growth would continue to inch up given the substantial rise in deposit rates and would ease the pressure on systemic liquidity over a period of time. We recommend investors to take advantage of high money market rates through accrual products like Ultra short term, short term bond fund and fixed maturity plans.

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.)