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June 2012

“Sell in May and go away” turned out to be true again as risk assets got sold off across the board. Treasury yields touched multi-decade low, US Dollar and Japanese Yen rallied while equities and commodities performed poorly. News flows from developed economies turned adverse, with the euro crises back at the forefront. The sentiments were dominated with higher probabilities of Greece exiting the European Union (EU) and rising bond yields of Spanish sovereign debt. The month was marred by concurrent concerns on domestic as well as international events. BSE Sensex closed down 6.3% m-o-m. Economic indicators continued to display trends of stress –
  • Industrial growth turned negative at (-) 3.5% in Mar-12. Output of eight core industries fell to 2.2% from 4.2% in the same month previous year.
  • GDP growth rate slipped to 5.3% in the 4th quarter last fiscal pulling down the annual growth for 2011-12 to 6.5%, lowest in 9 years due to poor performance of the manufacturing and farm sectors.
  • INR depreciated a meaningful 6.5% vs. the US Dollar over the month. This could be attributed to weak portfolio flows and higher trade deficit owing to moderation in the export growth. RBI’s efforts to shore up Rupee (like asking exporters to convert 50% of Forex into INR and hiking FCNR rates) had only a temporary effect.
  • WPI inflation rose once again to 7.23% for April vs. 6.89% in March largely on account of higher prices of primary articles.
  • The policy machinery did respond with select positive actions like petrol price hike (the most delayed and relevant pending action), New Telecom Policy and clarifying the confusion over the GAAR issue. However, given the major slowdown in fixed capital formation, a bolder vision and quick execution are required from policy makers.

Growth is central to Indian economic puzzle and certainly seems to be dipping right now. Currency weakness has impacted investor sentiments badly while negating the gains of fall in global commodity prices. The solutions are not immediate and the process should take some time to unwind with sustained incremental policy drive and a favorable external impulse.

The sustained worries on worsening fiscal situation, moderation in growth and sinking rupee did affect the sentiments on foreign flows. FIIs were net sellers with net outflow of USD 70 million as compared to an outflow of USD 250 million in the previous month. The 10-year benchmark G-sec yield also ended lower 8.37% (down 30 bps over the month).

The quarterly results season just got over and suggests a sharp deceleration in revenue growth. Margins remained under pressure, although the pace of decline is abating. Consequently, on a reported profit basis, aggregate earnings will probably remain modestly negative for the third consecutive quarter, the drag coming largely from Industrials, consumer discretionary and materials. Interest expense has also risen materially as highlighted by the rising interest-to-Ebitda ratio.

Amidst this environment of gloom, one shouldn’t lose sight of the long term opportunity. The structural India story for which everyone was bullish on India is almost intact. Favorable demographics, rising incomes and consumption levels, high savings, opportunities in infrastructure and outsourcing, robust market infrastructure, all these are still true. Froth of boom years is getting cleared. Of course, policy makers have disappointed big time but one has a faith on Indian democracy for its self-correcting mechanisms. Among the fracas of these scams, one cannot ignore voters’ choice for leaders focusing on 2G (growth and governance). In chaos one takes note of the resurgence of democratic institutions like Supreme Court, election commission, CAG and media. We will move away from crony capitalism to a more transparent, rule-based market structure. Of course, these transformations are painful. A weak currency will help in boosting exports and curb imports which will correct the current account deficit over the medium term. Fall in global commodity prices augur well for India from inflation, fiscal deficit and corporate profitability point of view. From a historical perspective, equity market valuations are reasonable.

There is no denying that macro situation is scary and very close to crisis days of 1991. Global environment couldn’t have been worse. In India aggressive transformation never happens out of conviction, politicians deliver them out of compulsion. We are reaching that point. S&P is surely helping. If history is any guide, these are precisely the time when you get great opportunities to accumulate risk assets. Periods like October 2008 to March 2009 where headlines scared all of us and not when everything looked so rosy, the way it was in 2007.

Next few months will offer a great opportunity to invest in long bonds and equities. One must be alert and maintain the discipline of asset allocation rather than getting swayed by the high volatility that we are likely to witness. Patient investors would be suitably rewarded for risks.

In our equity portfolios, we continue to focus on bottom-up stock picking with criticality of quality (earnings, cashflow, business franchise and management) and valuation to the ultimate delivery of long term sustainable returns. We remain tactically alert to accommodate any short term cyclical opportunities in our portfolio.

Bond yields fell despite concerns about higher supply and tight liquidity. Incoming macro economic growth data during the month surprised on the downside and has led to markets re-pricing expectations regarding the RBI monetary stance and actions. IIP and GDP data reflected broad based deceleration in economic momentum. The GDP data releases have reinforced the slowdown in investment demand while pointing to moderation in consumption demand. Headline WPI inflation came in marginally higher than expectation at 7.23% even as the core inflation reading remained below 5%. The recent significant moderation in international commodity prices, if sustained and the pronounced slowdown in growth numbers is likely to change the RBI policy rate guidance as given in the April review. The RBI resumed its OMO purchase program in the month as system liquidity deficit remained above the stated comfort zone and significant currency depreciation led to additional Forex interventions. The government bond yields reacted positively to the OMO program with the 10yr benchmark yields moving down by about 30bps during the month. Inspite of the RBI refraining from continuing with the OMO since the last week of May, the weak GDP print has resulted in markets now discounting the possibility of additional rate cut as early as the June review.

Money market yields have remained relatively stable during the month on account of relatively lesser supply. Incremental RBI actions are likely to proactively address the liquidity deficit in the banking system so that monetary transmission becomes more effective. Towards this objective we anticipate the likelihood of additional CRR reduction and other liquidity infusion measures on an ongoing basis. 

We re-iterate our positive views on interest rates and recommend that any spike in long term yields should be used as an entry opportunity. We would look to maintain a moderately invested position currently in Gilt funds on account of possible RBI interventions through secondary purchases/ Open market operations (OMOs). Accrual products have been delivering attractive returns due to elevated short term rates. We recommend SBI income funds to investors with long horizon and some risk appetite as the core portfolio is earning high current yield while there would be tactical opportunities in G-sec and corporate bond market. Given that yields are at their upper end of the long term range, this would be an ideal time to invest in SBI Income fund with investment horizon of over a year.

Navneet Munot
CIO – SBI Funds management Private Limited

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

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