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May 2012

After an eventful first quarter, one witnessed an awfully yawning April where markets refused to take a direction and closed marginally down (-0.5% m-o-m). News flows from developed economies was mixed. Growth indicators held up well in the US but disappointed in Europe and Japan. BoJ and ECB continued with monetary easing. Although towards the end, markets started getting nervous on worries about Spanish public debt. Going forward, impending election season across the key global economies is expected to provide the undercurrent to most of the policy initiatives that one can witness.

Through the month, Indian capital markets were at the receiving end of a couple of negative developments from a global investing perspective as – 
  • S&P downgraded India's sovereign rating outlook from stable to negative but kept the rating unchanged at BBB- (due to slower investment cycle and economic growth coupled with a wider current account deficit).
  • GAAR: The confusion on the taxation to global investing flows (FDI and FII) remained ambiguously unaddressed. This had a direct impact on the foreign participation in the markets. One expects the government to provide the required clarity on this front to allay concerns of global investors. 
On shore, the trends remained mixed both on economic as well as policy indicators – 
  • The Index of Industrial Production (IIP) for February’ 12 got reported at 4.1% against market expectation of 6.8%. The markets though remain concerned with substantial restatement of historic data points.
  • Reserve Bank of India surprised positively with a 50 bps cut in the repo rate. The tone of the policy statement was more hawkish indicating limited scope for further cuts given the upside risks to inflation.
  • The headline inflation number for March’ 12 was largely in line with the expected number at 6.9%. Core inflation fell below 5% for the first time in last two years. 
  • Rupee continued with its downward spiral and ended at 52.7 against the dollar (down 3.7% m-o-m). Given the high current account deficit, the currency is extremely vulnerable to capital flows. Export growth has slowed down while change in outlook on sovereign rating to negative by S&P led to decline in FII flows in both equity and debt markets. Forex reserves were off the 17-month lows. 
  • The sentiment in bond market remained cautious despite higher-than-expected rate cut as inflation outlook remained worrisome due to weakening INR and elevated crude oil prices. 10-year benchmark treasury yields increased by 13 bps to 8.67% over the month.

The market liquidity remained lackluster with lesser than normal participation of the Foreign investors. Foreign institutional investors (FIIs) sold US$ 206 million worth of equities during the month. Domestic Institutional Investors (DII) were net buyers of US$ 151 million during April. Year till date, FIIs have invested US$ 8.6 billion into Indian equities. The earnings season is showing a mixed trend. The muddle-through eco-political setting is challenging the resilience of proven business models and entrepreneurs to show endurance to steer through this environment. A granular review of the earnings thus far, makes us stick to our view that we are currently traversing through the bottoming-out process of the earnings downgrades cycle in India.

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 superior returns. While we are cautiously optimistic on the outcome of the current investing environment, we remain committed to businesses that concentrate on shareholder returns and their sustainability. We also remain tactically alert to participate in opportunities that can accommodate benefactors of any turnarounds on policy front as well as economic outlook. 

It has been a challenging environment for investors since equity as an asset class has under-performed other asset classes for couple of years. If history is any guide, the trend should reverse, though it is difficult to predict the turning point. We recommend investors to maintain the discipline of asset allocation and invest in equity funds through systematic planning as long term fundamentals remain intact. The RBI cut repo rate by 50 bps but the guidance on further rate cuts was muted. The RBI highlighted upside risks to inflation and continuing pressure on the fiscal side constraining headroom for further rate reductions. The bond markets rallied after the surprise rate cut, however, gave up all the gains soon as concerns about supply, tight liquidity and weak rupee impacting inflation came to the fore. The systemic liquidity remained under stress as markets nervously watched a weakening rupee. Continuation of liquidity tightness in excess of the RBI comfort band of +/-1% NDTL has kept money market rates elevated. Short term  3 month CD rates have retraced from the March peak levels by around 200 bps, but still trade around 165 bps higher than the overnight rates. Long term yields have traded in a volatile range with an upward bias during the month, in spite of a net supply of only around Rs270bn including the redemptions and the secondary market purchases by the RBI. Going forward , considering the higher net supply during the coming months, in the absence of RBI support,  yields can potentially test near term highs. Credible Fiscal policy adjustments and any moderation in crude oil prices would  have an important bearing on the sequencing and pace of  additional rate reductions and market sentiments. Over the coming months, we expect volatility in yields giving largely tactical trading opportunities.

A structural improvement in money market liquidity would require that both the deposit – credit growth mismatch gets corrected and the pressure out of Forex intervention subsides. The resumption of CD rollovers over the next few weeks could lead to an upside in yields from current levels if liquidity remains strained. We anticipate RBI to be more aggressive in providing liquidity in case of further stress considering the requirement of efficient monetary policy transmission. This might cap sharp upward spikes in money market rates as seen in March 2012. 

Any large spikes 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). We would look to maintain a higher duration on an ongoing basis once there is more clarity on the rate cycle and fiscal situation. In the interim, we would maintain a conservative duration with a focus on accrual through 1-3 yr AAA bonds and 1 year CDs in income/hybrid products. 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 Pvt Ltd

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


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