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May 2014

While foreign investors have pumped in $ 5 billion into equities since the beginning of calendar year, domestic institutions have been net sellers. Sensex returns of around 5% in this calendar year can largely be attributed to improvement in macro situation and attractiveness of India relative to other emerging markets. Investors have concerns about China’s growth story, geopolitical issue of Russia-Ukraine and political and macro challenges in several other emerging markets. Bond yields across the world have been declining with yields in peripheral Europe, high-yield category etc falling to record lows. Strong investor demand, persistent low inflation and dovish signals from large central banks like US Federal reserve, European central bank and Bank of Japan have led to bullish trend in most of the segments of global fixed income markets. Unless the political mandate turns out to be extremely fractured, we believe that Indian markets have the potential to get lot more flows from global investors given the liquidity situation and relative valuation.

The Sensex ended almost flat in the month of April and the trend of mid and small cap indices outperforming the large cap index continued. Over the last 5 years, foreign investors have invested $ 90 billion and bulk of it has chased selective large cap stocks creating a big valuation gap between the ‘defensives’ and ‘cyclicals’ and also between large and mid and small cap stocks. This valuation gap has been getting corrected over the last 6 months with outperformance of cyclicals and also of mid and small caps. Given our view of bottoming of macro and corporate fundamentals and in the backdrop of investor’s positioning, there is still tremendous potential of alpha generation by broad basing the investible universe.

The earnings season is on and thus far it has broadly been in line with expectations. The benefits of weaker currency are accruing to sectors like IT, healthcare, textiles and engineering exporters. The street now estimates earnings growth of 9.4% and 15.2% for FY14 and FY15 respectively.

We maintain our view that macro fundamentals have bottomed with visible improvements in the external sector and early signs of recovery in the domestic growth. The collective efforts of the government and RBI in stabilizing the external sector have delivered good results. With decline in current account deficit and improvement in capital flows, Forex reserves have gone up from $ 275 to 310 billion and the currency has stabilized quite well. The IIP data is yet to show an upturn, however, deeper dive reveals that inventory levels are declining while construction companies are seeing build up in the order books after a very long period. There are near term challenges such as fiscal constraints, possibility of a poor monsoon impacting the growth and inflation outlook and stress in the bank’s balance sheet. However, a new government has the opportunity to unleash the growth potential by leveraging the structural strengths notwithstanding these near term challenges. The self-inflicted pain of low growth – high inflation syndrome can be corrected through better governance and right policy mix. Building physical and social infrastructure would surely be a major focus area for the new government. The next leg of growth has to be driven by reviving the investment cycle and boosting domestic savings that are channelized into productive financial assets. We believe incremental flows and concurrent firmness in currency would enable a positive reflexivity to the economic cycle for India. The current rally has a potential to gain sustained momentum when the local investors start increasing equity allocations.

Everyone is awaiting the election verdict on May 16th. Market is expecting a growth-friendly alliance to come to power. Going by the history, markets are likely to witness heightened volatility. Amidst the high decibel levels, we retain our focus on bottom up stock picking. We continue to stick to our belief to back businesses that have positioned themselves to benefit from economic revival through a well configured franchise, toned balance sheet and financial structure through the downturn, quality assets and competitive advantage to expand the exports footprint.

RBI in its April 1 monetary policy meeting maintained the status quo on policy rates with the broad direction of policy setting influenced by the Dr Urjit Patel committee recommendations. The policy stance underscores the disinflation “glide path” of achieving 8% CPI inflation by January 2015 and 6% by January 2016. Based on the current evolution of CPI inflation trends, RBI is likely to maintain a status quo on policy rates. In this context, a more directional stance on rates would primarily be dependent on the new government’s fiscal stance, with external sector developments also influencing the outlook on inflation. A more proactive liquidity management as seen in the last few months with term repo being the primary instrument would ensure that the overnight rates remain in line with the prevailing policy stance and also the short end of the curve remains well anchored in the absence of any additional liquidity premium.
Unlike past years, short-term rates didn’t ease significantly in April since this year rates were well behaved even heading into end of March with RBI comforting markets with regular term repo auctions.

The resumption of the government borrowing schedule was expected to result in yields remaining under pressure. Good investor appetite at higher absolute yields following the initial spike in yields, light market positioning and also replacement demand have however led to bond yields retracing from the highs. Long term government bond yields have also been supported by the lack of issuances in the corporate bond space following the notification of the Companies Act 2013. Even as yields corrected by about 30bps intra- month from the highs, government bond yields remained almost flat over the month.

Even as market positioning builds up leading up to the election verdict, a directional move in bond yields would be dependent on a more consistent and durable easing in CPI inflation and also the fiscal stance. Near term uncertainties surround the outlook on both. The Union Budget to be presented post the new government assuming office would provide better clarity regarding the prospects of fiscal deficit trends and the likely market borrowings for funding the same. The recent up move in global soft commodities and also the uncertainty surrounding the South West Monsoon could lead to markets repricing near term CPI inflation expectations. We expect that post the election verdict, the near term challenge would continue to be the evolving demand supply balance as the bulk of the bond maturities are frontloaded in the first 2 months of this fiscal.

We had been maintaining a cautious outlook on rates in view of the RBI policy stance and also the near-term challenges on the absorption of the government borrowing. A strong commitment on fiscal consolidation and concrete measures to ease supply side constraints by the new government could change the outlook as global backdrop is favorable for the bond market. We would continue to watch the events on the domestic political and global fronts which can have any bearing on the interest rates.

Navneet Munot
CIO – SBI Funds management Private Limited

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