The markets have given up their entire gains of the current calendar year on the back of persistent worries about global growth, Eurozone and geopolitical issues in the middle-east, disappointing corporate results, FII’s concerns on applicability of MAT and uncertainties about Monsoon.
The rating agencies joined the positive rhetoric on India outlook. With improving macro, political stability, inflation targeting by RBI, stronger buffers in terms of external sector etc, a rating upgrade is a question of “when” and not “why”. While some of the issues in terms of corporate sector balance sheet and real estate sector do remain, we believe for its demographics and institutional stability, India would receive better treatment relative to other economies by rating agencies.
We are also witnessing continuing interest of the domestic investor in equities with flows averaging almost a billion dollar every month. FIIs flows till date have been positive this year barring a small outflow in April on the back of currency worries, some shifting towards Chinese markets given its strong momentum and dampened sentiments on the FII taxation issue.
We have entered the results season with muted expectations. The early part has been sluggish with very little earnings beats. The markets would get tied to the management commentaries which are bound to be cautious and tentative. The pendulum never stops in the middle; the same managements had displayed extreme swings in sentiments and outlook when economic cycle was turning either ways previously. We expect the government to accelerate its actions on ground with increased outlay on projects in road, power T&D, railways and defense sector. A favorable monsoon can further enhance positivity.
Market has witnessed a decent correction. Indices are close to the lowest point year-to-date - down around 10% from the peak. Some of the froth, especially in the mid cap space is settling. This correction is healthy given that stocks had witnessed a dream run. Management commentaries on ground have been weak. As the decibels increase on this pessimism, we feel we are close to the trough on sentiments. One must learn from the recent experience of China where the market played out its own mind against the consensus rhetoric on an underweight trade.
In a growth scarce world with almost two-third of it with near zero cost of capital, India continues to stand out as an attractive opportunity. The incremental positive change in fundamentals and delivery in such environment have an amplified impact on valuation. The earnings growth expectation for the market is now 16-17% over the next two years. On valuations, we are slightly above the 10-year average. Mid-cap space is now trading at a slightly higher valuation, though we feel it is deserved as most of the earnings are yet to deluge-in with macro turning positive.
In terms of opportunities, market expectations and valuations are now displaying an interesting dispersion. While the “high quality” stocks have done exceptionally well in a growth scarce environment thus far, we feel going forward the trade-off would be in favor of corporates set to come off an adverse business cycle with a decent chance of growth rebound.
The market would look for cues from developments in the parliamentary sessions on the various bills, trends in monsoon, result commentaries from corporates and global outlook on currencies and commodities.
We feel the current phase of market weakness and volatility presents itself as an investment opportunity to a long term investor. We remain excited at this stage of the market, as changing consumer, emerging technologies and improved policy framework are creating new opportunities and have enhanced our research framework and universe to seize some of these emerging themes.
After having rallied sharply over the second half of CY14, bond yields have remained flat over the last quarter inspite of a cumulative 50 bps policy rate reduction by the RBI. As monetary policy setting becomes largely anchored to the evolution of CPI trajectory and given the inflation targeting framework in place, the hurdle for the extent of incremental easing has moved up. At the same time, over the near term any market data that points to uncertainty surrounding evolution of CPI would have a bearing on bond yields. Over the last month, the bond market faced headwinds arising from an uptick in crude prices, weakening currency and the Meteorological department forecast for a below normal monsoon for this year. FII debt flows slowed down over the month with net outflows till about the 3rd week.
Bond yields moved up by about 10 bps over the month as near term uncertainties increased, accentuated by FII selling and weaker currency. Notwithstanding heightened uncertainties surrounding monsoons and its impact on inflation, macro-economic conditions and credible policy efforts provide confidence on a more durable moderation in CPI going forward. Government bond yields have also been impacted due to the illiquidity premium priced in most of the on-the-run bonds currently with current issuance sizes closer to the maximum caps. With first half bond supply being lower as compared to the previous year and also considering lower credit demand, the demand supply equation remains favorable at the margin.
A rigid adherence to the medium term CPI target of 4% +/-2% would probably preclude aggressive near term monetary policy rate reductions. However as emphasized by the Governor, the RBI prefers real policy rates in the range of 1.5% to 2.0%. This would enable sufficient judgmental call on the trajectory of policy rates, considering the current business cycle and its likely evolution. Over the near term, CPI inflation is expected to average closer to 5.25% and with demand side pressures subdued, the RBI could have leeway to reduce policy rates further by about 25-50 bps, consistent with a real rate of 1.5% to 2%.
Our portfolio construct remains biased towards a higher duration given that medium term prospects for bond yields remains positive. We have tactically increased cash to take advantage of market movements but would be inclined to hold a higher duration on an average. However we remain alert towards any material changes in macro parameters that could alter the outlook on policy rate cuts and also the medium term CPI evolution.
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