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September 2013

It is indeed difficult to appreciate the bigger picture and a long term view in an environment where one is witness to the rupee plunging to new lows, market volatility shooting through the roof, G-sec yields touching record highs, crude oil rising on geopolitical concerns, FIIs selling amidst the Fed tapering talk and continuous flow of discouraging data points whether it’s WPI, CPI, IIP, PMI or GDP. We, human beings, have a tendency of extrapolating current trends in a linear fashion. Successful investing is not only about being agile and protecting the portfolio in such environments but also being nimble and not losing sight of opportunities that come along the way.

In the long run, money is made by focusing on ‘valuations’ and not getting swayed by prevailing sentiments. Markets move like a pendulum and always go to extremes on both sides; genius lies in one’s ability to take advantage of these extremes and not move with it. The prevailing sentiments in Indian markets are at an extreme and exactly opposite of where we were in 2007. There is a rush to downgrade growth numbers and earnings expectations for as long a horizon one can visualize and the race is for who can predict the worst possible outcome for equity, bond yields and exchange rates. The big list of what’s wrong with India and what will go wrong further is as long as what one used to read in 2007, only then it was about what would make India ‘’the place to be” in the 21st century.

Undoubtedly, we have made several mistakes over the last couple of years. The easy money, global tail winds and the cyclical upturn during 2003 to 2008 made all of us over-confident. When the world was pouring money and faith, we didn’t build the absorption capability. The Government chose the easy path and went on a consumption binge and the policy paralysis and logjam in execution that followed led to the current economic malaise. There have been some serious policy mistakes that are making us feel like a ‘dole-out’ nation rather than a ‘break out’ economy built on productivity improvement. Even the staunch believers of the India story are questioning their assumptions. We have a different take. We believe that the challenges faced by us now are not as deep as what we have faced even in recent history, though sitting in markets and reading headlines might make us feel so. There would hardly be any society in the history of the world with the kind of institutional structures and liberalism that India has built at such an early stage of growth. The adaptability and entrepreneurship is in-built in the DNA. It is true that policy makers deliver only when push comes to shove and we have delivered well only under demanding situations. And, this time is no different. But, a lot of decisions taken recently have gone unnoticed by the markets besieged by an environment of gloom and negativity.

The threat of sovereign downgrade is ensuring the fiscal belt remains tight despite a food security bill. If one looks at public debt to GDP and put it in the context of demographics, growth potential, prospect of improvement in tax-to GDP and lack of implicit social and medicare obligations, India looks far better than several economies that enjoy much better credit ratings. While the pressure of downgrade is ensuring discipline and action at our end, the likelihood of an actual event of a downgrade to junk status is remote, in our view.

The distortion in product and labour markets and an inefficient use of capital led to loss of competitiveness and it’s no wonder that even Ganpati idols and raksha bandhan bands are imported. We believe that a combination of factors including slow domestic growth, abating of cost pressures, better global growth environment and sharp currency depreciation will lead to a significant decline in our trade and current account deficit. There are signs that remittances and NRI deposit flow could increase. Our view is that the fears of US Fed ‘tapering’ and selling pressure in emerging market bond and equity markets may recede from hereon and flows can turn back positive. Sentiments are completely against the Rupee presently and illiquidity in the market is making it even more volatile. Positive surprise on the current account and flows can reverse sentiments to the other side, in our view.

Given that the luxury of easy and cheap capital is no longer available and the environment is as tough as it can get, these are leading businesses to cut flab. Downturns are necessary and have some positive effect in that sense. Businesses will have to revisit and reconstruct their business model for emerging realities. With cost pressures abating and a gradual increase in asset turnover, capital efficiency ratios will start showing improvement.

The banking system hasn’t taken the hit to the required extent, so far, though equity market valuations reflect the stress in store. Hopefully, this will catalyze institutional reforms in the area of wholesale lending similar to what we’ve seen in retail (like how CIBIL changed the dynamics of retail lending in India).

While a part of corporate India is strained, household balance sheets are in good shape, thanks to asset appreciation (real estate and gold) and very low leverage. This is different than most other countries, particularly developed markets. Good monsoons this year should help rural households though slow growth might impact urban consumers. While private consumption growth is at a decade low, structural factors supporting consumption growth have not dissipated. With real rates moving up and improved relative attractiveness, flow of money towards financial assets can increase on a structural basis. The spectre of equity and now even bond markets gyrating to the tunes of foreign money, on a day to day basis, can not last forever.

The primary and fundamental driver for bond yields is always the trajectory of growth and inflation. Other factors are secondary and technical. Looking at the growth-inflation dynamics, as currency market stabilizes, one can expect unwinding of RBI tightening measures and bond yields to soften going forward. We believe, from a domestic policy and macro perspective, given an extremely polarized view, scope for negative surprise is limited. While it is also pertinent to note that there is no room for complacency given the global environment. The situation in the Middle East and its consequences on the crude oil price, negative sentiments pertaining to risk assets in the face of ‘Fed tapering’ and re-emergence of risk from any part of the global economy that’s fragile will have a bearing on us. While the US Fed may like to make the unwinding of accommodative policy least disruptive and there would still be lot of easy liquidity pumped by the likes of Bank of Japan, the world has to learn to live without the overflow of easy money. Markets have to get its sanity back wherein economic and corporate fundamentals have a larger impact on price rather than actions and words of central banks alone.

That is the beauty of investing; most money is made when one has the courage and patience to invest when the environment looks hazy and markets move to an extreme. Looking at the bigger picture, having a longer term horizon that can withstand short term volatility and focusing on valuations at the micro level is the key.

We remain encoded to perform this task to the best of our ability at every opportunity the market provides.

Navneet Munot
CIO – SBI Funds Management Private Limited

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