The NDA government has completed its 100-days in office, while the Prime minister delivered an impressive address to the nation on Independence Day. The markets continued to respond positively to every incremental step with Sensex closing 3% higher for the month.
Thus far, the government has refrained from big bang announcements but has concentrated on incrementally resolving ground level issues that set the fabric right when it comes to getting investment cycle back on track. Prime Minister’s message also focused on medium term socio-economic development
issues like financial inclusion, skill development, job creation, reviving the “make in India” spirit, digital governance, and promoting preventive healthcare and also tourism through a “clean India” campaign. The government will have to deal with some critical issues like allocation of natural resources where matters are sub-judice presently. Prime Minister’s ambitious plan for financial inclusion has started with a great momentum. This would not only help in expediting the Direct benefits transfer (DBT) and reducing the leakage in government expenditure but will also lead to increased tax revenues over a period of time as larger part of the population join the mainstream economy. This will also help in improving the savings rate with higher part of those savings channelized into productive assets.
The Prime minister’s visit to Japan has generated huge attention from the global media. We believe that strategic and economic co-operation between these two powers would be one of the most defining relationships in the history of Asia. Visits of some other dignitaries to India and his travel to US should
further strengthen the growth pillars for the economy with bilateral alignments that can bridge the technology and capital gap. The government is now operating from a position of strength when it comes to these alliances, as India is emerging as a favored investment destination from a long term perspective. The market expects these visits to fast-track long term FDI flows towards strategic sectors like infrastructure, defense and finance.
On ground, economic indicators (GDP, current account, IIP, vehicle sales) and anecdotal evidence (urban job creation, business sentiments) indicate that growth momentum is slowly building up. The external backdrop was mixed with divergent trends in key countries. While the US seems to be on a recovery path, concerns have re-emerged about Euro-zone which would lead to more accommodative policy by ECB. One of the positive developments for India is softening of global crude oil prices.
In spite of the recent run up, the market is trading at 12-month rolling PE of 16 times, which is marginally above the 10-year historic average. While the market is likely to consolidate its recent gains, we feel that it is well positioned to deliver a sustainable bull run on the back of stabilizing macro, reviving earnings growth, near-average valuations, and better liquidity both from the foreign as well as domestic investors. Going forward, we need to watch out for the incremental economic data points, RBI policy, corporate earnings and Government’s “action on the ground”. The risk factors to watch out are – impact of monsoon, shift in global liquidity and interest rate expectations, geo-political developments and surge of equity supply on-shore.
We believe that this growth cycle in India would consist of new winners, making mid-caps an interesting investible space. The power of possible compounding and strength of business models would be key variables that investors would seek and reward in this space. We also expect this space to benefit from a higher dispersion of earnings upgrades in a positive business cycle.
The RBI in the Bi-monthly Policy review in early August re-emphasized the January 16 CPI target of 6% for the Monetary Policy stance. This reinforces expectations of an elongated pause in policy rates, while firmly ruling out any near term monetary easing.
Bond yields moved up in the initial part of the month by about 15 bps across the curve following the RBI review and the release of CPI number for July which came in above market expectations. Government cash balances remained in surplus helped by a higher than budgeted surplus transfer from the RBI. In view of the comfortable government balances, the auction calendar was reduced by Rs. 160 billion for the remainder of the half year period ending September 2014. FII buying remained strong during the month with the Gilt investment limit which was recently enhanced by USD 5 Billion by reallocating the long term investor limit of USD 10 billion getting exhausted. This led to yields retracing subsequently. The gilt curve flattened over the month as limited auction sizes and also certain specific FII demand kept long term yields relatively supported. AAA PSU spreads tightened in the 3-5yr segment, while remaining relatively stable at the long end.
Macro-economic data points released over the last month showed further improvement in growth parameters even as a weaker monsoon had its impact on food price inflation. The CPI data for July 2014 came higher than estimates at 7.96% y-o-y driven by a m-o-m spike in vegetable prices. Food price inflation measured 9.2% y-o-y whereas core CPI remained more or less stable. The South West Monsoon which picked up in July after a deficient period in June on a cumulative basis stands at 16% deficit till date.
The RBI’s focus on anchoring CPI expectations lower towards the 6% glide path target has resulted in markets pricing out any near term rate cuts. On the other hand, an improvement in external sector balances, reserve accretion, credibility in Monetary Policy stance and also a decisive electoral verdict have
resulted in higher capital inflows led by FII debt flows. With the Gilt limits exhausted, incremental flows could be selectively seen in better rated corporate bonds, especially at the short end. The strength of US Dollar and RBI’s drive towards increasing Forex reserves would keep the upside checked for rupee despite strong capital flows.
The revised liquidity management framework announced by the RBI should lead to overnight rates remaining better aligned with the policy rate once regular auctioning of government cash balances is operationalized, given that frictional liquidity pressures have largely been on account of build-up of government balances.
We have been maintaining a moderate duration stance, considering positive medium term outlook while acknowledging that near term market direction could be more range bound in the absence of specific triggers and also a deficient monsoon which can impact CPI direction. Macro fundamentals especially relating to external sector have improved significantly over the last few months even as core CPI has trended lower. The RBI policy stance meanwhile provides more comfort in terms of commitment to address CPI inflation and also to anchor inflationary expectations. This may entail a near term prolonged pause in policy rates, but provides a sound footing to revive growth in a non-inflationary manner with macroeconomic stability.
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