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September 2014

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.

Navneet Munot

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