June 2017

9

Jun
7

Year-to-date, Indian equity market has been one of the best performing asset class. NIFTY has risen 17.5% in the first five months fueled by both global and domestic factors. While India definitely stands out, most other global equity markets (both developed and emerging) are also in green so far this year.

These are interesting times. Despite an avalanche of uncertainty in areas of global trade, taxes and treaties, Britain moving out of European Union and increasing news flow on geo-politically unfavorable events, market seems to be unusually calm. Globally, volatility across asset classes is extremely low. Is this a “new normal” - slow but steady growth, low inflation and extremely accommodative monetary policy; or investors are complacent? Paradoxically low volatility can make the financial system less stable and subjected to larger swings over time. Only time will tell.

Global defense spending rose by 1% to US$ 1.6 trillion in 2016 and could rise further. US, the world’s biggest military spender at US$ 622 billion in 2016, has ended its budget cuts on defense, while European defense budgets showed the first increase in six years. China will continue to spend more along with rising rift around South China Sea. India this year surpassed Russia and Saudi Arabia to have the fourth biggest defense budget. With US pulling out of Paris climate accord, simmering issues within NATO and other USallies, terrorist attacks in Europe, strategic threats from North Korea conducting missile tests, growing vandalism of ISIS, global defense spending is likely to rise further for territorial protection and power projection. While, this is concerning from the perspective of global peace, this definitely means an up-cycle for companies connected with defense spending in any manner.

India is at a bit of variance with rest of the world in terms of its overall policy. Government’s focus on reforms over the last three years has led the market to have a stronger faith in Indian structural growth story. From the day the Modi Government came into power, the countdown on delivering its election agenda promises began. The measures have been multi-pronged from widening of the tax net via speedy implementation of GST and getting parallel economy into the mainstream, cutting leakages in the money spent on rural India, shifting Indian’s appetite towards financial savings and incentivizing states to promote growth-friendly policies thus moving towards the an operating template of co-operative federalism.

Turning to the markets, earnings outcome for 4Q FY17 were in line or marginally better than expectations. The results concluded in second consecutive quarter of double digit profit growth (15% compared to 11 % in 3Q FY17 for NIFTY 50 companies), taking the full year corporate profit growth to +7% for FY17 after 3 years of flat to negative growth. That said, bulk of the NIFTY earnings growth (absolute amount) can be attributed to PSU banks and metals.

While revenue growth was reasonable, operating margins declined due to waning of the benefit from lower commodity prices and currency appreciation weighing on margins of the exporting sectors. Moderate demand and competition across most sectors are limiting the pricing power of the businesses, making them rely majorly on ability to reduce their operating and financing cost. The interest expense for the corporates is gradually falling, which reflects a combination of deleveraging and sharp fall in cost of funds. While this is positive, weak operating profit dents the pace of deleveraging.

Given the lack of broad based strength in profit matrix, consensus estimates for FY2018 earnings saw a marginal downgrade (1-2%) and means that current expectation of ~16-18% growth in profits in FY18 looks more achievable now. Valuations have run up and both Sensex and NIFTY are trading above 18 times 1 year forward earnings. Investors are taking an optimistic view on economic growth and on policy steps such as the implementation of the goods and services tax (GST), real estate regulations and an ordinance which empowers the Reserve Bank of India to intervene directly to help clean up the Rs9.6-trillion bad loan mess in Indian banking. Sentiment is certainly more upbeat and fund flows from foreign and domestic investors continue to support the current highs.

Looking solely at the aggregate valuation may not represent the true picture. First, while the Indian market looks rich, but so do other emerging markets and even US. Secondly, we see a wide dispersion in the sectorwide and stock-wide valuations. While growth investors would be glad to ride sectors and stocks with rich valuations where the earning momentum is strong, others can find their picks where valuation comfort is relatively better. We reiterate our faith in bottom-up stock picking.

Turning to the bond markets, a lot has changed in last couple of weeks, particularly for this year inflation’s projection. First, the construct of GST rates turned out to be non-inflationary. Crude prices fell and other commodity price also turned favorable for inflation. The state budgets revealed that we are going to have a much more staggered implementation of the 7th Pay commission. Demonetization effects on economy seem to have ended now. We thought that vegetable prices would mean-revert after being abysmally low between November to January, but that did not happen. Currency appreciated- contrary to market and RBI’s expectation at the start of the year, leading to a lower imported inflation. Monsoon looks favourable as of now. These are quite many favorable turn of events and makes us comfortable on our inflation trajectory for this year. Consequently, RBI may turn less concerned about inflation. On top of that, even without penciling for any OMO purchase this year, the demand supply equation of government bonds seems well balanced. This makes us more confident to build duration at the opportune moments like we did in last two months.

Navneet Munot, CIO – SBI Funds management Private Limited

May 2, 2017

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

 

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