June 2018

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Jun
4

Geo-political risks continue to dominate investor attention. As feared, US walked out of the Iran nuclear agreement; it’s dialogue with North Korea failed to fructify and the trade tensions with China sharpened. Political risks staged in Italy, Spain and Venezuela. Argentina economic crisis further deepened. Malaysia saw the change of power and the new government intends to switch from the progressive Goods and Services tax to Value Added Tax as an indirect tax regime. All these countries are witnessing their respective bond markets retaliate negatively.

These developments also have a contagion effect on the other emerging markets (including India) via various channels. The first and quickest impact is felt in the form of broad-based risk-reduction in investor portfolios. FII flows have turned negative in the emerging market equities and bonds.

A second channel of contagion during risk-aversion tends to be via funding gaps. Countries with substantial current account gaps (such as India and Indonesia) tend to command relatively higher risk premium, which gets compensated via either currency weakness or higher yields or both. In response, Indonesia has already hiked the policy rate and the pressure is building for Indian central bank to follow the suit. The risk-off sentiment is also associated with rising US dollar which puts additional depreciation pressure on the EM currencies. Rupee has been a sharp under-performer and has depreciated nearly 6% YTD.

Rupee’s weakness has caught everyone’s attention and comparison with 2013 is inevitable. India today equals or fares much better on most of the parameters. Inflation has halved since 2013, growth momentum stands better, CAD is ~2% vs. 4.8% then, and overall government deficit is down by 40bps. It has built US$ 145 billion of reserves since the ‘taper tantrum’ and Forex reserves are way above the traditional norms of 6 months import cover and 100% short-term debt cover. But the changing color of foreign money and experiences from crisis suggest looking beyond traditional metrics. Our main vulnerability has gradually transitioned from trade-imbalance to indebtedness and risk of FII outflows. The reserve cover of external debt has fallen over time and susceptibility to volatile FII money capital flight is higher than five years ago.

India’s un-hedged exposure to crude always comes to test the country’s macro when the crude prices are on the rise. India is the third largest importer of crude oil and imports 86% of its consumption needs. Every US$ 10 rise crude prices (per barrel) leads to US$ 15 billion rise in India’s import bill. That said, the effect on CAD may not be one-on-one as higher crude prices are partly symptomatic of improved global growth and hence has a positive bearing on India’s exports receipts and remittances from Indian workers working abroad. Nevertheless, we do expect the current account to worsen to US$ 70 billion in FY19 (2.5% of GDP).

There are structural issues in India’s external account dynamics. East-Asian countries led first by Japan and now followed by China reached middle-income status mainly due to strong exports. But Indian exports is practically unchanged from seven years ago (US$ 306 billion in FY12 and US$ 303 billion in FY18). Further, with countries gradually adopting anti-immigration and the citizens’ first approach, the remittances weapon is developing slow rust. To add, Indian feet are increasingly itching to explore rest of the world while students dream to add foreign degree ‘feather’ to their hat. Yes, the digital transformation is a blessing but our affairs with I-phone, Xiomi and social media will lead to more dollar outflows. All these are reflective of rising standard of living but make it harder to manage the current account pressure and increase the country’s reliance on foreign capital.

Lack of innovation and economies of scale are structural impediments to India’s export story. Revenue of the top 500 companies makes just 28% of GDP vs. 78-79% in US and China. The R&D spending is as low as 0.8% GDP while China and the US spends 2-3% of its GDP on innovation. A study in economic survey highlights that countries had spent anywhere between 2.5-4.5% of GDP on innovation during their development phase. Innovation helps to provide a new product palette to export- whether it be goods or services. This is pertinent in an environment when the world is turning protectionist.

Digitization in India provides one such silver lining. Internet penetration is fast picking in India and the pace is simply unparalleled by any other country. Digitization coupled with unique identity card and improved connectivity can enhance the productivity and offer a new template to operate. Hopefully, the benefits of it may spill over to exports- particularly in services exports.

Indian economic growth continues to shape up. Q4 FY18 GDP grew 7.7% supported by both higher consumption and investment. For full FY18, GDP clocked 6.7% growth vs. 7.1% in FY17. Even though economic momentum picked up in 2H, it wasn’t enough to offset the weaker growth in 1H.

In FY19, we expect growth to pick up to 7.5-7.6% in FY19 vs. 6.7% in FY18 helped by the favorable base, fading away of GST and demonetization related disruption and cyclical recovery in select segments. That said, a full-fledged recovery will face headwinds from NPA issues, rising crude prices (implying higher import bill) and tightening liquidity (translating into higher lending cost).

Coming to corporate earnings, 4Q FY18 PAT for NIFTY stands at 5.1%- much lower than street expectations. That said, the quality of the earnings break-up is relatively better and most of the auto, consumer and retail lenders reported healthy prints. We expect ~ 20% growth in FY19 NIFTY earnings aided by the growth tailwinds and favorable base for corporate lenders. With price and time correction, valuations have come off a bit though remain high relative to history and bond market (yield differential between Sensex and 10-year G-sec is 100bps higher than long-term average). Against this, and recognizing the fallacy of averages, we remain focused on bottom-up stock picking.

Coming to the bond market, rising crude and other commodity prices puts the inflation trajectory at slight risk. We reckon that the probability of a rate hike has increased amidst adverse risks on inflation, fiscal and currency. Bond yields have shot high and at 7.80% (10 year G-sec). The market seems to be pricing at least 50-75bps of hike. If there is a rate hike, there could be short-term panic in the markets and the yields may inch-up further. But then, market is likely to settle broadly around where it is today.

Typically, the shorter end of the curve is more closely anchored to the repo rate. However, even the shorter end of the curve has risen even higher owing to the tight liquidity in the system. While the Net LAF is broadly neutral, the vast majority of banks are struggling for liquidity. Above trend currency outflow and FX selling by RBI (which in turn absorbs rupee liquidity) had led to sharp drop in banking system liquidity. CP and CD yields have risen by 100-140bps across the curve. Rise in the cost of funds for banks and NBFCs will translate into higher lending rates. Thus, the market is already reeling under tighter monetary policy, even when RBI kept the rates unchanged and maintains a “neutral’ stance.

In sum, one can fathom either of the situation transpiring. When crude and Dollar index are rising and there is a generalized depreciation pressure on EM currencies, RBI will either must allow rupee to keep depreciating and support the domestic economy by providing the required liquidity or support rupee, sterilize it partially by OMO purchases and let the liquidity run tight. In either case, bond yields may not find support for some time. More than RBI action, fundamentals such as GST trends, MSP action, Crude trends, inflation trajectory (fiscal, inflation and external account fundamentals) will have a more lasting impact on bond yields. And yes, even some clarity in RBI’s statements will just add a little bit of wonder!

Navneet Munot
CIO – SBI Funds Management Private Limited

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

 

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