October 2017

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Oct
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Global economy has been depicting synchronized improvement in growth. Chinese economic activity has strengthened in 2017. The recovery is much more broad-based instead of driven only by infrastructure and housing construction. After almost six years of steady decline, Chinese private business investment grew in 2017. Industrial profits, business confidence and the capacity utilization rate have also shown notable improvements which in turn is feeding into higher global commodity prices.

Along with China, growth in other key economies has also barreled ahead, with the strongest acceleration coming through the Eurozone. The latest PMI prints paint a picture of further improvement. However, what is puzzling is despite the improved growth and record low unemployment rate, wage growth has stayed persistently weak which in turn is feeding into muted inflation. The undesirably low inflation, but improved global growth and asset price gains, is complicating the task of major central banks that have thus far stayed put on their ultra-accommodative monetary policy. With improved growth and easy money, financial markets remain buoyant.

India has seen a host of pertinent structural reforms in last couple of years such as wide-scale implementation of direct benefit transfer, GST, crack-down on black money, Pension fund investing in the equity market, drive towards financial inclusion, phasing away of the fuel subsidy, real estate regulation act (RERA), Insolvency and Bankruptcy Code (IBC) , UDAY, revamping of crop insurance, digitizing land records, e-auction of natural resources, focus towards single window clearance and so forth. They were much needed reforms to bring in productive efficiency and ensure more efficient utilization of resources. But in the interim, it has undeniably disrupted the operating template of the Indian businesses and led to a deeper growth shock than anyone would have anticipated. At the same time, while the Indian policy makers have won the battle on twin deficits (current account and fiscal deficit), both government and RBI are still grappling to resolve the twin balance sheet issues of high corporate leverage and non-performing assets with the corporate lenders particularly public sector banks (accounting for 60% of the bank lending).

In the near-term, we may see pressure building on some of the macro parameters. Stress is visible in the government’s balance sheet and both Centre and State may find it difficult to stick to their stated deficit targets for FY18. The rapid fall in oil prices was positive for Indian macro. Now, with oil prices inching up, an important driver has gone. Indian exports have not been able to keep up with the improving global trade cycle. Jury is still out on the role of appreciating rupee in sluggish exports. While rupee had appreciated against dollar in 2017, it has depreciated against some of the other key trading partners such as euro and yen. Despite that, Indian exports have been languishing when compared to other Asian peers. Some of the sector-specific challenges such as in IT and Pharmaceuticals, where India had its inherent competitive advantage are also contributing towards weaker than desired exports growth. At the same time, Indian exporters are grappling with the pending input tax credit under GST which has led to a sudden jump in their working capital needs and inhibits their ability to take more orders. We expect India's current account deficit to be wider than last year on the back of a stronger rupee, weak export orders and expectation of higher import demand once GST related uncertainties are put to rest.

Investment continues to remain very weak. Given the twin balance sheet problem, uncertain growth and excess capacities, private capex will take some more time to revive. As the private investment remains elusive and government face limited space to stimulate the economy, earnings growth is likely to stay challenged for some more time. We have already seen substantial downgrades in earnings projection for this financial year.

Indian equities fell for second month in succession. NIFTY fell by 1.3% during the month. FIIs pulled out US$ 1.8 billion in September while domestic mutual fund invested US$ 2.7 billion. YTD, NIFTY has delivered 19.6% in local currency terms and 24.4% in USD term. YTD, MSCI EM index is up 25.5% in USD terms.

Helped by robust mutual fund inflows, valuations continue to stay rich (Sensex is trading at 20 times 1 year fwd earnings). We believe that the near term growth challenges will overshadow the benefits arising from the long term structural reforms, and keep corporate earnings in check. Further, as these reforms create higher transparency in the economy, monopoly profits are likely to get destroyed and India Inc as a whole should settle down for relatively lower return ratios.

Hopefully, initial wrinkles in reforms such as IBC, GST and RERA should iron out over the next year and place India on a higher productive potential. Higher growth on the back of the productivity gains resulting from structural reforms should be longer lasting. While the long-term India story remains intact, markets underestimated the cyclical challenges. Given the abundant liquidity and ongoing near-term disruptions, we remain focused on bottom-up approach in picking stocks.

While the demonetization and other related reforms have impacted the economic growth, it is leading to financialization of savings and other interesting consequences. While real-estate sector is struggling for growth, mortgage lending is touching the record highs. Retail credit, too, is rising at a rapid pace. We are witnessing a surge in the balance sheet of Non-banking Finance companies (NBFCs), Micro finance institutions (MFIs), Housing Finance Companies (HFCs) and Small finance banks. Payment banks will join soon. On the supply-side, mutual fund inflows into bond funds have also been surging, which has helped drive a boom in corporate bond issuance. This is why total credit growth has been running well above the relatively depressed growth in bank lending.

Undoubtedly, household’s balance sheets are relatively healthy and under-leveraged. It has been a growth driver when government and corporate balance sheets are under strain. However, if history is anything to go by, faster than normal growth in any sector may lead to challenges later on. Capital is chasing players with low experience. We have seen the same earlier in case of Indian telecom and power sector. Hence, it is absolutely pertinent to go with players which have enhanced underwriting capability and risk management template.

In the latest monetary policy meet held last week, the RBI kept policy rates unchanged. The central bank is dealing with two divergent developments. On one hand, growth has weakened and this raises the prospects of output gap widening which itself will have benign impact on inflation. On the flipside, is the build-up of generalized price pressures in July and August CPI data and the added risk of fiscal slippage, both for states and the central government. Given that inflation is the primary objective for the MPC, it is only logical that the MPC should hold out on rates till data makes it clear that inflation likely to remain close to its target. To sum, the recent macro-developments has set a somewhat higher hurdle for further rate cuts in the near future. So unless significant downside inflation surprises continue, market participants will likely be hesitant to price in another rate cut just yet. Further, the rising risk of fiscal slippages (both from Centre and State) is making the market concerned on the deterioration of demand-supply dynamics. We expect fiscal related pressures to gradually dominate market moves, with a material possibility of additional market borrowings over the 2H of FY17. Anticipating these demand-supply challenges, we had tactically reduced the duration in our fixed income portfolios and would be likely building them again at the opportune time.

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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