Equity indices touched new highs in July. Year to date, Nifty has delivered 23%. That said, India returns were
very much in line with global equity performance. Emerging market equities, too, delivered a stellar
performance with MSCI-EM rising 24% YTD. The latest communication by the US central bank signalled a
more gradual rate tightening path and hopes of a better global growth and earnings have lifted appetite for
risk assets.
Even as the equity markets scale new peaks, what is notable is that volatility is at its lowest in more than
two decades - both globally and in India. One of the factors attributing to low volatility across the asset
classes is the super-normal liquidity. Even as the US Fed had stopped expanding its balance-sheet since
2014, the book size for G-7 central banks as a whole has continued to grow. With global physical asset
investment being low, money is finding its way into financial assets.
Volatility is a reflection of shifting market expectations. Expectations drive asset prices and are generally
thought to be adaptive. A stable and unidirectional market creates a certain set of expectations, which in
turn, leads to increased investor flows. Therefore, in the short run, other things being equal, low volatility
may feed into itself.
That said, it is not without risks. Globally, while political risks have receded in Europe, they remain alive
across the rest of the world with potential spill-over effects. The risk of US economic policy disappointing is
also high at this stage and remains an important risk to monitor. All said and done, risks emanate at the
time least anticipated and from sources unfathomed of.
Global bond yields fell during the month and dollar index (DXY) softened as markets seem to believe that
economic reforms in the US may take longer to materialize. The recent dovish tone from both US Fed and
ECB, too, aided the yields softening and furthered the dollar weakness against other currencies. While this
may have comforted the market in the near-term, we continue to believe that the future unwinding of
Central Banks’ extraordinary monetary policy is inevitable.
In India, continued optimistic expectations on growth despite consistent earnings downgrades in each of
the last few years and unidirectional nature of FII and mutual fund inflows coupled with low interest rates
explain the steep rise in equity valuations and consequent fall in volatility. Market is also gaining comfort in
reform measures of the government. The reforms such as GST, are bound to set economic systems in order
and should feed into enhanced productivity and hence growth. India’s political stability has been getting
reinforced throughout the year.
Two key developments to watch in India are earnings trajectory and progress on bank NPA issues.
The IBC (The Insolvency and Bankruptcy Code, 2016) seems to have kicked off finally. After multiple delays
due to court interventions initiated by borrowers, the bankruptcy process has now got judicial backing that
can be used in future cases to prevent similar delays. Along with the recent ordinance (in May) providing
RBI powers to direct banks to initiate insolvency proceedings against borrowers, the IBC is likely to quicken
the pace of stressed asset resolution as the mechanism provides a definite time frame for resolution,
beyond which the case will proceed for liquidation. If NPA clean-ups pick up pace over next year, this could
lead to a fresh trigger of more capital inflow in India.
While we are still in the midst of the earnings season, the results thus far reflect a weaker profit and sales
growth during 1Q FY18. Most companies blamed the GST related business adjustment for weak profit data.
To that extent we should see the earnings normalize once the restocking process starts and businesses
assume the normalcy. For FY18 and FY19, market expects earnings to be in the mid-teens as the hopes stay
abreast on growth revival of the Indian economy.
Fundamentally, one should expect the growth to pick-up. Indian growth recovery has been protracted
owing to weakness in the physical investment. The precondition for investment pickup will be visibility of
strong final demand, a more productive/competitive manufacturing sector and a strong balance sheet of
the investor. While the demand is weak presently, the extent of potential final demand is unmistakable
given a large base of young population, large infrastructure deficit and relatively lower cost of factors of
production. Given the spate of policy measures to improve business conditions and lower interest rates,
the revival of capex cycle is more a matter of “when” than “if”. In the present scenario, it will be a function
of corporate deleveraging and resolving of banking sector NPAs. This is precisely the reason why market
has constantly been pencilling more buoyant earnings projections despite 5 years of downgrades in
succession.
For investors, the key takeaway is that if India’s macro fundamentals remain robust, the growth
‘expectation’ story continues to hold, and if the global environment remains uninspiring, this phase of low
volatility and rich valuations (Sensex at 20 times 1 year forward earnings) might continue for some more
time. Businesses are capitalizing on the robust liquidity and we expect equity supply to gather pace. This
may cap the market returns. Bottom-up stock picking becomes even more critical given the current
valuations.
Indian bond yields, too, fell during the month as signals of more gradual tightening by Fed, lower crude
prices, and weakening DXY ticks more boxes to justify a Repo rate cut in India, apart from the growth
inflation trajectory. In line with the market expectations, RBI cut the repo rate by 25bps to 6.00% as some
of the inflation risks envisaged earlier this year had abated and growth has weakened. In our view, the
current neutral stance of the RBI factors in the 4% inflation for Q4 FY18 and acknowledges that upside risks
to inflation has receded. This sets 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 25bp cut just yet. Further, given that remonetisation has slowed considerably since July, RBI will
have to continue to mop-up excess liquidity over the next few months. As such bond yields are unlikely to
soften further in the near-term.
Indian bonds have out-performed during the year as inflation has under-shot the market expectations and
the currency appreciated- thus implying a double-digit dollar returns. India has received US$ 27 billion in FII
inflows in the calendar year (till July end) led by debt inflows (US$ 17.5 billion).
However, an increase in trade deficit in the last few months shows that demand for dollars is increasing
which should cap any further appreciation in the rupee. On the contrary, while a weaker dollar does add to
the strength of rupee (and EM currencies in general), the expanding trade deficit only shows that rupee
may come under pressure in case FII inflows reverse later in the year.
Navneet Munot
CIO – SBI Funds Management Private Limited
August 4, 2017
(Mutual funds investments are subject to market risks, read all scheme related documents carefully).
