The year began on an optimistic note with Sensex touching a new-22 month high; however, weak cues from global markets and profit booking at higher levels brought markets down. While the Sensex was down 6%, there was heightened activity in mid and small cap stocks. Corporate earnings growth for 3rd quarter of FY 2009-10 came broadly in line with market expectations. The market expects around 20% growth in earnings in FY 2011. After 10 months of net inflows, January saw net outflows from foreign investors.

US GDP for the 4th quarter of 2009 came at an impressive 5.7% and several other economic data points from other parts of the world were also encouraging. However, a large part of GDP growth in US came from inventory re-building. We maintain our view that current recovery in global economy particularly in developed world is a “statistical recovery” coming on the back of lower base and massive policy stimulus. It may get choked again in case policy makers hasten to take back the stimulus. We expect a below-trend economic growth in developed world for an extended period and asset prices would ultimately reflect that. The massive policy stimulus has saved the world from falling into a deep recession; however, stretched sovereign balance sheets are a big area of concern. The recent events in Dubai and parts of Europe are a grim reminder of this fact. The genesis of financial crisis was in excessive leverage which at an aggregate level has not come down. It is just that leverage has shifted from private to sovereign balance sheets. Looking at the volatility and risk premium, markets are showing lot of complacency, however, there are reasons to be cautious. In this kind of environment, maintaining a discipline of asset allocation while retaining flexibility of mid-term course correction would be important for investors.

The Reserve Bank of India announced a hike in the Cash Reserve Ratio of Scheduled Banks by 75 bps (from 5% to 5.75%) in its monetary policy unveiled on January 29th. This is expected to suck out Rs. 36,000 crores from the Banking system. The central bank chose to keep all other key rates unchanged. RBI has clearly continued on the exit path that it has embarked on in October, 2009 policy. RBI noted the need to carry forward the shift from ‘managing the crisis’ to ‘managing the recovery’ stance articulated in the previous policy. Though inflation is predominantly supply driven, there is an increased risk of spill over in to a wider inflation. In this context, RBI has hiked its baseline projection for WPI inflation for end-March 2010 to 8.5% from the earlier 6.5% (October policy). Simultaneously, GDP growth for 2009-10 is now expected at 7.5% instead of the earlier 6%. RBI would be calibrated in its approach as it would not disrupt the recovery process while anchoring inflationary expectations.

The next big event for market would be the Union Budget to be unveiled on February 26. We expect the government to gradually reverse most of the fiscal stimulus next year as recovery in private consumption and investment picks up. The government will have to do a fine balancing between supporting the recovery process while containing the fiscal deficit. We expect improvement in the revenue side driven by economic recovery, increase in tax rates, auction of 3G telecom licenses and disinvestment receipts. There would be room available for containing the expenditure side as some of the one-off items like arrears of sixth pay commission payment would not be there next year. We expect the fiscal deficit to be around 5.5% of GDP with net borrowing to be almost similar as current year. A large borrowing program this year could sail through due to MSS unwinding, support from RBI through open market operations and bank’s demand due to lower credit growth. As RBI sucks out excess liquidity and bank credit growth picks up, managing the borrowing program next year would be challenging. Having said that, we believe that markets have already started factoring in the impact of large borrowing for next year and the steepness in the yield curve completely reflect these fears. In the very near term, we expect yields to remain range-bound and a flattening in yield curve through upward move in short term rates.

We maintain our view on equity market that it is likely to consolidate the gains for some time and bigger driver of returns would mainly be earnings growth rather than expansion in valuation multiples. We expect markets to witness higher volatility in the very near term due to global events. While using macro understanding to hedge the tail risk, we retain our focus on bottom up stock picking which we believe is the key to generate better returns on a consistent basis.

Regards,