Globally, the economic data point towards tapering of growth momentum and as the US Fed chairman said, the environment remained “unusually uncertain”. Our assessment is that given the powerful forces of deleveraging in household and financial sector balance sheets and limited flexibility on the fiscal side, deflation remains the bigger near term risk for developed world. In this backdrop, we expect monetary policy to remain extremely accommodative leading to excess liquidity supporting asset markets despite worsening economic fundamentals. Despite record fiscal deficits, treasury yields are at multi month low as bond prices are pricing in possibility of deflationary environment to continue. One of the silver linings is healthy corporate balance sheets which supports the downside in equity and credit markets.

Prices of several soft commodities like Wheat, Sugar, Cocoa etc shot up sharply on production disruptions in some key regions. Sharp swings in supply situation due to climatic conditions and demand side accentuated by financial investment are leading to unpredictable and violent moves in some of these commodities. Energy, food and water are some of the long term structural issues due to ‘climate change’ and changing population and growth dynamics in the world. There would be distinct impact (opportunities as well as challenges) on several businesses which investors should keep an eye on.

Corporate results for First quarter of FY 2010-11 announced so far have shown a mixed trend. While the top line growth has been ahead of expectations, there was pressure on margins in some of the sectors. Banks results were better than expected and the sector outperformed the market last month. IT companies showed a strong top line growth reflecting robust demand environment across verticals, however, there was divergence within the sector in terms of growth in margins and bottom line. The sectors which reported negative growth in earnings were Cement, Telecom and Power. In case of companies in engineering sector, sales growth was below expectations. However, given the record ‘Bill to book ratio’, there is strong visibility of growth over the next several quarters. Within the economy, investment would be a bigger driver of growth for next few years and several companies in the infrastructure sector would be beneficiary of this trend.

Foreign Institutional Investors (FIIs) continue to pour money into our equity market with their year to date investment crossing $ 10 billion mark. The long term structural story of India based on favorable demographics, domestic consumption, high savings, infrastructure build up and opportunities in off shoring is quite compelling. Recently announced reforms on fuel prices, new draft Direct Taxes code and government’s efforts to push GST have aided to positive sentiments. Having said that, market is trading at fair valuation and near term gains could be capped. We recommend that in view of a structural growth story and opportunities in stock picking, investors should remain invested in equities instead of trying to time the market. In the near term, market would watch developments in the global markets and trends in Monsoon. Progress of monsoon has to be keenly watched which is relatively more critical this year due to pressure on food prices and its impact on rural economy, inflation and Govt. finances.

It its first quarter review of monetary policy, RBI increased repo rate by 25 bps to 5.75% and reverse repo rate by 50 bps to 4.50% which will shrink the corridor between these two rates to 125 bps. In the backdrop of strong growth momentum, widening current account deficit, higher credit-deposit ratio and elevated inflation and inflationary expectations, RBI had to increase the pace towards normalization of monetary policy. Indeed, the global environment is quite hazy and that might be weighing on RBI’s mind, however, price situation in both goods and asset markets were clearly indicating towards early signs of overheating.

Banking system has moved to a balanced to tight liquidity scenario from the high surplus scenario of the past two years. This has been a result of RBI’s shift from a balance sheet expansion mode to a tightening stance as India’s growth and inflation pick up. This trend of liquidity withdrawal has been further accentuated by significant currency leakages from the banking system and the highly uncertain global environment that has not only impacted our current account but has also not yet yielded the anticipated capital flows. In this backdrop, short term rates have shot up sizably to the extent of 1-2% over the last few months. With pick up in credit, seasonal factors and impact of systemic changes like Base Rate and RBI rate increases, it is expected that short term rates may remain elevated notwithstanding intermittent bouts of easy liquidity.

While Government’s fiscal position received a big boost in the form of telecom license auction receipts and decontrol of some of the petroleum products, the borrowing programme would still be large for the Banking system to absorb, especially in a stubbornly inflationary scenario. However, continued global uncertainty and bleak prospects of growth in the developed economies has kept a check on rising bond yields. On balance, it is expected that interest rates would see an upward bias but at the same time, upsides would remain capped with further improvements in government balance sheet, drop in inflationary readings aided by base effect and expected pick up in Banks’ NDTL growth due to good inflow of overseas liquidity in to our economy. With increasing global linkages and foreign participation, debt markets here are expected to witness increased volatility instead of secular trends.

Our fixed income funds have a very cautious positioning on duration and liquidity. As far as liquid and ultra short term funds are concerned, we will continue to maintain relatively lower maturity profile and higher liquidity. While the core portfolios of fixed income funds are invested in highly liquid short term assets, we would play duration on a tactical basis as we expect higher volatility. We recommend investors with risk appetite to invest in our short term fund and dynamic bond fund which are positioned to take advantage of these opportunities. From a medium term perspective, there would be good entry opportunities in long bonds in this quarter. We re-iterate that while domestic situation warrants higher rates, one must not ignore strong deflationary forces in rest of the world.

Regards,