April 2018



Concerns regarding trade war have been uppermost in Investors mind currently. Barring, the labeling of China as a currency manipulator, the Trump administration has broadly gone ahead with all points laid out in their 7-point trade plan during their election campaign. The US trade negotiators have increased nationalistic orientation. The country has imposed higher import/anti-dumping duties on host of items (solar cells, washing machine, steel, aluminum), is seeking re-negotiations in the NAFTA, has withdrawn from Trans-Pacific Partnership and has filed 90+ cases against its trade partners at WTO. The US is tilting towards trade reciprocity where the guiding principle is the quantum of trade deficit being run with its partners.

These measures could attract retaliatory approach from bigger economies, and some of the key trade partners. For instance, China has started parallel investigation on sorghum imports from US, and Europe aims to revisit its trade policy with the US.

2017 witnessed a significant up-turn in global trade (4.9%) after two years of slow growth. This, in turn had positive implications on global growth. Historically, trade liberalization had resulted in positive economic outcomes. US trade nationalism policy principally runs counter-intuitive to overall free market and will have an adverse effect on functioning of global value chain and overall economic growth.

That said, US administration could face pressures from its own multi-national companies to revisit the stance. There could be preference to dialogues over conflict with trade partners. It could also lead to surge of bilateral and regional deals and higher focus on trade in services and investments. China’s One-Belt One Road and the regional comprehensive economic partnership among 16 Asian economies is a case in point.

The gradual tightening of global liquidity is also keeping investors on edge. Having raised interest rates six times, the US Fed is on course to deliver at least two more hikes this year. We re-iterate that a variety of crosscurrents is symptomatic with continued volatility going ahead. While fundamentals continue to support equities, the goldilocks of strong growth and contained inflation is ebbing.

Coming to the domestic economy, the macro-economic indicators continue to paint a mixed picture. Feb CPI inflation (at 4.4%) was lower than RBI and market expectation, trade deficit narrowed, and growth indicators like overall industrial production, cement production and auto sales depicted robust growth.

On the other hand, 3QFY18 Current Account deficit (CAD) widened to 2.0% of GDP vs.1.4% in 3QFY17. FYTD 18, CAD deficit is at 1.9% of GDP. A deeper dive into the details pre-sages some concerns in the coming quarters. Overall CAD is likely to triple from US$ 15 billion in FY17 to US$ 45 billion in FY18 and worsen further in FY19. Net FDI has fallen due to increase in repatriation of earlier investments by foreigners and outward investment by Indian companies. We expect Net FDI to hover around US$ 30 billion in FY18 and FY19 thus making India increasingly reliant on volatile portfolio inflows to meet its currency needs.

Risks in FY19 come from the capital account side as foreign investors might prefer to be on the sidelines ahead of general elections. The global monetary policy tightening may also add to the tapering of portfolio inflows. Finally, a part of NRI deposits garnered in 2013 is due for maturity in 2H FY19. The RBI can cushion the currency volatility with its warchest of $ 420 billion, further depreciation in rupee cannot be ruled out. This can also dampen the attractiveness of carry returns from India.

On the fiscal side, after a 30bps slippage by the Union government, a review of state budgets released so far (14 states) also point to 30-40bps slippage in FY18. The recent GST meeting has kept the date for implementation of e-way bill unchanged at 1st April, which is expected to improve the compliance. But the simplification of return filing remains unsettled and will keep unnerving the small business. Overall, we would be keenly watching the GST trends.

In the GST brouhaha, the government’s effort to promote Direct benefit transfer has gone under-praised. Very recently, the government has also brought the rural housing subsidy program under Direct Benefit Transfer (DBT) mechanism. The number of schemes under DBT has gone up to 434 schemes from merely 50 two years ago and the quoted savings to the exchequer stands at Rs. 700 billion.

While the goldilocks situation of India macro may be ebbing, micro-picture may start to throw up some silver linings. The corporate profitability has likely bottomed out and may stand to gain from improving growth and productivity (with ease of doing business, improved logistics, and simplified indirect taxes). Risks from regulatory changes aside, labor costs have stabilized in India and increased availability of working age population may work to keep it low. With increased transparency, real-estate costs are likely to be contained. Finally, while the interest and raw-material cost have marginally increased in recent months, they have fallen considerably relative to the levels seen 3-4 years ago. All these factors should broadly help to improve the business margins going ahead.

We re-iterate that while the global policy, Indian macro and politics and developments in the banking system will lend its due noise to the markets, it is the earnings trajectory that one needs to watch closely. Valuations, despite its recent corrections (Sensex at 19x 1 year forward earnings), run high relative to its own history and bond market yield. And to that extent, earnings revival is absolutely critical. We believe in a more bottom-up approach for Indian equities (owing to the fallacy of averages).

Softer than expected inflation prints and the revisions in the central government borrowing program for 1H FY19 provided the much-needed relief to bond market. Central government borrowing for 1H FY19 was pegged at 2.88 trillion i.e. 22% lower than 1H FY18. The duration mix was favorably changed too with the share of 10-14 years maturities reduced from 52% to 29%. A new bucket of 1 to 4 year was introduced.

The rise of G-sec yield in last 6-7 months can be attributed to higher crude prices, inflation pickup, fiscal worries and the worsening of demand-supply dynamics. While the fiscal and external account continues to be less than comforting, inflation is softening and demand-supply dynamics could shape-up in FY19.

We expect overall 4Q FY18 inflation to average around 4.7%, nearly 40 bps lower than central bank’s expectation of 5.1% for the quarter. Fiscal do pose some risk, and central bank will be closely watching government’s actions in terms of the inflationary impact of pre-election policy measures. That said, we build an unchanged policy rate in 2018 as our base case.

Secondly, in concurrence with our balance of payment expectations, we believe that the central bank will have limited space to inject primary liquidity via FX intervention. It will have to resort to OMO purchases, later in the year, to fill the gap - thereby creating a demand for G-sec. Further, the increasing penetration of insurance and pension fund will increase their investment base for government securities. We believe, investor should build exposure gradually over the next few months given the attractive valuations.

Navneet Munot CIO – SBI Funds Management Private Limited

April 2, 2018

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


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