May 2017

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May
2
Indian equity market has been one of the best performing equity market year-to-date. Foreign investors’ allocation to emerging markets has risen. Within that, India with an outlook of recovering growth and corporate earnings and reform oriented government, offers a lucrative opportunity. At the margin though, FIIs have pulled out money in last few weeks.

Looking ahead, global markets will be taking cues from political development in Europe (outcome of the French election, ECB’s exit policy), tax-administration reforms of the US (Trump’s reform agenda has been slow to pan out thus far) and developments in China. We also need to watch Geo-political events as they have the potential to out-turn the current regime of low volatility laid down in the global market due to comfortable liquidity and improving growth scenario.

In India, looking at the aggregate earnings growth could be misleading during this earning season. While NIFTY PAT is likely to post a double digit growth, it is largely driven by the low base of few cyclical sectors such as PSU banks, metals and oil & gas. Moreover, the positive tailwinds from soft commodity prices are fading and FY2017-18 could face some disruption from GST implementation. To sum, despite the healthy earnings growth expectations for Q4 FY17, we remained cautioned at the quality of the earnings recovery.
Market expects the improvement in earnings to extend into FY18. However, valuations have grown well ahead of profits growth and Sensex is currently trading at ~18 times 1 year forward earnings (compared to historical average of 16x). One of the factors explaining richness in valuations is the rising liquidity in the equity market. The reduced attractiveness of physical assets and a scenario of structural fall in interest rate are leading the household to steer towards equity investment. Abundant liquidity can keep the market away from its fundamental equilibrium level for an extended period of time.
Additionally, stable macro, contained inflation, strengthening external account, political stability and reform oriented government could lead one to argue than Indian equity should command a lower risk premium relative to history and support the valuation premium. These factors, too, tend to make the current valuations defendable as greater number of market participants bet on better economic environment and earnings trajectory.
To sum, while we get fidgety looking at the rich valuations, there are factors which could keep the valuations high. Moreover, we are bullish on Indian economy from the medium to longer term perspective and continue to focus on bottom-up stock picking. For FY18, the upswing in world trade is also benefitting India. Indian exports growth has been in the positive quadrant for six months running and bodes well for the manufacturing and hence overall economy. On top of that, the public sector investments continue to provide the support and the implementation of stalled projects has picked up sharply in last two years. This in turn frees up the blocked capital which can be utilized for other productive purposes. That said, fresh capital investment from the private sector continues to fall short of the required vigor.

India offers many low hanging fruits. A case in point could be the state of ‘Uttar Pradesh’- a state that has historically pulled down India’s growth, but has the potential to become a growth locomotive for the country. Uttar Pradesh inhabits nearly 200 million people (i.e 16.5% of India’s population) but ranks one of the lowest (better only to Bihar) in terms of per-capita GDP. The state has annual per-capita income of Rs.40,000 ( ~ USD 621) compared to nations’ average of approx Rs. 94,000 per annum. The state has fared poorly on many economic parameters; such has literacy rate (ranks 29th among all states), poverty ratio (30% vs. national average of 21.9%) electricity penetration (~500 kwh per person- nearly half of national average) and so forth, thus being a huge drag on the rest of the country thus far. The focus on economic development in this one state alone could pull the overall GDP of the country.
Looking at the bond market, 10 year G-sec yields have sharpened since mid-February following a more hawkish stance by the central bank.

RBI’s latest monetary policy minutes had a tone of hawkishness mainly because the central bank believes that the growth will improve in FY18, but the current muted inflation prints are not sustainable. Last couple of monetary policies has clearly brought out the RBI’s priorities. There is a clear change in stance and reinforced desire to bring inflation decisively towards the 4% target. Not only is it their mandate (since August 2016), but the central bank believes that at a time of heightened global risks (firming global inflation and volatility in financial markets), it is an important defense for the economy.

While the retail inflation is currently well behaved, it is headed to inch upwards owing to anticipated pressures from GST implementation, adoption of 7th Pay commission by states, tailwinds from soft commodity prices dying off and closing operating margins for the companies. Worth noting is that we are not even calling for capacity underutilization to close out anytime soon. Moving Indian inflation sustainably to 4% would require significant productivity improvement and easing the supply side constraints. The government has taken significant steps with regards to managing food inflation. However, few of the non-tradable parts of core inflation components, particularly health and education, have remained stubbornly high, owing to insufficient reforms in these sectors. Taming these services inflation would require structural steps to be taken by the government.

Against such a backdrop, we expect an extended pause in the policy rate and the bond yields to be guided by other developments such as demand –supply dynamics, global yield movements and banking system liquidity. The central bank is currently absorbing the liquidity via reverse repo auctions and Issuance of MSS bonds.

From a longer-term perspective, the narratives around bond yields are broadly positive, guided by reduced risk premium for Indian G-secs, expectations of polity continuity and reform momentum in the country. We have been taking tactical calls on duration at the opportune time.

While we take the board macro call on duration, credit call is a more nuanced and tricky one. The improvement in India’s economic fundamentals, legislative and regulatory improvement, disintermediation of the credit market – all lay down positive narratives for the lending market. But at the same time, corporates face host of disruptive forces and hence not all sectors can be served on the same credit platter. We focus on a completely bottom-up approach for credit picking in our portfolios.
 
Navneet Munot, CIO – SBI Funds management Private Limited

May 2, 2017

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

 

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