August 2017

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Aug
7

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).

 

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