January 2018

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Jan
4

2017 was the year of new highs or new lows.

Global growth finally shaped up as we head into the tenth anniversary of global financial crisis. In 2017, global growth is likely to be the strongest since 2011 (IMF projects 3.6%) and is expected to edge up further in 2018. Unemployment rate fell to new lows (in US, Eurozone, China, Japan and UK) but failed to spiral wage growth momentum. Thus, inflation across most economies fell short of the set targets. That said, as the signs of financial market exuberance became more evident and central banks fathomed the inefficacy of loose monetary policy to spur any further growth, some of them- the likes of Korea, Canada, and England- joined the US in raising rates. ECB announced it tapering program. The US succeeded in passing its tax reform. Re-iterating our thoughts, this can potentially initiate similar actions from across the world and support the growth momentum.

Despite the rising Fed rates and improving growth in US, DXY (US Dollar Index) headed south through the year as Eurozone, Japan and China depicted positive surprise on macro front. The index touched a 3-year low of 91 in September following the increased geopolitical tension with North Korea; and have been broadly gyrating around 91-94 levels there since.

2017 proved good for equities with MSCI-world index delivering 20% while volatility levels (VIX Index) falling to historic lows. Non-surprising election outcomes in Europe, improving growth with low inflation helped reduce equity market volatility.

In line with the EM equities (up 30%), Indian equity markets, too, delivered 29% returns in local currency terms and 37% in US$ terms. Performance down the capitalization curve was stronger with mid-cap delivering 48 % and small-cap growing by 60%. Most key sectors generated positive returns, with growth being strongest for the Real-estate and metals. Strong domestic flows were a big support to the market. Equity related schemes garnered over Rs. 2 trillion (twice the amount garnered in 2016, and four times of total FII equity investment).

Demonetization, RERA and GST have disrupted the traditional modus operandi of Indian businesses. Hence, while the financial markets (particularly equity and currency) participated in the global rally, the Indian growth could not keep pace with strength in the global growth. In line with the weak growth, earnings belied market expectations, yet again.

Rupee was extremely stable in comparison to other EM currencies and appreciated by 6.3%. Current account deficit was fully funded by just the FDI flows. Inflation touched the historic lows (1.5% in June 2017) and fiscal deficit saw gradual consolidation. While the EM equities and currencies rallied, EM bonds markets came under pressure. India 10-year G-sec yields, too, treaded higher to close the year at 7.33% (up 81bps y-o-y). Rising fiscal risk, bottoming out of inflation, rising commodity prices (particularly crude), the start of gradual monetary tightening and consequently rising yields globally indicated the end of rate-cutting cycle by RBI.

For the first time in last six years, the central government will borrow more than budgeted, indicating a likely miss in fiscal deficit target (likely by 30bps). Outlook for government finances in FY19 is also not significantly better. While the GST related revenue disruptions should peter out, the government will face the pressure on expenditure. The onus of supporting growth and investment will also rest on the government as it heads into the last full year budget before the 2019 general election.

The global monetary easing cycle is over and the central banks are likely to either stay pat or embark on a cautious rate hike cycle. ECB will most likely stop its net asset purchases when the current program ends in 2H 2018. US dot-plots indicate three rate hikes in 2018. However, as the policy rate moves higher and the gap to longer-term rate closes, the ability to provide a more reliable forward guidance will diminish leading to more volatility in financial markets.

Crude oil prices may remain elevated on OPEC member’s commitment to production cuts and improving global growth. On the other hand, it is getting increasingly difficult to establish a consensus on US Dollar. While the tax reform and consequent growth improvement in US lend strength to Dollar, doubts are raised when growth elsewhere is taken in cognizance. Crude and US Dollar Index will be the two global parameters to closely watch in 2018 as it can have significant implications on Indian and global markets.

Domestically, fiscal and politics are key risks to watch. It is an election heavy year with eight state elections, which would also set the tones for 2019 general elections. Consequently, Union budget is likely to be rural focused and hence the related sectors should benefit. It will be important to watch tax collection buoyancy as it will have its bearing on government’s ability to spend particularly on capex.

Disruptions pertaining to reforms measures will phase out as we progress through 2018 and lead to some growth recovery on the back of revival in consumer sentiment and pick-up in business manufacturing activity. Some green-shoots of increased capacity additions can be seen in the cement, steel and Oil & Gas space, but a broad based strength in private investment in lacking. The latest Q3 FY18 data on new project announcement (released by CMIE) has fallen to Rs. 768 billion, the lowest level since 2004. We would be keenly watching if India is finally able to participate in global growth recovery. Some of the large export sectors such as textiles, Gems & jewelries, pharmaceuticals and IT services haven’t done as well due to industry specific challenges. From a broader perspective, India hasn’t invested enough in innovations and R&D which requires considerable attention by the policy makers and industry.

Hardening of yields may have an impact on domestic flows and global liquidity tightening could challenge the FII investment. To that extent, earnings trajectory will be closely watched in 2018. In the latest Q2 FY18 results, the downgrades in earnings were negligible in most sectors and there is an increased hope of revival in earnings cycle in 2018. The revival in earnings is absolutely critical for such rich valuations to sustain. Last few years have favored growth over value stocks. However, recently we have seen interest emerging in contrarian themes such as corporate lenders, telecom and construction. After the stellar performance in 2018, particularly in mid and small caps, it is very important to keep an eye on valuations. We remain focused on bottom up stock picking.

While the growth may recover, the rising crude price challenges the stable macro of Indian economy. The downward trend in CPI inflation has also likely ended thus leading the RBI to maintain status-quo on rates.

As we head in 2018, one should also watch out for trend reversal on rates and bank credit growth (both to rise). We are optimistic on the NPA resolution process and in line with that, expect bank credit growth to recover in FY19. Against this back-drop, deposit mobilization and liquidity will be the key. Banks are sitting on SLR holdings of ~28% of NDTL against the mandated norm of 19.5%. Drawdown of excess SLR holdings may adversely affect the banks’ appetite of government bonds.

Though, purely from valuations perspective G-sec yields are turning attractive, one needs to watch the impact of credit recovery on G-sec demand and shaping up of crude trajectory.

Navneet Munot
CIO – SBI Funds Management Private Limited

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

 

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