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Market Outlook
Indian equities gave up some of its gains last month. Year-to-Date, NIFTY has delivered 21.2% in local currency terms and 29% in USD term. YTD, MSCI Emerging market index is up 26% in USD terms.
While FIIs pulled out US$ 2.3 billion in August, mutual funds cushioned the fall and invested a net of US$2.7 billion during the month. This trend of 'financialization of savings' has kept the Indian domestic fund flow upbeat. We expect the primary issuance to increase substantially to capitalize on the large domestic flows.
There are hosts of global events to worry about. The immediate focus will be on US debt ceiling limits. As the US treasury has already hit its debt limit earlier this year, the congress has only a few weeks to negotiate an agreement to raise the debt ceiling. Lawmakers face serious consequences if they fail to agree funding before the fiscal year ends on September 30.
The Trump administration in US has thus far struggled for real actions on its campaign promises. The fine-prints of the ambitious US$ 1 trillion infrastructure plans are yet to be spelt out and so are the nitty-gritties of healthcare and taxation reforms. Consequently, dollar continues to weaken as the market tempers down its expectations from US growth. That said, the Trump administration will be desperate to pull-off some concrete tax reform ahead of the November 2018 congressional elections.
Despite the repeated warnings from the US, North Korea has been pacing up its nuclear weapons and the ballistic missiles program. Given its totalitarian regime, advancement in technical capacity to launch nuclear weapons is a genuine geopolitical risk. While the base case is that a military escalation doesn't blow out of proportion, it is also not surprising to see the financial markets finally starting to react to the risk. Safe haven demand has pushed up gold to a year-high while equities have given up some gains.
Something under-appreciated by the financial markets is the world's rendezvous with climate change. Hurricane Harvey has already set record as America's most severe deluge. Down south-east in India, Bangladesh and Nepal, monsoon floods have played havoc. While the weather bureau have advanced in terms of early warning of such natural disasters, it is absolutely imperative for the governments and businesses to adopt a more foresighted approach towards the consequences of global climate change.
The Philips Curve theory - long guiding bible of developed economy central bankers is getting tested at the practical levels. The theory advocates inverse relationship between inflation and unemployment, as lower levels of unemployment generally creates bargaining power among workers, leading to wage increases and hence inflation. Thus, it stresses the role of economic slack in driving price and wage inflation. Currently, unemployment is close to all-time lows post GFC across developed economies while inflation remains lower than desired levels. Central banks there are being given two contrasting signals, which in turn complicate their future course of action. Not surprisingly, Janet Yellen's speech at Jackson Hole primarily hovered around defending regulatory changes delivered post 2008 crisis. The remarks on future course of actions, particularly on the commencement of balance sheet contraction were strategically missing.
While the US Fed balance sheet has stopped expanding since late 2014, total balance sheet of G7 central banks has continued to expand. Protracted quantitative easing and persistently low interest rates have led to asset price inflation and raises the risk of fault-lines in one or more instruments of the financial markets.
While the macro structure of the financial markets have definitely strengthened post the 2008 crisis (tighter regulations in derivative markets, introduction of Basel III norms etc), its time the central banks move beyond the 'employment-inflation metrics' in their monetary policy discourse. Assets prices today are key channels of monetary policy transmission. Spreads between bonds issued by some of the junk-rated companies in Europe and US government bonds has nearly wiped out. The central banks should mull over restraining the over-exuberance in credit markets. There are times when monetary policy needs to take into
account such financial imbalances. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. Furthermore, the bursting of bubbles throughout history has been associated with crisis that wipes of savings of generations and gets followed by sharp declines in economic activity.
Locally, market's optimism was dented by weaker than expected Q1 GDP and earnings data, weakening trends in monsoon, GST disrupting the business operations and territorial issues with China at Doklam. While the Doklam standoff has eased, replenishment of inventory (post GST disruption) has begun; - there still are uncertainties around real impact of GST in the next few quarters. Hence, earnings could be volatile for a quarter or two.
1QFY18 growth weakened to 5.7% much below market expectations of 6.5%. The nominal GDP growth slowed to 9.3% y-o-y from 12.5% in the previous quarter. Resonating growth trends, NIFTY earnings, too, contracted ~10.0%, worse than street expectations of a 5-6% decline. The majority of the drop has been led by OMCs (on account of inventory losses), higher NPA provisioning and sector specific challenges in IT and Pharma. Other factors explaining the tepid earnings were the adverse impact of GST as the process of inventory clearing was visible across the sectors. To that extent, results should improve as the process of restocking start from the current quarter. Earnings revival is absolutely critical for such rich valuations to sustain (Sensex is trading at 21 times 1 year fwd earnings).
While the long-term India story remains intact, we believe that given the abundant liquidity and ongoing near-term disruptions, one should focus on bottom-up approach, picking stocks with earnings clarity, economic moat and reasonable valuations.
RBI has cut the repo rate for the first time this year to 6% in August as inflation continued to print well below the RBI's expectations. The result has been raising real interest rates. The high real rates are also the reason why the rupee has remained so strong. FIIs have invested US$ 20 billion YTD and have nearly exhausted their auction limits in both central government and corporate bonds.
RBI's 2016-17 Annual report showed that nearly 99% of the specified banking notes (SBNs) returned to the banking system. Further, the exercise to remonetize the country and absorb the excess liquidity from the banking system dented the RBI's net income by approximately Rs. 220 billion leading to a lower dividend transfer to the government. That said, in the medium term, benefits from demonetization including increased tax compliance and financialisation of savings will likely play out.
Rising dollar flows coupled with slowing pace of remonetization implies that the RBI is stuck with surplus rupee liquidity for ten months now. With short-term currency forward books rising to US$ 28 billion, the liquidity conundrum is here to stay for a while. Inflation has bottomed but is likely to stay in reasonable limits (sub-4%). On the other hand, challenges in private investment pose concerns on potential growth. Thus, looking ahead, growth inflation dynamics is likely to keep the hopes of a rate cut alive.
Mutual funds' investments are subject to market risks, read all scheme related documents carefully.
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