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Asset Allocation Quarterly

Sep 4, 2017

“I would have written you a shorter letter, but I ran out of time” – Blaise Pascal

Sanctum Asset Allocation Framework

This week, we update our asset allocation pairs framework which forms the key input into our asset allocation profiles and strategy. We use a relative valuation factor based framework.

For instance, we compare Equities versus Bonds, Gold vs. Cash, USD vs. INR, Corporate vs. Government Bonds and so forth to come up with relative preferences.

For each asset pair, we analyze macro, valuation, risk and technical factors and assign a score to each factor. Our scores and relative asset preferences feed into our wealth profiles and form inputs to our investment strategy. In all instances, our models are intended to imbibe discipline into the investment process and eliminate reliance on emotional investing.

Sanctum Asset Pairs Framework

Asset Allocation Quarterly

Scoring Methodology & Interpretation

Asset Allocation Quarterly

For example, in the table above, the score for Large Caps Versus Mid Caps is +3. The score has shifted 6 points from the previous quarter, indicating a strong shift towards large caps.

Further, our positive, negative and neutral ratings are listed from a preference for the first asset class listed in the table. In this case, a positive rating on valuation, for instance, would be from the perspective of large caps.

Equities Vs. Bonds

Asset Allocation Quarterly

Relative Asset Valuation Tilts Slightly Towards Bonds – Negative

The yield on the 10 year is at 6.5% and the yield on equities (trailing) is at 4.3%. Nifty yields have dropped with the rise in prices, and weak earnings. We would highlight that the relative yield analysis does not factor in capital appreciation for either asset class and is only a relative yield measure.

Relative Yields Slightly Favor Bonds

Asset Allocation Quarterly

Yields on bonds have dropped quite sharply the past couple of years and remain in what can only be called a downtrend. The net result of this race in equity and bond yields lower is that the relative attractiveness remains at neutral levels for bonds and equities, with a slight skew in attractiveness towards bonds, as well as a relative shift in preference towards bonds.

Valuations Remain Elevated for the Nifty – Negative

At the index level, the Nifty P/E is at extended levels, both on a forward and trailing basis. These levels on the Nifty have usually been associated with sub-par returns on the index. Further, while the Nifty sports a PE-to-growth (PE/G) ratio of over 3 times, bottom up portfolios such as the Sanctum PMS portfolios sport a number closer to 1.2-1.3 times.

Nifty Price/Sales Ratio Is At Elevated Levels…

Asset Allocation Quarterly

Expensive on a Price to Cash Flow at +1 S.D.

Asset Allocation Quarterly

The Term Premium of G-secs Over the Repo Rate Has Narrowed – Negative

The term premium for the 10 year g-sec over the repo rate has narrowed in recent weeks. Given the 10 year rarely ventures below the repo rate, the opportunity for a flattening of the slope of the yield curve remains low.

A Narrowing Term Premium Favors Equities

Asset Allocation Quarterly

Real Ten Year Yields Have Risen – Negative

A rise in real rates has been a clear negative for equities in the past few years. Real rates were negative in the summer of 2013 when markets were selling off, and rose in Nov-14 and Jul-15, presaging the sell-off in the second half of 2015.

While Rising Real Rates Are a Negative for Equity

Asset Allocation Quarterly

Corporate Earnings Muted By GST Impacts – Negative

The key takeaway on earnings this past quarter has been the weak bottom line growth. Only 43% of companies have met expectations and earnings performance for the quarter can only be classified as disappointing relative to expectations.

Nifty Earnings Growth Is a Mere 5% YoY

Asset Allocation Quarterly

Short Term Earnings Momentum Remains Flat

Asset Allocation Quarterly

Technical Momentum – Positive

Flows continue to drive the market. AMCs continue to aggressively deploy capital and are absorbing and dominating FI flows.

Domestic Flows Driving the Market

Asset Allocation Quarterly

Large Cap Vs. Mid Cap

Asset Allocation Quarterly

Large Caps Attractive on Trailing P/E – Positive

The trailing P/E ratio for large caps is 23.1 versus 31.9 for mid caps. While we play lesser emphasis on forward estimates, the forward P/E for large caps is 18.1 and mid caps are 19.9.

While the ratio favors large caps, we would note that the growth prospects clearly appear to be more attractive for mid caps.

On a relative basis, large caps delivered better relative earnings performance in the concluded quarter.

Large Caps Are Relatively Attractive on Valuation

Asset Allocation Quarterly

On Forward Valuations As Well…

Asset Allocation Quarterly

Technical Momentum Strong for Large Caps – Positive

The skew towards large caps was driven by a three point swing in the technical score, with strength in momentum clearly favoring large caps.

Large to Mid Index Above the 150 DMA…

Asset Allocation Quarterly

Corporate Bonds Vs. G-Secs

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Limited Spread Compression – Neutral

Spreads between the 10 year and AAA bonds have narrowed, and are now at five year averages, leaving little likelihood for spread compression.

10 Year G-Sec & AAA Bond Spread

Asset Allocation Quarterly

Short End Credit Spreads Are Narrow – Neutral

Spreads between the 10 year and AAA bonds remain narrow, leaving little room for compression.

G-Sec & AAA Corporate Bond Yield Curve

Asset Allocation Quarterly

Term premium at 20 bps while the tenor spread between G-Sec and AAA is around 100 bps – Positive

Rates have been in a downtrend since late 2014. While the spread between the repo rate and the g-sec is now a paltry 20 bps, the spread between g-secs and corporates is roughly 100 bps, a positive for corporate bonds.

Term premium at only 20 bps

Asset Allocation Quarterly

PSU Yield curve has become steeper in the last 3 months – Negative

Finally, the PSU bond yield curve has steepened in the past three months, implying rising risk premiums for higher yielding, risk assets, and an indicative negative for corporate bonds.

PSU Bond Yield Curve

Asset Allocation Quarterly

Volatility & Risk – Negative

Intra-day g-sec volatility is at average levels for the past few years. From a liquidity perspective, g-secs hold the edge over corporates, despite the recent rise in interest in corporates from foreign debt investors.

Flows – Neutral

FI flows into debt have been strong year to date, but with the limits on FI investment being reached, further flows from FIs look to be muted. While the shorter term outlook looks to be neutral, we believe FI interest in g-secs and corporates continues to hold strong.

FIs Have Invested 19.6B YTD in Debt

Asset Allocation Quarterly

Technicals – Positive

Technical momentum for Corporates is skewed positive, with the 10 year g-sec looking set to challenge it’s longer term DMA, while corporate bonds remain in a downward trend, as also evidenced by MACD.

Corporates Remain In a Bullish Trend

Asset Allocation Quarterly

While G-Secs Have Reversed S/T Momentum

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Bonds – Short Vs. Long

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1/10 Spread – Neutral

The yield spread between the long and short end of the g-sec curve remains in neutral territory, but we’d note with a strong trend headed towards the long end at some point. For now, the indicator points neutral.

1/10 Spread Is In Neutral

Asset Allocation Quarterly

Relative Valuation to U.S. Treasuries – Positive

The current spread of 4.4% is much lower than the historical average. However, we’d note that for the first time in years, the stability of the INR is leading to unhedged exposure in g-secs by FIs, with the possible expectation of slight currency appreciation. The indicator, though, points positive for short term bonds.

Relative valuation of long end vs. U.S. not attractive for long term bonds

Asset Allocation Quarterly

5/10 G-sec spread – Neutral

The interest rate spread between 5 year and 10 year g-secs is in neutral territory.

5/10 Spread is Neutral

Asset Allocation Quarterly

Duration of Dynamic Bond Funds – Neutral

The actions of dynamic bond fund managers appear mixed. While Kotak Bond and Reliance Income have been reducing exposure to duration, Birla Sun Life Dynamic Bond Fund and ICICI Pru Income remain long duration.

Duration of Dynamic Bond Funds

Asset Allocation Quarterly

Expecting an uptick in inflation – Positive

With rising commodity prices that were part of the reason for dismal earnings, expectations are that inflation will tick up in coming months. That suggests that the short end of the curve will be a better place to be.

Gold – Moving Towards Slightly Underweight

Asset Allocation Quarterly

Bullish Sentiment for Gold – Neutral

Gold Bullishness has shown leading characteristics over the past couple of years. There’s been a noticeable uptick in Gold bullishness since Jan-17; however, Gold in U.S. terms is up a meagre 12.1% YTD. Further, recent divergence suggests that bullishness is waning.

Gold Bullish Sentiment & U.S. Gold

Asset Allocation Quarterly

Gold-Oil Ratio – Negative

Over the past 20 years, a contract of Gold has been able to purchase 15 barrels of Oil on average. Today, a contract of Gold purchases 27 barrels of Oil, suggesting that Gold on a relative basis is now vastly over-valued relative to Crude, suggesting a negative bias to Gold prices for the future.

Gold & Oil Ratio

Asset Allocation Quarterly

U.S. Inflation – Negative

Gold has traditionally been viewed as an inflation hedge and benign inflation trends in the U.S. suggest that inflationary pressures on the commodity are light, not only from a Crude oil perspective but also from an inflation perspective.

U.S. Inflation & U.S. Gold

Asset Allocation Quarterly

U.S. Real Rates – Negative

Real U.S. rates affect the cost of carry for Gold. Real inflation is also a leading indicator for Gold prices. With real rates in a declining trend over the past few months, the outlook for Gold remains neutral.

Treasury Inflation Protected Sec & U.S. Gold

Asset Allocation Quarterly

Trade Weighted Dollar – Neutral

The relationship of the trade weighted dollar with Gold is dual in nature, with a positive correlation during crises and negative correlation otherwise. During normal times, the relationship is tenuous. The dramatic weakening of the trade weighted U.S. dollar over the past year has not witnessed an attendant rise in the price of Gold. A weakening U.S. dollar is a strengthening signal for Gold, but the relationship has not held true of late.

Trade Weighted Dollar & U.S. Gold

Asset Allocation Quarterly

S&P Volatility Index – Negative

Despite recent geo-political tensions between the U.S. and North Korea, the VIX has declined modestly. Risk appetites and desire for risk assets has led to a decline in VIX and with limited uncertainty in global assets, any flight to safety trade (Gold) does not seem likely or imminent.

U.S. and INR Gold Price – Neutral

INR Gold has shown a divergence versus U.S. Gold due to the imposition of domestic levies. Demonetisation also negatively impacted demand for Gold. Post demonetization and post restrictions, the price of INR Gold has demonstrated lower volatility and lower upside, and remains range bound.

INR Gold & U.S. Gold

Asset Allocation Quarterly

Demand for Gold by ETFs – Neutral

ETF Gold holdings remain mired in a neutral range, post a spike late last year, and domestic desire to hold risk assets remains strong.

Technical Momentum – Positive

Gold stays solidly above the 200 DMA and MACD, suggesting that U.S. Gold is in an uptrend technically.

Technical Momentum & U.S. Gold

Asset Allocation Quarterly

USD Versus INR

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USD Weakening Versus Major Currencies – Negative

The unravelling of the political currency that Donald Trump enjoyed in the first 100 days is the primary cause of reversal trade and weakening in the Dollar index. Capital rushed to the U.S. as rhetoric trumped reality, and as reality sets in, capital is heading back outside the U.S., to emerging markets, Japan and Europe. That in our opinion, is the primary driver.

It’s Not Just INR Strength, It’s Dollar Weakness

Asset Allocation Quarterly

A Strong Domestic Fiscal Situation Helps the INR – Negative

The unravelling of the political currency that Donald Trump enjoyed post-election is the primary cause of weakening in the Dollar index in our opinion, as capital seeks returns outside the U.S.

India’s External Debt Exposure Has Declined

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FX Reserves and Import Cover

Asset Allocation Quarterly

All Flows Point to a Stable Strengthening Rupee – Negative

Benign Crude, a strong fiscal situation, strong flows into equities and debt, rising forex reserves and reforms….

Crude and USD INR

Asset Allocation Quarterly


Why the Market Rallied on Weak GDP Data

Demonstrating the perversity of market action at times, stocks rallied sharply last week when the first announcements of a weak GDP print came out on the newswires. Our interpretation, and the only logical one, is that markets are either looking beyond GDP data to a rebound in the current quarter, or the alternative of an accommodative RBI or government stepping forward to spur the economy.

Managements Upbeat on GST Restocking…

Many managements during the call mentioned that Jul-17 was a month where there was a visible pickup in inventory stocking. This bodes well for consumer facing sectors and the economy.

Credit Growth Stabilized in Mar-17

Notably amongst the vast morass of data is the recent tick up in consumer credit to 6.4% from a bottom early this year at 4.1%. While certainly not reminiscent of the hey days, it’s at least headed in the right direction.

Commercial Credit Bottomed in Mar-17

Asset Allocation Quarterly

India Does Not Sell at a Premium to Emerging Markets

Asset Allocation Quarterly

Flows Continue to Drive the Market

While markets remain expensive, flows remain strong. For now, that factor more than others, is driving the markets. The domestic investor has now absorbed all the selling of the FIIs and then some, and flows show no sign of ebbing.

Nor does India sell at a premium to other emerging markets, or developed markets.

We Do Not See a Turn in the Business Cycle

At a macro level, our asset allocation models tell us that bonds are at a slight positive weighting versus equities. Past data confirm the view. Forward expected returns at the index level are muted when compared with history. However, as we’ve stated previously, we do not see any signs in the domestic or global macro economy to suggest a turn in the business cycle

Our pairs asset allocation suggests continuing strength or stability in the INR, a continued negative bias for Gold but less so, moderate preference for large caps and a slight preference for bonds, particularly corporate bonds and shorter term maturities.

However, the performance of stocks – some of which we’ve held in our PMS – confirm that more than anything, getting the right sectoral allocation has been critical, as has stock selection the past three years. Minda Industries, for instance, has quadrupled since we bought it in Titans last summer. It would take bonds 28.5 years to deliver similar 300% returns. Leaving aside the exceptional, many stocks have delivered 40-60% returns.

In contrast, long term bonds offer a best case expected return in the very low double digits, if the duration bet works out with an aggressively easing RBI. Using Sanctum core portfolios as a base case for a bottom up portfolio, the long term growth is 18%-20%. Bonds win out versus the Nifty 50, which in this cycle has averaged roughly 8%. But bottom up growth portfolios will outpace bonds over the longer term.


Therefore, a reasonable way to reconcile macro and micro is to maintain discipline on asset allocations, ensuring yield expectations are met, rebalance if necessary, while preserving exposure to high growth portfolios and assets, while staying within the asset allocation construct. Alternatives and add on approaches are structured products, hedging at cycle turns, and tactical approaches.

Technical Strategy

It was a positive week for the market with the Nifty gaining 1.19% to close at 9974 levels. Domestic fund flows continue to be strong which have absorbed the foreign outflows in Aug-17. After consolidation of last three weeks’ 9685-9950 levels, index has given breakout on the upside. Momentum indicators have also given positive crossover on daily chart. Now, if index sustains above 9900-9850 it can see rally towards 10140-10180 levels. But 10000 level is the immediate resistance for the market which has the highest open interest for Nifty call options. On the downside 9685 level which was last month’s low becomes critical level for the market. Also in Nifty options, 9700 strike price put has the open interest indicating the strong support level for the market. Nifty put/call ratio has moved up to 1.38 suggesting a base for the market on the downside. India VIX last month touched a high of 15.20 and retreated back to 11.68 levels which is supportive for positive sentiment.

Asset Allocation Quarterly