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Dependency Revisited

May 16, 2016

There is nothing reliable to be learnt about making money. If there were, study would be intense and everyone with a positive IQ would be rich. – John Kenneth Galbraith

For over a decade, India’s been captive to the whims of foreign institutional investors. That’s not a bad thing; however, FI flows in the past few years have at times been driven by liquidity rather than fundamentals, leading to unwarranted volatility in domestic markets. Gov. Rajan has been vocal about these impacts.

In light of the government’s decision to amend the Mauritius tax treaty, the follow on question is how will this impact FI flows and the domestic market? The broader question is where are we in regards to our dependency on FI flows?

Trend Changes in Institutional Flows

A 10 year look back does not paint a rosy picture. Cumulative FI Flows started picking up in early 2012, right at the start of a strong period for Indian Equities. Sadly, the domestic investor wasn’t as accurate in their entries. Indian institutions were net sellers from Jan 2012 to March 2015.

A closer look is instructive.

Over the past twelve months, the domestic institutional buyer has been a substantial and consistent buyer of Equities. Cumulative domestic inflows have been offsetting foreign outflows and acting as a floor for the market.

We wouldn’t venture to guess where the Nifty would be today were it not for domestic inflows into equities. This is great news, because the FI buyer will come back to India at some point. When they do, it’ll provide further impetus, support and liquidity to the markets.

The ‘financialization’ of India’s investor base is only getting started. The market’s dependency on foreign flows may be waning. That’s good news for all concerned.

FIs Were a Massive Buyer of Indian Equities from Mar 2009 Till Mar 2015… While Domestic Institutions Turned Net Buyers in March 2015

FI Massive Buyer

IIP & CPI: Double Whammy or Blip?

Just when investors were beginning to prepare a charge on Nifty 8,000, the economy threw up a double whammy of dismal news. March IIP growth was a disappointing 0.1% YoY against 2.0% growth in Feb-16 and consensus forecast of 2.5%. April CPI print came at 5.39%, the fastest pace since January, driven higher by costlier retail food prices (+6.32% YoY) and pulses (+34.13%).

In our opinion, the IIP series is volatile while the CPI reading of 5.39% isn’t a cause for alarm just yet.

The contraction in capital goods in the IIP raised concerns on the recovery in private capex cycle. As we’ve discussed previously, an uptick in the private capex cycle is still some ways away. Low capacity utilization rates will only serve to impede the process.

We prefer to focus on strengthening consumer trends and strong public sector investment. The RBI has done its job and provided the spark that was necessary to give the economy a kick-start. The seventh pay commission and a favourable monsoon look likely to provide a further impetus to economic growth.

We’d add that a shift in rural incomes appears underway with rural infrastructure spending, ‘Housing for All’ and a myriad of programs helping spur healthy demand in rural and semi urban areas.

Our immediate area of concern is Governor Rajan’s re-appointment for a second term. We were early in our admiration for the man, his politics and policies when it wasn’t fashionable to do so.

Domestic Investors’ Buying Has Been Offsetting FI Outflows

FI Outflows

Fixed Income

On April 18th, we stated that “we continue to feel the RBI will have limited room to cut policy rates beyond a further 25 bps.”

On May 9th, we stated the rationale for easing had weakened as inflation was likely to edge up in coming months.

We believe that the RBI will have limited room to cut policy rates – at most by 25 bps – due to evolving inflation and real-rate dynamics. We are nearing the end of the rate-cut cycle and long end rates are expected to trade in a range for the medium term.

Pending implementation of the 7th Central Pay Commission which would be followed by implementation of respective state pay commissions and PSU pay scales, we feel that retail inflation is unlikely to fall below baseline projection of 5% by Mar 2017. As per RBI, the direct impact of the 7th CPC recommendations on headline inflation is expected to be around 150 basis points while the indirect effects are estimated to be around 40 basis points.

Market is also factoring these expectations. In spite of having relative favourable supply dynamics for first half, the 10-year G-sec yield has inched up by 3 bps since April 1 and currently trades at 7.45%. Further, the FII participation in debt so far this year has been tepid.

Subdued Demand from Banks in spite of Positive Carry

Banks enjoy a positive carry environment today. Banks have the ability to borrow at overnight money (6.50% levels) and can deploy anywhere on the G-Sec curve (7.00% to 7.90%). In spite of this positive carry opportunity, banks have been wary to increase G-Sec exposure because of a lack of directional confidence about the economy.

Looking at our expectations and the yield curve, we feel short end rates can move lower over the next few months, as the liquidity situation eases further and hence ultra-short and short term funds should do well. For the medium term, we recommend focusing on moderate credit oriented accrual funds.

Technical View

Though the Nifty index made a high of 7916, it was unable to sustain above 7900, pulling back into a trading range, settling at the 7815 level – up 1.05% for the week. Nifty Futures continue to see profit booking as traders unwind their long positions every time price retreats from higher levels. At the same time 7700 and 7800 strikes, which have highest open interest for Puts, provide support to the market.

This week, if market breaks below 7780-7750 level, with momentum indicators already giving negative crossover with their respective averages; we could expect a decline towards 7650-7600 levels. Immediate resistance for market stands at 7900-7920 levels, but 8000 Call which saw further addition of OI will cap the gains for the market and any unwinding will be positive for market. Broader range for market is seen between 7950-7650 levels and breakout from the same will set the trend for market.


We Believe the Secular Trend Will Prevail

Looking at the bigger picture, let’s acknowledge that retail inflation has halved in the past couple years and further gains will require additional work.

We believe in the government and RBI’s intent and ability to reduce inflation further. While we may see yields stabilizing or firming slightly in coming months, we continue to believe initiatives underway will harness inflation further over the longer term.

For instance, the waterways project will reduce the cost of transport by over 40%. Innovations in irrigation, supply chain logistics, agro-products, technology and better market transparency are just a few areas the government and entrepreneurs are targeting.

The path to a low inflationary regime will not be easy and will not happen overnight. However, fiscal and monetary reforms will serve to move us towards the Governor’s long term vision of a low inflation economy. The rewards will be well worth the effort.

With this backdrop, we expect global flows into India will rise with a rising share of global growth and global GDP. A host of factors which we’ve addressed in previous commentaries will ensure the domestic investor stays invested.

Mutual Fund Folios Are Up 13.1% YoY……With 40 Lakh New Accounts in the Past Year

Mutual Fund Folios

Incidentally, India (Nifty) is the top performing major market over a one and three-month period. Yesterday’s emerging markets are today’s global growth engine and yesterday’s cyclicals are today’s secular.

There will be potholes on the freeway to wealth. We hope the domestic investor keeps the faith. If they do, in a patient, wise and selective manner, they are bound to be handsomely rewarded.