Jul 24, 2017
“The contrary investor is every human when he resigns momentarily from the herd and thinks for himself” – Archibald MacLeish
It’s been a tough decade for the rational investor. Interestingly, one simple rule over-rode all others; following the actions of the central banks led to outsized returns. Today, skepticism and fear is elevated, primarily on valuation concerns. There’s chatter about ground realities not being great and financials struggling, but early indications on earnings from IndusInd, RBL Bank and Bajaj Finance have been impressive, particularly considering June numbers were impacted by GST fears. Consumption appears to be showing signs of recovery as well, with bellwethers Hindustan Unilever and Jubilant Food delivering good numbers. It remains a market of haves and have nots.
Macro Outlook
The macro outlook for the economy looks good. Agricultural growth has seen a pickup over the past four quarters and this trend is likely to continue this year. Services growth bottomed in Q4 CY16 and showed a small uptick in Q1 CY17. Industry growth, however, remains a spoiler, decelerating from a growth rate of 10.3% in Q4 CY15 to a lackluster 3.1% in the recent quarter.
Agriculture and Services Look Well Positioned While Industry Growth Has Decelerated
PMI data lend further support to the improving macro outlook, with services and the PMI composite index demonstrating a rising trend, while manufacturing remains mired in a muted recovery.
There’s a likelihood the market is possibly under-appreciating the vast impact GST will have in bringing the unorganized and underground economy into the fold. The government looks set to benefit from rising tax rolls and the consumer looks set to benefit from pass-on savings, as witnessed in the automobile and FMCG sectors. Finally, publicly listed corporates look set to benefit from the move towards organized, improved operational efficiency and challenges confronting the unorganized players. In the shorter term, corporate also looks set to benefit from inventory re-stocking this quarter.
Pickup in Rural
We expect a pickup in rural spending on the back of two decent monsoons, farm loan waivers, government initiatives in agriculture, irrigation, construction, housing and the 7th pay commission.
Government Vs Corporate Bonds
There has been a gradual widening trend in spreads between the 10 year g-sec and AAA over recent months. Spreads widened in particular during demonetization and have since seen a slight contraction. However, the ten year g-sec repo rate spread has also narrowed. The widening spreads versus corporate bonds are reflective of the marked improvement in the country’s fiscal situation, stable exchange rate, a recognition of ground-breaking reforms implemented, and improving economic prospects at the macro level. In contrast, improvements in the corporate sector remain a mixed bag. As witnessed in the previous quarter earnings reports, debt burdens remain challenging for corporates and operating leverage has yet to kick in at a macro level.
Spreads between the 10 Year G-Sec and 10 Year AAA Have Widened
Our view remains that the economy is on a recovery path, particularly in services and rural consumption. We expect to witness improvements in the second half of the year and Q4CY17 to be the quarter where we anticipate a noticeable improvement in corporate performance.
The 10-year g-sec AAA spread is also elevated relative to shorter term maturities, suggesting a likelihood of compression in coming months, purely on a mean reversion basis. Corporate upgrades to downgrades are averaging around 1.5 times positive to negative currently, which is within ranges witnessed during recoveries and indicative of an improving economy.
The AAA PSU yield curve has shown a similar curve steepening over the past couple years, again highlighting the relatively higher risks relative to g-secs – and opportunities – in the PSU space vis-a-vis g-secs.
The FPI Investor Is Back
Globally, the FII investor is back with a vengeance, on recognition that the Trump trade is high on hype and low on delivery, and a hawkish Fed and a decidedly unappealing, liquidity dampening, rising rate environment. FII flows year to date are the highest on record since 2014. While flows into g-secs by FPIs have rebounded, it’s noteworthy that average daily volumes in corporate bonds have also shown strong growth, arguing for a positive view on interest rates in the short term.
FII Flows Have Strengthened
Notably, however, the current spread between Indian and U.S. treasury bonds is now at 4.18%, which is roughly 100 bps lower than the average spread over the past few years. The spread compression suggests that we’re yet again at levels on the 10 year g-sec that are unlikely to excite FIIs much longer. What we can safely conclude is that the FII investor would be a buyer should g-sec rates head back above 6.75%.
We remain positive on corporate bonds relative to g-secs, particularly with active management, management oversight, alongside the expectation that the economy will demonstrate stronger momentum towards the latter half of the year, and will be reflected in corporate upgrades and an attendant narrowing in spreads.
Lower volatility in recent weeks points to softer G-Sec yields
G-sec volatility has remained fairly low the last couple of weeks on several data points such as favorable and consistently low CPI readings, good monsoon progression and smooth GST roll-out. In fact, smoothed volatility appears to be coming off relatively high short term peaks seen in May-Jun-17 after the reading of 2.2% CPI for May-17. With declining volatility, price discovery risk has mitigated. Alongside an increasingly stable political backdrop, this risk softening trend should continue in the short run and there remains room for further volatility reduction from elevated levels seen in May-Jun-17.
Corporate bond yields positioned better for potential uptick
From a technical viewpoint, both G-Secs and Corporate bonds trade marginally below their 30DMAs. However, both indices are pushing up against the moving average, suggesting that the momentum on the rally is waning. This confirms the declining volatility we noted earlier. On a relative basis, we expect corporate yields to continue to outperform g-secs in the near and medium term. Further, corporate bonds still offer relatively attractive yields in the 7.3% plus range.
Duration
We’ve been of a neutral view on duration since the end of last year. The 10 year rate initially spiked post demonetization on the RBI’s move to a neutral stance and has since dropped back to earlier levels as investors saw a trading opportunity.
Spreads between the 10 year and shorter maturities have compressed in the past few months. Inflation data continues to outperform the RBI’s expectations in a strong fashion. While the strength in FPI flows would certainly suggest that a case can be made for a continued rally in government bonds, that’s a contrary call given our view on the business cycle, and one we’re not prepared to make without reliable and confirming evidence, given our holding horizon is generally 3 years.
More likely, we prefer to focus on the contours of the recovery, acknowledging the risk to our call is dominant global liquidity flows that can overwhelm domestic factors over the short and medium term.
We Remain Duration Averse
In the absence of compelling data supporting a continuing decline in the term structure on rates, or opportunity at the long end of the curve, we remain duration neutral, preferring to play higher yields via corporates and AT-1 bonds.
We remain of the view the economy is on a recovery path, positive on accrual funds, avoiding long duration and preferring to focus on corporate bond funds over g-secs, and select actively managed PSU AT-1 bonds.
G-Sec Spreads Have Compressed in Recent Months
State Development Loan Growth Rose Sharply in 2015-16 But Is Contained in 2016-17
Equities Versus Bonds
Room to Ease Gives Equity Investors the Edge, and Comfort
Despite the Nifty PE entering the higher end of the valuation band, we’d note that the spread between the CPI and the repo rate has widened in recent months to multi year highs, leaving room for the RBI to ease, should the economy show signs of rolling over. The clamor for a rate cut is already loud amongst corporates. The luxury of impending rate cuts, if necessary, and an RBI that has no foot to stand on around inflation concerns, creates a positive macro backdrop and gives equity investors further comfort.
Nifty Valuations are Elevated But Benign Policy Remains on Standby
Valuations Remain Extended, but Compensating Factors Are Also At Play
We’ve written previously on our views on valuation. Nothing’s changed, and valuations arguably deserve to a premium in light of the strong macros. One further point we’d note is the multiplier benefits of benign crude oil benefits, which are accruing to the economy, and to consumers.
On a relative basis, our relative valuation model that was a screaming buy in December last year, is now solidly in neutral territory, arguing for a slight edge to equities.
Despite a recent valuation re-rating in the Nifty, our Relative Valuation Model Remains in Neutral
Forward estimates and earnings delivery make equities appear marginally more attractive than bonds
Analysts Are Forecasting a 18.7% CAGR Over the Next 3 Years; We Think That’s Aggressive
Flows – The Rise of the Domestic Investor
Domestic Investors Continue to Pump Money into Markets
For FY18 year to date, inflows from domestic sources at Rs. 20,200 Cr. ($3.1bn) have outstripped FII inflows by a wide margin. The same case can be made all the way back to October 2016. The rising allocation of Indian households towards equities points to sustained flows and reduces the prospect of volatility that may arise from sudden withdrawal of foreign capital. However it is important to note that liquidity is no hedge for valuations or market excesses.
Outlook
Indian Market Remains One of the Top Performers Globally
The Indian Market Remains Amongst the Top Performers Year to Date (in USD)
Rs. 36,000 Cr. Cash Waiting to Be Deployed by MFs
Cash levels at equity mutual funds (MFs) continue to remain high, amid stocks hovering near record highs. Against Rs. 36,000 Cr. of the cash component in Apr-17, May-17 witnessed a slight rise in absolute cash levels to Rs 36,300 Cr. Notably, equity schemes have seen inflows of nearly Rs. 10,000 crore each in Apr-17, May-17 and nearly in Jun-17 as well. Flushed with liquidity, fund managers are facing difficulties in deploying the cash, as stock prices remain elevated. This has resulted in a sustained pile-up in cash at most fund houses.
Flows from HNIs and domestic investors continue unabated and have dwarfed FI flows this year. As we’ve noted in the past, equities is the only asset class that rises in demand as prices rise higher, and is ignored or sold when asset valuations are cheap.
Signs of Froth & Greed Emerging
However, we’d note that signs of froth are emerging in IPOs and investor risk appetites are rising.
Economy on Recovery Track
For now, portfolios continue to deliver. It remains, more than ever, a stock picker’s market. We remain watchful, but our initial thoughts are that earnings appear to be coming through, despite GST impacts. We would note that it is very early days on earnings reports.
With a largely neutral outlook on Bonds and higher expected returns from equities, we would position ourselves with a favourable bias towards equities, while noting price paid for entry is crucial and that’s where active management talent is required.
Current domestic valuations do look stretched but the early indications for the June quarter are that financials – private banks and NBFCs – are executing, consumption is showing signs of a pickup and there have been no alarming negative surprises to date.
We remain of the view that we’re mid cycle in the recovery, with demonetization, GST and a host of factors positioning the economy for better performance in the second half of the year. While we’re certainly watchful on valuations, froth and greed, for now, we continue to see a glass half full on growth prospects.
Technical Outlook
It was a week of consolidation at higher levels for the market as it closed at 9915 just shy of previous all-time high of 9915. For the week, index has formed doji candlestick pattern indicating market may continue to see sideways action if it fails to move above 9930 levels. Momentum indicators have given positive crossover on daily chart, while on weekly chart continue to remain at overbought levels which is generally the case in long trending up moves. On the upside 10000 strike price call has highest open interest (OI) in Nifty options, suggesting it is likely to act as resistance for the market. Sustaining above 9930, immediate level for Nifty is seen at 10032 and then 10200 odd levels. Nifty OI Put/call ratio is at 1.41 levels after touching 5 year high of 1.53, suggesting market has support at lower levels with 9800 strike having highest OI for puts to act as support. On Friday in Nifty put options, 9700 strike price saw OI unwinding and 9850 and 9900 saw OI addition suggesting, market participants expect market to hold current levels heading into expiry week. Thus, on the downside immediate support is seen at 9790 and then at 9675 levels. INDIA VIX measure of volatility closed at 11.08 and continues to remain at lower levels which, is supportive for the market.
