Apr 11, 2016
Equity
Positive Developments in the Domestic Economy
Over the past few weeks, we have been noting a number of positive economic developments in the domestic economy. In particular, we see upticks in leading and coincident indicators in the transportation sector. This is of particular importance as transports are a leading indicator of economic activity.
Valuation Remains on the High Side
While positive factors are visible, valuation concerns remain & the upcoming FY4 2016 earnings season is a concern. This could play out in a couple of scenarios. The market could start taking haircuts to stocks that disappoint. Earnings results being backward looking in nature, the market could alternatively choose to look past the previous quarter and focus on the New Year. The direction taken we think will depend on global cues, obviously, but also on the economic data presented this month, particularly inflation, credit growth and services/manufacturing production.
What gives us further pause on the index, is the heady valuation. Rarely have markets bottomed at levels we saw in February. The earnings season will offer further clarity on future market direction.
If earnings disappoint, it only increases the work that lays ahead of the market and as usual, analyst estimates will need to be revised lower. Over the longer term, markets will re-gain higher levels only on the back of earnings growth.
The Nifty Index is currently trading at 15.3x 12 months’ forward earnings against a 10 year average of 14.6x; while the midcap index is trading at 16.6x against historical average of 13x of 12 months’ forward earnings. Given the weak earnings outlook, the market run up appears to be ahead of fundamentals.
Stock level volatility could be high on earnings misses and so vigilance on active portfolios is strongly advised on the day of earnings release.
Our preferred area of focus is structural, predictable growth with reasonable valuations, low balance sheet leverage in sectors with attractive long term demographics. Our favored themes remain selective pockets within finance, pharma, cement and auto. We prefer growth over value. We prefer domestic growth stories over companies that have developed markets exposure. We are watchful for opportunities in consumer related opportunities, however valuations remain a concern.
Globally, we will add more commentary as we get access to data and models, but for now, we believe global risk remains elevated and all that is achieved with additional quantitative measures is that the can gets kicked down the road.
India may well be the only major economy that is tackling its NPA head on in a transparent and rational manner. We remain hopeful that fiscal discipline, solid monetary policy, and the avalanche of government initiatives should bear fruit at some point in the future in the actual on ground numbers.
The global economy remains a risk. However, the larger risk is allowing the fear of global forces to lead to sub optimal investment choices as we believe the domestic story remains a standout story.
From a technical perspective, the NIFTY 50 Index faces strong resistance around 7780-7800 levels having completed its 61.80% retracement of the previous downside move from 8350 to 6808 levels. The market tested support at 7550 levels and for now that support has held. However, with the upcoming releases on earnings, we believe the market remains susceptible to the downside to 7300-7400 levels.
Fixed Income
The Reserve Bank of India (RBI) cut its key policy rate by 25 basis points and announced significant changes to the liquidity framework, in line with our expectations.
Overall, the tone remains accommodative with greater focus on liquidity management and transmission of current and past policy rate cuts into lending rates. While the accompanying policy commentary is definitely guiding for further rate cut(s), we continue to feel that the RBI will have limited room to cut policy rates beyond a further 25 bps over the course of this year due to evolving inflation dynamics.
The RBI has clearly admitted in this policy review that there are uncertainties surrounding the inflation path emanating from various factors. Further, as per RBI forecasts, the biggest risk to the baseline projection of 5% on CPI by Mar 2017 is the implementation of the 7th Central Pay Commission which could impart up to 200 bps of uptick. We expect a further 25 bps rate cut depending on three key variables – the forthcoming monsoon distribution, stable headline CPI and further transmission of rates by banks to end consumers.
Outlook
We expect a further rally in the short end of the yield curve while long end rates are expected to be range bound. The risk-reward payoff in our existing duration trade seems to now be tilting towards risk but we continue to ride the current momentum and remain watchful for any action. We continue to look out for selective offerings of preference shares at 9%+ levels and moderate credit funds with a blended rating of AA and YTM’s of around 10%.