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Prudence In The Short Term

Apr 22, 2016


We laid out a clear and optimistic green shoots story for Indian equities in our maiden Sanctum Investment Strategy Call earlier this week

At the time the Nifty was at 7550. The market obviously saw the same things we saw and we have seen the Nifty zoom higher by 4.0% in a holiday shortened week.

We also discussed global risks and valuation concerns. The former will not recede any time soon and the latter has worsened. Traditionally, there are a few different strategies to manage risk: a) balanced asset allocation b) rebalancing c) tactical asset allocation, d) hedging, e) dollar cost averaging, and f) opportunistic strategies. We have managed risk very effectively in the past using a combination of these strategies. Please do contact us if you would like to discuss risk management frameworks.

Implications of Positive Economic Data & Monsoon

You would have read the news on CPI, Monsoon, IP, so we share a few thoughts on the data.

The 5% inflation level is a psychologically important level. With inflation coming in below 5%, Governor Rajan’s vision of 2-3% inflation starts coming into focus. Low inflation is growth nirvana. The benefits to the markets will be tangible. Lower corporate borrowing and consumer borrowing will release greater corporate profits and disposable income. Good for Equities, Good for Bonds.

Further, the data certainly appears to suggest that accommodative policy could go longer and somewhat farther than the markets expected. This was our view at the beginning of the week, prior to the benign data releases, as we mentioned there was a case for additional easing that could be made.

Steady policy towards attracting foreign capital appears to be paying dividends. On a YTD basis (April’15 to February’16) FDI flows touched USD 41bn. Despite a gloomy corporate outlook, tax collections in the recently concluded year surpassed the revised budgetary target collections.

Normal to above normal monsoons should help revive the rural economy and consumption. After two consecutive years of below normal monsoons, the state meteorological agency IMD has forecasted an above normal monsoon at 106% +/- 5% for 2016, in line with the private forecaster Skymet. They expect El Nino to weaken in June-July 2016 and to turn neutral in August-September, leading to La-Nina phenomena. Central and west India are expected to receive excess rainfall.

We live in a world that is starved for yield and growth. We think the window on attractive yields is starting to slowly close in India. Again, a lower rate structure is a clear positive for Equities.

Governor Rajan used the word “revolution” again with respect to the payments infrastructure.

Sectors showing strength this week:

  • Autos
  • Housing Finance
  • Iron/Steel
  • Chemicals
  • Textiles
  • Food/Sugar
  • Packaging

Autos were the best weekly performer. It is always enlightening to step back. Over the past two years, Midcaps have delivered 21.8% while the Nifty 50 one third of that.

A strong case can be made that India is on a path to a cyclical pickup in economic growth. That being said, prudence dictates that chasing the indices post a 1000 point rally (on the Nifty) is usually an unwise choice. Indices are extremely overbought post today’s action and as investment managers, we would be inclined towards profit protection strategies rather than adding exposure.

The market could certainly head to 8,000 or higher; however, valuation levels are now significantly above fair value and well ahead of earnings, especially if we consider that the index has delivered no earnings growth in almost 2 years. Assuming earnings grow at 8% this year, the yield on Equities at current levels is a dismal 5%. We remain proponents of sector and stock selection; what the index does is essentially immaterial except from a benchmark perspective.

On the most recent data, the trailing 12 month EPS for the Nifty 50 has actually decreased to 364 from 371. If the earnings season is as bad as expected, this number could possibly fall further. We will start sharing an earnings scorecard this week forward.

For clients looking to add equity exposure to index benchmarked investments, we would wait for a pickup in earnings, confirmation of a recovery, a decline in prices, or an improvement in valuations; alternatively, a phased allocation approach is suggested.

For bottom up portfolios, stock selection, stock valuation and sector focus will be the primary determinants of future returns, even ahead of asset allocation, so the caveats above do not necessarily apply.

For advisory portfolios, we would focus on Credit/Diversified Finance, Consumption, Autos, Pharma, Select Private Banks, NBFCs, Chemicals, Textiles and Cement/Building Materials.

Technical View

From a technical perspective, the NIFTY 50 Index has crossed strong resistance zone of 7,780-7,800 levels and in the process closed above 61.80% retracement of the previous major down move from 8,350 to 6,808 levels. During the truncated week market tested support of 7,550 levels and has seen a sharp rally from lower levels giving a close above 7,800 levels indicating good strength in the market. On the derivatives side, huge amount of OI addition was seen in 7,700 Puts was seen, suggesting that this level will act as an immediate base for the market. Now sustaining above 7,700 levels, we expect the momentum to continue towards 8,000 odd levels. However, due to upcoming earnings season market may remain highly volatile within range 7,600-8,000 with positive bias.

Fixed Income

Government bonds rose as retail inflation in March eased to a six-month low, increasing chances of more monetary easing going ahead. However, gains were limited ahead of a fresh supply of government bonds auction later today. The benchmark 7.59% bond maturing in 2026 was trading at 101.23 rupees, yielding 7.41%.

The retail inflation (CPI) for March’16 came at 4.83%, much lower than the market expectation of 5% and revised estimate of 5.26% in Feb 16. Largely, the fall can be attributed to favorable base effect. More importantly, decline in services component momentum has offered much respite.

Further, expectations of above-normal monsoon rains, which will likely help keep food prices in check, also supported sentiment. Indian weather office expects annual monsoon rains to be 104%-110% above long term average this year, with 94% probability of the monsoon to be normal to excess.

The market is showing a muted reaction to the sharp fall in inflation as market participants are awaiting the auction results, and want to keep light positions ahead of long weekend. We are likely to have range bound trading at least until the bidding of auction.