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A Rise in Complacency & U.S. Risk Premiums

Feb 6, 2017



  • Complacency Starts to Set In
  • Trump’s Fiscal Stimulus Not a Done Deal
  • Honeymoon with Wall Street Waning
  • French Bonds Spiking


  • Consensus Bullishness Abounds
  • Why Markets Loved the India Budget
  • Interest Rate Forecast
  • What is Driving Equities Higher?
  • Outlook

I’ve lived through some terrible things in my life, some of which actually happened ( Mark Twain )


Trump’s Infrastructure Stimulus Will Require Democrat Assistance

Unlike Mark Twain’s lament, it is looking like some terrible things could happen under Trump’s reign. It is also becoming evident that Trump will almost certainly need Senate Democrats to get infrastructure legislation through Congress.

While Senate Democrats want to build on existing government programs and adding to the deficit, Trump has emphasised tax credits that would pay for themselves.

Meanwhile, Republicans that control the levers of congressional power underscored this week that adding to the deficit to pay for the stimulus is a non-starter.

Trump Refines His Infrastructure Plan

The President told the nation: “We will build new roads and highways and tunnels and airports and railways across the nation. We will fix our existing product before we build anything brand new, however.” That is a waffle on his original stance in less than a month; not exactly what markets had in mind.

Risk On U.S. Assets Is Rising

The past few days have amply demonstrated that President Trump is impulsive and liable to act without concern for convention or precedent.

The U.S. has always been perceived as a model of capitalistic efficiency and a country that generally acts in the best interests of corporates and capitalists. As we said last time, throw out the old rule book.

Mr. Trump has demonstrated an open willingness to take away the rights of classes of people he has views against, and that is a worrisome development. This immediately reduces the attractiveness of the U.S. as a safe haven for financial assets, as well as negatively affecting the willingness of skilled workers to migrate there.

Protection & Isolation Part of the Strategy

Protection and isolation are priorities for the U.S. Immigrants could have their lives disrupted at a moment’s notice. As a result, harassment, prejudice, discrimination and hate are likely to rise in the U.S.

Currency War Launched

Trump’s top trade advisor Peter Navarro accused Germany this week of using a “grossly undervalued” euro to “exploit the US and its EU partners. News of the statement sent the EURUSD surging and the dollar tumbling to fresh 2 month lows.

The Trump administration is increasingly willing to antagonise EU leaders, particularly Angela Merkel. Mr. Trump has called the EU a vehicle for Germany and Nato, an obsolete alliance.

Expect currency volatility to pick up. Investor opinion is shifting negatively for the U.S., not just in the short-term but the long-term as well. Policy uncertainty works slowly, but surely, and leaks into actual uncertainty and financial decisions.

Mr. Trump’s nationalistic, protectionist and militaristic tendencies are increasing global tensions and the risk of conflict, and taking center stage over dominant drivers such as central bank policies.

The Global Uncertainty Index Has Spiked

The Global Uncertainty Index Has Spiked

While the USD Index Is at a 2 Month Low

And This Reliable Global Leading Indicator Is Showing Global Weakness

And This Reliable Global Leading Indicator Is Showing Global Weakness

French Bonds Spike

The final slate of candidates for French national elections in April-May is nearly complete and judging by the French government bond risk spiking, the decision to choose radical left wing Benoit Hamon to represent the French Socialists has investors worried about the fiscal future of the country.

Mr Hamon’s win marks a fierce rejection of the business-friendly policies implemented by President François Hollande. It reveals a desire among Socialist party sympathisers to return to core leftwing policies after Mr. Hollande’s unpopular term.

Euro Bonds Off to Worst Start to a Year On Record

Euro Bonds Off to Worst Start to a Year On Record

Fixed Income

Fiscal Prudence & Reduced Borrowings

The Budget scored heavily on the fiscal discipline demonstrated by the F.M. keeping the fiscal deficit at 3.2% for the current year and targeting 3% for the next 3 years. The F.M. also clearly articulated that a sustainable debt path must be the principal macro-economic anchor of our fiscal policy, which sounds downright alien in today’s QE and fiscal stimulus driven world.

Reduced Net Market Borrowings

The budget limits net market borrowings of the government to INR 3.48 lakh crores after buyback, much lower than the INR 4.25 lakh crores of the previous year. Further, the revenue deficit stands reduced to 2.1% from 2.3%.

Possibility of a Financial Windfall

During the period 8-Nov-16 to 30-Dec-16, deposits between INR 2 lakh and INR 80 lakh were made in about 1.09 crore accounts with an average deposit size of INR 5.03 lakh. Deposits of more than INR 80 lakh were made in 1.48 lakh accounts with average deposit size of INR 3.31 crores.

The opportunity universe of INR 3.3 crores across 1.48 lakh accounts is INR 4.89 lakh crores. Including penalties, this represents a large opportunity for the government to increase its tax collections.

Rates Unlikely to Head Higher

Taking the new information on reduced borrowings and fiscal prudence into consideration, our view is that rates are unlikely to head higher from here. We think that rates will remain generally range bound, with a slight bias towards declining gradually.

RBI Stays on Hold

We are hard-pressed to see the RBI lowering repo rate by more than 25 bps as best case. Our view is that if the RBI was unconvinced on lowering rates when the economy desperately needed it in December, it would be surprising and shocking for them to come forward with a rate cut, now that many sectors of the economy are showing a smart recovery and the F.M. has announced a strong pro-growth budget.

The Repo Rate & 10 Year G-Sec Are Appropriately Aligned

The Repo Rate & 10 Year G-Sec Are Appropriately Aligned

We Expect FI Flows to Remain Tepid

We Expect FI Flows to Remain Tepid

The Steepening of the Yield Curve Is a Healthy Sign for the Economy

The Steepening of the Yield Curve Is a Healthy Sign for the Economy

The Spread Between G-Secs & AAAs Remains Wide On the Long End

The Spread Between G-Secs & AAAs Remains Wide On the Long End

Our view on Fixed Income remains unchanged. We would skew towards accrual bonds, locking in rates on a diversified portfolio of select higher yielding corporate bonds, income funds, AT-1 bonds and one off opportunities.

Why Markets Loved the Budget

Qualitative Thoughts on the Budget’s Impact

It is instructive to step back to 2014. Inflation was out of control, vegetable inflation spiraling upwards of 16%. Corruption was rampant in all manner of day to day affairs. Getting things done with the government was painfully slow and arbitrary. Corruption at the highest levels was out of control with massive scams. Politicians were viewed as corrupt.

Fast forward to 2017. Inflation – WPI & CPI – is at 3.5%. Growth is on track, averaging 7% with a possibility for pickup. A legitimate campaign has been waged against black money. Not a single scandal has been unearthed at the national level. Governance is improving and procedures are transparent.

FDI Up 36% in the First Half of 2016-17

FDI to the country has increased from INR 1.07 lakh crore to INR 1.45 lakh crore in the first half of 2016-17, up +36%, despite a 5% reduction in global FDI inflows. The government’s foreign exchange reserves are strong at roughly 12 months of import cover at $361 billion.

Unexpected Benefits of Demonetisation

Tax evasion had become a way of life in India and a parallel economy was operational. Demonetisation is leading to a cleaner, larger GDP while having a painful short term impact. Demonetisation will lead to strong long term benefits in reduced corruption, reduced terrorism, greater digitisation, increased financial flows, higher tax collection and a larger white economy, which will eventually lead to higher GDP and tax revenues. Demonetisation has flushed the banks with liquidity and capital and led to a transmission of lower rates to real estate and corporate borrowers.

Doubling Farm Incomes in 5 Years Will Spur Spending

The Budget’s key concerns are housing for the poor, relief to farmers and credit support to MSMEs, encouragement of digital transactions, infrastructure and poverty alleviation. For farmers, the government wants to double farmer income in five years, and bring about self-sustenance and not dependence, by helping increase production and productivity, providing access to credit, irrigation and micro irrigation funding, while providing insurance against natural calamities.

One Crore Households Out of Poverty

For rural, the plan is to bring one crore households out of poverty by 2019, 50,000 Gram panchayats poverty free by 2019, and sustainable livelihood for every deprived household. MNREGA has been reoriented to support the plan to double farmer income, by creating productive assets to improve farm productivity and incomes.

Lakhs of farm ponds and compost pits will contribute greatly to drought proof gram panchayats. The budget provision for MNREGA has been increased to INR 48,000 crore from INR 38,500 crore.

100% Rural Electrification Will Bring Productivity

Further productivity gains will accrue by achieving 100% village electrification by May 2018. Sanitation coverage is up to 60% from 42% in 2014. The total allocation to rural, agriculture and allied sectors has been raised 24% to INR 1.87 lakh crore.

Affordable Housing to Receive Infra Status

With the infra tag, affordable home developers will be able to avail access to cheaper credit and reduce cost of development, the approval process will be simplified and will lead to job creation and greater economic activity.

Rs 2.41 Lakh Crores for Transportation

Allocation for roads has been stepped up to INR 64,900 Cr. from INR 57,976 Cr. last year. For transportation sector as a whole, including shipping, rail, there is a total of INR 2,41,387 Cr. targeted. Such a large number will spur economic activity across the country.

Unlocking Value in PSEs & CPSEs

The government is keenly focused on unlocking the value of PSEs and CPSEs. CPSEs will be strengthened through consolidation and M&A to create an integrated entity with presence across the value chain, that will enable higher risks, avail economies of scale and take better investment decisions.

PSEs & CPSEs Are Rising

For the first time in years, we are re-adjusting our stance on government enterprises because the government has sent a very strong message to PSUs and PSEs in general on improving their performance. With a more directed management strategy, PSEs have the ability to compete effectively in many sectors given their close relationship to the government and associated strong preference in being awarded contracts.

A new CPSE ETF will be launched in 2017-18.

A Tax Non-Compliant Nation

Here were the statistics the F.M. shared on tax non-compliance. As against estimated 4.2 crore persons engaged in organised sector employment, the number of individuals filing return for salary income are only 1.74 crore. As against 5.6 crore informal sector individual enterprises and firms doing small business in India, the number of returns filed by this category are only 1.81 crore.

Out of the 13.94 lakh companies registered in India up to 31-Mar-14, 5.97 lakh companies have filed their returns for Assessment Year 2016-17. Of the 5.97 lakh companies which have filed their returns for Assessment Year 2016-17 so far, as many as 2.76 lakh companies have shown losses or zero income. 2.85 lakh companies have shown profit before tax of less than INR 1 crore. 28,667 companies have shown profit between INR 1 crore to INR 10 crore, and only 7781 companies have profit before tax of more than INR 10 crores.

Among the 3.7 crore individuals who filed tax returns in 2015-16, 99 lakh show income below the exemption limit of INR 2.5 lakh p.a., 1.95 crore show income between INR 2.5 to INR 5 lakh, 52 lakh show income between INR 5 to INR 10 lakhs and only 24 lakh people show income above INR 10 lakhs.

Of the 76 lakh individual assesses who declare income above INR 5 lakh, 56 lakh are in the salaried class. The number of people showing income more than INR 50 lakh in the entire country is only 1.72 lakh. We can contrast this with the fact that in the last five years, more than 1.25 crore cars have been sold, and number of Indian citizens who flew abroad, either for business or tourism, is 2 crore in the year 2015. From all these figures we can conclude that we are largely a tax non-compliant society.

Real Estate & Financials Are Top Performers Since Budget Day

Real Estate & Financials Are Top Performers Since Budget Day


What has Been Driving This Market?

Simply, it has been extremely strong flows and above expectation earnings.

In what can only be called yet another unanticipated outcome of demonetisation, the domestic investor has been a consistent buyer of Equities. In particular, the flows coming into the markets in January have been unrelentingly positive.

The Domestic Buyer Has Been Supporting Equity Markets

The Domestic Buyer Has Been Supporting Equity Markets

At Some Point the FII Will Return to Equities

At Some Point the FII Will Return to Equities

The FII Investor Has Also Stayed Away from Debt

The FII Investor Has Also Stayed Away from Debt


A Review of Our December 27th Commentary

Here is what we said when markets were bottoming on 26-Dec-16:

It is imperative to stay the course, use volatility and the market’s emotion to advantage, use selloffs to add exposure to Equities. Equities remain at attractive valuations relative to Fixed Income. The long term investor can take advantage of the manic tendencies of the market. We also think the stage is set for the domestic economy to bounce back in the second half. Quality companies are available at valuations that will yield great forward returns on a 2-year horizon. (“Markets & Uncertainty, 26-Dec-16, Nifty50: 7908)

We Are Seeing Complacency Starting to Set In

We remain staunchly bullish long term, and our bullishness is further strengthened by the Budget’s strategic intent.

However, at this point, we are starting to see consensus bullishness, complacency and the first signs of greed. As custodians of our client’s hard earned assets, we forever remain vigilant of what lurks around the corner. Particularly when we find ourselves on the side of the majority, it is time to pause and reflect.

While it is clear that the U.S. economy is improving, we are certainly uncomfortable about the emerging reality of a belligerent world superpower.

It is more important now that the markets have run up quite aggressively to be prudent in fresh money allocations.

Investing in mutual funds with reasonable valuations, focused strategies and sectoral exposure are three different ways to ensure sensible investments.

Our long term outlook on Equities remains bullish. We will stay the course, while being watchful of events unfolding globally and domestically.

Earnings Scorecard

With half the companies in the Nifty 50 reporting, 15 of 26 have reported positive surprises. In the CNX 500, 93 of 179, again more than half have reported positive surprises. Materials, Industrials, Financials and IT have delivered strong results to date.

Earnings Scorecard

Technical Strategy

The Nifty50 saw the week end with 1.15% gain to close at 8741 levels. Now the rally has retraced 78% of the decline from September, 2016 high of 8969 to December, 2016 low of 7894 in six weeks. FIIs have also turned buyers in equity segment with Rs 4335 crores of net inflows for last three last weeks after last quarter of outflows. For last couple of days index has been sideways and consolidating its gains while stock specific action is seen in the market. Relative Strength index (RSI) on daily time frame has reached overbought levels, but on higher time frame i.e. on weekly chart it is yet to reach overbought zone, thus suggesting head room on the upside. Nifty options open interest(OI) put/call which has inverse correlation to index has also seen dip from its recent high of 1.27 down 1.08 is positive. The highest OI in Nifty options is seen at 9000 strike, suggesting as the next level for the index; while on the downside 8500 put has the highest OI which will act base for the market. Crossing 8760 levels next level for the market is the high of 8969 levels and then even possibly all-time high of 9119 levels. On the downside 8550-8450 is the support zone for the market.

Technical Strategy