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The Third Leg

Apr 16, 2018

All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out – Peter Lynch

This week we share a host of data on the domestic economy and reassess the global and domestic risks facing investors to arrive at our fortnightly investment outlook update.


High Frequency Indicators on the Economy Are Generally Healthy

We share charts and data below on consumer durable and non-durable goods production, utility vehicle sales, passenger and cargo traffic, credit pickup in retail and services, IIP capital goods production, capacity utilization, and transportation. Leading high frequency indicators suggest that an improvement may have occurred in Q4. Going forward, consumption will also be aided with the likely implementation of the award on salaries and allowances at the state level and in public sector entities.

Gross Fixed Capital Formation Is Showing Signs of a Pickup

After three quarters of sluggish economic performance, gross fixed capital formation (blue bars in chart below) is showing signs of a pickup, touching a six-quarter high in Q3. Should fixed capital investment trends persist, alongside government spending and healthy consumption trends, the much awaited three pronged, broader recovery could come forward.

A Pickup in Construction Activity Bodes Well for Rural Consumption

A marked pickup in construction activity, an employment-intensive sector, looks set to support rural consumption. Trends in rural demand have already been improving, as reflected in sales of two-wheelers and tractors, and expectations of a normal monsoon will further aid rural recovery.

Gross Fixed Capital Formation Is Showing Signs of Recovery…
…While Consumption Remains Resilient Evidenced in Autos, Travel & Consumer

Gross Fixed Capital Formation Is Showing Signs of Recovery

Financialization & Credit Trends Remain Strong…
…Retail Credit is Growing at 20.4%, Services at 14.2% and Agriculture at 9%…
…Housing Loans Are Showing Strength Alongside Rising Capital Goods Production

Financialization & Credit Trends Remain Strong

Capacity Utilization Is Rising, As Is Consumer Durable and Non-Durable Goods Production

Capacity Utilization Is Rising, As Is Consumer Durable and Non-Durable Goods Production

Transportation Activity Remains Healthy While Construction Activity Has Picked Up

Transportation Activity Remains Healthy While Construction Activity Has Picked Up

A Pickup in New Order Activity But Consumer Confidence Has Waned…

A Pickup in New Order Activity But Consumer Confidence Has Waned

But Challenges Remain Evident Including Government Financing and NPAs

Challenges remain, however, and primary amongst them is the government financing schedule at the center and equally importantly at the state levels, and the concurrent risk of government financing crowding out private investment.

New Orders, Pending Orders and Backlog Trends are Showing Improvement

RBI surveys also report new orders received by companies surveyed in Q4 CY17 recorded substantial growth over levels in previous quarters and a year ago. The rise in new orders is supported by rising backlogs and pending orders and provide further support of a discernible pickup in economic activity.

But Consumer Confidence Has Waned

Across a variety of measures, consumer confidence waned in the previous quarter. Consumers noted rising worries about job security and reported worsening economic situations and worsening expectations of the future. The outlook for the year ahead was less positive than in previous surveys.


Crude Worries Are Back with Brent Above $72

Nothing impedes recovery and hurts equities like rising crude. It’s not the spectre of war in Syria, but the impact on crude oil that is the worry. Brent crude has risen above $72, levels that were not on our radar at the beginning of the year.

Indications of a Deceleration in Global Growth Amidst Global Trade Fears

Major economies are showing a small deceleration in growth from previously strong growth levels. This was likely driven by rising uncertainty around U.S. trade policies, volatility in the markets and a risk off environment. Trade war rhetoric remains at large, and it remains to be seen how this story evolves.

Fed Hikes, Valuations, Leverage and Liquidity

As we’ve discussed regularly, rising Fed funds and Libor, embedded leverage and liquidity withdrawal remain concerns. More specifically, Fed rate hikes into a global slowdown could be the proverbial classic mistake that is invariably committed at cycle peaks. Rising short rates, whether it be Libor the U.S. Fed Funds rate are also late cycle indicators that bear watching.

The Citi Major Economies Economic Surprise Index is Rolling Over…
…Global PMIs Have Shown Softness…
…And Short Rates Are Rising in the U.S. and U.K.

The Citi Major Economies Economic Surprise Index is Rolling Over



Mutual Fund Flows Remain Steady, FI Flows Volatile

The foreign institutional buyer has been a provider of volatility (see chart below). They were large buyers in Oct and Jan, large sellers in Aug, Sep and Feb. Meanwhile, domestic MFs are pumping in roughly INR 10k Cr a month, or $1.5 billion a month, and that’s the key support for markets.

Key Concerns Remain

The Nifty 50 now sells at 26.0 times trailing earnings, and Nifty 50 trailing EPS sits at 402. On May 16th, 2014, Nifty trailing earnings were 361, which means earnings are up 11.3% over the past three plus years. We’d note the situation is exacerbated at the index level and things begin to look rosier when key sectors such as PSU, Telecom are excluded.

Crude’s follow on impact on rising subsidy burden, and consequently yields, is another concern and could potentially crowd out private investment. Finally, NPAs and inward facing PSUs remain an issue, though we’d argue much has been done to address the matter.

The Conundrum of Overvaluation

Further adding to the complexity of the investment landscape is the persistent and prevalent issue of overvaluation, particularly at the index level, which is creating a divergence, as is sometimes the case, between market performance and economic performance.

FI Investments in Equity Have Been Negligible Since August ’17…
…MF Investments in Equities Have Slacked in March ’18 But Remain Steady Around 10K Cr a Month

FI Investments in Equity Have Been Negligible Since August

Performance Dispersion is Rising…

Only when the tide turns back do you discover who’s been swimming naked. It is increasingly evident that dispersion in returns is rising. For instance, large cap funds have delivered 6% to 28.0% over a 1 year period, while the mid cap universe from 3.5% to 35.3%. Active manager outperformance is no longer to be taken for granted. Manager selection will be critical moving forward.

Style, Manager, Price, Sector and Stock Factors Are Key

Appropriate sectoral allocations stock selection, style and manager selection, will be key determinants for portfolio returns going forward. Earnings will provide further clarity on the state of the economy and indications look promising.

Sector Preferences

We prefer private banks, consumption, passenger and utility vehicles, commercial vehicles, specialty chemicals, construction, industrials, midcap tech and emerging growth.

We’re bullish on quality growth at reasonable price. However, we remain skeptical that the index demonstrates these characteristics. Nor do we believe the index will deliver meaningful earnings growth and by extension, meaningful performance.

While recognizing hopeful domestic trends such as a good earnings season ex-public sector banks and telecom, and a pickup in investment, our portfolio hedge remains in place and is paid for through the end of April. As of this writing, net of hedging costs, our PMS large cap and multi cap fund are outperforming their benchmarks across 1 month, 3 month, 6 month, YTD and 1 year time periods.

The market has withstood primarily FI selling on the back of steady domestic MF flows. The proposed pickup in private investment is welcome news if it sustains, alongside structural reforms, resilient consumption and government spending. It could well be the third leg to lead to more consistent, reliable growth ahead.

Fixed Income

Interest rates have been volatile over the past month and we attribute the rise in yields to disappointment in the size of the cap raise for FPI investors, public banks turning sellers as yields fell, worsening budget math as a result of rising crude oil prices, a weakening U.S. dollar and a very aggressive state loans financing schedule that added to market worries on financing. There continues to be a lack of clarity on new sources of capital that will absorb debt demand in light of expected subdued demand by the commercial banks.

Directionally, rates continue to be volatile and this volatility signals investor uncertainty and unease. Risks continue to be skewed slightly to the upside on rate movements. Conservative strategies in this environment remain ultra short term bonds for conservative investors and corporate credit funds. Within corporate credit, we slightly favor credit opportunity managers over income opportunity managers but a diversified portfolio would be fine to invest in both. Finally, we’d consider FMPs should rates approach recent peaks.


The Nifty posted third consecutive week and seventh straight day of gains to close at 10481 levels up by 1.44% for the week. However, broader market benchmarks, BSE Midcap and BSE Smallcap underperformed during the week gaining 0.5% and 0.3% respectively. On the day Nifty has formed spinning top candlestick pattern as open and close around same levels while index failed to make headway on upside or downside represented by shadows. Thus, indicating indecisiveness in the market and index may see brief pause in the rally as it may trade sideways to negative. In Nifty Call options, strike price 10500 has highest open interest in Calls which is going to act as resistance and index also failed to sustain above it on Friday. Hence sustaining above 10520 index can rally towards 10630 and then 10700 levels where 61.8% Fibonacci retracement of the whole fall is seen. While in Put options, 10200 to 10400 strikes have significant open interest suggesting as base for market which has shifted higher. On the downside immediate support for index is seen at 10360 levels and then at 10200 levels.


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