Market and economic outlook – August 2013Market and economic outlook – August 2013

Executive summary

◌ःIn August’s monthly report, we discuss theimpact of RBI’s liquidity tightening on thestock markets.

◌ःWe explain the ramifications of the dual◌ःWe explain the ramifications of the dualpolarization developing within the market.

◌ःAnd finally, we give you an early snapshot ofQ1FY14 quarterly results.

Market outlook

Asset Class Current Levels( as on July 31, 2013)

Summary View Why Risk to our View

Equity Nifty: 5,755.05

Sensex: 19,345.70

Fed’s September

meet will

determine market

If QE tapering

begins, could pose

risk of further FII

If Fed decides to

delay tapering,

markets would Sensex: 19,345.70 determine market

direction.

risk of further FII

outflows.

markets would

maintain level.

Index Watch

Index Name %age change in July YTD (%)

S&P BSE SENSEX -0.04 -0.86

S&P BSE Mid-Cap -7.19 -22.18

S&P BSE Small-Cap -5.96 -28.12

S&P BSE IT 20.18 30.80

S&P BSE Tech 17.29 24.89

S&P BSE FMCG 4.86 14.28

S&P BSE Health Care 2.49 11.54S&P BSE Health Care 2.49 11.54

S&P BSE OIL & GAS Index -3.80 0.19

S&P BSE AUTO Index -1.14 -8.14

S&P BSE Consumer Durables 2.28 -18.95

S&P BSE BANKEX -13.71 -20.74

S&P BSE Capital Goods -10.04 -24.72

S&P BSE Power Index -8.46 -25.24

S&P BSE PSU -12.01 -25.95

S&P BSE Realty Index -12.74 -38.13

S&P BSE METAL Index -11.31 -38.27

FII and MF flows in equity market

Month FII investment (Rs-cr) MF investment (Rs-cr)

Jan 22,059.2 -5,212.4

Feb 24,439.3 -847.9

March 9,124.3 -1,550.6

April 5,414.1 -1,422.9April 5,414.1 -1,422.9

May 22,168.6 -3,507.1

June -11026.90 -269.00

July -6253.10 -2184.30

Cumulative 65,925.50 -14,994.20

RBI’s liquidity tightening

◌ः Since Ben Bernanke, chairman of US Federal Reserve,spoke of tapering quantitative easing, emergingmarkets have taken a beating.

◌ः The era of easy liquidity roaming the globe in search ofhigher returns is ending.

◌ः In India there was sharp outflow from the debt market◌ः In India there was sharp outflow from the debt market(nearly $9 billion since mid May), causing a rapiddepreciation of the rupee.

◌ःOn July 15, the Reserve Bank of India (RBI) stepped into defend the rupee.

◌ःDidn’t hike repo rate. Instead reduced liquidity tosupport the currency.

RBI’s liquidity tightening

◌ः It limited the amount of money that banks couldborrow from the repo window to Rs. 750 billion. Sincethis was lower than the amount that banks wereborrowing from the repo window then, it amounted toa decrease in liquidity supply.

◌ः Any amount over and above that available through the◌ः Any amount over and above that available through therepo window would have to be met through what isknown as the marginal standing facility.

◌ः Earlier, the cost of borrowing from this window was 100basis points above the repo rate. RBI hiked it to 300basis points above repo rate (10.25%).

RBI’s liquidity tightening

◌ः The RBI also announced plans to soak up liquidity fromthe banking system through OMOs (which did not gothrough).

◌ःOn July 23, the RBI introduced further restrictivemeasures. It curtailed each bank's borrowing from themeasures. It curtailed each bank's borrowing from therepo window to 0.5% of its deposits.

◌ः It also reduced the flexibility that banks enjoyed inmanaging their cash balances with the RBI for meetingtheir cash reserve ratio.

Reasons for RBI’s measures

◌ःGiven the pull-out of money from the debt markets,and India's high current account deficit, speculation onthe rupee had become a one-way bet.

◌ः By taking these measures to stem the rupee’s fall, thecentral bank hoped to deter speculation.central bank hoped to deter speculation.

◌ःMoreover, a sharp depreciation in the value of therupee has the potential to ignite imported inflation (bymaking imports costlier).

Risks in the current situation

◌ः The trade deficit remains high: imports, which arelinked to domestic demand, remain high but exportshave fallen.

◌ः The current account deficit is at a high level (4.8% inFY13) in both relative and absolute terms.

◌ः This means that India’s funding gap has become very◌ः This means that India’s funding gap has become verylarge.

◌ः There is overreliance on short-term borrowings. Theamount of money borrowed abroad that has to berepaid within the next 12 months is almost two-third ofIndia's currency reserves. This is a cause for worry forthe RBI and the government.

Risks in the current situation

◌ःOur markets have also become very dependent onshort-term portfolio flows.

◌ः If there is a crisis somewhere else in the globe, whichtriggers outflows, the rupee could tumble further.

◌ः As the rupee tumbles, foreign investors' prospects of◌ः As the rupee tumbles, foreign investors' prospects ofmaking profits in dollar terms take a hit. That creates avicious cycle: outflows lead to rupee depreciationwhich then triggers further outflows.

◌ः Any further decline of the rupee would prolong theRBI's liquidity tightening cycle.

Risks in the current situation

◌ः If the liquidity tightening measures last for long, theywill definitely affect India's growth prospects.

◌ः This will in turn reduce the attractiveness of India'sequity market.

◌ः If there are outflows from the equity markets, the◌ः If there are outflows from the equity markets, theimpact would be much greater.

◌ः FII investment in the BSE top 500 companies is almost $200 billion compared to the $ 30 billion investment inthe debt market.

Best-case scenario

◌ः The rupee stabilizes at its current level.

◌ः The markets may have over-reacted to the Fed’s statementson QE withdrawal.

◌ः The US economy may recover more slowly than the Fedexpects. In that case, QE tapering would be very gradual ormay be delayed. Clarity on this will only emerge after theFed’s September meeting.

◌ः This would reduce pressure on emerging market assets.

Best-case scenario

◌ः The government may take steps to reduce CAD byimposing import tariffs.

◌ः It may even try to promote exports, especially in areaswhere India has a competitive advantage.

◌ः The government may even organize for a lumpy inflow◌ः The government may even organize for a lumpy inflowof dollars, via sovereign or NRI bond issue, or byallowing PSUs to raise money abroad.

◌ः This influx of dollars would reduce pressure on therupee.

Best-case scenario

◌ःSo rupee could stabilise towards the end ofSeptember or early October.

◌ःIn that case, rate cuts could resume as early◌ःIn that case, rate cuts could resume as earlyas in the October 29 policy review (HDFCchief economist Abheek Barua’s view in arecent note).

Best-case scenario

◌ःThe Indian economy’s ability to attract andabsorb capital flows is also higher now(compared to 1998 when RBI had to move lastto protect the currency).to protect the currency).

◌ःFII and ECB limits have also been relaxedconsiderably.

◌ःThe FDI limit in 13 sectors is currently beingrevised to attract stable inflows.

How long will liquidity tightening

last?

◌ः The US Fed's next meeting is on September 15. If itchooses to begin tapering the QE program, the rupeecould depreciate further. RBI could then take moremeasures to prop up the rupee.

◌ःOn the other hand, if the rupee stabilizes, we could◌ःOn the other hand, if the rupee stabilizes, we couldwitness a gradual withdrawal of liquidity tighteningmeasures.

◌ः Rate cuts could restart after a suitable interval.

◌ः In all probability, liquidity tightening measures will onlybe withdrawn in Q42014.

Long-term panacea

◌ःIn the long term, the currency will onlystrengthen on a sustainable basis if there is anincrease in exports and decline in imports.

◌ः◌ःThe trade deficit is likely to decline, accordingto Credit Suisse, over the next two to threemonths (measures taken by the government toreduce gold imports; improving prospects of USeconomy would lead to more exports to thatcountry).

Impact of tightening

◌ःHigher short-term rates: The immediateimpact of these measures was that short-termrates in the call money market shot up.

◌ःWhile earlier this rate used to hover betweenthe reverse repo and the repo rate, now ithovers between the repo and the MSF rate.

Impact of tightening

◌ःSlower growth: Liquidity tightening in aslowing growth environment has the potentialto worsen India's growth prospects.

◌ः In its first monetary policy review on 30th July,◌ः In its first monetary policy review on 30th July,the central bank revised its GDP growthestimate for FY14 downward from 5.7% to 5.5%.

◌ः Many brokerage houses may also revise theirearlier growth estimates.

Impact of tightening

◌ःRate cuts pushed back: The prospects of further rate cuts, which have been a major driver of the markets this year, have been pushed back. pushed back.

Impact on financial sector

◌ः The prospects of rate-sensitive sectors, especiallybanking and NBFCs, have been affected adversely.

◌ः In particular, banks with low CASA (current account,savings account) ratio that were dependent onwholesale funding, will be affected.

◌ः◌ः Some of these banks are Yes Bank, IndusInd Bank, andBank of Baroda.

◌ःNBFCs like LIC Housing Finance, HDFC, MMFS, SHTF andIDFC, which depend on market borrowing, could see arise in their funding costs due to liquidity drying up.

◌ः Loan growth estimate for FY14 is currently 15-16%. Thiscould get revised downward

Impact on financial sector

◌ःWith the 10-year bond yield shooting up,banks also registered mark-to-market losseson their investment book.

◌ःAsset quality of banks (in particular, public◌ःAsset quality of banks (in particular, publicsector banks which have been plagued moreby this problem) is also unlikely to improveif rates don’t come down.

Impact of tightening

◌ःLeveraged consumption is also expected to beaffected in an environment where rates are notfalling. Sectors like auto and real estate will beaffected.affected.

◌ःThe rise in rates will also affect the balancesheets of overleveraged companies (especiallythose in infrastructure).

Positive impact

◌ःOn the positive side, if rates remain high overthe medium term, they could trigger financialsavings. Investors could move away from realestate and gold if they get positive real returnsfrom financial products.from financial products.

◌ःThe rupee's depreciation will be positive for sectors like IT, pharma and other exporters (stocks such as TCS, HCL Tech, and Bajaj Auto).

Negative impact

◌ः Companies which have taken forex debt on theirbalance sheets to fund their domestic businesses willbe hit by the rupee’s depreciation as their net worthwill get eroded.

◌ः The impact on profit and loss account will be limited to◌ः The impact on profit and loss account will be limited tomark-to-market losses.

◌ःUsers of commodities will also be negatively affected.

◌ःGovernment’s fiscal deficit may rise as oil and fertilizersubsidy burden may rise (due to rupee depreciation).

Polarisation within the market

◌ः Portfolio managers’ favourite grouse today is that themarket is forcing them to buy the same set of stocks---those which have been the winners over the past fiveyears (defensives, primarily pharma and consumer, andlately, IT).lately, IT).

◌ः They continue to command premium valuations, andthese valuations continue to rise.

◌ः At the opposite end of the market spectrum, stocks arevery attractively valued.

◌ः Concentrating their portfolios in premium valuationstocks carries risk

Polarisation within the market

◌ःWhat is significant is that the trailingearnings growth and RoE of India's bestcompanies vis-a-vis the worst is in line withhistory (according to Morgan Stanley), whilehistory (according to Morgan Stanley), whilethe PE and PB differential between the bestand the worst is the highest ever (after thetech bubble). What explains this?

Polarisation within the market

◌ः The valuation premium is not driven by the quantum ofoutperformance.

◌ः It is driven by the fact that the opportunity set of stocksdelivering superior performance is dwindling. The numberof stocks delivering 20% plus earnings growth and 20% plusreturn on equity is at a decade low.return on equity is at a decade low.

◌ः As a result, the money pool is getting concentrated inthese stocks, driving their valuations up.

◌ः The under performers of the last five years may not beable to achieve much for some time. Hence investors donot see any reason for these stocks to enjoy a highervaluation

Polarisation within the market

◌ः The economy has to turn. Only when the growth cyclebroadens will the premium between the two sets ofstocks contract.

◌ः The recent liquidity tightening measures have furtherdelayed the prospects of an improvement in thedelayed the prospects of an improvement in theperformance of rate-sensitive stocks.

◌ः In the near term, therefore, the defensive stocks thathave done well in the past may continue to enjoyhigher valuations.

Polarisation within the market

◌ः Besides sector-wise polarization, segment-wisepolarization is also happening within the market.

◌ः Large-cap stocks are outperforming mid- and small capsby a wide margin.

◌ः Amid growing market turbulence, investors are dumpingsmall- and mid-cap stocks and seeking refuge in large capssmall- and mid-cap stocks and seeking refuge in large caps(which are better equipped to handle volatility).

◌ः As a result, while benchmark indices like Sensex and Niftycontinue to hold on to reasonable levels, the broadermarket is in the doldrums.

◌ःWhile the Sensex is flat, the small-cap index has lost by-28%.

Q1 Earnings

◌ः Based on the results that have come in so far, it is clearthat topline growth has slowed down considerably (withconsumption and investment both slowing down).

◌ः It was flat y-o-y for a sample of 93 companies(excluding financials).(excluding financials).

◌ःOperating profit was up just 6.7% y-o-y.

◌ःNet profit was up 13% due to cost-cutting by companiesand higher ‘other income’.

◌ः Current Sensex earnings estimate of around Rs 1,300for FY14 may be downgraded further.

Thank You