Prspectives on Indian Market, Economy, Scenario, Equity, Debt, Mutual Fund

2. Market and economic outlook – August 2013Market and economic outlook – August 2013

3. Executive summary
◌ःIn August’s monthly report, we discuss the
impact of RBI’s liquidity tightening on the
stock markets.
◌ःWe explain the ramifications of the dual◌ःWe explain the ramifications of the dual
polarization developing within the market.
◌ःAnd finally, we give you an early snapshot of
Q1FY14 quarterly results.

4. 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 wouldSensex: 19,345.70 determine market
direction.
risk of further FII
outflows.
markets would
maintain level.

5. 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

6. 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

7. RBI’s liquidity tightening
◌ः Since Ben Bernanke, chairman of US Federal Reserve,
spoke of tapering quantitative easing, emerging
markets have taken a beating.
◌ः The era of easy liquidity roaming the globe in search of
higher 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 rapid
depreciation of the rupee.
◌ः On July 15, the Reserve Bank of India (RBI) stepped in
to defend the rupee.
◌ः Didn’t hike repo rate. Instead reduced liquidity to
support the currency.

8. RBI’s liquidity tightening
◌ः It limited the amount of money that banks could
borrow from the repo window to Rs. 750 billion. Since
this was lower than the amount that banks were
borrowing from the repo window then, it amounted to
a decrease in liquidity supply.
◌ः Any amount over and above that available through the◌ः Any amount over and above that available through the
repo window would have to be met through what is
known as the marginal standing facility.
◌ः Earlier, the cost of borrowing from this window was 100
basis points above the repo rate. RBI hiked it to 300
basis points above repo rate (10.25%).

9. RBI’s liquidity tightening
◌ः The RBI also announced plans to soak up liquidity from
the banking system through OMOs (which did not go
through).
◌ः On July 23, the RBI introduced further restrictive
measures. It curtailed each bank's borrowing from themeasures. It curtailed each bank's borrowing from the
repo window to 0.5% of its deposits.
◌ः It also reduced the flexibility that banks enjoyed in
managing their cash balances with the RBI for meeting
their cash reserve ratio.

10. Reasons for RBI’s measures
◌ः Given the pull-out of money from the debt markets,
and India's high current account deficit, speculation on
the rupee had become a one-way bet.
◌ः By taking these measures to stem the rupee’s fall, the
central bank hoped to deter speculation.central bank hoped to deter speculation.
◌ः Moreover, a sharp depreciation in the value of the
rupee has the potential to ignite imported inflation (by
making imports costlier).

11. Risks in the current situation
◌ः The trade deficit remains high: imports, which are
linked to domestic demand, remain high but exports
have fallen.
◌ः The current account deficit is at a high level (4.8% in
FY13) 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 very
large.
◌ः There is overreliance on short-term borrowings. The
amount of money borrowed abroad that has to be
repaid within the next 12 months is almost two-third of
India's currency reserves. This is a cause for worry for
the RBI and the government.

12. Risks in the current situation
◌ः Our markets have also become very dependent on
short-term portfolio flows.
◌ः If there is a crisis somewhere else in the globe, which
triggers outflows, the rupee could tumble further.
◌ः As the rupee tumbles, foreign investors' prospects of◌ः As the rupee tumbles, foreign investors' prospects of
making profits in dollar terms take a hit. That creates a
vicious cycle: outflows lead to rupee depreciation
which then triggers further outflows.
◌ः Any further decline of the rupee would prolong the
RBI's liquidity tightening cycle.

13. Risks in the current situation
◌ः If the liquidity tightening measures last for long, they
will definitely affect India's growth prospects.
◌ः This will in turn reduce the attractiveness of India's
equity market.
◌ः If there are outflows from the equity markets, the◌ः If there are outflows from the equity markets, the
impact would be much greater.
◌ः FII investment in the BSE top 500 companies is almost $
200 billion compared to the $ 30 billion investment in
the debt market.

14. Best-case scenario
◌ः The rupee stabilizes at its current level.
◌ः The markets may have over-reacted to the Fed’s statements
on QE withdrawal.
◌ः The US economy may recover more slowly than the Fed
expects. In that case, QE tapering would be very gradual or
may be delayed. Clarity on this will only emerge after the
Fed’s September meeting.
◌ः This would reduce pressure on emerging market assets.

15. Best-case scenario
◌ः The government may take steps to reduce CAD by
imposing import tariffs.
◌ः It may even try to promote exports, especially in areas
where India has a competitive advantage.
◌ः The government may even organize for a lumpy inflow◌ः The government may even organize for a lumpy inflow
of dollars, via sovereign or NRI bond issue, or by
allowing PSUs to raise money abroad.
◌ः This influx of dollars would reduce pressure on the
rupee.

16. Best-case scenario
◌ःSo rupee could stabilise towards the end of
September or early October.
◌ःIn that case, rate cuts could resume as early◌ःIn that case, rate cuts could resume as early
as in the October 29 policy review (HDFC
chief economist Abheek Barua’s view in a
recent note).

17. Best-case scenario
◌ःThe Indian economy’s ability to attract and
absorb capital flows is also higher now
(compared to 1998 when RBI had to move last
to protect the currency).to protect the currency).
◌ःFII and ECB limits have also been relaxed
considerably.
◌ःThe FDI limit in 13 sectors is currently being
revised to attract stable inflows.

18. How long will liquidity tightening
last?
◌ः The US Fed's next meeting is on September 15. If it
chooses to begin tapering the QE program, the rupee
could depreciate further. RBI could then take more
measures to prop up the rupee.
◌ः On the other hand, if the rupee stabilizes, we could◌ः On the other hand, if the rupee stabilizes, we could
witness a gradual withdrawal of liquidity tightening
measures.
◌ः Rate cuts could restart after a suitable interval.
◌ः In all probability, liquidity tightening measures will only
be withdrawn in Q42014.

19. Long-term panacea
◌ःIn the long term, the currency will only
strengthen on a sustainable basis if there is an
increase in exports and decline in imports.
◌ः◌ःThe trade deficit is likely to decline, according
to Credit Suisse, over the next two to three
months (measures taken by the government to
reduce gold imports; improving prospects of US
economy would lead to more exports to that
country).

20. Impact of tightening
◌ःHigher short-term rates: The immediate
impact of these measures was that short-term
rates in the call money market shot up.
◌ःWhile earlier this rate used to hover between
the reverse repo and the repo rate, now it
hovers between the repo and the MSF rate.

21. Impact of tightening
◌ःSlower growth: Liquidity tightening in a
slowing growth environment has the potential
to 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 growth
estimate for FY14 downward from 5.7% to 5.5%.
◌ः Many brokerage houses may also revise their
earlier growth estimates.

22. 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.

23. Impact on financial sector
◌ः The prospects of rate-sensitive sectors, especially
banking and NBFCs, have been affected adversely.
◌ः In particular, banks with low CASA (current account,
savings account) ratio that were dependent on
wholesale funding, will be affected.
◌ः◌ः Some of these banks are Yes Bank, IndusInd Bank, and
Bank of Baroda.
◌ः NBFCs like LIC Housing Finance, HDFC, MMFS, SHTF and
IDFC, which depend on market borrowing, could see a
rise in their funding costs due to liquidity drying up.
◌ः Loan growth estimate for FY14 is currently 15-16%. This
could get revised downward

24. Impact on financial sector
◌ःWith the 10-year bond yield shooting up,
banks also registered mark-to-market losses
on their investment book.
◌ःAsset quality of banks (in particular, public◌ःAsset quality of banks (in particular, public
sector banks which have been plagued more
by this problem) is also unlikely to improve
if rates don’t come down.

25. Impact of tightening
◌ःLeveraged consumption is also expected to be
affected in an environment where rates are not
falling. Sectors like auto and real estate will be
affected.affected.
◌ःThe rise in rates will also affect the balance
sheets of overleveraged companies (especially
those in infrastructure).

26. Positive impact
◌ःOn the positive side, if rates remain high over
the medium term, they could trigger financial
savings. Investors could move away from real
estate and gold if they get positive real returns
from 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).

27. Negative impact
◌ः Companies which have taken forex debt on their
balance sheets to fund their domestic businesses will
be hit by the rupee’s depreciation as their net worth
will get eroded.
◌ः The impact on profit and loss account will be limited to◌ः The impact on profit and loss account will be limited to
mark-to-market losses.
◌ः Users of commodities will also be negatively affected.
◌ः Government’s fiscal deficit may rise as oil and fertilizer
subsidy burden may rise (due to rupee depreciation).

28. Polarisation within the market
◌ः Portfolio managers’ favourite grouse today is that the
market is forcing them to buy the same set of stocks---
those which have been the winners over the past five
years (defensives, primarily pharma and consumer, and
lately, IT).lately, IT).
◌ः They continue to command premium valuations, and
these valuations continue to rise.
◌ः At the opposite end of the market spectrum, stocks are
very attractively valued.
◌ः Concentrating their portfolios in premium valuation
stocks carries risk

29. Polarisation within the market
◌ःWhat is significant is that the trailing
earnings growth and RoE of India's best
companies vis-a-vis the worst is in line with
history (according to Morgan Stanley), whilehistory (according to Morgan Stanley), while
the PE and PB differential between the best
and the worst is the highest ever (after the
tech bubble). What explains this?

30. Polarisation within the market
◌ः The valuation premium is not driven by the quantum of
outperformance.
◌ः It is driven by the fact that the opportunity set of stocks
delivering superior performance is dwindling. The number
of stocks delivering 20% plus earnings growth and 20% plus
return on equity is at a decade low.return on equity is at a decade low.
◌ः As a result, the money pool is getting concentrated in
these stocks, driving their valuations up.
◌ः The under performers of the last five years may not be
able to achieve much for some time. Hence investors do
not see any reason for these stocks to enjoy a higher
valuation

31. Polarisation within the market
◌ः The economy has to turn. Only when the growth cycle
broadens will the premium between the two sets of
stocks contract.
◌ः The recent liquidity tightening measures have further
delayed the prospects of an improvement in thedelayed the prospects of an improvement in the
performance of rate-sensitive stocks.
◌ः In the near term, therefore, the defensive stocks that
have done well in the past may continue to enjoy
higher valuations.

32. Polarisation within the market
◌ः Besides sector-wise polarization, segment-wise
polarization is also happening within the market.
◌ः Large-cap stocks are outperforming mid- and small caps
by a wide margin.
◌ः Amid growing market turbulence, investors are dumping
small- 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 Nifty
continue to hold on to reasonable levels, the broader
market is in the doldrums.
◌ः While the Sensex is flat, the small-cap index has lost by
-28%.

33. Q1 Earnings
◌ः Based on the results that have come in so far, it is clear
that topline growth has slowed down considerably (with
consumption 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 companies
and higher ‘other income’.
◌ः Current Sensex earnings estimate of around Rs 1,300
for FY14 may be downgraded further.

34. Thank You