Hexagon Wealth

December, 2013
Market Watch

On 1st November, the Sensex rose to a record high of 21,239 in muhurat trading. We were underweight on equities even when the index was at its peak as we believed that the rally was not backed by strong fundamentals. This conservative stance was justified as the index fell by nearly 2% in November closed at 20,792 on the last trading day of the month.

                                        DECEMBER 2013


The S&P BSE Capital Goods Index was the biggest gainer during the month as some companies attracted attention from investors as they delivered better-than-expected earnings. Most stocks in the sector are still trading at relatively attractive valuations as the polarisation between defensives and cyclicals persists.

While being sufficiently invested, we continue to be cautious on valuations as the market is currently being propelled by the expectations of a BJP victory in the elections next year.

A negative surprise – such as a Third Front government – may lead to a significant correction.

The Federal Reserve’s plans to taper its quantitative easing programme (QE) may also keep markets on the edge. A sustainable rally is contingent on earnings growth (fundamental) which is still a few quarters away.


An uptick in GDP but not a broad-based recovery

In the second quarter of FY14, India’s GDP growth edged up to 4.8% from a four-year low of 4.4% in the first quarter. However, this is the fourth consecutive reading below 5%. The increase in economic activity in the second quarter was mainly driven by agricultural growth which was supported by the buoyant monsoon. The rebound in exports also supported growth and contributed to the decline in the CAD to 1.2% of GDP in Q2-FY14. Nevertheless, it is too early to determine whether the economic slowdown has bottomed out. Over the next few quarters, agriculture and exports may support growth but as shown in the table below, there are several hurdles to growth in the short-term.


A sustainable recovery may only occur when interest rates fall and structural reforms are implemented. The onus for these will rest with the new government which will need to act quickly to ensure that India returns to the high growth trajectory of the 2000s.

What can investors do when yields rise and bond prices fall?

In November, the yield of the benchmark 10-year government bond crossed the psychological 9% level. This presents a favourable opportunity for long-term investors to initiate investments in duration funds as historically; the 10-year yield has exceeded 9% levels for only for brief periods and has quickly fallen below 9%. During the last 10 years, the benchmark government bond yield has closed above 9% only on 37 occasions out of a total of 2,512 trading sessions.

Investors with 3-5 year horizons with can consider locking into accrual-focused long-duration funds as these funds have invested the majority of their portfolios in corporate bonds which are trading at very attractive levels after the rise in yields. These funds may generate capital appreciation once interest rates fall.

Investors who can tolerate volatility can also invest a small portion of their fixed income portfolios in dynamic income funds. These funds are relatively more aggressive than accrual-oriented funds as they also invest in government securities. Hence, these funds may be volatile in the short-term but have the potential to generate higher returns over 2-3 years if interest rates fall. The table and the graph below illustrate this phenomenon.


In November 2011, the benchmark 10-year yield was close to 9% but fell to nearly 7% in May 2013. During this period, dynamic funds outperformed accrual-focused funds. However, since May yields have risen by nearly 200 bps while dynamic income funds have generated negative returns. During this period Hexagon’s recommended accrual-oriented funds and conservative dynamic funds (dynamic funds which are suitable for investors with 12-18 month horizons) have outperformed dynamic income funds.

Has the earnings downgrade cycle bottomed out?

The latest earnings season suggests that it may be the beginning of the end of the earnings downgrade cycle. Several companies beat expectations and surprised analysts positively. These companies now enjoy higher earnings estimates. There are some other green shoots ahead as the good monsoon is expected to boost agricultural growth and rural consumption.

For the Nifty companies, top line growth improved after the bleak performance in the previous quarter. However, this failed to boost profits as raw material costs and interest expenses hurt margins. The weak rupee also increased input costs for some companies. Consequently, profit growth continued to trend lower. The graphic below shows that the divergence between defensives and cyclicals persisted in the second quarter.


The outlook is relatively bright for the IT and pharmaceutical sectors which may continue to benefit from the weak rupee (although recently, there have been concerns about the processes followed by a few Indian pharma companies that has resulted in their stock prices falling). The recovery in the cyclical sectors is probably a few quarters away as the underlying economy is weak. Hence, broad-based earnings upgrades are not likely in the immediate future.

No clarity on the taper

In November, fears of QE tapering re-surfaced as the US economy reported better-than-expected employment numbers for October. Third-quarter GDP data also beat expectations.

The signals from the Federal Reserve are conflicting. The minutes from the FOMC meeting held on October 29th suggest that the policymakers plan to trim QE in the next few months. On the other hand, in a testimony before the Senate Banking Committee, Janet Yellen, the nominee to be the next Fed chairperson suggested that tapering was not imminent. She stated that the “labor market and economy [are] performing far short of their potential”.  As the timeline of tapering is uncertain, markets may be volatile until there is more clarity from the Fed. India is likely to be adversely affected by the taper, at least in the short-run.

However, as discussed in last month’s newsletter, India is now less vulnerable to a reversal in global liquidity. This is mainly because the CAD is expected to decline this year. Consequently, the rupee and the markets may not react to the taper as negatively as they did earlier in the year because of the recent positive developments shown in the graphic.


Additionally, at first, the Fed will probably just gradually reduce the pace at which liquidity is injected rather than reduce the liquidity in the system. In Chairman Ben Bernanke’s own words: “Any slowing in the pace of purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not [applying] the brakes”.

Some rupee depreciation is perhaps inevitable as unlike many of its emerging market counterparts, India has a current account deficit. But investors can effectively hedge the rupee by investing in U.S. focused equity funds. These funds may generate higher returns for Indian investors if the rupee declines against the dollar. One must be mindful of the high valuations that US stocks already have.

China implements big-bang reforms but is India the better place to invest?

The Chinese leadership concluded the 18th Communist Party Third Plenum by announcing bold and widespread reforms to liberalise the world’s second largest economy. These include enhancing the private sector and relaxing the one-child policy. These reforms make India’s policy paralysis appear bleaker by contrast and influenced UBS’ decision to downgrade India to "neutral" from "overweight" and upgrade China to "overweight". However, according to EY’s Capital Confidence Barometer Report, India is a more attractive destination for investment than China.

Although India’s GDP growth is stagnating at a decade low, the country has several advantages which China lacks. The proposed reforms in China are addressed at remedying unfavourable demographics and shifting towards a model of consumption led growth. China has an aging population which is projected to shrink unless the one-child policy is relaxed. China is already relaxing these policies, as we write. On the other hand, India has a relatively young and growing population. The domestic consumption story is relatively strong and is one of the factors which contributed to the high growth rates of the 2000s.India is also ahead of China in liberalisation - the Indian government has announced plans to open up sectors to foreign direct investment and Indian private companies are very successful.

Nevertheless, India still needs to make the most of its demographic dividend and other advantages to catch up to China. The country needs to implement structural reforms to create a more conducive environment for business.

Global Indices: Wall Street Journal
Domestic Indices: BSE/ Accord Fintech



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