Hexagon Wealth

February, 2014
Market Watch

The Sensex notched a fresh record high of 21,374 on 23rd January but trended lower in the last week of the month as Indian markets were adversely affected by the global aversion to emerging markets. During the whole month, the index fell by 3.1% - the worst monthly performance since August.

                                        DECEMBER 2013


As shown in the table, IT stocks outperformed the broader market as leading companies such as TCS, Infosys and Wipro reported higher earnings. The earnings of these companies may be supported by the weak rupee and by the recovery in the U.S. and Europe. However, companies in other sectors may not be as fortunate as the economic slowdown and higher interest rate costs have depressed margins in several sectors. This is particularly true of cyclical industries. Even FMCG companies – which are generally immune to downturns – may experience lower volume growth because of the slump in consumption. Notable exceptions include Colgate-Palmolive and Marico.

We are still underweight on equities as fundamentals do not support a sustainable rally. Earnings upgrades are not yet imminent and a disappointing result in the elections may lead to a sharp correction. Valuations are not very attractive as the Sensex is currently trading at a forward Price-Earnings ratio (P/E) of about 16x –marginally higher than the long-run average of 15x (based on FY14 earnings).


The future of monetary policy

On January 28th, the RBI unexpectedly hiked the repo rate by 25 basis points to 8%. The market had expected the central bank to keep the main policy rates unchanged as wholesale price inflation (WPI) and retail inflation (measured by the CPI) declined in December. In spite of this, the RBI still chose to raise interest rates as CPI inflation is above the level suggested by the Dr. Urjit Patel Committee.

                                      Reaction to the Taper

The panel also recommended that the CPI should be the main anchor for monetary policy as it reflects the Indian consumption basket more accurately. Historically, the RBI has focused on WPI to determine monetary policy.

However, it is likely that the committee’s recommendations will only be implemented gradually as structural measures and fiscal consolidation are also necessary to set the “set the economy securely on the recommended disinflationary path” outlined by the Patel committee report.

The report also implies that interest rates are unlikely to be lowered in the near-term as the real policy rate is negative. In December, annual CPI inflation was 9.9% - this is well above the repo rate of 8%. Even if interest rates do not fall, our recommended income funds may still add value for investors as the RBI Governor hinted that further rate hikes are not imminent given the current assessment.

Is the rupee immune to the emerging market rout?

Emerging markets had a poor start to 2014 as political protests, concerns over inflation and balance of payment issues led to dramatic falls in some emerging market currencies.

Will the contagion affect India? To some extent, India may be insulated from the financial turmoil in other emerging markets.


This is because over the last year, Indian policy makers have taken steps to reduce the current account deficit which is expected to fall below 2.5% of GDP in the current fiscal year. Consequently, India is less vulnerable to a reversal in foreign investment. The RBI has also taken steps to build up its reserves so it has more firepower to deal with a falling rupee. Furthermore, unlike Turkey and Ukraine, the political situation in India is relatively stable. These factors helped the rupee outperform its emerging market counterparts recently as shown in the graph.


Hence, India is unlikely to be significantly hurt by the turmoil in other emerging markets. Unlike other central banks, the RBI will not have to implement emergency rate hikes to stabilise the rupee. Long-term investors may still favour India as the country has a higher growth potential than most other emerging markets except China.

The Indian economy starts 2014 on a mixed note

In January, India’s manufacturing sector expanded at a faster pace as the HSBC Manufacturing PMI rose to a 10-month high of 51.4. The rise suggests that the Indian economy is gradually turning a corner although there are some near-term challenges. These include high interest rates and sluggish consumption and investment. The services sector is sluggish and fiscal consolidation may also impede growth in the near future.

Positive and Negative

Nevertheless, India’s GDP growth is expected to rise in the next fiscal year. The recovery will be supported by rural demand and stronger exports as the global economy is expected to improve. A revival in the investment cycle may also contribute to the improvement in growth as the government has recently implemented several measures to clear stalled projects. Since its creation in January 2013, the Cabinet Committee on Investments has helped resolve bottlenecks for projects worth Rs 5 trillion.

Between 2014 and 2016, the World Bank expects India’s economy to grow faster than most other emerging markets except China.

Growth Forecast

By 2016, the gap between the growth rates of the two countries will shrink to 0.4% from 3% in 2014. To sustain this momentum, Indian policymakers need to introduce reforms to lower inflation and improve infrastructure. India also needs to improve transparency and reduce bureaucracy to attract investments.

Shadow banking in China

In 2013, China’s economy expanded by 7.7% and exceeded the growth target of 7.5% set by the government. In spite of this, the world’s second-largest economy is unlikely to enjoy the double-digit growth which was the norm over the last few years.

The government and the People’s Bank of China are unlikely to stimulate growth as the focus of the new government is on improving the quality of growth and reforming the financial system. This also involves slowing credit growth which is now in double digits although GDP growth has fallen below 10%.

Shadow Banking

The stock of credit has increased more than 60% since 2007 to 210% of GDP in the fourth quarter of 2013. The rise in debt mirrors the levels seen by the U.S., Europe and Asian countries before they crashed.

Over the last few years, the rise in credit has been driven by “shadow banking”. This includes wealth management products, off balance-sheet lending, trust companies, insurance firms and other financial products which are not as closely regulated as traditional banking activities. The shadow banking system has expanded during the last few years as the Chinese government has prevented deposit rates from rising. Hence, savers have used shadow banking products to earn higher returns.

Recently, there have been concerns that a default in the shadow banking system may result in a financial crisis which would have global repercussions. Hence, it is important for the government to adhere to the pledges made in the Third Plenum and reform the financial system and regulate shadow banking activities.

Where are oil prices headed?

Over the last five years, crude oil prices have risen but this trend may not be sustained. The upside to oil prices may be limited for several reasons.

Firstly, the Federal Reserve’s decision to taper QE may adversely affect oil prices. Over the last few years, some of the easy liquidity infused through QE pushed up the prices of commodities such as oil and gold. Consequently, the prices of these commodities may fall as the stimulus is withdrawn and the dollar strengthens. The charts show that oil and gold prices have been negatively correlated to the dollar.

Gold & Dollar

Oil & Dollar

Secondly, the Chinese government has announced its intentions to rebalance the economy and shift to a model of consumption led growth. Therefore, the government and the central bank may be willing to sacrifice some short-term growth to correct the structural imbalances in the economy. This may limit gains in oil prices as China has surpassed the U.S. and is now the world’s biggest importer of oil.

The shale oil boom in the U.S. – the second largest importer of oil – may also lower the demand for oil as the U.S. becomes self sufficient and reduces its dependence on imported energy. Lower demand from the U.S. and China may depress oil prices.

Finally, the recent U.S. deal with Iran may reduce geopolitical tensions in the Middle East and hence cap the upside in oil prices.

Lower oil prices will benefit India as the country is heavily dependent on imported oil. A fall in crude prices may help reduce India’s import bill and the current account deficit. Simultaneously, falling crude prices are also likely to benefit oil marketing companies (OMCs) as this will lead to lower under recoveries which will reduce the government’s subsidy burden and fiscal deficit.

ICICI Prudential Income Opportunities: Story Intact

ICICI Prudential Income Opportunities Fund has a hold-till-maturity approach and invests in high-quality long-dated fixed income securities issued by corporates and PSUs. The fund’s credit risk is relatively low as the fund focuses on high-quality (AAA) fixed income instruments. But the interest rate risk may be quite significant as the fund usually has a high modified duration.

This strategy hurt its performance between July and September as the NAVs of long-term funds fell after the RBI unexpectedly tightened liquidity and hiked the repo rate. Generally, a rise in rates leads to a fall in prices of long-term bonds (known as a mark-to-market loss).

Nevertheless, the fund has recouped its mark-to-market losses over the last few months. ICICI Prudential Income Opportunities Fund is the best performing income fund on a 5-year basis although long-term yields have risen during this period. In January 2009, the yield of the benchmark 10-year government bond was around 6%. The yield rose to 8.77% on 31st January 2014. During this period, the fund has generated a CAGR of 8.27% and hence outperformed its benchmark (the Crisil Composite Bond Fund Index) which generated a CAGR of less than 6%.

The fund is likely to add value for investors in the long-run but may be subject to volatility in the short-term.

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



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