Hexagon Wealth

January, 2014
Are we heading into the Biggest Gamble ever?

The end of August 2013 was a low point in our markets, with the Sensex falling to just below 18000 on concerns of a rapidly weakening rupee. These events were presaged by a rising current account deficit, to alarming levels, falling exports, rising inflation and rising interest rates. The fact that earnings growth and GDP were falling to dismal low single digits did not help matters. Fortunately, steps taken by the RBI to curtail speculation on the Rupee helped and it recovered from its lows. With signs of an improving current account deficit, the stock market index rose rapidly to touch previous highs and surpass them.

At this point, there should have been a reality check. Inflation refuses to come down and remains in the 10% range. Interest rates cannot be bought down till that happens.

Growth has been suffering since the country is in an inflation fighting mode rather than a growth promoting mode. The weak governance by the incumbent government has shaken the confidence of industrialists who do not want to invest till there is a stronger government at the centre that is pro-growth. There is yet no sign of that happening.

Inflation has moved into the wage cycle that makes it so much more challenging to control.

And yes, the Fed’s ‘taper’, whose effect will take some time to materialise.

So we seem to be trading with great optimism that in the light of all the above, our earnings growth will be so high in the coming year as to demand a 18x price Earnings multiple! Admittedly, the markets are factoring in a win by BJP and an end to mis-governance. But it does seem to be an uphill task for BJP to win 272 seats required for a majority. Hence, the General Elections are going to be the biggest determinant for market direction currently.

As shown in the table below, equities reacted sharply after the last two elections. After the 2004 elections, the Sensex fell dramatically but notched its biggest one-day rise after the 2009 elections. But on both occasions, the market’s reaction was not reflective of India’s economic performance. In the years after 2004, India’s economic growth accelerated until the slump caused by the 2008 global financial crisis. But in 2009, the market’s rise was not mirrored in the underlying economy. India’s GDP growth has slumped during the last few years and slipped to a 10-year low of 5% in FY13.


If market is not happy with the result there is bound to be a large fall - large, because we are higher than where we ought to be in terms of index level.  On the other hand, if there is a good election result, markets could jump up and create new highs. (It is also yet to dawn on investors that for any new government to start producing results would take time given the bad state that India is presently in.)

So we are heading for a cliff, if the election result is not desirable.  And a jump if there is a desirable result. Since so much hinges on one event, and so much hope riding, taking any call on the market is a gamble, right?

Market Watch

On 9th December, the Sensex rose to a record high of 21,239 after the election results. Since then, the index has receded from the record high but is still relatively close to its peak and rose nearly 2% in December. The market largely ignored the Fed’s decision to taper QE from January as the actual reduction in QE will be fairly modest at first. The Sensex is currently trading at a Price-Earnings ratio (forward P/E) of about 16.4x – this is marginally higher than the long-run average of 15x (based on FY14 earnings). During the whole year, the index rose by nearly 9%. 

                                        DECEMBER 2013


Our recommended growth-oriented large-cap funds managed to outperform the Sensex and delivered double-digit returns as the top holdings of these funds included IT and pharmaceutical stocks.

These sectoral indices topped the charts in 2013 as the rupee depreciated against the dollar and the U.S. economy accelerated.

However, the S&P BSE Auto Index, the S&P BSE Bankex, the S&P BSE Capital Goods Index and the S&P BSE Consumer Durables Index generated negative returns during the year as stocks in these sectors were adversely affected by deceleration in growth and the reversal in in the interest rate cycle.


The Fed finally pulls the trigger

In December, the Commerce Department revised its estimate of third-quarter GDP growth upwards to an annualized rate of 4.1% - the strongest rate of growth in two years. Other economic indicators have also been positive – industrial production and household wealth have surpassed their pre-recession peaks while after-tax profits rose to an all-time high in the third quarter of 2013. The unemployment rate fell to a five-year low of 7% in November. This trend is likely to be sustained in 2014 as growth is expected to accelerate.

The recent bipartisan federal budget deal recently passed by Congress is likely to reduce the fiscal drag on growth. The deal is likely to reduce the budget deficit by $20 billion to $23 billion and simultaneously ease the automatic spending cuts (known as sequestration) by $40 billion in 2014 and by $20 billion in 2015. The agreement between the Republicans and the Democrats has also reduced the probability of another government shutdown in January.

All these factors influenced the Federal Reserve’s decision to scale back its quantitative easing programme (QE). On December 18th, the Fed announced that it would gradually taper its monthly bond-buying program during 2014, starting with a modest reduction of $10 billion in January.

Global markets had priced in the announcement and did not react as negatively as they did between May and August. Indian bond yields actually fell after the announcement and FIIs bought shares and bonds. The depreciation in the rupee was very marginal. 

                                      Reaction to the Taper

The Dow Jones and the S&P 500 notched new record highs as investors reacted positively to the Fed’s upbeat outlook for the economy.

A stronger U.S. economy may also benefit Indian exports. Furthermore, the withdrawal of QE is expected to stabilize commodity prices. This may ease the pressure on India’s current account as the country is a net importer of many commodities.

The FOMC highlighted that tapering was not tightening as the Fed plans to hold short-term interest rates near zero if inflation remains below 2% even when unemployment falls below 6.5%. Furthermore, Mr Bernanke emphasized that tapering was contingent on the strength of the economic recovery. The Fed may even choose to increase the pace of its monthly stimulus if the economy does worse than expected.

A pause in rate hikes but for how long?

In the mid-quarter monetary policy review on December 18th, Dr Raghuram Rajan surprised the markets positively and left the main policy rates unchanged after two consecutive repo rate hikes. However, the central bank may be forced to hike rates again if inflation does not trend downwards. In November, headline wholesale price inflation (WPI) rose to a 14-month high of 7.52% (on an annual basis). This is outside the RBI’s comfort zone of 5%. Consumer price inflation (CPI measured by the new series) rose to a record high of 11.24% in November.

Markets may be volatile in the short-run as the near-term interest rate outlook is uncertain. Furthermore, the reduction in QE may lead to an increase in bond yields in the U.S. This may reduce the potential return differential for foreign investors who have invested in Indian bonds and lead to a reversal of FII flows.

Nevertheless, interest rates are likely to fall in the medium-long term because of the severity of the economic slowdown.

The slump in growth and consumption may limit upside pressures to inflation as corporate pricing power is muted. This is reflected in core inflation which has fallen over the last few months.

Food inflation may also fall as the monsoon in 2013 was one of the best in recent years and the harvest is expected to be robust. Moreover, the CAD may not be an obstacle to monetary easing if exports continue to grow faster than imports. India is now less vulnerable to a reduction in global liquidity as the country will still be able to finance the CAD even if FIIs redeem their holdings. This is because the central bank has received more than $30 billion through foreign currency non-resident deposits and a special concessional swap window. The RBI is now better positioned to support the rupee (and thereby limit imported inflation) as the central bank’s foreign exchange reserves have increased over the last few months.

Long-duration funds may be volatile in the short-run, especially if the RBI raises interest rates again. Therefore, these funds are only recommended for investors with investment horizons of 3-5 years. This holding period will enable investors to benefit from a complete interest rate cycle. Furthermore, as the near-term outlook for interest rates is uncertain, investors should consider maintaining a laddered fixed income portfolio by investing in a mix of short-term, medium-term and long-duration funds to mitigate downside risk.

The WTO approves a landmark deal

Almost two decades after the World Trade Organisation (WTO) was founded, its members approved a historic agreement to liberalise global trade. This is the first global trade agreement since the WTO’s creation in 1995.

A study by the Washington D.C.-based Peterson Institute of International Economics estimates that the agreement is likely to inject $960 billion into the global economy and create 21 million jobs. 18 million of these jobs are likely to be created in developing countries. The deal will also be a sentiment booster as it will revive confidence in the WTO’s ability as the organisation has failed to achieve an agreement in the Doha round which started more than a decade ago.

Indian exporters should benefit as the deal will help them reduce transaction costs and become more competitive.  Naina Lal Kidwai – the President of FICCI - said that " the agreement on trade facilitation would help in reducing transaction costs, cutting red tape, improving transparency besides simplifying and streamlining customs and port procedures".

In spite of these benefits, the Indian delegation to the WTO summit refused to approve the deal unless the country was allowed to implement its Food Security Bill.

The deal temporarily exempts India from the WTO rule that limits farm subsidies to 10% of total output (the passage of the Food Security Bill would result in India breaching this rule). In exchange for the exemption, India agreed to the trade facilitation pact to lower trade barriers. Hence, the deal is effectively a double victory for India - exporters will benefit from less “red tape” and lower costs while the UPA government has secured a political victory as the agreement still allows India to implement the Food Security Bill.

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



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