Hexagon Wealth



July, 2013
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Market Watch

The Sensex closed 1.8% lower in June as global markets were hurt by the spectre of QE tapering. The index finished the month on a positive note and rose by more than 500 points on the last trading session of June as energy stocks reacted positively to the proposed hike in natural gas prices.

But this 1.8% masks the gyrations that the market went through before it saw better sense. The Sensex fell to nearly 18,500 before the recovery to 19,396 at the end of the month. Markets globally preferred to view the Fed announcement in a fatalistic manner rather than understand what the Fed was trying to say. (Of course, much has been written about how ‘bad’ the Fed is when it comes to communication abilities.) And of importance to our investors, the fall gave us an opportunity to buy equities with the cash that we have been holding for a few months!

The Cabinet Committee on Economic Affairs (CCEA) announced that the price of domestic natural gas would be doubled from $4.2 to $8.4 per mmBtu, from next April. This may help India attract more investments in the energy sector as higher gas prices will make exploration more profitable. In the short-term, the hike may adversely affect the power sector and push up the fertilizer subsidy, but the long-run impact will be positive. Higher natural gas prices will also raise government state's share of taxes and revenue from production and reduce India’s dependence on imported energy. The government’s decision led to a rally in energy stocks as the S&P BSE Oil & Gas Index rose by 2.8% in June.

SENSEX

SECTOR INDICES



The S&P BSE IT Index also rose during June as the Rupee depreciated against the dollar. Nevertheless, most of the sector indices were in the red as FIIs sold Indian bonds and equities. Markets may be volatile in the short-term as global investors digest the Federal Reserve’s stance. Investors could increase their allocations to large-cap funds (which are generally more stable than small & midcap funds) and to conservative funds such as ICICI Pru Volatility Advantage Plan.

FII_june

A post-QE world


In June, the Federal Reserve announced that it may start tapering its quantitative easing program (known as QE-3) towards the end of 2013. The Fed plans to gradually reduce the pace of its monthly stimulus as it believes that the downside risks to employment and growth have moderated.

International Indices



Global markets reacted negatively to the announcement as liquidity concerns overshadowed the Fed’s bullish economic projections for 2014 and 2015. In June, most indices generated negative returns. Indian markets were relatively better off as the Sensex fell less than 2% - while most other EM indices declined by more than 5%, as shown in the table. However, markets may have overreacted for two reasons.

Firstly, the Fed may retain QE if economic data is weaker than expected. While the Dow Jones notched new highs this year and the rebound in the housing market is impressive, the overall recovery is slower than it was after previous recessions.

Last week, the Commerce Department sharply revised down first-quarter GDP growth to 1.8% from its previous estimate of 2.4%. Officials at the Federal Reserve tried to calm investors by emphasising that QE will not be reduced until the economy strengthens.

Secondly, the proposed tapering in QE will not immediately result in interest rate hikes. 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”. The Federal Open Market Committee (FOMC) highlighted that it would maintain low interest rates as long as unemployment is above 6.5% and inflation does not exceed 2.5%. In May, unemployment was 7.6% while inflation was only 1.4%.

In the short-term, a reduction in QE may hurt India as the country has benefited from the influx of global liquidity from QE programs over the last few years. Some capital flows may be withdrawn and re-invested in the U.S. Nevertheless, there is a silver lining - commodity prices have also fallen since the Fed’s announcement. A sharp rebound is unlikely because of slowing growth in China. This may benefit India as the country is a major importer of many commodities.




Will India benefit from slowing growth in China?

­ In June, the Shanghai Composite fell by nearly 14% - its worst monthly performance since August 2009. The fall was partly because of the “credit squeeze” during the month. Chinese banks found themselves short of cash due to seasonal effects. However, the central bank did not infuse liquidity and allowed rates to spike in the interbank market (where banks lend money to each other to meet their daily needs). A key benchmark - the Shanghai Interbank Offer Rate or SHIBOR rose to an all-time high.

The People’s Bank of China eventually released a statement and stated that it had infused funds into some financial institutions to improve liquidity while the governor said that the central bank would maintain stability.

The central bank’s delayed and muted response suggests that the bank is trying to slow credit growth which is now in double digits although GDP growth is less than 10%. Slowing credit growth may cause short term pain and drag down GDP growth which fell to a 13-year low in 2012. However, the new leadership has pledged to rebalance the Chinese economy and reform the financial system by reducing the country’s reliance on exports and investment and increasing the share of consumption in the economy.

Hence, the government and the central bank may be willing to sacrifice some short-term growth to correct the structural imbalances in the economy. Slowing growth in China may lead to further declines in commodity prices as China is the world’s biggest consumer of many commodities, including oil. Lower commodity prices may offset the negative impact of the falling Rupee and prevent significant increases in imported inflation. 

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The CAD and the battle against gold imports

In FY13, India’s current account deficit (CAD) rose to a record high of $87.8 billion (4.8% of GDP) from $78.2 billion (4.2% of GDP) during 2011-12. However, the CAD declined sharply in the 4th quarter of last fiscal.

The CAD may fall in FY14 if the recent fall in commodity prices is sustained. Last year, gold and oil imports accounted for nearly 45% of total imports and added to the pressure on the current account.

The government and the RBI have implemented several measures to curb the demand for gold over the last few months. These include the recent hike in import duty on gold to 8% and the restrictions on loans against gold. Additionally, investors can no longer convert credit purchases of gold and jewellery to EMIs.

The private sector also joined the fight against gold imports in June. Reliance Capital suspended gold sales and fresh investments in Reliance Gold Fund of Funds (which invests in Reliance Gold ETF). India’s biggest jewellers’ association – the All India Gems and Jewellery Trade Federation – asked members to stop selling gold bars and coins. The association represents about 90% of the jewellers in India.

A reduction in gold imports may lead to an improvement in the current account as gold prices have fallen significantly this year and are now close to three-year lows. This fall alone will deter further buying of gold by investors and speculators. The moderation in the CAD may provide the RBI with space for interest rate cuts as the central bank has expressed concerns about the quantum and financing of the CAD. Our recommended medium to long-term debt funds may generate higher returns if interest rates fall.




Will FIIs come back to India?


In June, foreign investors sold Indian bonds worth $5.68 billion. This contributed to the fall in bond prices in June as the yield of the benchmark 10-year bond rose by 20 basis points.  Hexagon’s strategy of limiting exposure to long term bond funds has paid off – unlike the trend, we have been advocating a more conservative strategy in debt funds based on macroeconomic indicators. Some of our recommended debt funds managed to limit losses and Templeton India Low Duration Fund, Templeton India Short Term Income Plan and Templeton India Corporate Bond Opportunities Fund outperformed their categories and generated positive returns in June.

Indian equities were also unpopular (but not as unpopular as other EM equities!) in June as FIIs sold equities worth $1.85 billion. The reversal in FII investments contributed to the decline in the Rupee which hit a record low of Rs 60.72/$ on June 26th. But the Rupee was not the only casualty as most EM currencies fell against the dollar last month. Global investors dumped EM bonds and equities on expectations of QE tapering.

Over the last few years, quantitative easing programs have depressed bond yields in developed countries. Consequently, foreign investors poured in funds into EMs such as India to benefit from higher yields. A 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.

The government hiked the overall FII investment limit in government securities from $25 billion to $30 billion in early June to attract more investments. But, this may also increase the volatility of FII investments in debt.

GDP Growth

FIIs may continue to favour India in the medium to long-term when investors start focusing on fundamentals rather than on global liquidity.

Although India’s growth slowed to a 10-year low of 5% last fiscal, the country is still growing faster than most developed countries and its BRICS peers (with the exception of China). India’s economy is also growing faster than other emerging economies such as Mexico and Turkey. This trend is likely to be sustained in the next few years.

Additionally, SEBI’s proposed measures may make India more attractive for FIIs. In June, the regulator proposed measures to simplify the rules and registration procedures for foreign investors.

Nevertheless, this month’s volatility highlights that in the long-run, FII investments are not a stable source of financing for the CAD. The government should focus on attracting FDI instead as FDI flows are generally more stable and have positive spillover effects. FDI often increases competitiveness, and results in technology transfer and knowledge transfer.

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

FII/MF data: SEBI





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