Hexagon Wealth

March, 2014
Market Watch

In February, the Sensex rose by 3%. The index notched a new record high of 21,935 on 10th March and crossed 22,000 in intra-day trade. Strong FII flows contributed to the rally as FIIs bought equities worth $400 million in February - the second highest inflows among Asian emerging markets. According to Financial Express, only Indonesia has received higher FII inflows at $658.94 million.The FII inflows also supported the rupee which appreciated against the dollar by 1.5% - the biggest monthly gain since October 2013.

                                        MARCH 2014


Foreign investors are now relatively more bullish on Asia’s third largest economy as the some of the country’s macroeconomic fundamentals appear to be improving. Furthermore, recent opinion polls suggest that there is a low probability of a fractured election verdict. The recent opinion polls also suggest a growing probability of the BJP-led National Democratic Alliance (NDA) coming to power after the forthcoming general election. These results contributed to the rally in cyclical stocks (which are more sensitive to growth) during the month as shown in the table. These stocks were also supported by the Finance Minister’s decision to reduce excise duties.


A respite for India’s current account

In the third quarter of FY14, India’s current account deficit (CAD) fell sharply to a four-year low of $4.2 billion or 0.9%. In the same quarter last year, the deficit rose to a record high of $31.9 billion (6.5% of GDP). The high CAD weighed on sentiment last year and contributed to the sharp decline in the rupee as investors feared that a reduction in global liquidity as the Federal Reserve tapered its quantitative easing programme would make it difficult for India to finance its deficit. The decline in the CAD was predominantly because of the government’s measures to restrict gold imports. The recovery in developed economies and the weak rupee also boosted exports.

For the full year, the CAD is expected to be below 2.5% of GDP – a level the RBI has described as sustainable. Consequently, India is now less vulnerable to QE tapering as the deficit is likely to be financed even if FIIs turn against India. Nevertheless, policymakers cannot afford to be complacent as external risks may push up the CAD.

During the last few days, oil prices rose to 12-month highs because of fears over military tensions in Ukraine. Russia’s move to send troops into Crimea – a peninsula in Ukraine – pushed up commodity prices. Investors worried over supply disruptions as Russia is one of the world’s biggest producers of oil. The geopolitical tensions also pushed up the price of gold to a four-month high because of the metal’s safe haven status. Edible oil prices may also rise as Ukraine is the world’s biggest producer of commodities such as sunflower. Ukraine accounts for nearly all of India’s sunflower oil imports. Sharp rises in the prices of commodities such as oil and gold may reverse the recent declines in the trade and current account deficits.


More importantly, prolonged tensions may adversely affect global markets as it may dampen investor sentiment. This may lead to a withdrawal of foreign investment from emerging markets such as India as investors are likely to rush towards assets such as U.S. treasuries which are perceived to be relatively safer. Therefore, the next government needs to focus on sustaining the recent momentum in export growth and reduce the country’s dependence on volatile FII flows while implementing measures to attract relatively more stable foreign direct investment. Fuel price hikes are also necessary to limit India’s oil demand and the CAD. According to a HSBC report, “policy makers still have to walk the straight-and-narrow [path] when it comes to monetary, fiscal, and structural policies to make sure that the deficit remains contained”.

A tale of two peaks

The Sensex first crossed 21,000 in intra-day trade in January 2008 before the global financial crisis. The index has now notched a new record high of 21,935. Nevertheless, current valuations are relatively more attractive than they were at the peak in January 2008.

Sensex EPS Trend

During the last six years, there has been a dichotomy between earnings and market performance. Since the peak in January 2008, the Sensex has risen by less than 1% (CAGR) while earnings have grown at 8% during the same period (CAGR).

In the third quarter of FY14, the aggregate sales of the Sensex companies grew by 14% (y-o-y) while profits after tax rose by 20% and beat street estimates. During the last two quarters, the Sensex PAT growth has positively surprised markets. Hence, earnings estimates for FY15 have been revised upwards.

However, since 2008, defensive sectors such as fast-moving FMCG, IT and pharmaceuticals have significantly outperformed cyclical sectors such as capital goods, cement and real estate.

Sectoral breakup of Sensex

Hence, the gap between the valuations of cyclical and defensive stocks has expanded as shown in the chart above. These valuations may converge gradually as India’s economy recovers.

Has inflation turned a corner?

In January, India’s retail inflation (measured by the CPI inflation) fell to a two-year low of 8.79% while wholesale price inflation fell to an eight-month low of 5.05%. Lower vegetable prices contributed to the declines in the two indices. Retail inflation has now moved closer to the level recommended by the Urjit Patel committee. The panel has suggested that the RBI should bring down CPI inflation to 8% by January 2015.


The decline in inflation did not translate to lower bond yields although FIIs favoured Indian bonds in February. The yield of the benchmark 10-year government bond rose by 9 basis points as the RBI’s announcement to conduct term repo auctions in March lowered the probability that the central bank would buy bonds through open market operations. High cutoff yields set at an auction of state development loans also weighed on bond prices. In spite of the rise in yields, the majority of our recommended long-term accrual and dynamic income funds managed to generate positive returns in February and outperformed the Crisil Composite Bond Fund Index.

Accrual funds may continue to add value for investors in the immediate future as the RBI Governor hinted that further rate hikes are not imminent in the last policy review. The slump in growth and consumption may limit upside pressures to inflation as corporate pricing power is muted. Nevertheless, the timing of interest rate cuts is uncertain as core CPI inflation has not yet declined and was flat at 8.1% in January. Real interest rates are negative as CPI inflation is still higher than the repo rate. Negative real interest rates discourage financial savings. Furthermore, the recent tensions in Eastern Europe may push up commodity prices which may in turn increase imported inflation. Consequently, investors should maintain laddered portfolios with a mix of short-term, medium-term and long-duration funds to counter volatility.

Is FY14’s GDP target possible?

In the third quarter of FY14, India’s GDP rose by only 4.7% - this was lower than the growth of 4.8% in the second quarter and was the seventh successive quarter in which GDP growth was below 5%. The government expects India’s economy to expand by 4.9% in FY14 – but this target is unlikely to be achieved as it implies that growth will have to accelerate to 5.7% in the fourth quarter of the current fiscal year.


Although the government has taken steps to clear stalled projects, these projects are unlikely to contribute to growth significantly before the next fiscal year. Most corporates will probably postpone investment decisions because of the approaching general elections.

Nevertheless, recent forward looking indicators suggest that the Indian economy is likely to improve modestly in the future. In February, the HSBC Manufacturing Purchasing Managers Index (PMI) rose to a 12-month high of 52.5. This suggests that the manufacturing sector expanded during the month as the index was above the threshold of 50 which separates expansion from contraction.

Additionally, further rate hikes do not appear to be imminent as inflation appears to have peaked. High interest rates have been one of the headwinds to growth in FY14 as higher inflation forced the Reserve Bank of India (RBI) to raise interest rates by 75 basis points in the second half of 2013.

Most organisations expect growth to rise in 2014-15. The International Monetary Fund (IMF) and the World Bank expect India’s economic growth to accelerate to 5.4% and 6.2%, respectively, for 2014-15. 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 stalled projects start generating returns.

But the recovery is contingent on structural reforms. Policymakers need to implement measures to reduce the bottlenecks for investments. The new government also needs to rebalance the budget by reducing wasteful subsidies and increasing capital spending to improve infrastructure.

Can the Finance Minister deliver on “the red line”?

In the interim budget, the Finance Minister announced that the fiscal deficit for the current year would be only 4.6% of GDP - lower than the targeted level of 4.8% of GDP. However, between April and January, the fiscal deficit has already exceeded the revised estimate. Mr. Chidambaram has repeatedly stated that “the red line” will not be crossed as the fiscal deficit will not exceed 4.8%.

This implies that to meet the shortfall, the government may be forced to cut spending which may add to the pressure on growth as tax revenues are unlikely to rise because of the economic slowdown.

The cut in spending is likely to hurt growth especially because capital expenditure (rather than subsidies) is to be squeezed. Capital expenditure is necessary to boost infrastructure and productivity and support long-run growth. Furthermore, the government also deferred oil subsidies worth Rs. 35,000 crores to the next fiscal year which could increase the fiscal burden on the next government.

The budget may push up growth in a few sectors in the short-run as Mr. Chidambaram slashed the excise duty on capital goods, consumer goods and automobiles.

Budget - The Hindu

These sectors have been adversely affected by high interest rates and the economic slowdown. The automobile sector has also been hurt by the fuel price hikes. In 2013, car sales fell by 10% - the first annual decline in 11 years. Hence, the government’s measures are likely to boost growth in the short-term but the government may still find it difficult to achieve its growth target in FY14 as meeting “the red line” will involve reducing spending in other areas.

Recommendation Review: IDFC Equity Opportunities Series 1

During the last few months, asset management companies have launched a flurry of close-ended small and midcap funds. The trend originated last year when IDFC Mutual Fund launched IDFC Equity Opportunities Fund Series 1 – a three-year close-ended fund. We recommended this fund to our clients last March as we believed that the fund’s philosophy and the stellar track record of the fund manager (Mr. Kenneth Andrade) would offer investors an opportunity to benefit from the higher returns of small cap companies over a complete cycle

IDFC Equity Opp

The fund is now nearly a year old and declared a dividend of 15% in February. Since its inception, IDFC Equity Opportunities has generated a return of 26% and has outperformed its benchmark (the S&P BSE 500 index) and the BSE midcap and small cap indices as shown in the chart.

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



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