Equity markets were down 1% in the month as markets fretted over rising geo-political tensions between India and Pakistan which had momentarily escalated but later-on eased out. As per the latest GDP data released, India's economic growth slowed to a 5-quarter low of 6.6% in October-December period of this fiscal. With inflation concerns easing, the Reserve Bank of India on 7th Feb cut the repo rate by 25 basis points to 6.25 per cent and changed the monetary policy stance from calibrated tightening to neutral. Economic indicators remain a mixed bag, Consumer credit growth remains healthy but auto sales, air passenger growth have weakened sharply. 

In terms of sector level performances, the best performing sectors were BSE Auto (+1.7%), BSE Oil & Gas (+1.4%), BSE Reality (+1.2%) while the sectors which were major laggards were BSE Power (-2.8%), BSE Bankex (-2.3%) and BSE FMCG (-2.3%). Foreigners bought equities worth US$2.2 bn during the month while domestics sold US$86 mn worth of equities. In the recently concluded quarterly result season Nifty companies posted 23% Sales, 5% EBITDA (earnings before interest, tax, depreciation and amortization) and 6% PAT (profit after tax) growth and the direction of earnings revision is still trending down, dominated by a big miss in some of the large-caps in global cyclicals like Tata Motors. Domestic cyclicals led by financials are picking up the baton from global cyclicals as the major driver of earnings growth. Corporate banks and technology delivered a strong performance even as Autos and cement disappointed.
 
As such as Indian markets are steadily climbing diverse walls of worry, the latest among them having been the geo-political tensions between India-Pakistan, macro conditions are improving mainly in the form of softer commodity prices, falling interest rates and moderating valuations, notwithstanding impending election risk. Even as global markets are reflecting anxiety on US growth prospects, our in-house view remains that of steady expansion with low inflation leading to lesser market volatility than in 2018. US monetary policy is becoming less accommodative but the Fed is “not tightening”, only “normalising” policy which can still support economic and business expansion for a long time, in our view. Meanwhile, newsflow around US-China trade related discussions is turning positive at the margin and is imparting stability to global markets. While Indian markets will likely tread cautiously until its national elections in April-May 2019, recent improvement in macro factors will likely restrict meaningful downside. Incrementally, we do turn constructive on the market from an opportunity standpoint; particularly in the mid and small cap segment given meaningful valuation corrections in several good quality businesses. We urge investors to consider using present conditions of the market to normalise their equity exposure and take advantage of the sharp correction seen in the mid and smallcap segment over the past 12-15 months.

Our portfolio approach continues to remain balanced with bottom-up stock selection and sector selection playing an equal role. We believe evidence is emerging on strengthening a pro-cyclical stance and some portfolio shifts to capture a potential industrial/manufacturing recovery are being undertaken. Cyclicals with comfortable balance sheets and attractive valuations or companies with strong franchise value but presently facing growth headwinds do attract our attention. 

February was set up for some key events impacting Indian Fixed Income markets.  MPC (Monetary Policy Committee) policy meeting, Interim finance budget and Federal Reserve Policy in US were going to direct the movement in yields. February started with 10 year Gsec yield at 7.48% and ended with 7.59% - a 11 bps move. However, there was lot of intra-month volatility on back of the events mentioned above. 10 year bond yields moved up by 20 bps early in the month (post interim budget) to then rally by 22 bps (post MPC meeting and 25 bps cut in repo rate).  Profit booking then saw yields move back up by 20 bps to 7.67% and then close down 8 bps to 7.59%.  

The Interim finance budget was seen as fiscally expansionary through schemes for farmers and other sections. Whilst there were positives for the debt markets like relaxation of certain FPI rules and limits, market remained more focused on the increased supply of g-secs in the long end.  Government stated FY ’20 fiscal deficit target of 3.4%, which will be unchanged for FY’19 end. Previous target of increased fiscal consolidation, thus suffered slight set-back.  

The above event was followed by MPC meeting, where the committee cut repo rates by 25 bps citing low headline inflation of 2.05% and continued low path of inflation for FY ‘20. Monetary stance was also changed from hawkish to neutral allowing the committee to cut rates further, should growth continue to weaken. Committee said that balance of growth risks are on downside and stands ready to act decisively should that materialise. This was a very favourable development for bond markets with yields rallying. The new RBI governor is focused on growth and alluded to monetary and liquidity support as and when needed.

On the global front, Federal Reserve Bank US (FED) became very dovish on rate front as well as balance sheet reduction front. With inflation (core CPI 2.1%) around FED’s target range and financial conditions in US tightening due to weak equity and credit markets, FED said they are likely to stop balance sheet reduction later in the year and will be patient on interest rate rises. Forward rates curve in US is currently pricing no interest rate rises in US for remaining FY ’19. This clearly will be helpful for Emerging Markets and help to contain the rapid rise of USD.  

Liquidity in the banking system however, remained tight in February as credit growth increased at a faster rate than deposit growth. In addition, currency in circulation (CIC) remains high. RBI continued to provide liquidity through OMOs. With year-end approaching, liquidity shall remain tight.

Oil prices have continued to remain in a narrow range of $62-$66 for the month of February.  

In addition to the above, relations between India and Pakistan flared up . Fixed Income markets initially sold with yields increasing 7-8 bps, but since then have largely recovered those moves.

Credit spreads in general have been widening, primarily in the longer end of the curve as liquidity remains tight. Markets have been very discerning and are pricing even slightly riskier credits much wider. This opens up attractive opportunity for significant alpha through appropriate credit selection. We think the NBFC sector will continue to be under pressure till a systemic liquidity / capital solution is found for the sector. However, financing is available for most names, albeit it higher rates.

We think GDP growth is slowing down on back of slower global growth and slowing domestic consumption.  High frequency data like vehicle sales points to slower growth ahead. On inflation front, we think headline CPI for CY20 should be comfortably within 4%. Thus with growth slowing and real interest rates high, RBI will likely cut rates twice – once in its next meeting in April and one later on.  Liquidity tightness will improve post March when government will be able to spend for the new fiscal year whereas RBI remains available to address liquidity tightness in the system. Additionally certain public sector banks, which were under prompt corrective action (PCA framework) have now been remediated and should be able to lend thereby improving availability of credit. We also think FPI flows in debt markets which have been negative for last 12 months will likely reverse post elections and help to drive yields tighter. Thus we think the path is set for yields and credit spreads to compress, albeit with bouts of volatility. In the given market conditions, we urge investors to start selecting funds in alignment with their investment horizon and marginally longer depending on their individual risk appetite. With the drop in the headline CPI and a lower CPI forecast for CY20 (under 4%) we do expect further reductions in the repo rate over time. Hence, some additional duration over the investment horizon should work in favour as the risk return matrix is tilted in favour of lower rates. The risks to this view emanate from higher government borrowing calendar of FY20.