Nifty remained volatile during Feb and fell ~7% during the month, as India continued to face a weak macro exacerbated by headwinds to global growth due to risks presented by evolving corona virus situation. India’s perceived limited vulnerability to the virus led to a short-lived bump in Nifty early-Feb, but Indian markets soon fell in line with global cues as the increase in new confirmed cases outside China led to a WHO warning of a possible global pandemic. Back home, US President Donald Trump made his maiden state visit to India but departed without delivering on a trade deal despite years of high-level negotiations. India’s supreme Court rapped telecom companies and government officials for not complying with its order to deposit the statutory dues by January 23, but news of government unlikely to invoke Vodafone Idea’s bank guarantees provided some comfort to investors.

In terms of India’s domestic economic activity indicators, barring consumer credit growth, most other indicators like auto sales (wholesale), consumer durable production continues to remain weak. Both FIIs (Foreign Institutional Investors) and DIIs (Domestic Institutional Investors) remained net buyers to the tune of $0.7bn and $2.3bn each in February taking their YTD totals to +$2.1bn and +$2.7bn respectively. DMFs (Domestic Mutual Funds) were net buyers of $0.7bn whereas Domestic Insurance cos. also bought $1.7bn. All sectors, except Telecom (largely supported by Bharti Airtel), closed lower, with Realty seeing the biggest fall (down 16%).

Our outlook is still for a modest cyclical economic recovery over the next 12-18 months led by moderately better global growth, steady domestic and improving global liquidity and probable incremental rural tailwinds. This recovery currently however is hostage to the corona virus situation. For now we would like to run with the assumption that while global and local economic activity will stay disrupted, it would settle down in the next 2-3 months. In the very near-term how the Government/RBI handles the Yes bank reconstruction exercise and the resolution of the telecom imbroglio remains critical for the normalization of the financial sector and will likely induce short term market gyrations. The resultant adverse market reaction in the interim would give investors an opportunity to buy decent businesses as they turn more attractive on valuations.

As the economic cycle improves, market opportunities are likely to widen and investment opportunities may favour mid/small caps during the course of 2020. Mid/Small caps after a considerable underperformance have meaningfully outperformed the frontline index over the past 3-6 months. While we do take a more constructive stance on the economy and markets as a whole, we remain measured in our conduct with regard to portfolio choices. We keep our growth expectations measured while simultaneously increasing the bar on quality of businesses and balance sheets that attract us.

There was a sense of relief in the bond market post the union budget in early Feb’20. It was due to announcement of :

• No additional borrowing for FY20 (It was earlier widely expected that there would be additional borrowing for FY20)
• Lower than expected market borrowing for FY21
• No more than a 50bps slippage in fiscal deficit for FY20 and FY21 and well within the FRBM (Fiscal Responsibility and Budget Management) corridor

The bond yields started to soften post the budget and has continued even post the monetary policy review in the first week of Feb’20. The policy added to the positive sentiment due to

• No change in the monetary policy stance from ‘accommodative’ despite the rise in headline CPI (ascribed as temporary due to the rise in prices of vegetables primarily Onion)
• RBI’s forecast in headline CPI to drop closer to 3.2% by 3QFY21
• Announcement of 1 year and 3-year LTRO (Long Term Repo Operation) for upto Rs 1 lakh crore

These factors led to build up of positive sentiment amongst debt marked investors and the bond yields softened by approx. 20-40bps across the curve. The yields of shorter bonds fell more than the yields of longer bonds.

The banking sectors credit disbursement growth remains low at around 7%, compared to a 20-year average growth of 18.15%. Such low levels of credit growth were last seen during the period right after demonetisation in 2016 for a very short period. This low credit disbursement growth reflects both lack of demand for loans and poor risk appetite of the lenders.

We do expect RBI to continue to the play the role of an enabler and keep pumping surplus liquidity in the hands of the banks and bring down the cost of loans. In the absence of any credit risk appetite we expect the bulk of the surplus liquidity to chase the risk-free sovereigns followed by blue chip AAA credits.

The marked slowdown in growth in the COVID-19 affected economies is expected to prompt the central Bankers to ease monetary stance and maybe in a coordinated manner. The yields of bonds on DMs have started ever since and the US treasury yields are trading at historical low levels.

Strong net positive foreign flows helped in building India’s foreign exchange reserves. RBI’s intervention in the currency market has built up the forex reserves and now stands at a historical high of $ 476 bn. The dollar purchases by RBI ensured that the rupee didn’t appreciate sharply and also enabled injection of liquidity to the tune of Rs. 2-3 trillion over the last 6-7 months. The excess liquidity has been slowly building up from June’19 onwards. However, absence of any risk appetite amongst the bankers has failed to reallocate this excess liquidity into any other form of lending nor helped in pricing the lending at a cheaper rate. The transmission of lower rates into the economy has got halted due to absence of risk appetite amongst the bankers.

Outlook

We are broadly in agreement in the direction of the CPI projections of RBI. However, we feel, incase the present trend of the vegetable prices normalize, our projections are lower than the RBI’s forecast by about 20-50bps at various points of CY20. More so, after the recent softening of the prices of most vegetables.

The advent of the COVID-19 is expected to affect growth and lead to some supply shocks. This may prompt the MPC members to soften the monetary policy rates sooner. It has been acknowledged in the last policy document about space available with the MPC for future action. We do expect them to move swiftly considering the further slowdown in the domestic economy. The Non-government portion of GDP growth for Dec’19 has been under 4%.

The message in the Feb’20 policy document and the media interview of Governor Das later suggests focused attention by RBI towards ensuring transmission of policy rates into the economy and also ensuring that banks are able to price loans at a cheaper rate.

The LTRO is a targeted effort to ensure availability of liquidity for a period of 1 year and 3 years for upto a total amount of Rs. 1 lakh crore at the repo rate, which is being viewed as a powerful tool being used by RBI to ensure that the transmission eventually happens.

The availability of liquidity for long period of 3 years will now first ensure that the yields of sovereign bonds and blue-chip AAA credits move lower in line with the move.

The decline in yields of bonds till the 3-year point ideally should eventually push down yields for long bonds (bonds greater than 3 years maturity) as well. While the decline in the yields of sovereign bonds and AAA bond yields do not ensure transmission of this decline in borrowing cost to credits below AAA, but eventually the banks are expected to move in their commercial interest and price loans and borrowings of other credits at a lower rate.

In this environment we urge investors to select funds longer than their investment horizon and depending on their individual risk appetite and of high credit quality. Its important to invest in high credit quality funds particularly during this period of volatile credit environment and 3-decade slow banking sector credit growth.