Amid volatile sessions, the BSE-30 Index ended flat in August. Trade tensions between US and China, US Fed commentary on future rate cut, a global sell-off, Modi government’s revocation of Jammu & Kashmir’s special status and fading hope of any measures to revive the economy weighed on investor sentiment. However, RBI’s higher than expected repo rate cut (35 bps) and additional transfer of excess provisions to the central government, coupled with rollback of surcharge on FPI (Foreign Portfolio Investment) and few other government measures to boost the economy later in the month brought some relief to the market. On Friday (30th Aug) finance ministry’s announcement of mega mergers between few public sector banks, may not have any major near-term benefits on the credit environment, but is a step in the right direction, in-terms of long-term consolidation and keeping public sector banks relevant. GDP growth figures for Q1FY20 at 5% were one of the lowest in 25 quarters. In terms of India’s domestic economic activity indicators, barring consumer credit growth and electricity consumption, most other indicators like auto sales, consumer durable production continue to weaken sharply. Monsoon rainfall continues to remain healthy and water levels in reservoirs have improved significantly, which should bode well for the Agri/Rural economy.

Consumer durables, infotech, auto were the sectors in green, whilst Metals, Bankex, Power and Cap goods fell sharply during the month. After buying consistently for 5 consecutive months, FIIs (Foreign Institutional Investors) continued to be sellers for the larger period of August while DIIs (Domestic Institutional Investors) continued to increase buying in August turning them net buyers YTD. Capital market activity remained muted.

Current issues around the Sino-US trade stand-off does create additional global headwinds in addition to the challenges of slowing domestic growth. Medium-term, our positive outlook is premised on improving macro factors - controlled inflation, stable commodity prices and currency, improving asset quality and credit growth cycle and likely moderation of interest rates. Moreover, recent improvement in monsoons also augurs well for a potential rural demand recovery. Since the last 6-9 months, we have been constructive on the Indian equity market from an opportunity standpoint; particularly in the mid and small cap segment given meaningful valuation corrections in several good quality businesses. Recent growth challenges seen across few sectors of the market are however, unlikely to abate in a hurry and may keep earnings growth muted for a few more quarters. However, measures announced by the Govt to address these challenges are a welcome step and should mitigate some of the anxiety around the same. The Finance Minister has hinted at additional measures likely to be announced to beat the growth slowdown.

From a scheme management standpoint, we continue to restrict ourselves to a bottom-up approach to stock selection and portfolio construction until stronger evidence of more broad-based growth emerges. Given the extent of the slowdown across various sectors of the domestic economy, we keep our outlook on growth recovery muted for the next 2-3 quarters. We prefer to evaluate investment propositions based on flat to weak growth assumptions for the ensuing future and resultant price to intrinsic value equation. We maintain a high sense of alert overall and remain wary of balance-sheet related risks to businesses.

The 35 basis point repo rate reduction by Monetary Policy Committee (MPC) in early August’19 was targeted to address the dwindling economic growth. While not all market participants were expecting a rate reduction of more than 25bps, the data on growth slowdown and ‘inflation deficit’ suggested an immediate action.

In this situation the rally in the bond market should have continued in August, however, it was not visible. The slowing economic growth conditions, the rate reduction by RBI and the rate environment in other economies should have led to drop in bond yields. The pause in the bond market rally may be ascribed to the possible stretch on the fiscal position due to drop in tax revenue collections vis-a- vis budget target due to economic slowdown.

The much awaited Bimal Jalan report on the transfer of reserves was finally accepted last month and Rs. 1.76 lakh crores will get transferred to the government. This news also had limited positive effect on the bond investors’ sentiments as it is being estimated that the ability of RBI to transfer higher dividend to government in the following years seems limited.

However, the sharp drop in the GDP growth of Q1FY20 to 5% has once again increased reasons to believe steeper rate reductions in the coming months.

The reason also gets supported by:

• Benign inflation environment- The drop in the core inflation data to closer to 4% is being reasoned out as drop in demand and which is now visible across several sectors.
• Softening international oil prices as growth slows in several other economies.
• Improved sentiment amongst foreign investors leading to positive foreign inflows into debt
• The drop in global yields particularly in US and Europe improves the relative attractiveness of the EM bonds

The weakening inflation pressures globally have increased reasons to believe successive rounds of rate reductions and QE across the globe. The Fed’s mid cycle 25bps rate reduction and the rally in bonds in Europe which is pushing the yields to historic low levels seems to be pricing in some probability of recessionary conditions in the globe. This rally in bonds is expected to have a spill over positive effect on Indian bonds as well. Additionally, Indian policy makers also seems to be front loading the easy monetary policy action to support revival of growth whilst the NBFC and HFC deal with problems of lack of investor appetite in the capital market and lack of liquidity. However, the government’s intent to pick up first loss of 10% for upto Rs. 1 lakh crore of NBFC loan is a step in the right direction.

The cumulative rate reduction has been 110bps from the beginning of the year, including the last rate cut of 35bps. However the drop in the bank lending rates has been a fraction of this 110bps. The lack of risk appetite amongst banks and lack of equity capital has been an impediment for the banks to reduce the lending rates.

We also feel that improvement in the liquidity in the hands of the banks will help in transmission of lower rates into the economy.

The eventual drop in interest rates should help in balancing the overall leverage across sectors over a period and ideally may help in attracting equity capital as earnings from savings and debt investments move lower. However, it remains to be seen whether this theoretical cycle follows through in India in this environment.

Restraining of the fiscal deficit target at 3.3% for FY20 and proposal to move overseas for part government borrowings has been cheered by the debt investors and has allayed the fears of excessive government borrowing to some extent. However, the confusion about the size, timing and certainty has led to sharp bear moves in the bond market.

Outlook –

We reason that the slowing domestic growth is due to both slowing global growth and slowing domestic consumption. Headline CPI (presently at 3.15%) for CY20 is expected to be comfortably well within 4% due to benign oil prices, drop in core inflation and soft food prices. The drop in core inflation in India to ~ 4% levels in the recent months after staying at over 5.5% for the last few years highlights the slowing domestic consumption.

Thus with slowing growth and high real interest rates, RBI is likely to continue the rate reductions and attempt to push lower rates into the economy. However, drop in repo rate do not always guarantee lower borrowing cost and hence we feel RBI may infuse liquidity so as to help lower the deposit rates of the banks and enabling them to price their loans cheaper.

In this environment we urge investors to start selecting funds in alignment with their investment horizon and longer depending on their individual risk appetite. Some additional fund duration over an investors investment horizon should work favorably, as the risk return matrix is tilted towards lower rates. We expect the actions of RBI to create additional demand for gilts and bonds in this environment.

The risks to this view emanate from higher government borrowing calendar of FY20. However, it may get neutralized through creation of higher demand for gilts and bonds by infusing liquidity into the system by RBI, OMO and or from higher demand for Indian bonds from foreign investors amidst low rates globally and the recent transfer of higher reserves from RBI to government.