Despite a weak start, Sensex gained 3.8% in October ’19 month post a 25 bps repo rate cut by RBI followed by another small fiscal stimulus through DA (Dearness Allowance) hike of 5% for government employees/pensioners. On the political front, the BJP emerged as the single largest party in both Maharashtra and Haryana in the recently concluded state elections. On the global front, China claimed that part of the trade deal with the US was completed triggering renewed optimism over the trade wars resolution whereas, the UK and the EU struck a long-awaited Brexit deal, but the UK House of Commons rejected PM Johnson’s deal and chose to go for Christmas general elections. The US Federal Reserve cut interest rate by 25 bps but signalled its rate-cut cycle might be at a pause. In terms of India’s domestic economic activity indicators, barring consumer credit growth and electricity consumption, most other indicators like auto sales (wholesale), consumer durable production continues to remain weak. Auto sales data for October ‘19 does, however, suggest some pick up in retail sales during the festive season, especially for passenger cars. Auto, Oil & Gas, Healthcare were the top performing sectors, whilst Infotech and Cap-goods were relatively weak (Source : Bloomberg). In terms of flows, FPIs invested US$1.8 bn and DIIs bought US$656mn worth of equities. Capital market saw muted activity.

In the ongoing result season for 2QFY2020, the Nifty and the broader universe components appear to have met expectations on revenue and operating earnings but surprised on PAT owing to the revision in tax expenses post the corporate tax cuts. In terms of PBT, Automobiles and Healthcare have exceeded, while Cement and Capital Goods have lagged behind expectations. Not all corporates are shifting to the new tax regime due to considerations around MAT credit and other exemptions. Notably, the trend in earnings revision seems more balanced thus far, which was skewed significantly in favor of downgrades in the past quarters. This can be attributed to the revised lower tax assumptions. Commentary from Management of respective sectors is incrementally positive for Automobiles and Corporate Banks, while it is stable for FMCG. Commentary remains cautious for IT (especially on margins) and capex-oriented companies.

At a global level, the US Fed twin policy of rate hikes and balance sheet tightening of 2018 appears to have reversed course even as global money supply (M1) trends are bottoming out. With most central banks around the world in easing mode and US-China trade talks once again assuming the right direction, conditions for improved global economic activity and price inflation are developing. This should in turn augur well for risk assets such as equity.

Locally, current growth trends in India are still running below potential, but medium-term; our positive outlook on the economy is premised on improving macro factors - controlled inflation, stable commodity prices/currency and continuing moderation of interest rates. Measures such as corporate tax cut, good monsoons and accelerating rural spends – interestingly disbursements under the PM Kisan Yojna scheme, a rural income support program, more than doubled in just the month of Oct to Rs400 bn v/s the Apr-Sep 2019 period – should aid India’s growth recovery. Improvement in global conditions should likely benefit India through stabilisation of exports, rising WPI and improving liquidity. It is imperative, that RBI maintains and builds upon its monetary aggression.

From a portfolio management standpoint, we 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 would also like to keep our outlook on business growth recovery muted for the next couple of quarters even though the recent tax cut should aid overall earnings growth this fiscal. 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 continue to be wary of balance-sheet related risks to businesses.

The bond yields have largely stayed unchanged over last month despite the last repo rate reduction of 25bps in early Oct’19. (With this last 25bps cut the cumulative repo rate reduction from Feb’19 is 135bps). The fears of fiscal slippage in this FY have kept the bond yields elevated. The sharp reduction in the corporate income tax rates, sub-par collections in the GST each month; the drop in the headline growth rates and the media coverage of the distress in several manufacturing sector has kept the yields unchanged in the last few months.

While the monetary policy stance has been maintained at accommodative, and the minutes of the monetary policy suggest that the repo rates may be lowered further, given the growth slowdown has failed to enthuse the bond investors. Although in the borrowing calendar, government has stuck to the original fiscal target, the market is finding it challenging to come to terms of the governments’ intent. Although government has multiple avenues to bridge the gap, the market feels the government may access the bond market for additional borrowings if the need arises.

Last month the headline CPI has moved up from 3.21% to 3.99%, mostly due to the rise in the food prices attributed to the unseasonal rains. RBI opines that the upward price pressure from food will be offset by the downward movement in oil prices.

The Q1FY20 real GDP growth was at 5% and hence recently RBI reduced the full year growth estimates to 6.1% from 6.9%.

With the recent reduction in the repo rate, the spread between the 10 year benchmark and the repo rate is 150bps whilst the long period average is under 80bps, also supported by:

• Benign inflation environment. The drop-in core inflation data to closer to 4% is being reasoned out as the drop in demand, 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.
• Possible inclusion of Indian bonds in international bond indices (presented by Bloomberg in Sept’19 in NY in the presence of PM Modi).

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 cumulative rate 75bps rate reduction and the rally in bonds in Europe, which is pushing the yields to historic low levels seem to be pricing in some probability of recessionary conditions around the globe. This rally in bonds is expected to have a spill over positive effect on Indian bonds in time. Additionally, the Indian policy makers also seem to be front loading the easy monetary policy action to support a revival.

Based on RBI’s suasion we observe few banks have started to link their lending rates to an external benchmark which RBI feels will work towards transmission of rates into the borrowers. So far, the transmission of lower rates into the system has been lacking.

The refinancing of debt in the financial services sector and risk aversion is also keeping the investors away from most of the lower tier credits.

So far, the transmission of lower rates has been restricted to only few select top tier credits in an environment of risk aversion. The eventual drop in interest rates should help in balancing the overall leverage across sectors over a period of time 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.

Outlook
We reason that the slowing domestic growth is a function of both slowing global growth and slowing domestic consumption. The average headline CPI (presently at 3.99%) for FY20 is expected to be comfortably well within 4% due to benign oil prices, drop in core inflation and soft food prices (although there is some rise in vegetable prices in the recent period). 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 reduction 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 maintain sufficient surplus 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 one’s 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.

Any upward revision in borrowing calendar of Government for FY20 may pose a risk to this view. However, it may get neutralized through creation of higher demand for gilts and bonds by infusing liquidity into the system by RBI, OMO, long-term repo 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.