Nifty (+7.8%) continued its uptrend in December (outperforming the region) aided by strong FII inflows supported by a weakening Dollar (DXY down ~2.1% in December). Global risk-on sentiment continued with the roll-out of vaccines across regions and US government announcing a follow-on ~$900bn stimulus. Markets had a temporary scare from a new & more infectious strain of Covid found in UK but recovered quickly as vaccine candidates were found to be effective against it. On the domestic front, daily confirmed Covid cases dropped ~50% vs November to ~20k levels. Many high-frequency data points (E-Way bills, GST collections, Power demand) for December improved and continued to show a positive YoY growth trend even as the impact of festival-related holidays normalised. Indian government has formally approved the emergency use of two coronavirus vaccines as it prepares for a mass inoculation drive during the year. On flows, DIIs (Domestic Institutional Investors) continued to be sellers to the tune of ~$5bn due to redemptions, while FII’s (Foreign Institutional Investors) pumped in ~$7bn in the Indian equity markets. Within sectoral indices, Realty, Metals, Consumer Durables, Infotech and Cap goods outperformed, whereas Power, Auto, Bankex, Oil & Gas and Healthcare underperformed the BSE Sensex.

Several economic trackers on aggregate, peg India at 95-100pc of pre-Covid activity levels, indicating that the economy is fast normalising. Recovery post the festive season has sustained, which is reassuring. Urban indicators for travel & realty have seen good improvement. Record GST collections align with several broad indicators' strengths. No Covid second-wave in India so far has been a relief. In our last communication, we drew out our base case scenario suggesting a continuing favorable set-up for equities as growth moves above trend, the global earnings cycle recovers, and risk assets are supported by ample money supply growth. Gradual reopening of face-to-face sectors could favor cyclicals and a rotation away from growth into value sectors. Our assumption in this scenario is that an effective vaccine will be developed and rolled out in the back half of 2021.

In the economic picture of 2021, we also visualise the early phases of India's recovery witnessing comeback of credit growth after nearly 3 years of deceleration, modest pickup in core inflation even as food inflation cools off in the early part of this year and a rise in commodity prices, which in the early stages will likely be passed on by corporates thereby defending profitability amongst others. Moreover, our interactions with many corporates suggest that even in a ‘return to normalcy’ scenario, they can effect durable changes to their cost structure by variabilising fixed costs, especially on employee compensation, advertising and promotion, apart from renegotiating lease rentals, logistics, R&D and travel.

To reiterate our message last month, as global economic recovery takes hold, we expect a style reset in global investing with growth/momentum yielding to value/mean reversion trades in the first part of 2021. Some of this sentiment should rub off in India too thereby favoring financials and industrials/cyclicals. A tactical shift has been undertaken across a number of our strategies by increasing weight in the value component of our portfolios. At an aggregate level, we continue to adopt a middle path in portfolio construction with regards to sector exposure, market cap bias and the balance between growth and value. In general, our portfolios continue to be positioned for better risk-adjusted return outcomes over a 3-5 year period.

India’s economic recovery continued to gather pace in December 2020 as the Covid-19 situation improved further with declining number of fresh cases, despite the festive & winter season and as demand conditions remained buoyant across most sectors. High frequency leading indicators suggest that the economic activity level has recovered to 95% of the pre Covid-19 levels.

November GST collections were supported by normalization of economic activity accompanied by festive demand along with improved compliance associated with recent system changes and drive against GST evaders and fake bills. Total GST collection was at INR 1,152 bn for November (up 11.6% yoy). Gross GST collections up to 9MFY21 were at INR 7.8 trillion – down 14.1% yoy.

Headline CPI inflation for November 2020 surprised positively, coming in at 6.93% as against the market expectations of 7.2% - 7.3%. The better than expected inflation print was largely on account of a fall in food inflation, while, on the other hand, core inflation firmed up in November to the highest levels in over two years at 5.8%. Wholesale inflation firmed up to 9-months high of 1.6% in November 2020, driven by the price gains in the manufacturing segment.

Systemic liquidity remained in huge surplus at an average of ~Rs. 5.5 lac crore in Dec 2020 and marginally increased over the previous month. Bank’s credit growth continued to languish at ~6.1% amidst credit risk averseness & lack of new opportunities while the deposit growth remained healthy at ~11.1%.

RBI’s MPC (Monetary Policy Committee) minutes released during the month show that while all the MPC members unanimously voted for continuing with their accommodative policy stance as in the previous policy, it was also accompanied by rising concerns on inflation and improving confidence on growth.

During December 2020, rates were more volatile, especially on the short end as the overnight rates jumped from ~2.90% to as high as ~3.25% before falling below 3% towards the month end. G-Sec performed relatively better in 5 to 10 - year segment while the corporate bonds outperformed the G-Sec in 2 to 3 - year space.

Outlook

RBI in its Dec Monetary Policy had maintained its accommodative stance on policy rates & broadly remained supportive of creating conducive conditions for growth revival, even as persistently high inflation remained a cause of concern for the MPC. We believe that in the near term, the inflation trajectory has peaked & lower inflation in coming months led by correction in vegetable prices & improving supply chains may offer some relief to the MPC members. Additionally, with the growth recovery still in nascent stage & increasing Covid-19 concerns more in global context, we expect RBI to keep rates on hold and maintain its accommodative policy stance for the foreseeable future and into FY22.

More critical over the short to medium term is RBI’s stance on systemic liquidity as the short-term rates continue to remain below the reverse repo rate. While RBI has resisted from taking any specific liquidity measures as of now, we believe RBI will gradually reduce the excess liquidity in a market non-disruptive way, beginning with not extending the lower CRR (Cash Reserve ratio) of 1% beyond March 2021 (that will suck out close to Rs. 1.5 lac crore). Nonetheless, we expect RBI to maintain surplus liquidity over the medium term to ensure a conducive rate environment for borrowers.

Another big event is General Budget for FY 21-22 to be presented in Feb 2021 which will layout Central Govt’s fiscal plan for FY22 amidst a high slippage expected in FY21 due to Covid-19 led disruption. We expect RBI to continue with its Open Market Purchase Operations so as to be able to clear huge G-Sec supply scheduled in rest of FY21.

Against the backdrop of RBI’s accommodative policy stance, surplus liquidity with expectations to reduce gradually & inflation trajectory, we believe that the short end rates will remain range bound over the next few months and wait for cues on systemic liquidity. Favorable demand supply dynamics in short end segment with lack of issuances will support the levels. We believe 2 year to 4 year segment provides attractive carry over the shorter tenor segment, while keeping the interest rate volatility measured. On the longer end, we expect interest rates to drift lower as the term spreads still remain high relative to the historical levels (current 10 yr G-Sec over Repo rate at ~190 bps which historically has been 70-80 bps) and we expect RBI to continue with its Open Market Purchase Operations / Operation Twist.

Additionally, we believe global macro conditions with risk-on trade on hopes of Covid-19 vaccination, and a benign global liquidity led by central banks have set the stage for a sustained outperformance of emerging market (EM) assets over the next few years. The expected weakening of the US dollar and the relatively higher accrual offered by Emerging Countries like India can create a strong FIIs demand for domestic fixed-income securities especially in 5 to 10 year segment. CY2021 has begun on a positive note with FIIs being the net buyers, though we need to wait for a sustainable buying.

Credit Environment has improved gradually with various measures taken by RBI and opening of economy now. Nevertheless, one has to remain cautious & very selective on credit as of now as still weak economic conditions and challenges faced by banks (led by rise in NPA, drop in capital adequacy) poses hurdles for immediate pickup in credit growth. Banks & financial companies will have to start reporting their slippages on asset quality in 2HFY21 as the moratorium is over in August 2020. We believe credit dispersion will continue, with very high-quality credits benefitting from this but the lower quality credits continuing to be avoided for the time being.