Indian equities were down 4.9% (Sensex) logging one of the worst July in recent years. The full Budget (FY20) presented on 5th July-19, chose fiscal prudence and stuck to the path of fiscal consolidation as it did not announce any major stimulus measures to arrest the slowing economy. Some budget proposals like the hike in the surcharge for the super-rich (non-corporate), and government's proposal asking SEBI to evaluate increasing the minimum public float for listed companies from 25% to 35%, were taken negatively by the FPI’s (Foreign Portfolio Investors). On the global front, US Fed cut rates but disappointed the street by the quantum (25bps) and fairly hawkish commentary. India’s domestic economic activity indicators, barring consumer credit growth and electricity consumption, most other indicators like auto sales, consumer durable production continued to weaken sharply. On the monsoon front, after a poor start, the southwest monsoon gathered pace and have delivered above-average rainfall, reducing the shortfall to 11% (from 35% at the end of June). As of 30th July, more than 2/3rd of the country had received normal or excess rainfall, a continuation of which, should bode well for the Agri/Rural economy.

IT and Infotech were the only sectors in the green, whilst Consumer Durables, Auto, Metals, Cap goods fell sharply during the month. After buying consistently for 5 consecutive months, FIIs (Foreign Institutional Investors) turned sellers in July as the proposed increase in the surcharge on non-corporate FPIs created anxiety amongst foreign investors. DIIs (Domestic Institutional Investors) increased buying in July turning them net buyers YTD. Capital market activity remained muted.

Budget FY20: FM Nirmala Sitharaman in her first budget speech stuck to fiscal consolidation and lowered fiscal deficit target to 3.3% of GDP. The budget fell short of expectations that the government will try to revive the subdued consumption environment. Key Highlights –

• Proposed increase in the surcharge (from 15% to 25% for taxable income between Rs. 20 mn and Rs 50 mn and to 37% for those earning more than Rs. 50 mn) on super-rich non-corporate entities. On the other hand, threshold for applicability of lower corporate tax rate of 25% increased from Rs. 250 crores to Rs. 400 crores
• It proposed a one-time 6-month partial credit guarantee to PSU banks for purchase of high-rated pooled assets of financially sound NBFCs
• Thrust on Infra capex +12% YoY with allocations to Rail +24% YoY, Defense +10% YoY
• Some boost to affordable housing segment through additional tax incentives for home loan borrowers while there was no major incentives for Autos except some push to Electric Vehicles.

The current Sino-US trade stand-off does create additional global headwinds in addition to the challenges of slowing domestic growth. Medium-term, our positive outlook for the market 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 goes well for a potential rural demand recovery. Since the last 6-8 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 hence may keep earnings growth subdued for a few more quarters.

From a portfolio 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 bond market was in a grip of a strong rally tracking the slowing economic conditions and the rate environment in other economies. The decline in yields was in the range of 35-40 bps. The rally in the sovereign bonds continued due to:

• Expectations of steeper repo rate reduction from RBI, particularly as the economy slows further
• Benign inflation environment
• Softening international oil prices
• Improved sentiment amongst foreign investors leading to positive foreign inflows
• Addressing the fiscal through potential transfer of revaluation reserves of RBI to Government (Bimal Jalan committee, the final report is awaited)
• Slowdown in global growth particularly in US and drop in US treasury yields by about 65bps YTD

The weakening inflation pressures globally and domestically have opened up reasons to believe successive rounds of rate reductions and QE across the globe. The Fed’s mid cycle 25bps rate reduction and the historical low yields in European bonds have led to rally in bonds across the globe, including India. Additionally, Indian policy makers also seem to be preparing for front loading the easy monetary policy action to support the revival of growth whilst the NBFC and HFC deal with problems of lack of investor appetite in the capital market and lack of liquidity. These actions might not entirely address the trust deficit and wide ALM (Asset and Liability Management) position within the distressed NBFCs. In fact, the investors are looking forward to redressal of defaulting credits before any additional exposure to the second-tier credits from this sector. At the least, we expect the MPC members to push through higher doses of rate reduction and infuse liquidity in order to address the deficit liquidity within the Banking sector (addressed, to some extent), NBFC and housing finance companies as well.

This anticipated action of RBI is expected to work towards improving the surplus liquidity within the banking system and eventually help in the transmission of the lower rates for the borrowers. But for now, this transmission might just be limited to the top-tier  credits. The drop in interest rates should also help in balancing the overall leverage across sectors over a period of time and ideally may help in attracting equity capital as costs of savings and investments move lower. However, it remains to be seen whether this cycle follows in India in this environment.

Restraining of the fiscal target at 3.3% for FY20 and proposal to move overseas for part government borrowings has been cheered by the debt investors and has now shredded the fears of excessive government borrowing. However, the confusion around this 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 3.18%) 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 sub 4.5% 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 attempts to push the lower rates into the economy. However, drop in repo rate do not always guarantee lower borrowing cost, and hence we feel RBI may take additional actions and 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 marginally longer depending on their individual risk appetite. Some additional fund duration over 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 a 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.