Amid volatile sessions, the BSE-30 and Nifty-50 indices settled lower by 2.6% and 3% in the month of May. Mid-cap and small-cap indices underperformed large-cap and were down 5% and 8%. Worries over high crude oil levels, a potential global economic slowdown amid aggressive policy tightening, lockdowns in China and ongoing Russia-Ukraine conflict dented investor sentiment. On the sectoral front, only Auto and FMCG indices ended in green. Metals, power and consumer durables indices declined 16%, 12% and 11%.

Other key domestic developments during the month—(1) RBI announced an unanticipated interest rate hike of 40 bps, , (2) the Indian government unveiled a number of measures to control inflation—(a) cut excise duty on petrol by Rs8/ltr and on diesel by Rs6/ltr, (b) imposed a hefty export duty on steel products and raw materials, also lowered import duty on key raw materials for steel production, (c) announced a curb on the export of sugar beyond 10 mn tons. During the month, FPIs sold US$ 5.2 bn worth of Indian equities in the secondary market while DIIs bought US$6.6 bn.

High-frequency indicators representing industrial activity exhibited steady gains across most segments. GST collection in May (reflecting activity in Apr) moderated in sequential terms to Rs1.4tn (vs. Rs1.68tn in Apr). Both power demand and rail freight accelerated on a sequential and YoY basis in May. Two-wheeler sales and passenger vehicle sales also rose off a low base. Credit growth accelerated to 10.8%YoY in May - 34-month high. Fuel consumption grew by double digits in May. Services PMI touched an 11-year high of 58.9 in Apr, led by higher new orders on the back of improving demand. Air passenger traffic growth rose by 5.1%MoM in May from 2.5%MoM in Apr. CMIE's unemployment rate moderated to 7% in May from 8.3% in April. Mobility (ex residential) remained at steady levels reflecting continued reopening vibrancy.

The early onset of the upward rate cycle by RBI and the intensity of hike (40bps) did come as a negative surprise to the market. However, in our view based on recent measures undertaken by the RBI and the Govt described above, India’s inflation peak could be well short of the past and correspondingly interest rate hikes too are unlikely to be of a magnitude that would start hurting demand. Meanwhile, some commodity prices have witnessed a meaningful correction (LME Metals Index down nearly 20pc since mid-March), some pockets of weakness in global consumer demand post recent rate hikes and efforts to normalise US-China trade relations will all likely lead to inflation moderation down the line. From an India standpoint however, continuing strength in the oil market remains a cause for concern.  Inflation and interest rates will be the singular point of debate for the market in the months ahead.

On the earnings front, 4QFY22 net income of Nifty-50 Index increased to 24% yoy and 9% qoq while cumulative earnings of Nifty 500 Companies logged yoy and qoq growth of 30% and 10% during the same period, albeit on a low base (marred by 2nd wave). Even as the aggregate performance of this result season is in line with broad market expectations, it did quite clearly underscore the pressure on corporate profitability due to the significant rise in commodity inflation. Going forward, we expect this impact to soften 2HFY23 onwards and corporate bottom lines to more closely track revenues therein. We continue to believe that India’s overall profit pool has reasonable resilience to ongoing inflation shock and should not see material downgrades hereon. Market valuations are now at or marginally below its 5-yr average and not too far out even from 10-yr averages. The ongoing uncertainty, particularly around the world economy will keep equity market returns on leash for most part of 2022. However, we stay constructive on India’s improving economic cycle and inherent stability and believe the balance of this year will provide good opportunities at portfolio and investment planning for potential returns during 2023 and beyond.

Interest rates hardened sharply during the month as significantly higher than expected April’s Consumer Price Index (CPI) inflation came in at 7.79%. Further, elevated inflationary pressures led by global commodity price surge prompted RBI to go for a pre-emptive strike on inflation by undertaking off cycle repo rate hike of 40 basis points (bps) in May 2022 and subsequently by 50 bps in June policy review taking the repo rate to 4.90%. RBI had also increased the Cash Reserve Ratio (CRR) by 50 bps to 4.50% in May 2022, thereby withdrawing liquidity of Rs. 870 billion from the system.

With these moves, RBI has shifted its focus from growth supporting to inflation controlling policy and justified that the rate hikes were undertaken to anchor inflation and inflation expectations, which had changed rapidly post the Russian Ukraine crisis. The MPC minutes of May meeting, and June policy review clearly highlighted the concerns on inflation breaching the upper band of 6% and reflects the intent of MPC to continue with its focus on taming inflation till inflation comes within the targeted range of 2% to 6%.

As spiraling inflation remained a key concern, the government also stepped-up its efforts to help tame the inflation. The government slashed fuel taxes on petrol and diesel, which will lead to reduction in inflation by 20 bps directly and 50 bps indirectly. Further, it announced an additional fertilizer subsidy of Rs. 1.10 lakh crores to cushion input costs to the farmer. Together, these subsidies would lead to revenue loss of ~0.80% of GDP.

While the conservative budget estimates on the revenue side will help offset some bit of the revenue loss by the government on account of subsidies announced, still the fiscal estimates may move up marginally by 0.20% of GDP, which in turn may translate to increase in gross market borrowing by Rs. 1.50 trillion.

Given the increased focus on controlling inflation, rapid move up in normalizing the policy rates to pre-pandemic levels and higher than expected market borrowing, bond yields have hardened considerably. The bond yields moved up sharply in May with 1 year to 3 years AAA corporate bonds yields seeing an uptick of ~80-100 bps, the 5-year segment yields rose by ~60 bps and 10-year yields went up by ~37 bps. The 10-year government security moved up by 28 basis points to close at 7.42% on the month end.

Outlook

In CY 22, globally inflation has taken centre stage, compounded by the Russian Ukraine crisis. We believe that inflation trajectory is uncertain and would remain elevated throughout the year. Global factors which could impact the inflation trajectory include geopolitical uncertainties emanating from Ukraine-Russia crisis, quantum of rate hikes by US Federal Reserve, elevated commodity prices driven by high energy prices, etc. On the domestic front, the persistently high food prices pose an upward risk to inflation.

With these challenges surrounding the global economies, many Central Banks will continue to tighten the monetary policies to tame inflationary pressures.

In India, at the current juncture, our view is that RBI is likely to move towards a repo rate of 5.75% to 6.00% by April 2023 from the current 4.90%. However, the question which is unanswered is whether this would be the terminal repo rate. On inflation, the consensus view is that the average inflation would be around 6.50%-7.00% in FY 2023; however, the inflation trajectory going into FY24 remains uncertain. We would look at the incoming data on various global and domestic factors highlighted to understand inflation trajectory in FY24 along with RBI’s monetary policy stance to determine the terminal repo rate.

With a huge fiscal supply and RBI’s expected fast withdrawal of ultra-accommodative policy, we expect interest rates to remain volatile with an upward bias till a consensus on terminal rates comes. 

We feel that 6 months to 1 year segment of the yield curve provides an opportunity to risk-averse investors amidst expectations of repo rate hike going forward. Given that 1Y to 3Y rates are significantly higher pricing more rate hikes going forward. For investors looking at the core allocation, the 1 to 3 years segment of the yield curve remains well placed from carry perspective.  Hence for us, the sweet spot remains the short end of the yield curve which stands to benefit from the absolute level of relatively high yields, while not getting impacted by the rate volatility, in comparison to the longer end of the curve.

While credit environment is expected to continue improving over the medium term, current extremely narrow spreads of AA / AA+ over AAA bonds do not provide favorable risk adjusted reward opportunities, and we expect liquidity premium to increase sharply over a period of time thereby posing mark to market challenges for this segment.