The BSE-30 Index and Nifty-50 Index were up 1.1% and 0.9% respectively in December aided by a slew of positive global developments, such as the easing of US-China trade tensions and a sweeping win by Boris Johnson’s Conservative Party in the UK elections (which paves the way for swift exit from the EU). The US Federal Reserve maintained status quo on key policy rates, by cutting policy rates by 25 bps and signaled constancy through 2020. On the domestic front, the RBI kept the policy rates unchanged but maintained an accommodative stance and indicated that there is space for future rate cuts. In terms of India’s domestic economic activity indicators, barring consumer credit growth, most other indicators like auto sales (wholesale), consumer durable production continues to remain weak. FIIs pumped in an additional ~$1bn in December even as DIIs (Domestic Institutional Investors) sold ~$0.1bn during the same period. Among sectoral trends, Metals (+6.6%), Realty (+5.3%) and IT (+4.4%) were the best performing sectors during the month whereas Cement (-5) was the worst performing followed by FMCG (-2.8%) sector.

Despite widespread anxieties about the risk of a recession in the US during the past year, the US economy continued to grow at a satisfactory pace of 2.1% p.a. in the third quarter of 2019. Markets are worried by continued low investment, slowing trade due to US-China tariff wars, and other geopolitical risks such as Brexit and military conflicts and disruptions to oil supplies in the Middle East. The reasons why these concerns are misplaced are that (i) the US business cycle upswing is still firmly intact, (ii) US private sector balance sheets are still in good shape, (iii) inflation remains low and (iv) monetary conditions have eased substantially during the past six months. We continue to maintain that at a global level most central banks around the world would continue being in an easing mode. With US-China trade talks once again assuming the right direction and Brexit matters approach resolution, conditions for improved global economic activity and price inflation are developing. This should in turn augur well for risk assets such as equity.

Domestic data points more recently are now turning somewhat mixed from negative earlier. For instance, (i) Dec’19 GST collections registered a robust growth of 9%YoY despite late Diwali in 2018, (ii) manufacturing PMI (Purchasing Manager’s Index) surged to 52.7 in Dec’19, signaling the fastest expansion in 10 months, (iii) capex aggregates (CMIE) for 3QFY20 improved and (iv) the YoY contraction n core industries index moderated in Nov’19. However, Centre’s fiscal revealed slower spending growth in Nov’19 given receipts constraints. Medium-term, we think building blocks for a modest economic improvement in 2020 v/s 2019 are in place. Recent govt. policy measures such as corporate tax cut, good monsoons and accelerating rural spends should aid India’s growth recovery. Moreover, it may be important to highlight that some quantum of food inflation visible recently is desirable from the perspective of aiding rural income growth and remains our base case expectation. Improvement in global conditions should likely benefit India through stabilisation of exports, rising WPI and improving liquidity. In the meanwhile, continuing on measures to ease system liquidity thereby enabling steady recovery in overall credit growth especially out of NBFCs will likely be critical.

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 modest for 2020 even though the recent tax cut should aid overall earnings growth. 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.

Bond prices fell over the month of Dec’19. The fall in bond prices were due to:

• Disappointment over status quo on rates in the December monetary policy
• Fears of additional government borrowing to meet the tax deficit

The negative market sentiment led by the above 2 reasons led to fall in bond prices. In fact, the negativism was acute and at the worst the 10 - year benchmark g-sec yields had moved up from 6.47% to 6.80%.

Later in the month, RBI started buying the 10-year benchmark as part of the OMO in order to address the negative sentiment in the market and through an operation ‘twist’ whereby RBI bought approx. Rs. 10k of long bonds while simultaneously sold extreme short bonds. This operation twist led to some flattening out of the yield curve. The yields at the long end softened by approx. ~23bps after a couple of OMO.

The headline inflation was 5.54% for Nov’19, much beyond the economist estimates. The sharp rise in onion and green vegetable prices led to the rise in headline inflation. There has also been some rise in few other food articles also. The inflation led by rising prices in onion and green vegetables is expected to be seasonal in nature. While the rise in food article prices might be sticky, the prices of green vegetables might see some seasonal drop.

The MPC (Monetary Policy Committee) members last month had unanimously decided to keep rates unchanged despite the sharp drop in GDP growth possibly due to recent rise of the headline inflation and wanted to await to see the transmission of the previous rate reductions.

Bond yields have remained elevated for the last 4-6 months despite rate reductions and accommodative stance due to fears of additional G-sec supply by the government in order to make up for the lower tax revenues.

While there has been a rise in the headline inflation the core (inflation ex food and fuel) inflation dropped closer to 3.4%. We expect the future course of rate of action will be dictated by

• Growth inflation dynamics and
• Progress of transmission of lower rates into the credit market

The room for further rate reduction would depend on the growth and inflation trajectory. While the MPC members feel that there is space for rate reduction, the decision to press the ‘pause’ button when the growth is at a multi-year low gives rise to uncertainties in the minds of the investors. However, the volatility in the markets has suddenly got accentuated due to

• the recent geo-political tension between Iran and US has led to a sharp rise in the international oil prices leading to oil prices jumping above $70/barrel. The entire market is watching this development closely to see the effects of this tension.
• The recent rise in bond yields in the developed markets

Moreover, based on RBI’s suasion, few banks have started to link their lending rates to an external benchmark, which RBI feels will work towards transmission of rates. So far, the transmission of lower rates into the system has been mostly in high quality credits due to risk aversion. The drop in interest rates should help in balancing the overall leverage and ideally help in attracting equity capital as earnings from savings and debt investments become unappealing. However, it remains to be seen whether this theoretical cycle follows through in India in this environment.

Outlook

We expect to see some softening of the headline inflation over the months due to some price correction of the vegetable prices. However, the sustainability of oil prices beyond the $70/barrel will have some impact on the headline inflation. We reason that the slowing domestic growth is a function of both slowing global growth and slowing domestic consumption.

While, slowing growth and accommodative monetary policy stance gives room for further rate reduction, we think that further policy actions will be guided by evolving growth-inflation dynamics.

Amid a mix of positives (mainly accommodative monetary policy stance & surplus liquidity) and negatives (mainly due to rising inflation & fears of fiscal slippage), we feel that benchmark yields are expected to remain range bound and move lower depending on the quantum of bond purchases by RBI through OMO.

In this environment, we urge investors to select funds in alignment with their investment horizon and depending on their individual risk appetite and of high credit quality.