The Nifty declined 2.5% in August, whereas the mid-cap and small-cap indices outperformed large-cap and were up 3.7% and 4.6%, respectively. Sector-wise, oil & gas (-5%), banks (-4%), and FMCG (-2.7%) declined the most, whereas consumer durables (+4.2%), IT (+2.7%) and capital goods (+2.7%) gained the most. Globally, almost all markets ended in red. Hong Kong, Shanghai, and Brazil were down 8.5%, 5.2%, and 3.6%. The decline in the month was triggered by the US sovereign rating downgrade and, the slowdown in the Chinese economy. In India, despite the strong 7.8% Real GDP growth in 1QFY24 (6.1% in 4QFY23), a seasonal spike in CPI inflation data and a weak monsoon in August (cumulative rainfall is 9% below the long-term average) pulled down the Nifty. FPIs bought US$1.5bn of Indian equities in the secondary market, whereas DIIs bought US$3 bn.

During the recently concluded Q1FY24 earnings season, the BSE500 Index companies showed muted revenue growth of 7% YoY but a strong PAT growth (up 46%YoY). Companies witnessed a sharp expansion in margins both on a QoQ and YoY basis, with aggregate EBITDA margins of the non-BFSI BSE-500 universe of 16.4% being the highest in seven quarters. Consensus earnings estimates for the BSE-500 universe were stable despite the strong YoY earnings growth.

High-frequency data for August improved for a lot of key variables, both on a MoM and YoY basis and the overall trend remains healthy. GST collection for August (reflecting activity in July) was up 10.8% YoY. PMI manufacturing accelerated to 58.6 in August from 57.7 in July. Credit growth remained largely steady at 14.9% in August (adjusted for HDFC merger) from 14.7% in July. Growth in both rail freight and power demand improved in YoY terms. Early trends for auto sales exhibit that two-wheeler sales declined at a slower pace while passenger vehicle sales accelerated from last month. Services PMI remained strong, even as it slowed slightly to 60.1 in August from 62.3 in July, on the back of continued new orders. Air passenger traffic improved on a YoY basis. Weak external demand has weighed on goods exports, but services exports have continued to reflect strength in YoY terms. The CMIE unemployment rate inched up to 9.7% in August from 7.8% in July, while consumer sentiment recorded a marginal uptick from last month.

While market behaviour for us over the past 2-3 months has been on anticipated lines, some concerns on supply-side challenges in key commodities, such as oil due to Non-OPEC supply controls and food commodities due to the weak monsoon pattern in August, have emerged. With the China and US economies moderating at the margin, there is not much of an argument for a demand-led rally in crude, and the recent up move may, therefore not have been long-lasting. On food inflation, we expect the Govt to be responsive through supply-side measures, particularly in an election year. We also expect RBI to look through short-term agri-inflation and focus on the core – which is still under control- thereby not resorting to any dramatic change in the interest rate cycle. Our base case remains for a long pause until the end of CY23, though India may be compelled to raise interest rates in CY23 if global central banks choose to do so, given our narrow rate differential with these countries. This may, however, not be a long-drawn situation, and India may be able to pursue a softer rate cycle in 2024, somewhat independent of global conditions.

While broader market returns have been considerably strong in the recent few months, and that can open up the possibility of a modest pullback, we choose to not lose sight of the unfolding economic cycle and its strength in India, which, in our view has just taken roots in the past 12 months. Broader market returns (small and midcaps) of the past 2 years are 15-16% compared to >20% CAGR returns in past cycles of economic expansion. We therefore advise investors with a 2–3-year horizon, to stay the course and probably deploy incremental capital through the SIPSTP format, noting the sharp surge of recent months. We reckon conditions are also gradually building up for a probable recovery in consumption demand as the drag of inflation and interest rates recedes, leading to better affordability. On the global front, the US economy appears to be on course for a soft-landing even as the Fed remains vigilant of core inflation.

On balance, our conviction on a strong economic cycle unfolding in India, therefore, over the next 4-5 years, is getting re-affirmed. We believe this will widen investment options in the market. We re-iterate that India equity is clearly emerging as one of the most attractive investment destinations when seen from a 3–5-year time scale.

The global monetary policy outlook remained challenging as growth / inflation data continued to give mixed signals. China provided yet another policy stimulus to kickstart the growth engine, which has led to some pickup in global commodity prices. Crude oil remained in a tight demand-supply zone with extended oil production cut by OPEC, and Brent crude crossed USD 90 per barrel. Food supply chain disruption & monsoon deficit on El Nino fears raised concerns about global food prices. Significant increase in fiscal supply in the US remained an overhang on interest rates.

Global rates remained volatile during August and further hardened with many countries witnessing new highs over the last 1 year, and US 10-year G-Sec crossed 4.30% levels also. Indian rates also inched up in line with the global trend, and 10-year G-Sec briefly touched 7.25% during the month. Global uncertainty, elevated crude prices & higher domestic inflation expectations led by food prices imparted upward pressure. Corporate bonds remained relatively more resilient with limited new issuances.

Outlook

The domestic rate environment has become relatively more challenging compared to the previous month, with uncertainty on the global backdrop and as domestic inflation concerns & monsoon deficit worsened. August headline inflation is expected to remain upwards of 7% after a shocking 7.75% in the previous month and is now expected to far exceed RBI’s 2QFY24 inflation projection of 6.2%. Govt’s fiscal response to arrest rising food prices, cut in LPG prices, and fresh crop cycle of vegetables is expected to cool off the prices, but its re-affirmation by October / November inflation print remains critical.

While the uncertainty on various fronts has increased over the last month, we believe MPC will maintain a status quo on policy rates in October and sound watchful on the inflation trajectory. Inflation is expected to cool down from October onwards and provide comfort to MPC to overlook the recent spike. MPC is also expected to decouple itself from the global rate hike cycle on the back of a comfortable situation on the external front with a healthy Fx reserve.

MPC may continue to maintain the policy stance of “withdrawal of accommodation” & reiterate its 4% inflation target to guide the market expectations towards “higher rates for longer” which also provides flexibility against any extreme negative surprises on domestic inflation. In the interim, domestic rates may remain volatile and react to the global rates as well as incoming data points, especially on the inflation front.

Interestingly, domestic rates have surged back to almost March 2023 levels when the backdrop was much more challenging with expected global rate hikes, India’s relatively weaker external factors, and most importantly, almost a consensus view of the MPC rate hike in April 2023 policy. For instance, 10-year G-Sec has moved up from the sub 7% level seen in June 2023 to now at 7.20% - 7.25% and is very close to the 7.30% - 7.35% levels seen in March 2023. We believe India’s current fundamental situation is much better than that in March 2023, and the recent surge in market rates provides an attractive entry point to investors, especially in the 2 to 5-year segment, as elevated yields are expected to deliver positive returns over inflation. Near-term volatility led by evolving factors, if any, is expected to be range bound and should be ignored. Over the medium term, as the market builds expectations on the rate cut cycle at some point in time, it will enhance overall returns through mark-to-market benefit. Having said that, active fund management is critical as uncertainties may emanate from domestic inflation, fiscal supply, and global backdrop, which may influence various yield curve segments differently. The credit environment remains healthy, and selective AA / AA+ rated exposure can be explored at fair credit spreads.