Indian equities moved higher (Nifty +2.8%) in August, in line with the region and S&P, with the broader market also participating meaningfully. Dollar weakness, gradual re-opening of the economy and hopes of a vaccine, supported sentiments. While the growth rate / doubling rate of Covid virus spread in India, moderated over August, absolute daily cases scale new highs but death rate continues to be much lower than the world average encouraging the Indian government to give further relaxations under its latest Unlock 4.0 announcement. Geopolitical tensions flared up once again along the India-China border, which led to some sell off in the markets. After an initial bounce, the sequential improvement in some of the high frequency indicators has further moderated in August. On the monsoon front, till August 26, cumulative rainfall was 7.8% above long-term average (LTA) and spatial distribution of monsoon has been normal across most parts of India.

During the month, the RBI kept policy rates unchanged and maintained its accommodative stance in the Monetary Policy Committee (MPC) meet and announced few liquidity measures. In another reform measure towards giving thrust to local manufacturing in defense, the government raised the Foreign Direct Investment (FDI) limit in the defense sector under the automatic route from 49% to 74% and announced banning import of 101 defense items over the next 7 years.

In flow trends, slew of primary capital raises by financials led to a strong Foreign Institutional Investors (FII) net inflow of ~$6bn in August whereas Domestic Institutional Investors (DIIs) continued to remain net sellers ($1.5bn), largely contributed by Domestic Mutual Funds that saw some redemption in net equity flows. In terms of sectoral indices, during the month, Metals, Realty, Bankex, Power and Capital goods outperformed, whereas Infotech, FMCG, Oil & Gas and Heathcare sectors underperformed the BSE Sensex.

The relentless rally in the market of recent months does make investment choices increasingly difficult. Arguably, one can’t but acknowledge that stocks have outperformed businesses near-term. After the initial sharp rally driven by the moderation in the pandemic, massive stimulus and eventually re-opening of economies, the next leg of market performance will have to be propelled by earnings growth, wherein visibility remains quite constrained. Thus, a general market cooling off that provides for potential earnings disappointment will be healthy in our view.

Global and domestic monetary policy remains a key risk in our view and inflation readings of the recent past, though mainly led by supply-side dynamics, can confound policymakers. Recent measures and policy tweaks by the Fed and RBI do provide an assurance of continued easy monetary policy and benign interest rates for the foreseeable future.

Locally, one needs to be vigilant of the recent cooling off in economic indicators in a few pockets of the economy after the initial surge and the continued assertion of the spread of the disease. June quarter earnings reports were perhaps inconsequential due to the lockdown and markets will likely train their attention onto the upcoming result season starting October. Developments around Indo-China geopolitics and trends in the US presidential elections may drive market direction for the next couple of months.

As a fund house, our portfolio positioning while balanced at one level, does tilt towards an eventual cyclical recovery. Important sections of the market such as financials and parts of consumer discretionary still lag the broader market but some degree of risk aversion in the short run can favour defensives such as technology, pharma and telecom. Earnings-based valuation parameters would stay volatile for a while and can likely throw up incorrect conclusions. Today, investment decisions that discount near term earnings profile but are justifiable based on long-term intrinsic or franchise value of enterprises attract our attention. We continue to adopt the middle path in portfolio construction with regards to sector exposure, market cap bias and balance between growth and value.

The central government’s decision to open the economy in a phased manner has started to show up in terms of some uptrend in the business index. While the number of positive cases is on the upswing the uptick in the business index suggests lockdown fatigue amongst the people.

The overall GDP contracted by 23.9% YoY in the June quarter and inflation moved higher to 6.9% in July’20. The policy makers are at crossroads.

As the loan moratorium ended in Aug’20 the one-time restructuring opportunity for the banks without the need to classify a restructured loan as Non - Performing Assets (NPA) may be availed by the banks and borrowers alike during this period of credit distress. The distress in the credit market remains high. Although the status of asset quality remains under wraps, we expect the real NPA levels within the banking system to move into double digits and approx. closer to 15%.

While during a period of GDP contraction, the inflation series should ideally remain markedly soft, the headline Consumer Price Index (CPI) has moved higher, prompting the MPC to press the pause on rate reductions for now. The trajectory of northward bound CPI led by higher food (due to supply shocks) and gasoline prices and rising commodity prices.

Going ahead, we do feel that there is a fair chance for the inflation to soften if the supply bottlenecks are addressed by the government. Despite a pause in August policy, RBI Governors decision to stem out the negative movement in bond prices by announcing Open Market Operations (OMOs) (as operation twist) and softening the interest rate volatility concerns of the banks by increasing the HTM category has been welcomed by the market and the yields have started softening ever since the announcement in early Sept’20.

While there is surplus liquidity in the hands of the banks, the surplus cash with the banks has not been invested into productive assets and mostly been invested back with RBI at the reverse-repo rate (presently at 3.35%). We do expect RBI to announce measures to address these concerns at some point in time.

In this FY, the government's ability for additional expenditure appears limited due to drop in tax collections. The increased market borrowings to make up for the revenue deficit has been a negative for the bond market till the recent RBI policy announcements on operation twist. However, high dependence on market borrowings amidst a drop-in economic activity creates a strain on the government's fiscal position.

Outlook

• We expect both growth to remain soft to contracting, and inflation to eventually slow down over the next few months. RBI forecasts a contraction of GDP in FY21.
• For economic recovery the private sector investments and overall consumption needs to recover. Both fiscal and monetary stimulus works as an enabler for pick up in consumption.
• The challenges of the banks (led by rise in NPA, drop in capital adequacy) is the headwind for credit growth.
• Expect rate reductions to restart along with liquidity infusion from RBI. We would expect OMO and Long - Term Repo Operation (LTRO) over the months.
• Yields to remain benign and the steepness of the yield curve to reduce as and when OMO are announced by RBI.

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