ON EQUITY

The four pillars of the Indian equity markets are:

1. Macros
2. Flows
3. Earnings
4. Valuation

The Indian markets have changed to moderate to weak macros due to higher fiscal deficit, inflation and current account deficit.

On the brighter side, foreign investors continue to invest in India as the GDP registered a healthy 7.3% and IIP (production index) remained stable.

Domestic Macros

• May CPI has firmed up further to 4.87%. Core inflation is at 6%.
• RBI hiked the borrowing rates for the first time since 2014. We expect another rate hike in Au-gust.
• Need to watch out for MSP hike as the government had indicated in the budget that they in-tend to increase farmers compensation.
• IIP at 4.9% aided by 13% (YoY) growth in capital goods production.
• Current account deficit stood at 1.9% in the fourth quarter of FY2018. Although it is not as high as it was about five years back, this remains a concern
• Rupee to remain weak in FY2019 if crude prices remain high.
• Expect monsoon to be normal, which augurs well for the auto, FMCG and agrochemical sec-tors.
• Government spending may be ramped up because it has to finish certain projects before the election.

Global Macros

• US economy remains strong. Unemployment at low levels.
• Fed rate hikes. Negative for foreign fund flow into emerging markets.
• European Central Bank — rollback of QE (quantitative easing) program. This is negative for the emerging markets
• Crude continues to remain at elevated levels at 76%, which is 17% higher (YoY).
• Trade-related issues between China/European Union and the US
• On the positive side, geopolitical issues are mitigating, especially the improvement in US-North Korea bilateral relations.

Micros: Mixed, but improving

• IIP has started improving. Could go up.
• Commercial vehicle numbers could go up
• Service sector is likely to improve too

Flows: Mixed bag

• Mutual fund inflows remain strong at $8.8 billion. Strong SIP flows have contributed to the strong inflows.
• FII inflows have been very poor due to global headwinds such rising food prices etc. This is a stark difference from previous year when both MF and FII inflows were strong. However, this could be good because there was about $9 billion SIP inflow from the domestic side.

Earnings: Aggressive future estimates

• Earnings in the last couple of years were disappointing due to GST. But we believe there will be a 23% earnings growth in FY2019 and 19% growth in FY2020 on Nifty.
• They seem to be on the higher side but they are working on last years low base.
• Similar, RoEs will be healthy too. RoEs were 12.7% in FY2018, but we expect it be more than 15% in FY2019

Valuations: Global comparison

• India looks expensive on absolute and relative basis, a trend thats been observed for a few years now.
• Nifty valuation remains high. They are trading at 18x. They are rich valuations but they are not in a bubble zone. We feel theyd be in a bible zone if they are trading at more than 22x.
• Bond yields are higher than earnings yield. They are at 8% right now. This puts equity market valuations at risk.
• Midcap valuations have historically been lower than Nifty valuations. Thats because of strong inflows from the local side have resulted in the midcaps receiving more money. However, we do no think that will sustain. In the past, such situations have often resulted in a correction in the midcap valuation.

Investment strategy

• Returns to be based on earnings growth rather than PE expansion
• Several midcaps have corrected in the last two months due to additional surveillance
• Need to be very selective while choosing midcaps
• Focus on good management, superior earnings growth and reasonable valuations. Thats because there may political uncertainties in the coming months.
• Apportion larger allocation towards large caps, that too on the safer names.
• Preferred sectors: Automobiles, pharmaceuticals, agro chemicals, housing finance, metals, infra and construction

ON DEBT

Synopsis

• Further rate cut possibility bleak for now
• Debt markets appear to have overdone concerns and factored rate hikes
• Economic scenario not set for any near-term rate hikes
• Accrual strategy is the way to go
• Hold duration funds for your original time frame and avoid premature exit

These are extraordinary times. The equity market has rallied without earnings entirely coming on-board with hope that there would be an economic revival. The debt market on the other hand, appears to be factoring an interest rate hike, as if there is sound economic growth underway; that can force a rate hike. The equity market is optimistic and the debt market, writ with pessimism. But we prefer the pessimism in the debt market for the simple reason, that there is more opportunity in pessimism.

Whats causing the stress

From 6.5% in September 2017, the 10-year gilt has moved a straight 7.5% now. If we must narrow down the concerns over this yield move, they would be – inflation, fiscal deficit, and rising commodity prices. Let us look at these factors.

Inflation and rising commodity prices: Retail inflation moved from 3.58% in October 2017 to 5.21% in December 2017. High food inflation and impact of HRA hike under the 7th Pay Commission besides a low base are reasons for the rise. While, these factors are likely to settle, especially with food inflation showing no primary risk, sharp hike in crude price may pose a challenge to inflation. However, most experts opine that with US shale production remaining sound, the likelihood of countries like Russia opting out of production freeze and the continuing thrust on renewable energy in developed countries, a price shock in crude is unlikely. Hence, while this factor needs observation, it is far from threatening at present.

Fiscal deficit: With government spending reaching 96% of its targeted fiscal deficit in October 2017, worries of fiscal slippage dogged the market. Lower GST revenue because of rate cuts, further caused concerns. To add to this, the recent announcement by the Government of an additional Rs 50,000 crore of borrowing (0.3% of GDP), added fuel to the debt markets fear. This number was reduced to Rs 20,000 crore recently.

Despite a Moodys upgrade on our rating and a positive outlook by S&P, besides record inflows into debt market by FPIs, the market has taken the above-mentioned factors seriously enough to foresee a rate hike. Concerns exist, without a doubt. But is the reaction realistic or overdone?

What we expect

• We are not expecting any rate cuts unless there is any significant slowdown in the economy or very low inflation. Therefore, portfolios still positioned to play rate cuts can be risky.
• Having said that, a no rate cut does not mean the yields cannot ease from here. A moderate fall in inflation and data from Budget may provide cues for a yield ease. And remember, FPIs are piling up Indian gilts, seeing value in the swift up move in yields.
• The increase in yields in the short-term medium-term corporate bond space i.e. 1,2,3 and 5-year corporate bonds is higher than the increase in long-term gilts in the past one month. That makes the short to medium space attractive in terms of both accrual and in the event of a yield easing. This comes with less risk than long-dated gilts.
• A rate hike in the near term looks unlikely for the arguments we placed earlier. What we are expecting is a pause for at least a few quarters.
• Even in the event of any rate hike in the later part of the year, the current harsh move in yields is likely to leave the market less hurt and cause accrual to get more attractive.

What should your strategy be?

• We think a high risk-reward strategy is not a prudent one to play now. That means, taking calls on duration now can be risky, although an easing of yields can provide some quick gains. Avoid fresh entry into duration funds such as dynamic bond funds. If you are already running STPs or SIPs in this category, continue them until the end of this March fiscal and then continue to hold the funds but shift the SIPs to accrual funds.
• If you are simply holding duration funds (dynamic bond funds or gilt) we would strongly urge you to hold them for your originally intended period, to see through the cycle. We recommend these funds for not less than 3 years. Holding them to that tenure will be necessary to derive benefits. Exiting at this stage, especially if you entered in late 2016 or early 2017, will not be a wise decision. It is the same as exiting equity when market is down. For those who entered this space thinking that debt funds never deliver negative returns, you need to take your time frame more seriously and align your time frame with the right category of fund. That is paramount if you wish to avoid pain in the debt space.
• For fresh investors, an accrual strategy is adequate to earn FD-plus returns at this stage. With short to medium term yields rising sharply, we think the full spectrum of accrual – ultra short-term, short-term and income funds all provide sufficient opportunities with good quality debt instruments.
• However, we wish to alert you to the fact that these are abnormal times of liquid funds delivering higher than most other debt categories. This may not sustain as short-term rates are already stretched. Hence, choose your category based on your time frame rather than based on current returns.

Currency Outlook

2018 is shaping up to be a year defined by significant volatility and continued uncertainty. While consensus has developed around near-term US monetary policy, timing and direction of US fiscal policy are anything but certain, and the combined effect of both is unpredictable. Developments beyond our borders, among them Brexit, central bank actions, and geopolitics will also play a pivotal role in currency movements in the coming year, and are all subject to a range of outcomes. Below are a number of key themes for the year ahead, as well as a deeper dive into the outlook for a number of the major currencies.

2018 Themes:

1. Rising Yields and the Challenge to Asset Markets
2. US Fiscal Policy - A Damp Squib?
3. Brexit-Now it Gets Serious
4. Europe and Japan-The Tortoises Catching Up
5. Valuation
6. Geopolitics-The Perennial Wildcard

Even with trade negotiations between the US and China becoming more heated, volatility in major developed market currencies has remained muted. As measured by FX options, implied volatility is at lows for the year and well below levels seen following Italys political crisis.

Why has FX volatility fallen to new lows? Investors buying USD on safe haven flows arising from trade tensions – While new tariffs of 25% have been announced, Citis base case is they are unlikely to be implemented due to push back from financial markets and there could be a chance for a deal with relatively minor concessions for both the US and China. On September 5th, the US Trade Representative (USTR) is scheduled to complete their recommendations for applying further tariffs.

Major central banks have moved to curb FX volatility – The ECB is likely to delay any rate hikes for a year – until 2019 summer. The BoJs recent moderate policy adjustment is unlikely to be repeated until the next consumption tax hike projected in October 2019. The PBoC has introduced new measures against currency speculation including a 20% reserve requirement on forward FX purchases by local banks.

An uncertain political backdrop in the US – Ahead of the Congressional midterm elections in early November, investors are not clear how the US political map will unfold within the Republicans and whether they will seek to oppose their own President regarding tariffs with China.

Currencies are likely to remain range bound through August as markets await more clarity on trade and political tensions in the US.

With that clarity, Citi Analysts believe that investors could start to reduce exposure USD as a safe haven. As the USD rally loses momentum, investors may instead focus on commodity currencies, Japanese Yen and Swiss Franc.