Thematic Insights

02 Jan 2014

2014 Back to Normal

As we start with year 2014, we believe that macroeconomic variables will start getting normal. While there are global challenges in terms of US yield curve hardening and tapering of quantitative easing and also local challenge in terms of higher bond yields, we believe these factors are expected by markets at large. There is limited surprise. Also, investors have remained more cautious over last few years, since 2008 global meltdown, and that makes a case to invest in growth assets, albeit gradually. Looking back at 2013 what a year it was! The US government shutdown, the Snowden fear, the Twitter IPO, the when and how of the QE tapering, the Philippine death toll by Typhoon Haiyan & back home the Uttarakhand floods, the Rise of the Aam Admi party, the Namo fever, onion prices hike, Sachin resigns and Rughuram Rajan reins !!! It was a year of debates and discussions and scams Snowden, Syria, East China Sea, Bitcoin, Twitter, Blackberry, 2G telecom scam, NSEL crisis... Having said this, the global economy is possibly in the better shape, since 2008 financial crisis. The US economy is growing at a healthy pace (4.1 percent annual rate in the Jul-Sep quarter). The unemployment rate is 7%, though still high, its the lowest, since crisis period. Europe is not progressing as desired, but thats not focus area right now. Numbers coming from Japan have improved in the past one year, and it looks like a hard landing has been avoided in China, at least for now. Turning locally, broadly the Indian economy is probably bottoming out. Most of the macro parameters like GDP growth seem to have troughed (4.8 percent in the Jul-Sep quarter as against 4.4 percent in AprJun quarter). The softening of crude oil prices and curb on gold imports have been relief for the current account deficit (CAD). A widespread monsoon is expected to result in a significantly higher agriculture growth and have a cascading impact on other industries and services as well. However, the most important development from the markets (local as well as global) point of view in 2013 was the US Federal Reserves announcement that it will cut back its much talked about quantitative easing programme by $10 billion per month from January 2014. The Federal Reserve will now be buying $75 billion worth of assets from the marketplace. The announcement was well accepted by the financial markets and stock prices went up. This time around, the market responded positively, unlike in mid of calendar year when first time such measure was announced, because it was prepared for such an outcome, and the quantity of reduction in asset purchase was modest. Now looking forward, from an economic standpoint, in India, the most critical issue will be inflation. The consumer price inflation, which is being seen as the new normal anchor by the Reserve Bank of India (RBI), continues to remain above comfort level (it was in excess of 11% for the month of Nov13). Till the time, level of inflation comes down, interest rates will remain elevated and growth is unlikely to pick up in a meaningful way. The problem of high inflation is a result of supply chain constraints, high rural wages increasing more vegetavbles and protein intakes, higher minimum support prices for agricultural items. To address this problem of consistently high inflation, one needs stronger political will and fairly consistent long term economic policies. In midst of this, RBI governor has already made a statement that desire to fight inflation will remain priority in monetary policy. Besides, the biggest event of 2014, for the markets will be the general elections. Interestingly, few weeks back, markets celebrated Bharatiya Janata Partys victory in the recently concluded assembly elections. But, the gains were quickly overtaken by hard economic reality. Dont be surprised to see a similar

CAPITAL ADVISORS 308 Vimal Scoeity, Banganga, Walkeshwar, Mumbai 400 006, India Tel: +91 22 23683782 Email : jshah@capitaladvisors.co.in Web : www.capitaladvisors.co.in

outcome after the general elections even if what is seen as a favourable formation is voted into office. The new government will have the challenging task of bringing down twin deficits, containing food prices and rebooting investments, and above all higher confidence and better sentiment. With domestic economic slowdown, tax revenue collection has been lower and with the idea to curtail rising fiscal deficit government is trying to reduce public expenditure. The same will have impact on economic recovery. Till these indicators (inflation, deficits and low capex) are brought under control, any meaningful sustainable recovery in the economic activity will be difficult to come by. Additionally, if we get a coalition government in 2014 general election, there will be further challenge for the economy. In 2014, we believe that overall interest rates expectations would be derived from currency movement and governments fiscal position. RBI may focus on real interest rate enjoinment in order to protect further currency depreciation. We believe emerging growth inflation dynamics and effect of upcoming elections on the fiscal situation may dictate the direction of interest rates. The longer term G-Sec may continue to be under pressure because of the high government borrowing and rising concerns on fiscal slippages. The election event may not affect short term yields in big way as RBI has clarified that cap on the repo will continue which will make the overnight rates dependent on overall liquidity conditions in the system with a upward cap of 8.75%. In this process, the shorter end of the curve may outperform longer end. Also, lets not ignore firming up of US 10 year yield above 3%. On currency front, major driving force will be US tapering impact. Controlling liquidity and hence rising interest rates shall have impact in terms of dollar strengthening. This means, Indian rupee should weaken. Though, reducing current account deficit shall provide some cushion, to rupee weakness. Looking at equities, now - frontline equity indices rose by almost 9% - thanks to FII inflows. The investor participation in equities is at a record low, be it local investors (retail and HNI), or DIIs (mutual funds and insurance companies). In Indian Equities, FIIs have invested almost USD 19.6 trillion, during CY2013, whereas DII and retail investors have reduced their

equity holding. Looking at long term, the economy has a promising future, which will be reflected in the equity market. After six difficult years, we expect a range bound equity performance with positive bias. If one looks at indices performance more diligently, there is extreme polarisation, with nearly top 15-20 stocks that are over-owned by FIIs and whose prices have more than doubled in the past six years. As for the remaining, some are 40-60% lower than their peaks. We expect the rally shall spread to mid-caps and small-caps and participation of individual investors, as well as HNIs, will gradually increase. For the sectoral play, currency movement will be driving factor. We expect pharmaceuticals and InfoTech to perform well and face lesser volatility. However, as the economy revives, automobiles, capital goods and select infrastructure stocks will also do well. In infrastructure, one needs to avoid companies that are over-leveraged and have fallen into a debt trap in recent years. Over-arching ConclusionIndividual investors (including HNIs) should focus on building their portfolios in line with their risk profiles. They should not be carried away by the bullish sentiment, but be disciplined in asset allocation and avoid any leveraged speculation. Tactical allocation in favour or against any particular asset class should be relative to strategic asset allocation. Final word . . . "Its not where you take things from, its where you take them to ... makes all the difference." Let year 2014 be a year of accomplishment and happiness for you -personally as well as professionally. Wishing you and your family a Healthy, Wealthy, Peaceful, Joyous, Safe and Enlightening New Year !

Jignesh Shah jshah@capitaladvisors.co.in

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