Market and economic outlook april 2013

Market and Economic outlook –Market and Economic outlook –

April 2013

Executive summary-Economy

◌ःWhile Wholesale Price Inflation (WPI) inflation hassoftened to below 7%, Consumer Price Inflation (CPI)remains in double digits.

◌ः Index of industrial production showed positive growth inJanuary, but there is no sign of a sustained recovery.January, but there is no sign of a sustained recovery.

◌ः Owing to high CPI and high current account deficit (CAD),RBI has signaled a pause in rate cuts after the 25 bps cutin repo rate on March 19.

Executive summary-Economy

◌ःHigh CAD has emerged as a major point ofworry for policymakers and marketparticipants.

Executive summary-Politics

◌ःUPA’s strength has been reduced furtherafter the DMK’s withdrawal. Getting reformsrelated legislation passed may become moredifficult.difficult.

◌ःAs the government gets into election modelater this year, its commitment to fiscalprudence may take a back seat.

Executive summary-international

◌ः As the US economy improves, quantitative easing may betapered. Will affect liquidity flows into emerging markets(EMs) like India.

◌ः As US market becomes more attractive, flows into EMsmay be affected.may be affected.

◌ः The crisis in Cyprus showed that even a crisis of minormagnitude can snowball. If it leads to a risk-offenvironment, that could reverse the FII flows coming intoIndia.

Executive summary-Markets

◌ः The market has stayed range-bound this month. Mid- andsmall-cap indexes have fallen more than the Sensex.

◌ः FII inflows in March were less than half compared toJanuary and February.

◌ः Market is worried about bad economic data, winding downof QE, political weakness at the Centre, and so on.

◌ः Among positives, commodity prices have softened andvaluations have become more attractive.

The Economy

CPI inflation: still in double

digits

◌ः Headline CPI inflation for February 2013 moved up to 10.91% (y-o-y) from10.79% in the previous month.

◌ः The index rose 0.63% month-on-month (m-o-m) in February, which wasthe fastest m-o-m increase since October 2012.

◌ः The rise in CPI inflation was the result of return of food inflation. Food◌ः The rise in CPI inflation was the result of return of food inflation. Foodinflation had eased in the last few months due to seasonal factors.

◌ः Under food items, the major contribution came from cereals and proteinproducts.

◌ः The next big contribution came from transport and communicationfollowed by housing.

CPI will moderate –

with a lag

◌ः According to a note from Morgan Stanley, high CPI is symbolic of theills that have afflicted the Indian economy.

◌ः The government’s policies have encouraged consumption withoutimproving supply.

◌ः Now the government has begun to go down the road of fiscal◌ः Now the government has begun to go down the road of fiscalconsolidation. As the government reduces its fiscal deficit, CPI willdecelerate.

◌ः However, inflationary expectations have become so deeplyentrenched that it will take time for CPI to moderate.

◌ः High CPI will keep short-term rates elevated (prevent ratecuts), something that the market doesn't like.

WPI inflation: lower compared to

CPI

◌ः WPI for February 2013 came in at 6.84%, higher than the 6.62% in January 2013.

◌ः WPI rose despite a favourable base effect.

◌ः WPI rose 0.6% month-on-month (m-o-m).

◌ः Year-on-year primary articles rose 9.7%, fuel and power◌ः Year-on-year primary articles rose 9.7%, fuel and power10.5%, and manufactured products 4.5%.

◌ः Both primary articles and fuel power rose m-o-m.

◌ः Only manufactured articles declined 0.1% m-o-m.

◌ः All three broad categories within primary articles rose: foodarticles (up 0.2% m-o-m), non-food articles (1.6% m-o-m) andminerals (0.9% m-o-m).

IIP: marginal recovery

◌ः The index of industrial production (IIP) posted positivegrowth in January after having declined for six out of10 months in FY13.

◌ः IIP rose 2.4% y-o-y in January 2013 whereas it had◌ः IIP rose 2.4% y-o-y in January 2013 whereas it hadcontracted 0.5% in December.

◌ः IIP rose 2.2% m-o-m in January vis-a-vis the 1.1% m-o-mfall in December.

IIP over last 13 months

4.1

8.3

4

6

8

10

IIP (y-o-y) %

1.821.1

4.1

-3.5

-0.9

2.4

-1.8

0.1

2.7

-0.4 -0.1-0.6

2.4

-6

-4

-2

0

2

4

Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13

IIP (y-o-y) %

IIP has seen negative growth in a number of months in the recent past.

IIP-component wiseY-o-Y M-o-M

Overall IIP 2.4 -0.5 2.2 -1.1Mining -2.9 -3.4 1 2.7Electricity 6.4 5.3 0.1 2.1Manufacturing 2.7 -0.7 2.8 -1.6

Use-based

Basic 3.4 1.8 -0.3 1.1Basic 3.4 1.8 -0.3 1.1Intermediate 2 0.7 1.3 0.8Capital goods -1.8 -0.6 5.5 2.4Consumer goods 2.8 -3.6 3.6 -1.9

Durables -0.9 -8.2 1.2 -10.1Non-durables 5.3 -0.4 5.3 3.6

Some positivity in January due to electricity and manufacturing. Negative growth in durables points to weakening consumption.

IIP data may not improve soon

◌ःDespite some positivity in JanuaryIIP, growth outlook continues to be weak.

◌ःThe improvement in January IIP data maynot sustain.

RBI cuts rate, signals a pause

◌ः RBI reduced repo rate by 25 basis points from 7.75% to 7.50% on March 19. Reverse repo rate now down to 6.50%.

◌ः Cash reserve ratio (CRR) left unchanged at 4%.

◌ः Why did RBI cut the repo rate?

◌ः One, Q3FY13 GDP growth rate came in at decade-low ◌ः One, Q3FY13 GDP growth rate came in at decade-low 4.5%, compared to 5.3% in Q2FY13.

◌ः Recovery in GDP growth likely to be gradual.

◌ः WPI inflation has moderated in recent times. Core inflation is down.

◌ः Government's measures aimed at fiscal consolidation provided RBI room to go in for a small cut.

Will rate cuts continue?

◌ःThe central bank was cautious about future ratecuts. Why?

◌ःFood inflation remains high. Administered fuel◌ःFood inflation remains high. Administered fuelprices have been hiked in recent times. Likely topush inflation upward.

◌ःWide divergence between CPI and WPI. While WPIhas softened, CPI continues to be in double digits.

◌ःCurrent account deficit (CAD) is high. If interestrates are cut, it would result in more consumption,leading to higher imports and worsening of CAD.

◌ः

Will rate cuts continue?

◌ःHence RBI indicated there is limited room forfurther cuts.

◌ःMost economists expect interest rates to be cut byanother 50 bps in FY14.

Will banks reduce lending rates?

◌ःDespite cut in repo rate by the central bank, banksmay not lower their lending rates.

◌ःWith deposit growth slowing down, several bankshave raised their deposit rates in recent times.

◌ः

have raised their deposit rates in recent times.

◌ःWith banks' cost of funds rising, it will be difficultfor them to cut lending rates.

◌ःMany banks in difficulties due to high NPLs. Hence,can’t afford to lower rates.

High CAD poses a risk

Oct-Dec 2011

Oct-Dec 2012

%age change

Current-account deficit -19,954 -32,546 63.11

of which

Merchandise trade balance -48,704 -59,604 22.38Invisibles 28,750 27,059 -5.88Invisibles 28,750 27,059 -5.88of whichSoftware services 15,806 15,901 0.60Private Remittances 16,208 15,670 -3.32

Capital account deficit 7,680 31,761 313.55

of which

FDI 4,963 2,526 -49.10Equity inflows 1,898 8,781 362.64Loans 1,602 10,630 563.55Other capital 4,703 4,544 -3.38

High CAD poses a risk

◌ः The current account deficit for the December 2012quarter came in at a very high 6.7% of GDP.

◌ः This happened because merchandise trade balance(imports less export) has grown by 22.38% y-o-y.

◌ःOn the other hand, invisibles (combination of software◌ःOn the other hand, invisibles (combination of softwareearnings and private remittances) declined 5.88% year-on-year.

◌ःOf the two components of invisibles, software servicesrose 0.60 per cent but private remittances declined -3.32 per cent.

High CAD poses a risk

◌ः Next, let us look at the capital account.

◌ः FDI, which represents stable inflows, is down -49.10% y-o-y.

◌ः Equity inflows, which are unstable, have grown 362.64%.

◌ः Even external loans have grown rapidly by 563.55% y-o-y.

◌ः Thus, India's current account deficit is being fuelled by hot money◌ः Thus, India's current account deficit is being fuelled by hot moneyinflows.

◌ः If at any time these flows decline (say, due to the normalisation ofmonetary policy in the West or due to the creation of a risk-offenvironment), financing the CAD will become difficult.

◌ः The rupee could see another bout of rapid depreciation.

Worst of CAD probably behind us

◌ःAccording to a note from Morgan Stanley, however, the worst of CAD is probably behind us.

◌ःThe trade deficit should improve from the ◌ःThe trade deficit should improve from the next quarter, helped by the government's fiscal restraint.

◌ःSoft crude prices may also help.

UPA strength reduced

post DMK pullout

◌ः The DMK pulled out of the UPA coalition in protest against thegovernment's position on US-backed UN resolution on war crimescarried out during Sri Lanka's civil war.

◌ः The DMK had for long been putting pressure on the Indiangovernment to protect Sri Lanka's minority Tamil population.

◌ः The government survived owing to outside support from the◌ः The government survived owing to outside support from theSamajwadi Party and the Bahujan Samaj Party.

◌ः The pullout has left financial market participants jittery.

◌ः Getting reforms-related legislation passed will become even moredifficult. Reforms are also expected to take a back seat owing tostate elections followed by the general election next year.

The equation in Lok Sabha

post DMK pullout

Who has how many seats in Lok Sabha

Party No. of seats

Congress 203

NCP 9

Rashtriya Lok Dal 5

J&K National Conference 3J&K National Conference 3

IUML, AIUDF, BPF, Kerala Cong. 5

Others 6

UPA 231

Outside Support 49

Samajwadi Party 22

Bahujan Samaj Party 21

Rashtriya Janata Dal 3

Janata Dal (Secular) 3

Total (with outside support) 280

Total no. of Lok Sabha seats 540

Will fiscal consolidation continue in

a pre-election year?

◌ः According to Morgan Stanley, history suggests thatgovernment expenditure always rises in a pre-electionyear.

◌ः Therefore, the market is sceptical about thegovernment's ability to achieve the 4.8% fiscal deficitgovernment's ability to achieve the 4.8% fiscal deficittarget for FY14.

◌ःHowever, according to Morgan Stanley, the worst of thefiscal deficit and the current account deficit areprobably behind us. The note adds that a falling twindeficit is good for stocks.

International scenario

US economy improving

◌ः According to Mohammed A El-Erian, CEO and co-CIO of PIMCO, the United States' economy is healing, and doing so in an accelerated fashion.

◌ः Most U.S.-based multinational companies are on a solid footing.◌ः Smaller firms are gradually recuperating.◌ः Banks have rebuilt their capital cushions and reduced dubious ◌ः Banks have rebuilt their capital cushions and reduced dubious

assets.◌ः More and more households are re-establishing healthier balance

sheets, especially as employment picks up.◌ः The US budget deficit is on a downward trend, helped along by

higher revenues and lower pressure on spending (payments to jobless have fallen).

Will QE continue?

◌ःMembers of the US Federal Open Market Committee(FOMC) have begun to debate the wisdom of continuingwith the QE program.

◌ःMany members favour ending, or at least tapering, theprogram.program.

◌ः Currently the US central bank purchases $ 85 billionworth of bonds from the open market every month.

◌ः Earlier the QE programme was expected to end onlywhen there was significant improvement in the labourmarket. But now there are indications that it may endearlier.

Will QE continue?

◌ः If the central bank continues with the QE program for too

long, it may result in an inflationary spiral that may

become difficult to control. Sharp buildup of inflationary

expectations may occur.

◌ः Excessively loose monetary policy also leads to excessive ◌ः Excessively loose monetary policy also leads to excessive

risk taking in financial markets.

◌ः If interest rates begin to rise, the value of bonds held by the

central bank would erode, resulting in capital losses which

could wipe out the paid-up capital of the US Fed.

◌ः In his testimony to the U.S. Congress, Fed Chairman Ben

Bernanke said he's in favour of continuing with QE for the

moment.

Will QE continue?

◌ः So an abrupt end to the QE program may not happen. But thesize of QE could be reduced in the near future.

◌ः The US Fed’s policies have forced several other central banks(BoJ, ECB, etc) to also follow loose monetary policies (to aidtheir own economies but also to prevent their currencies fromappreciating). If US Fed winds down QE, others will follow suit.their own economies but also to prevent their currencies fromappreciating). If US Fed winds down QE, others will follow suit.

◌ः This has implications for India.

◌ः Given its massive current-account deficit, the country hasbecome excessively dependent on short-term money flows tobridge its current-account deficit.

Growing attractiveness of US

market

◌ः Another risk to the Indian economy arises from the growingattractiveness of the US market.

◌ः According to a recent article by Akash Prakash, CEO of AmansaCapital (in Business Standard), emerging markets havesignificantly underperformed the S&P 500. In the last twoyears, the MSCI emerging markets index is down nearly 10%significantly underperformed the S&P 500. In the last twoyears, the MSCI emerging markets index is down nearly 10%while the S&P 500 is up 20%.

◌ः As more and more investors believe in the growingattractiveness of the US markets, at some point inflows intothe Indian markets will be affected.

◌ः The reallocation of assets from the US market to emergingmarkets, which we have seen in the past, could reverse.

Cyprus: crisis contained

◌ः Cyprus became the fifth country within the Eurozone to negotiatea bailout.

◌ः In this second deal to bail out Cyprus, a € 10 billion ($ 13 billion)loan was made to the country. This has reduced the probability ofCyprus exiting the Eurozone.

◌ः Bank of Cyprus, the largest bank, will be restructured.◌ः Bank of Cyprus, the largest bank, will be restructured.

◌ः Laiki Bank, the second-largest bank, will be wound up.

◌ः These banks got into trouble because they had invested a lot oftheir money in Greek bonds.

◌ः Savers with accounts below € 100,000 have been spared.

◌ः Losses will be borne in the following order: shareholders, juniorbondholders, senior bondholders, and finally, uninsured depositors.

Repercussions of the deal

◌ः The collapse of Cyprus's oversized banking sector, which along with tourism was the mainstay of the economy, will cause an economic slide. It is expected that Cyprus's economy may shrink by 10-15% in 2013 and 5% in 2014.

◌ः Capital controls have been imposed on depositors so that there is no run on the banking system.no run on the banking system.

◌ः The decision to punish larger depositors means that a lot of money that is currently deposited in Cyprus will go elsewhere (one third of Cyprus's deposits are Russian).

◌ः People will also fear depositing money in weaker banks within peripheral Europe.

Repercussions of the deal

◌ः This will make it harder to keep sick banks alive in acrisis.

◌ः If and when a bank run starts, depositors will head forthe exit earlier and faster.

◌ःWhat is needed in Europe is a unified banking systemwith fiscal backstop. It also needs a joint depositinsurance scheme. Only this will break the link betweenweak banks and weak governments. But Europe islagging behind in these matters.

Repercussions of the deal

◌ः From the creditors' viewpoint, the era of all-encompassingbailouts is coming to an end.

◌ः Hereafter private investors will have to bear losses instead ofbeing bailed out by euro zone taxpayers.

◌ः◌ः The Finns, Dutch and Germans don't want greater pooling ofliabilities. They want the troubled Mediterranean countries toadopt reform measures and come out of trouble.

◌ः However, Northern countries need to design bailout packages insuch a way that they do not impose unnecessary hardships.They must also delay adopting austerity measures at home at atime when other Eurozone economies are still recovering.

Impact on India

◌ः The big risk that India faces is that any flaring up of risk in Europe could create a risk-off environment that may lead to lower FII inflows, or even cause outflows from India.

◌ः This would make it difficult for India to fund its CAD and lead to another bout of rupee depreciation.

◌ः The Indian equity markets, which are very FII-dependent, would also decline.

The Market

Market outlook

Asset Class Current Levels( as of Feb 28, 2013)

Summary View Why Risk to our View

Equity Nifty: 5,647.75 Markets will be

under pressure,

Bad economic

data; government

If RBI cuts rates

aggressively or

Sensex: 18,835.77

under pressure,

especially mid- and

small-cap stocks

data; government

weakened; US

market becoming

attractive. Absence

of positive triggers.

aggressively or

Q4FY13 results

show considerable

improvement.

Index Watch

Index1-month return (%)

YTD return(%)

Sensex -0.14 -3.8BSE Mid-Cap -2.55 -14.66BSE Small-Cap -6.47 -22.12

BSE Auto -4.44 -13.28BSE Capital Goods -1.82 -17.97BSE Capital Goods -1.82 -17.97BSE Consumer Durables -1.08 -8.98BSE FMCG Sector 4.41 -0.45BSE Healthcare 2.53 -1.94BSE IT 1.94 21.1BSE Metal -3.41 -22.54BSE Oil -3.72 -2.44BSE Power Index -5.59 -18.05BSE PSU -5.56 -12.54BSE Tech 0.1 13.44Figures as on March 28, 2013

FII inflows fall, MF outflow

continues

Month FII investment

MF investment

January 22,230 -865

February 22,122 -1,496

March* 10,399 -1,767March* 10,399 -1,767*Upto March 26; all figures in Rs crore

• FII inflows in March were less than half the level in January and February.

• Mutual funds continued to be net sellers even in March.

High dependence on FII inflows

◌ः The Indian economy has become very dependent on foreigninflows to fund its current account deficit.

◌ः If FII inflows ebb, either due to QE ending or the creation ofa risk-off environment due to the European situation flaringup again, the rupee could once again depreciate sharply.up again, the rupee could once again depreciate sharply.

◌ः With the rupee declining, the possibility of FIIs making aprofit declines further. This would create a vicious cycle,leading to more pull-outs.

◌ः The high dependence of Indian markets on FII money wouldlead to the decline of equity markets.

High dependence on FII inflows

◌ः This year India has already received about $ 10 billionof inflows, yet the Indian equity market is among theworst performers in Asia year to date.

◌ः Since January 2012, India has received over $ 35 billionof FII inflows.of FII inflows.

◌ः It has received a disproportionate share of the flowscoming into Asia.

◌ः If these flows stop or reverse, it would have a verynegative impact on the Indian market.

Why are market participants

worried?

◌ः Pessimism has once again increased within the market.

◌ः Both the mid- and small-cap index are down quite a bit year-to-date.Reasons:

◌ः Slew of bad data: GDP, CAD, CPI have all got market participantsworried.

◌ः

worried.

◌ः Political worries: Will reforms continue with the governmentweakened after DMK’s pullout? Will fiscal consolidation continue in apre-election year?

◌ः Will QE continue?◌ः Will FII inflows continue?

A few positives

◌ः Among the positives, valuations have become attractive. Valuations are approaching buy territory, as in the summer of 2012.

◌ः Commodity prices are not rising.◌ः India’s growth cycle is at an inflection point.

◌ः Bad data seems to have touched its nadir, including the investment rate and ◌ः Bad data seems to have touched its nadir, including the investment rate and exports, according to Morgan Stanley.

◌ः According to Morgan Stanley, the earnings cycle appears to be turning. Broad market earnings have reached a trough and may move up now, albeit gradually.

◌ः So far the level of global liquidity remains high. This is favourable for Indian stocks.

◌ः Bad sentiment is a good contra-indicator for stock returns.

Thank you