By: Navneet Munot, CFA, CIO, SBI Mutual Fund and Director IAIP
Post Brexit, the market has started to build in a lesser probability of a potential US Fed rate hike and also more easing from other economies. Bank of England cut rate this week and announced additional quantitative easing which is higher than market expectations. Japan’s Prime Minister Shinzo Abe unveiled fiscal stimulus measures. Australia cut its policy rate by 25bps, taking it to a record low at 1.5%. As of now, it appears that easy liquidity conditions could sustain in the visible future. Expectations of economic weakening are also possibly pushing monetary flows from Europe/developed market into Emerging markets and more specifically Asia.
Notwithstanding the reduced effectiveness of monetary policy in the developed world, the central banks have once again jumped to yet another round of monetary easing. As highlighted in earlier notes, it is just about the time when these nations realize the inefficacy of further monetary easing and switch to a much more effective and much needed fiscal stimulus particularly infrastructure spending. The latter will not only lead to job additions thus better income levels but also holds the potential to crowd in private investment.
A decade-long wait finally came to an end this week when the upper house of the Indian parliament cleared the Goods and Services Tax related Constitutional Amendment Bill. The bill clears the path for implementation of the GST, which essentially is a value-added tax system and subsumes a plethora of indirect taxes into one and ensures a single tax-rate across the country. The government has also readied model GST legislation and now needs to work on the next painful task of ironing out the thorny details of the proposed legislation. As per government plans, these details will be sorted out over the next three months, the GST Bill is likely to be tabled in the upcoming winter session of the Parliament and GST is proposed to be implemented from April 2017.
The key issue today is not the speedy implementation, but rather the efficacy of the finally achieved GST regime. It would rather be desirable to have a slightly delayed but a well-thought out GST than to rush into the implementation of half-baked taxation system. The design of GST, including the as-yet unknown rate, and its implementation, will dictate its effectiveness. That said, this reform may be disruptive in the near term and could also result in higher prices of select goods and services. But in the longer-term, holds the potential to boost economic activity substantially, improve the government’s revenue by broadening tax base and improving tax compliance, reduce economic distortions caused by inter-state variations in taxes and help achieve better transmission of prices.
Sensex posted sixth consecutive month of gains, retrieving the highest level since August 2015, fuelled both by $1.3 billion of inflows from abroad in July (the quickest pace since November) and revival of domestic funds flow in the equity market. Improved monsoon and sowing reports, the passage of the legendary 122nd Constitutional Amendment bill (GST), the pick-up of reform momentum by the government further improved the market sentiments. With adoption of Ind-AS (the new accounting standard) from this quarter, the results season has got extended to mid-September. But the earnings results released thus far indicate more hits than misses in the quarterly results. Fundamentally too, the incremental economic data reflects mild improvement in the economy.
While the current valuation at over 18 times FY17 earning is at a premium to the historical average, as of now it appears that the spade of reforms by the government and easy liquidity have built a suitable ground for the markets to remain at the upper end of valuations. Increasing global liquidity has the potential to take the global and Indian equity market to new highs, thus widening the gap between earnings reality and valuations.
In the bond market, 10 year bond yields rallied by 28bps last month, 10 year AAA corp-bond yields by 26bp and 3-month T-bill by 53bp. Yields are near multi-year lows primarily owing to a huge correction in the domestic banking system liquidity (from a deficit of Rs. 2-3 trillion in March to a surplus of Rs. 300 billion in July) while easy global liquidity conditions have also helped. Further, it appears that market is interpreting Rajan’s exit to lead to a more dovish successor. With significant improvement in monsoon and farm sowing news, the street has once again started to hope for reduction in food prices and CPI to come off by the year end. All these developments together have contributed to significant easing in bond yields.
The banking system liquidity conditions are likely to stay comfortable till November though there could be intermittent tightness due to advance tax outflows in September and plausible FX selling by RBI to address FCNR(B) related dollar mismatches. And hence, there is still some steam left in bond yields.
On the inflation front, the fixing of CPI target at 4% +/- 2% for next five years by the government under Monetary Policy Framework signals that both government and RBI is committed to contain inflation in India. It is a positive signal, indicates policy continuity and adds a huge credibility to India’s macro policy. Stable and contained inflation is extremely essential for exchange rate stability and ensuring the continued FII and FDI interest in India.
To that extent, the latest inflation print at 5.8% (for June 2016) is at the upper-end of the tolerance band. While we are confident of easing food price pressures; the higher revenue spend by the government, bottoming out of commodity prices, implementation of seventh pay commission, expectation of consumption led recovery in growth and finally the rolling-out of GST makes us wary of building reflationary pressures in the non-food segment. In our view, inflation is likely to be sticky around 5-5.5% over next one year which consequently leaves very limited scope for additional rate cuts. That said, government’s focus to ease business conditions, reforms envisaged for the rural sector and infrastructure is likely to result in higher productivity which could lower inflation further to 4% in the medium to longer term.
Owing to current mix of events and comfortable liquidity outlook for next few months, we remained tactically exposed to the longer end of the curve, but would be inclined to remain over-weight in the 5-8 year bucket of G-secs. We remain alert towards any material changes in global scenario and local macro parameters that could alter the outlook on policy rate cuts and also the medium term CPI targets.