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There are risks to this EM rally

Navneet Munot, CIO, SBI MF

8th September 2016

In a nutshell

Navneet sees clear risks to the ongoing emerging markets rally which India is fully participating in, as this rally is built less on conviction of fundamentals and more on aversion to western monetary policy. Get ready for some volatility when US starts increasing rates, warns Navneet. That said, the comfort we can draw in India stems from the momentum of ongoing structural reforms that we haven't seen in the last 20 years, and the promise it holds for sustainable economic growth. In the bond market, Navneet sees limited scope for rate cuts as RBI is likely to stick to its path of progressive drop in inflation targets from 5% to 4%.

Market Outlook

Developed market (DM) equities got further support with central banks in the UK, Japan and Eurozone continuing their quantitative easing in recent months. DM equities are expensive relative to history and some $13 trillion worth of bonds are yielding negative returns. This has brought emerging markets (EM) assets back in vogue and investment into EM equities is at record high. India has garnered US$ 9.6 billion worth of FII flows in equities in the last six months and the market has rallied by 24% since its February lows.

There are risks to the EM rally as it is backed less by the conviction about fundamentals but rather by investors' aversion towards monetary policy in the west. A relatively hawkish commentary from policymakers at the Jackson Hole symposium in the US has led to a higher probability of Fed rate hike in September and December. If the US Federal Reserve starts to raise interest rates, the differential between US and emerging market yields may begin to narrow, undermining the durability of this rally. Hence a prolonged period of unusual calm seen during the summer is definitely at risk and EM equities may witness volatility in the months ahead.

While this definitely puts Indian market performance at risk, there are reasons to believe that Indian equities have relatively more strength to it than global sentiments.

There is an encouraging trend toward more structural reforms and less populist policies in India at a time when advanced economies are relying solely on cheap money. The current pace of policy reforms happening in the economy has been unmatched in last two decades. India made a big step towards a landmark tax reform (GST) in early August. Apart from taxation reforms, measures taken in last two years with regards to establishing the mechanism for transparent allocation of natural resources, push to Aadhar and the Direct Benefit Transfer mechanism, liberalizing the FDI regime, addressing the challenges in the power sector, the push to infrastructure and reforms in the banking sector have set the ground for structurally higher investment and higher growth in the economy. Some of the measures to push core infrastructure like expanding the network of roads, enhancing the efficiency of railways and building of cities are being looked from a fresh angle and with a magnanimous plan. While the current investment is largely being carried by the government and public sector, it is just a matter of time when the private sector starts to participate more aggressively in India's growth.

The reform in the rural sector (like the new crop insurance scheme, FDI in food processing, push towards better roads, electricity and irrigation, digital connectivity, financial inclusion) holds the potential to revive the rural demand which has been extremely tepid since last two years. While the central government has not been successful in carrying out the legislative reforms pertaining to land and labor, the states have taken the baton to address some of these issues.

Another sector which is witnessing a gradual transformation is the retail lending space. The drop in lending by banks to the corporate sector has compelled banks to focus on other lending avenues, primarily retail and small and medium enterprises (SME) segments. India, given its favorable demographics, has huge potential for rise in retail lending. NBFCs, small banks and payment banks, MFIs, new universal banks and MUDRA are creating the additional supply in the retail lending space. On the other hand, the government's initiative towards financial inclusion will create the necessary demand for these new avenues. With increased competitive intensity, there will be dilution in underwriting standards potentially creating some challenges in future; however, easy access to credit could be a big structural driver of economic growth in an under-levered society.

The splurge in consumer spending represents an opportunity for consumer sector companies as middle class population in India discover the delights of consumer credit to engage with their material dreams. The implementation of pay commission and rural economy revival will further lead to a strong demand in the consumer sector.

Finally, with the RBI's focus on easing the liquidity conditions in the banks, monetary policy has turned supportive of growth. Perhaps, the rise in currency outflow from the banks could be a signal of improved economic activity, which will gradually feed into corporate earnings numbers as well. The earnings result of first quarter of FY17 reflects mild improvement in corporate earnings and owing to above reasons, it should further improve from hereon. While we are surely concerned about valuations, equity markets may remain supported by the government's reform execution and sustained flow from domestic investors.

In the bond market, yields are near 7-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 since July) while easy global liquidity conditions have also helped. The announcement of Urjit Patel as the succeeding RBI governor has been seen as a signal of policy continuity and consequently left the market largely unperturbed.

While the inflation has surprised on the upside since the start of the year, hopes of increased domestic food production due to better monsoon and better global food output with subsiding of El-Nino conditions make us confident of correction in food prices during the remainder year. That said, there are reflationary risks from increased consumption, bottoming out of commodity prices, higher revenue spending by government and GST; but these pressures will be more gradual and will likely play out largely in next financial year. In our view, inflation will just meet RBI's FY17 targets of 5% and as the central bank has stuck to their inflation path of 4% by FY18, it reduces the scope of further deep rate cuts.

Recently, RBI has announced measures aimed at boosting the corporate bond market, long seen as one of the least developed parts of the country's financial system. The policy move, once effective, will allow banks to use corporate bonds as collateral for the RBI's overnight repo credit facility and to issue offshore rupeedenominated "masala bonds", while also giving foreign investors direct access to Indian bond trading platforms.

These measures are in sync with government's bigger agenda of improving the capital spending activity in India. In the absence of a deep corporate bond market, many long-term capital projects over the past decade have been funded by banks, which are now struggling with the consequences after borrowers in sectors such as steel and power proved unable to service their loans. Coupled with earlier steps to deter banks from amassing large exposure to a single borrower, the combined effect would be to reduce an excessive concentration of risk in the banking sector.

Masala bonds can be seen as a means of opening new sources of foreign capital for Indian companies, while avoiding the risk of foreign-currency borrowing. Such measures would further require that the policy makers continue their focus on rupee stability along with overall strong macro-fundamentals, which is very important to attract investments on a sustainable basis.

Navneet Munot, CIO - SBI Funds management Private Limited

September 6, 2016

Mutual funds' investments are subject to market risks, read all scheme related documents carefully.

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