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Today marked the 3rd Bi-Monthly policy statement by the RBI for the FY 2018-19 with members voting 5-1 in favor of a rate hike.

This was largely in line with market expectations and was already priced in, as post the release of the minutes of the monetary policy bond yields did not move much in either direction.

However, the MPC also continued to maintain a neutral stance, indicating that it is trying to play a delicate balance between inflation and growth, and decisions are being taken with the objective of achieving the medium term target for CPI at 4% within the range of +/- 2% and future data prints

The MPC mentioned that domestically various indicators suggest that economic activity has continued to be strong. Significant turn around in the production of capital goods and consumer durables, Progressive monsoon and increase in MSPs of Kharif crops are expected to boost rural demand by rising farmer’s income. Vehicle sales augur well for urban income growth.

Retail inflation i.e. CPI grew to 5% in June from 4.9% in May, driven by an uptick in inflation in fuel. Food inflation remained muted due to lower than usual seasonal uptick in prices of fruits and vegetables in summer months. Adjusting for the estimated impact of the 7th central pay commission’s house rent allowances (HRA), headline inflation increased from 4.5 per cent in May to 4.6 per cent in June. Low inflation continued in cereals, meat, milk, oil, spices and non-alcoholic beverages, and pulses and sugar prices remained in deflation. Factors mentioned above have resulted marginally downward revision in inflation projections for Q2 vis-à-vis the June statement. However, projections for Q3 onwards remain broadly unchanged on account of uptick of 20 bps in inflation expectation for 3 months and 1 year ahead horizon survey of households by RBI’s. RBI’s industrial outlook survey also reported higher input costs and selling prices in Quarter 1 of 2018-19. Input cost of companies polled in services PMI in June also stayed elevated. Farm and non farm input costs rose significantly in June.

The central government has decided to fix the minimum support prices (MSPs) of at least 150 per cent of the cost of production for all kharif crops for the sowing season of 2018-19. This increase in MSPs for kharif crops, which is much larger than the average increase seen in the past few years, will have a direct impact on food inflation and possible secondary impacts on headline inflation. Uncertainty around the full impact of MSP on inflation will only resolve in the next several months once the price support schemes are implemented and procurement by the government is visible.

Based on an assessment of the above-mentioned factors, inflation is projected at 4.6 per cent in Q2, 4.8 per cent in H2 of 2018-19 and 5.0 per cent in Q1:2019-20, with risks evenly balanced. Excluding the HRA impact, CPI inflation is projected at 4.4 per cent in Q2, 4.7-4.8 per cent in H2 and 5.0 per cent in Q1:2019-20.

The MPC notes that domestic economic activity has continued to sustain momentum and the output gap has virtually closed. However, uncertainty around domestic inflation needs to be carefully monitored in the coming months. In addition, recent global developments raise some concerns. Rising trade protectionism poses a grave risk to near-term and long-term global growth prospects by adversely impacting investment, disrupting global supply chains and hampering productivity. Geopolitical tensions and elevated oil prices continue to be the other sources of risk to global growth. On account of these risks, RBI governor stated that by keeping the neutral stance, the Monetary Policy Committee have kept the option of further rate increase or decrease open and dependent on future data.

With an election year upon us and possible fiscal risks emanating, along with global outflows on the back of higher US interest rates and a falling rupee, this may not be the last of the rate hikes in our view.

Your Investments

Financial markets have continued to be volatile and driven mainly by monetary policy stances in advanced and emerging economies and geopolitical tensions. Globally, equity markets have been volatile on trade tensions and uncertainty around Brexit negotiations. However, it also important that public finances do not crowd out private sector investment activity at this crucial juncture.

Capital flows to Emerging Economies declined in anticipation of monetary policy tightening in Advanced Economies. Also currency of Emerging economies have depreciated against the US dollar over the last month on account of strong USD supported by strong economic data.

Equities continue to remain overpriced from a price to earnings perspective in spite of recent corrections and a better growth outlook. However, good results so far by many companies, along with good growth expectations and better capacity utilisation bode well for earnings growth going forward.

Real rates continue to remain positive.The rising G-sec yield makes dynamic bonds and long term bond funds unattractive and the exposure to the same should be minimized. Bonds with a shorter duration of 3 months to 2 years are ideal in the given scenario. We therefore, continue to believe that investors should continue to have fixed income exposure through a combination of lower duration and short term strategies.

Your Loans

With an increase of 25 basis points by the RBI, the deposit rate of the banks could further increase which would be followed by lending rate hikes. Thus we suggest looking at prepaying or raising EMI amounts on your loans to negate the interest rate hike and future hikes that could follow.

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Oil has always had a major influence on India. Whether it be politics, stock markets or the general state of the economy, oil continues to have it’s say in these matters. And this is so because India is a net crude oil importer to meet it’s ever growing demands, and it is not just about energy requirements.

brent crude price chart

Oil in the last year has gone up 48.5% (Brent Crude Price in USD), whilst in the last three months alone it is up by 16.9%! This huge surge can and probably has started to show it’s effect across the various aspects of the economy. But as an investor into that economy, we hope to underline the impacts of this event on your portfolio holdings.

EQUITIES

  1. Inverse Relation:Data indicates that Nifty and Crude Oil prices have an inverse relationship. Between 2014-2017 whilst oil prices saw a significant drop the equity markets showed significant upwards trends. However the latest data seems to suggest that this inverse relation is currently not being witnessed, at least temporarily, with both the markets undergoing volatility and oil prices sky rocketing. Oil price rises however do impact both debt and stocks and hence need a careful watch.

nifty vs crude

  1. Oil Sector:Oil Marketing Companies (OMCs) are directly impacted by oil price movement. While retail prices have been continuously raised for the last few days, the worry remains that the government may ask these companies to absorb further hikes rather than passing them to end consumers for controlling inflation. Such a move could dampen their stock prices in the immediate future. Therefore if your stocks portfolio has high exposure to such stocks its time to review the same.
  1. Other Sectors:Besides oil companies, other sectors that do get affected are the Aviation and Consumer Durable sectors. For airlines, jet fuel is the single largest cost. Hence rises in oil prices prove serious strain on their margins. This can also be seen through their Q4 results. Also, a lot of companies such as rubber, paints, lubricants, chemicals and even footwear are heavily dependent on oil derivatives as raw materials for their products. Therefore a higher oil price has an indirect impact on their profit margins.
  1. Any positives?:Higher oil prices invariably lead to a slide in the Indian Rupee (which we will discuss below). But a weaker rupee can be a positive for IT and Pharma companies as a lot of their business in exports of services and goods.

FIXED INCOME

  1. Widening Current Account Deficit (CAD) and Fiscal Deficit:As India imports most of it’s oil needs, rise in oil prices means more money spent for the same amount of oil. This increases the Fiscal Deficit i.e. our expenditure is more than the revenue. As such the government then has to borrow more to meet this gap. This also puts serious pressure on the gap between total imports and exports and invariably leads to a ballooning CAD, resulting in loss of foreign exchange reserves.
  1. Weakening Rupee:As mentioned above, oil affects the CAD of our country which in turn has a direct impact on the currency due to higher Fiscal Deficits, Increased Borrowings and Current Account Deficits.

Year Rupee Dollar Exchange Rate % Change Avg. Brent Crude Oil Price per barrel ($) % Change
15-06-2008 42.48 91
15-06-2009 47.75 12.41% 58 -36.26%
15-06-2010 46.45 -2.72% 77 32.76%
15-06-2011 44.7 -3.77% 100 29.87%
15-06-2012 55.51 24.18% 110 10.00%
15-06-2013 59.53 7.24% 110 0.00%
15-06-2014 60.06 0.89% 110 0.00%
15-06-2015 63.6 5.89% 58 -47.27%
15-06-2016 67.5 6.13% 35 -39.66%
15-06-2017 64.62 -4.27% 55 57.14%
15-06-2018 67.45 4.38% 76 38.18%
  1. Inflation:Rising oil prices means rising input, freight and transportation costs for companies, which finally means bills and expenses increasing for the end consumers. In other words, strong reasons for rising inflation in the country.
  1. Where is the actual Impact?:For fixed income investors currently holding debt mutual funds, the above event has a negative impact on the underlying benchmark I.e. 10 year G Sec Bonds. As such, the yields of current 10 year G Sec bonds goes up, which results in a loss in value of bonds held (both sovereign and corporate). In fact, for any investor who may have recently put money into debt mutual funds may be experiencing a notional principal loss!

While elevated oil prices have certainly bought about uncertainties in both fixed income and equities, as an investor it is crucial to know the fundamental reasons of investing into your current investments, along with a certain understanding of when you would require the monies i.e. your time horizon. Like oil, there are always other factors that have short term impacts on portfolios, but by ensuring your appropriate asset allocation through consistent professional advice, your portfolio will likely navigate such times.

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Today marked the second and much awaited Bi-Monthly policy statement by the RBI for the new FY 2018-19.

In line with what bond markets expected, the Monetary Policy Committee (MPC) delivered a 6-0 verdict on an interest rate hike by 0.25%. The was largely in line with market expectations post the release of the minutes of the last meeting and thus the bond market had only a marginal impact of this change.

However, the MPC also continued to maintain a neutral stance, indicating that it is trying to play a delicate balance between inflation and growth, and decisions are being taken basis news flow and fresh data coming in.

The MPC noted that domestic economic activity has exhibited a sustained revival in recent quarters and the output gap has almost closed. Investment activity, in particular, is recovering well and could receive a further boost from swift resolution of distressed sectors of the economy under the Insolvency and Bankruptcy Code. This is in general good news for the economy.

Retail inflation i.e. CPI grew to 4.6% in April. The decision to raise rates is therefore in line with the objective of keeping the medium term inflation at 4% i.e. well within the 2-6% range.

Since the MPC’s meeting in early April, the price of Indian basket of crude surged from US$ 66 a barrel to US$ 74. This, along with an increase in other global commodity prices and recent global financial market developments, has resulted in a firming up of input cost pressure thus persisting in a high CPI inflation projection for 2018-19. On the other hand the summer momentum in vegetable prices was weaker than the usual pattern softening the food inflation in the short term, though this has been more than negated by the changes in oil prices. Household inflation expectations have also moved up sharply and  pricing power seems to be on its way up as well.

Taking these effects into account, the projected CPI inflation for 2018-19 is revised to 4.8-4.9 per cent in H1 and 4.7 per cent in H2, including the HRA impact. Excluding the impact of HRA revisions, CPI inflation is projected at 4.6 per cent in H1 and 4.7 per cent in H2.

Crude oil prices have been volatile recently and since consumption, both rural and urban, remains healthy and is expected to strengthen further, all this imparts considerable uncertainty to the inflation outlook, possibly on the upside. With an election year upon us and possible fiscal risks emanating, along with global outflows on the back of higher US interest rates and a falling rupee, this may not be the last of the rate hikes in our view.

Your Investments

Geo-political risks, global financial market volatility and the threat of trade protectionism pose headwinds to the domestic recovery. However, it also important that public finances do not crowd out private sector investment activity at this crucial juncture.

In most Emerging Market Economies (EMEs), bond yields have risen on reduced foreign appetite for their debt due to growing dollar shortage in the global market and on prospects of higher interest rates in Advanced Economies.

Equities continue to remain overpriced from a price to earnings perspective in spite of recent corrections and a better growth outlook. However, signs of improved demand and pricing power for companies, along with good growth expectations and better capacity utilisation,  bode well for earnings growth going forward. Corrections into equities could therefore be bought into.

Real rates continue to remain positive.The rising G-sec yield makes dynamic bonds and long term bond funds unattractive and the exposure to the same should be minimized. Bonds with a shorter duration of 3 months to 2 years are ideal in the given scenario. We therefore, continue to believe that investors should continue to have fixed income exposure through a combination of lower duration and short term strategies.

Your Loans

Even before the RBI meet, the banks had begun hiking both their lending and borrowing rates. This rise in lending rates was brought about by the rapid increase in bond yields and increased loan demand, especially in private banks.

With an increase of 25 basis points by the RBI, the deposit rate of the banks could further increase which would be followed by lending rate hikes. Thus look at prepaying your loans with excess liquidity.

A 6-0 verdict is therefore a clear indicator that inflation targeting continues to be the MPCs primary role, and a conservative stance will probably give foreign investors a more positive view on India.

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Today marked the first Bi-Monthly policy statement by the RBI for the new FY 2018-19.

The MPC notes that there has been a recovery in growth on a domestic level and various structural reforms introduced will support further long term growth. The MPC recognizes the downside risk to private financing and investments as well as growth on both a global and domestic level is brought out by deteriorating public finances and rising trade protectionism.

The MPC stated that the GDP growth is projected to strengthen from 6.6% in 2017-18 to 7.4% in 2018-19 with H1 2018-19 reflecting growth in the range of 7.3-7.4% and 7.3-7.6% in H2 2018-19 supported by revival in investment activity and global demand.

The MPC revised down the CPI for FY 2018-19 to 4.7-5.1% in H1 and 4.4% in H2 (inclusive of the HRA impact) keeping in mind that factors such as the revised formula for MSP (minimum support price), impact of HRA, further fiscal slippages, a weak monsoon and volatile crude prices could all pose upward risks to the near term inflation outlook.

Amongst the midst of global and local market volatility in both the equity and bond markets, the monetary policy committee maintained their neutral stance and kept the policy repo rate and the reverse repo rate unchanged at 6 percent and 5.75 percent respectively.

5 out of 6 members voted in favor of the policy while one member voted for raise in rates by 25 basis points.

The 10 year G-Sec fell sharply from 7.3% levels to 7.12-7.13% indicating that the market is putting to rest any near term rate hikes.

Your Investments

While the RBI does talk about economic recovery as well as a possible sustained long term recovery one can not ignore the volatility brought about by the juxtaposition between global recovery and the possible trade war between the United states of America and China.

Equities continue to remain overpriced from a price to earnings perspective in spite of recent corrections. Real rates continue to remain positive and interest rates (benchmarked by the 10 year G-sec) have cooled down from their high ranges of 7.7-7.8%.

We continue to believe that investors should continue to have fixed income exposure through a combination of accrual, short to medium and hold strategies. Considering a large state loan calendar interest rates could revert back to an upward movement scenario and thus we recommend maintaining only a 10% exposure to dynamic bond fund that have the flexibility to move across bond maturities.

Your Loans

For the first time in 2 years banks started increasing interest rates indicating a change in rate cycle. This rise in lending rates was brought about by the rapid increase in bond yields.

The RBI has maintained status quo on rates and has allowed banks to spread their bond losses over 4 quarters. This action by the RBI could cause lending rates to stabilize.

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According to Investopedia, “Geographical Diversification” is the practice of diversifying an investment portfolio across different geographic regions so as to reduce the overall risk and improve returns on the portfolio.

As with diversification in general, geographical diversification is based on the premise that financial markets in different parts of the world may not be highly correlated with one another. For example, if the US and European stock markets are declining because their economies are in a recession, an investor may choose to allocate part of his portfolio to emerging economies with higher growth rates such as China, Brazil and India.

There are two major advantages in diversifying one’s investment portfolio based on geography:

  • Taking Advantage of Opportunities in other Strong Economies:

A significant benefit to a geographic diversification of assets has to do with the way it allows you to mitigate risk by taking advantage of stable economies elsewhere in the world. It’s no secret that some economies are struggling to recover from the trying economic times of the last few years. Other countries, however, have seen higher growth rates due to a variety of factors. International portfolios have been shown, in general, to outperform domestic ones, this is because when there are so many markets to choose from, it is unlikely that the same country will ever repeatedly achieve the highest level of growth. With improved access to international markets and investment instruments such as mutual funds bringing down the costs, an additional option to further diversify has been to buy in international markets.

Picture1

(Source: Bloomberg, Kotak MF. As of 31st Jan, 2018)

The above returns data chart clearly shows that while the Indian Equity Markets have performed significantly in the last year, there were opportunities elsewhere which proved even better. Diversification into such economies can therefore result in better yielding portfolios.

  • Balancing out the risks:

While chasing better returns might definitely be one aspect of any investment portfolio, it is also crucial to understand how any strategy helps in mitigating the associated risks that are part of every investment decision. Geographic diversification provides a much needed balance that all investors strive for. If one of your assets is located in a part of the world that is or could be vulnerable, the investments in other geographies could compensate or buffer any unexpected losses. This is because despite the impact of globalisation, geographies and economies can still have limited correlation between them, and over time international markets could perform very differently to domestic markets. Following is a chart that shows how various sectors form part of some regions around the world, in % of total market capitalization:

Picture2

(Source: credit suisse global investment returns yearbook 2015)

As you may notice, different regions give different weightages to every sector. Thus by accessing these regions, you can in essence, reduce investment risks in individual sectors and therefore your entire portfolio as a whole.

Since the cycles that drive business and investment are experienced at different times in different countries, foreign markets seldom move in perfect tandem with each other. Losses in one market may be offset by gains in another. Geographical diversification significantly reduces the overall level of volatility and exposure to external factors. For an investor, theoretically this would mean that the more diversified your assets, the safer is your money. However it is true that a significant black swan event, such as the financial crisis of 2008, will likely deplete any such benefits, especially in the short term immediately after such an event. What is rather important to keep in perspective is (a) your investment horizon and (b) your risk taking capability to diversify into foreign markets.

 

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Inflation concerns mean rates stay as is…

As was broadly expected, The Monetary Policy Committee (MPC) on Wednesday left the policy repo rate and reverse repo rate unchanged at 6 percent and 5.75 percent, respectively. Out of six members, five members voted for no rate cut and one member voted for 25 bps rate cut. RBI continued to maintain its view that the 4% target on inflation remains its focus. Retail inflation measured by year-on-year change in the consumer price index (CPI) had recorded a seven-month high in October, and with an indicated range of 4.3% to 4.7% for the next two quarters, along with higher inflationary expectations getting built in through the possibility of higher oil prices and some possible fiscal pressure, this was very much in line with expectations. Surplus liquidity in the system has also continued to decline, reducing chances of rate cuts going forward.

Focus on the real rate of return

With the RBI referring to possible green shoots on growth starting to appear in the economy, it does seem that whilst they will continue to track data closely, strategies that are focussed on interest rates getting reduced are likely to face pressure. However, considering that real rates of return (returns from fixed income investments less inflation) continue to be significantly positive, we continue to believe that investing in fixed income is attractive.

Your Investments

Considering positive real interest rates, and equities continuing to trade at significant premiums to long term price to earnings ratios,  it may be a good idea to continue to have fixed income exposure through a combination of largely accrual, short to medium term, and hold to maturity strategies. For investors willing to continue to look at interest rates heading downwards, dynamic bond funds that have flexibility to move across bond maturities, can be explored for a small portion of the fixed income portfolio.

Your Loans

The RBI’s decision to hold rate cuts could indicate that there is unlikely to be any impact on existing lending rates, especially home and car loans by banks. Whilst the transmission of the rate cuts for bank loans over the last couple of years has only been partial, we believe that interest rates may not head down much more going forward.

Way Forward

Considering that the next policy meeting on Feb 6 and 7 is likely to be post the Union Budget, one will need to track how the government manages its fiscal policy and its focus on growth going forward. Global interest rates headed upwards, will also continue to drive RBI’s decisions on interest rates.

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India is currently among the most watched Emerging Market nations. To top that, the Indian Equity Markets have witnessed unprecedented growth in the recent months. The YTD returns for Sensex alone has been 26% (data from BSE India). The euphoria and high confidence on the Indian Equities has continued to remain, especially from the institutional investors both foreign and domestic.

This is also leading to make many individual investors question whether they should invest in equities or sit on the sidelines. While individual risk appetite and time horizon would be some of the basic factors to understand before investing, there are many other fundamental factors to track. While the debate has been raging on as to which indicators should be looked at or ignored to make sense of the valuations of the Indian equity markets, the following factors can help bring some sense of clarity to the overall picture. Factors such as:

Current Price to Earnings Ratio (P/E Numbers): One of the most traditional tools used globally at gauging the valuations of an equity market of a country. In the last one year alone (based on data from Oct 16 to Oct 17), the P/E Ratio for S&P BSE Sensex has averaged close to 22 times in comparison to its historical average of approximately 17 on a trailing basis. For the BSE Mid Cap and Small Cap of the same period, the P/E valuations are at an average of 33.8 and 81.13 times.

Corporate Earnings: P/E Ratios are directly linked to the corporate earnings of the country. As per Kotak Institutional Equities Estimates, the Expected Earnings for companies representing the Nifty 50 Index are approximately 2% in FY 2018. A variety of reasons are attributed to these low earnings expectations, most famously discussed are the implementations and effects of Demonetization and Goods and Service Tax (GST).

Crude Oil Prices: Nearly 80% of India’s energy needs are import dependent. A direct consequence of this is the risk to the country’s inflation rate if the prices of crude oil are to rise. A rise in oil prices results in lower cashflows/profits for companies and higher prices for consumers. Brent crude oil prices are currently firming up at prices upwards of 60$ per barrel. This is a definite concern from an Indian economy perspective.

Exchange Rates: The Rupee is currently considered overvalued basis its 10 year average (Source: Kotak Research). This has a dual impact on the economy i.e. (A) it increases attractiveness of imported products, resulting in increased competition for domestic companies and lower profits; (B) it decreases the value of exported products and therefore hurts the margins of export based industries such as the IT sector. Both have resulted in muted growth prospects for these respective industries.

Bond Yields: In an growing economy like India, both equities and bonds compete for capital. In a equity bull rally, money is taken out from bond markets and pumped into equities, forgoing risk to capital for riskier investments. Currently bond yields are inching up to the mid 2017 high of 6.987% yield for the 10yr G-Sec. However there has only been net inflows into fixed income. Foreign Portfolio Investments into Government Securities have already reached 83.94% of their allotted limit (data dated as per 6th Nov NSDL)

Inflation Rate: Inflation brings about it own risks to the stock markets. In the last Monetary Policy Committee meeting, the RBI revised the inflation projections for the rest of FY 2018 upwards to 4% – 4.5%. This may indicate a stop to future rate cuts, freezing any possibilities of reduction in lending rates. Medium term consequences for companies could possibly mean dearer than expected debt to  service, resulting in subdued profits and revenue.

Role of FIIs: The way that Foreign Institutional Investors park monies in the market can give an indication to the current picture of that market. While FIIs were very bullish on Indian Equities for most part of the calendar year, starting June they slowly but surely tapered inflows in equity, finally resulting in net outflows in the month of September and October. (Source: moneycontrol)

Global Scenario: On a global scale, economies are starting to look up, with further growth expected. According to IMF Economic Outlook, average expected GDP growth for FY 2017 is 2.5%. Globally, equity markets have participated in this growth including India. What probably may need to be put in perspective is that the rally in Indian Equities may be partly due to the global rallies taking place. Therefore the Indian equities are associated with risks in terms of foreign external factors like outbreak of war in the Korean Peninsula. Such events are likely to have negative impacts on the domestic markets.

Keeping in mind the above mentioned factors, Plan Ahead Wealth Advisors has a definite view that current equity markets are over valued and investors should exercise caution. The not so positive indicators from these mentioned factors should mean a significant correction cannot be discounted, keeping us wary of diving too much into equities without first educating investors of the potential risks in the short to medium term horizon.

 

 

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