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Monthly Equity & Debt Strategy – October 2018

Equity Strategy:

 

Indian markets witness contraction in outperformance given the rising risk to domestic macros

  • India VIX Index has risen probably due to spike in crude oil prices, a falling rupee and uncertainty ahead of the election season. The Nifty and the VIX index are generally negatively correlated and move in opposite directions to each other on most circumstances. While Indian equity markets have outperformed MSCI DM and MSCI EM on a YTD basis, the recent increase in Indian VIX since end Aug-18 has narrowed outperformance.
  • Indian equity market has witnessed steep correction of 7%, during last one month, as risk to macros have increased. While rate sensitives (specially mortgage financers) and leverage sectors have witnessed significant correction, export oriented sectors (IT and Pharma) have seen significant outperformance. Going forward as incremental liquidity becomes expensive leading to likely moderation in growth, valuations of NBFCs may witness contraction (premium valuations may revert to historical average).
  • Outlook for crude firms up in near term with the OPEC and other associated members’ decision (so far) to maintain oil production despite a likely curtailment of a significant portion of oil exports from Iran over the next few weeks. Also, weak global sentiment (intensifying trade war, USD strength) and consequent rise in systemic risks to EM’s may curtail FPI debt and equity flows leading to a large Balance of Payment deficit and its associated pressure on currency and external debt among others.
  • Structural changes that US markets may be witnessing, might have important market implications globally: Growth & Unemployment rates in US are forecast to diverge going forward (as per Fed forecasts), rising interest rates shall reduce Equity Risk Premium (thus, reduce relative attractiveness of equities) and third, declining global liquidity going forward may tighten financial conditions. One needs to be extremely brave to ignore the same. However, these are medium term risk and may not impact market in near term.
  • Equity Strategy: Elevated valuations (on+20% earnings growth estimates for FY19/20) in midst of adverse macros emanating from firming up of oil prices, rising yields, depreciating currency and tightening global liquidity calls for realigning in expectation for moderate upside in equities in medium term.

Fixed Income Strategy:

  • The recent events in bond markets have led to heightened volatility triggered by downgrade of ILFS followed with news flows over DHFL.
  • The macro headwinds (i.e. elevated oil prices, rising domestic & global interest rates, and pressures on twin deficit etc.) have led to hardening of yields (>125-150bps) in the last 1 year. On the other hand, banking liquidity (as measured in LAF window) has turned into deficit (>Rs. 1.2 lac crores) in the second week of September (primarily driven by advance tax outflows & half year ending) thereby putting further pressure on yields.
  • Amidst tight liquidity conditions & rising interest rates, the recent credit episodes (likes of ILFS, DHFL secondary market trade) have led to market fears over refinancing risks for NBFC sector, as a result leading to expansion in credit spreads and in turn further aggravated liquidity conditions.
  • As per interaction with AMCs and media reports, the regulators (RBI & SEBI) are taking cognizance of the current situation and may take necessary steps to provide liquidity.
  • In our conjecture assessment, it is not an environment of solvency crises at large and it appears to be more of illiquidity risk premium amidst rising interest rates driven by macro environment & risk aversion.