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Asset Pairs Quarterly

Dec 11, 2017

“Experience is what you got when you didn’t get what you wanted” – Howard Marks


Publishing mid year and year end outlooks allows us to step back and ponder the big picture. This year, we share our findings on the outcome of reforms of the nature pursued by the government. In brief, we find that the market is under-appreciating the pro-growth benefits of such initiatives. Separately, we are getting on ground verification via conversations across regions, suggesting a growing sense of optimism amongst businesses in key sectors such as infrastructure, affordable housing and building materials.

Separately, the signaling out of the OPEC meeting by Russia in particular, and the rise in inventories in the U.S., have allayed fears on a spike in crude. Crude looks set to stay in a manageable range, which was what an objective analysis suggested, and confirmation seems to have been provided last week. Our outlook for a continuation of the structured bull market in equities and for fixed income remain unchanged, with our preference for corporate bonds and shorter duration in fixed income remain unchanged. We remain underweight Gold.

Quarterly Asset Allocation Pairs Update

This week, we update our quarterly asset allocation pairs framework which forms the key input into our wealth profiles and asset allocation views.

The Model Favors Corporate Bonds, Shorter Term, Equities, Mid Caps, USD and Cash

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Equities Vs. Bonds

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Credit Growth Is Recovering, IIP & PMI are trending upwards, and Earnings Have Surprised…

Credit growth is convincingly bottoming out as highlighted by the RBI in their latest MPC meeting. Composite PMI has also moved into expansion mode, reporting the third consecutive reading above 50 since the GST related slowdown. PMI for Manufacturing shows a growth trend as well at 52, and the New Orders index in particular at 54 bodes well for future growth.

The IIP is also showing signs of an uptrend at 3.8%, the second consecutive respectable growth reading. The data shows signs of a recovery in capital goods, confirming the PMI data, as well as in Mining and the IIP index. Finally, earnings results have surprised positively with nearly 60% of firms in the CNX 500 beating or delivering in-line results.

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The Relative Attractiveness of Equities Vs Bonds Remains in Neutral Territory…

The earnings yield to bond yield ratio remains near neutral territory, and on this measure, the bull market looks slated to continue. While earnings yields have declined to a meagre 3.8%, bond yields have also come down, leading to the index staying in neutral territory.

Accomodative RBI, Lower Cost of Capital and Rising Inflation

With fiscal deficit pressure from farm loan waivers, infrastructure stimulus, PSU recapitalization and rising yields, the outlook on fixed income remains uncertain until clarity on government financing emerges. On the other hand, equities while expensive, are benefitting from a move to organized, recovering rural demand, stimulus spending, mildly rising inflation and a lower cost of capital.

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Large Cap Vs. Mid Cap

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Relative Valuation Scale Tilts towards Large-caps…

Recent months have seen a noticeable downward correction in the relative forward P/E ratio of large-to-mid caps highlighting the attractiveness of large caps on a valuation basis.

While Large Caps Trade At a Valuation Discount to Mid Caps

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But Earnings Momentum Clearly Favours Mid-Caps

While earnings disappointments have been much lesser in the large-cap space, mid cap earnings projections are decidedly more bullish than large caps. The differential in forward EPS CAGR on a relative basis, as well as the trend, lead to the model suggesting a preference for mid caps. For instance, while large caps have seen a revision in EPS growth from 18.3% to 18.7%, projections for 1 year growth have declined to 11.5% from 17.1%. On the other hand, mid caps have seen an acceleration in near and longer term growth expectations.

While Large Caps Are Projecting a Respectable 18.7% 3 Year Forward CAGR… …Mid Caps Are Projected to Grow At An Impressive 42.3%

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Corporate Bonds Vs. G-Secs

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Improving Credit Fundamentals and Strong FI Flows Into Corporates

The upgrade/downgrade ratio has started improving again, post the stress related to GST implementation, with upgrades outpacing downgrades at a ratio of 1:1.4. Credit quality appears set to continue improving, driven by deleveraging of balance sheets, lower interest rates, stable operating cycles and improving domestic consumption demand. Foreign Institutional flows into debt have been strong, with much of the incremental flows channeling into corporate bonds. On the supply side, private placement of corporate bonds remains at near term average levels despite a fall in yields. Meanwhile, G-Sec borrowing and the fiscal deficit remain concerns for the markets, adding further impetus to a preference for Corporate bonds.

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Asset Pairs Quarterly

However, the Recent Rise in G-Sec Yields Has Led to a Narrowing of Spreads

Spreads between AAA bonds and G-Secs have narrowed to 78 bps and are now below the long-term average of 103. Much of the run up in G-Sec yields can be attributed to pricing in incremental inflation and added supply expectations. The PSU corporate bond yield curve has also shown some flattening on the long end as well as some decline on the short end versus a year ago.

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Bonds – Short Vs. Long

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While Spreads Suggest the G-Sec Looks Attractive…

Spreads on the 1/10, and the 5/10 have widened above long-term averages, suggesting that the long end of the curve looks attractive. Further, the spread versus the U.S. 10 Year remains close to historical averages, again, attractive for FI investors.

But Dynamic Bond Funds Are Decreasing Duration…

Dynamic bond fund managers have broadly decreased their duration with Reliance, ICICI Pru and Birla all dropping their durations.

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And a Sustained Rise in Government Borrowings Remain a Concern…

The sustained rise in government borrowings at the state and central levels continues to exert pressure on the 10 year, and is the key factor behind the preference for short term bonds.

Firming Domestic Inflation Likely to Exert Upward Pressure on the Long End…

On the inflation front as well, firming up expectations garnered over the last 2 RBI MPC meets should likely pressure yields higher on the long end of the curve, making the short term fixed income securities a better relative play.

Surplus Liquidity in the System Favors the Short End…

Lower interest rates and normalization post demonetization have slowed bank deposit growth and credit growth is recovering, which alongside OMO operations has reduced systemic liquidity; however, there still remains a surplus of about INR 12 Lakh Cr. in the system. This in turn reinforces the view that short term lending by banks of this excess liquidity should contain act as a headwind for any rise in short term rates.

Technical Momentum Favors Short Term…

The technical momentum is a strong contributor to the call on short term rates, with a breakout on the 10 year government bond, compared to muted action on the shorter end of the curve.

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Gold – Remain Underweight

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Bullish Sentiment for Gold – Negative

Gold Bullishness has shown volatility in recent months but the longer term trend remains negative.

Gold Bullishness Indicator is Trending Lower

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Relative Valuation of Gold vs. Oil Remains in Overvalued Territory

The long-term average relationship implies a gold price of $852 per troy ounce vs. CMP of $1,249. The gold/oil ratio is one of the more stable relative valuation measures for gold.

Yellow Gold Overvalued vs. Black Gold

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Macro and Risk Parameters

Gold has traditionally been viewed as an inflation hedge and with inflation likely expected to heat up in the U.S. on pro-growth and tax-friendly fiscal measures of the Trump Government, this could be a potential positive for Gold prices going forward.

U.S. Inflation Remains Muted

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Volatility in the U.S. has been consistently trending down with the perception that the nation is increasingly looking confident on sustained consumption, additional kickers from the tax impetus on corporate profits as well a tightening labour market. Net-net, this is likely to prompt asset flows away from traditional “safe-haven” assets like gold and into “riskier” assets such as equities. We would note, though, that the US remains in the late stage of its cycle.

Lower Volatility Spurs “Risk-On” Away from Gold

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No Material Demand & BitCoin a Gold Disruptor

ETF Gold holdings have fallen in last few months, while at the same time speculative net contracts positions in the yellow metal have risen offsetting some of the holdings losses. Separately of note, the Winklevoss brothers have become billionaires in Bitcoin, and are calling Bitcoin a Gold disruptor.

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USD Versus INR – Neutral

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Macro parameters favourable for the INR

Foreign flows into India have been extremely resilient both at FDI and FII level and further, both in equities as well as debt, at $30-35bn CYTD17, which has helped cushion the current account deficit and supported the INR. Additionally, lower EMBI spreads imply a risk-on attitude of flows away from USD into EM debt further supporting emerging currencies like the INR. Further, the impact from rising crude oil prices looks to be contained at current levels.

Other valuation factors such as increase in India’s FX reserves, import cover and a decent fall in overvaluation levels in its REER from 4.5% to currently only 2.5% overvaluation (thus leaving only limited room for a further decline) should support INR strength.

Strengthening Reserves A Positive

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Technical Outlook

After last few weeks of selling in the market, bulls took control in last couple of trading sessions with Nifty closing up by 1.42% for the week at 10266. Index has recovered 50% of the one month decline from high of 10490 levels in just two days clearly indicating strength in the market. The bounce back has come from strong support of 10000 odd levels; where 61.8% Fibonacci retracement of the entire up move from September low of 9685 to November high of 10490 comes. Last two session’s strong bullish candle reaffirms the uptrend in the market and likely to retest its all-time high of 10490 levels. It has small hurdle of 10350-10410 levels where index might take a brief pause and then continue its up trend. Crossing and sustaining above 10490 levels, next target for index is seen at 10650-10700 levels. On the downside 10000-9950 remains strong support for the market where highest for open interest for Nifty strike price 10000 Put option is also seen. While 9685 is the critical support level for the market. FIIs, after Rs 19728 crores equity buying in November have been sore point for the market this month; they have sold Rs 4764 crores (provisional) sold in equity and Rs 4003 crore in Index future since start of December. India VIX witnessed spurt in last couple of weeks, but has come down in last two days. Going ahead watch out for VIX as volatility may rise and put pressure on the market as key events are lined up this month; Gujarat elections, US Federal Reserve and European Central Bank meeting this month

Nifty Daily chart

Asset Pairs Quarterly