Dec 9, 2019
Our quarterly asset pairs methodology is a key input into the formation of our investment strategy forecast and provides insights into relative attractiveness between asset pairs, and preferences within asset classes.
Equities Vs. Bonds
Valuations Remain Expensive While Relative Valuation Remains at Neutral
Equity markets have delivered strong returns over the past few months. As a result of the upward price action, valuations remain expensive with equities trading at multiples near the high end of the range, both on forward and trailing metrics. However, a meaningful decline in bond yields has kept the earnings yield – bond yield ratio at neutral levels.
Sputtering Economic Growth
GDP at 4.5% is at the lowest level since 2013. A quick glance at the chart shows that the GDP data is basically in a strong downtrend since Jan 2018, making it the worst two year performance in the past decade. Last quarter’s growth data showed a contraction in manufacturing and subdued investments. It was only government spending that bolstered the economy, with private consumption remaining subdued. High-frequency indicators suggest the slowdown has extended into October and November.
GDP Growth is at a Six Year Low and a Downtrend Since Jan 2018
Flows a Key Reason the Markets Are Higher
Despite the worsening macros over the last few months, investors have continued to pour money into equities and debt at a healthy rate. Foreign investors have pumped in ~USD6bn into equities in the last three months itself. The domestic SIP book remains healthy.
Earnings Upgrades Lower than Anticipated
There has been no meaningful pickup in earnings upgrades despite the massive corporate tax cut. Earnings revisions have been minimal in large caps as well as mid caps. One reason could be that high growth is already factored into analyst one year forward estimates.
The Equity Bond Asset Pair Continues to Favor Equities Marginally, and Less So Than Prior Quarter
A narrative of higher valuations, global liquidity, financialization, limited alternatives for investment and strong performance by a few leading companies has driven markets to new highs. The model continues to favor a positive tilt to equities, driven by strong flows and diminishing attractiveness of bond yields, and valuations supported by low interest rates.
Large Cap Vs. Mid Cap
Valuations Have Compressed for Mid Caps
Improving earnings and the sharp price correction in mid caps over the past couple of years have compressed mid cap valuation multiples and brought them in line with large caps. However, earnings revisions data remains dismal for mid caps. Further, the technical momentum does not indicate a switch to mid caps. The large cap to mid-cap asset pair model moves to neutral from a slight tilt towards mid caps in the prior quarter.
PE Multiples have Contracted for Mid-Caps, but Remain above Nifty PEs
Corporate Bonds Vs. G-Secs
Corporate Bond Spreads Remain Elevated
Spreads between AAA corporate bonds and G-Secs have expanded to 114 bps as of Nov-19, above the 10 year average of 93 bps. The spread has remained broadly stable over the past year. The credit upgrade/downgrade ratio continues to be under pressure with Q3 CY19 downgrades at 8 year highs. The 10 year Gsec repo spread widened during the IL&FS crisis late last year and has continued to hold on to the premium versus repo, on concerns related to fiscal deficit, elevated spending, corporate tax cuts and slowdown in tax and GST collections.
CRISIL Downgrades Have Accelerated Higher While the Repo 10 Year Spread Remains Wide
The asset pair model on corporate bonds versus duration remains unchanged at neutral, indicating no preference towards government or corporates.
Bonds – Short Vs. Long
1 year / 10 year and 1 year / 5 year Spreads Favor the Long End
The 1 year to 10 year spread has widened to a multi-year high, favoring the long end. The 5 year to 10 year spread has also widened to multi year highs.
Duration of Dynamic Bond Funds mix trend
IDFC and Nippon have increased duration in their dynamic bond funds, while ICICI has maintained duration at constant levels, and SBI dynamic bond fund duration has come off sharply. AUM weighted average modified duration has not seen any meaningful change over the last 4 months.
Inflation Outlook and Gross Borrowings Likely to Weigh on Long Term Bonds
Gross borrowings of over Rs. 7.0 trillion and large issuances from state governments are likely to add pressure at the long end of the curve, as most of the government borrowings are for 10 years and above category.
The tick up in inflation also played a key role in the RBI’s decision to not cut rates despite a slowing economy. Yet again, this will be a negative for long term bonds. However, the story on corporates comes with attendant risks as well, as the corporate downgrades ratio has accelerated higher.
The model stays neutral, indicating no preference currently between short term and long term.
Gold – Underweight Gold
Negative Indicators for Gold Valuations
The gold-oil ratio remains in over-valued territory, with the long-term average relationship implying a gold price of $894 per troy ounce versus gold’s current price of $1,475. Separately, volatility in global markets has declined over last few months, prompting asset flows from “safe-haven” assets like gold to “riskier” assets such as equities.
No Material Demand
ETF gold holdings have continued falling in the last few months, while at the same time speculative net contracts in the yellow metal have risen offsetting some of the holdings losses. Net-net, this remains an overhang for the precious metal.
The Gold Cash asset pair has moved to a moderately bearish view on gold, from a neutral view in the prior quarter, indicating a declining preference for gold.
USD Versus INR – Positive INR
Macro Parameters are Favorable for INR
India’s macro position continues to strengthen, with forex reserves rising and import cover improving. The dollar index has also weakened marginally in recent weeks. Additionally, FII and FDI net inflow run-rates have been fairly strong as investors return to Indian equities and debt in search of higher yield. Driven by the various positive measures, the asset pair model moves to a positive on INR from neutral in the prior quarter.
Asset Pairs Summary
Our asset pair recommendations stay positively skewed towards equities, but less so than prior quarter. On capitalization, the asset pair shows no preference between large and mid caps, therefore the decision devolves to stock and manager specific criteria.
Moving to fixed income, the corporate bonds versus g-sec asset pair stays at neutral. Some of the compression on PSUs and corporate bonds has played out. One area that has been beaten down quite significantly is credit, and we recommend adding exposure to conservative credit risk funds. The asset pair on short term versus long term allocations to debt remains at neutral.
The USD INR pair moves to a positive view on the Rupee versus the Dollar. The most meaningful shift is in Gold, where the Gold to Cash model moves to meaningfully underweight in Gold.
The Nifty hit all-time high of 12,158 in late November, but failed to capitalize on the breakout. Markets witnessed profit booking last week as India’s GDP came at six year low and status quo stance by RBI on monetary policy front surprised the markets. Nifty closed the week at 11,922 down by 1.12% for the week. Broader market indices BSE Midcap and Smallcap were down by 2.8% and 1.6% for the week. On the weekly, Nifty has formed bearish engulfing candlestick which is a reversal signal. However, India VIX measure of volatility was down by 1.87% for the week to close at 13.64 level. Thus, if VIX stays below 14.5 levels it may help arrest the correction in the market. Now immediate support of the Nifty is seen at 11,800 levels. Breaking below this next supports are seen at 11,630 and then at 11,490 levels. On the upside Nifty needs to sustain above 12,100 for the uptrend to resume towards 12,350. In Nifty December monthly expiry options, maximum open interest for Put is seen at strike price 12,000 followed by 11,500; while for Call maximum open interest is seen at 12,000 followed by 12,200. Nifty options open interest distribution data is suggesting a range of 11,700-12,200.