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Shifting Perceptions of Risk

Jul 25, 2016

Summary

Perceptions of global risk are shifting. Domestically, valuations on the index are rising. We look at various factors in formulating our investment strategy ahead.

A Shifting Landscape…

Developed markets, by their very definition, are supposed to demonstrate stability, sound governance, transparency and lower risk. Throw that playbook out the window.

Brexit shifted perceptions. We were amongst the first to note that emerging markets like India are a new safe haven in a world filled with turmoil. There is now a growing recognition amongst the institutional investor community that emerging markets are a relatively benign environment compared to the risks inherent in developed markets.

We are seeing fresh evidence of this in domestic bond, equity and currency markets. There is a perceptible shift in thinking about the risks of investing in emerging markets.

Equities

Nifty 50 Valuations are starting to become a cause for concern…

We have been generally okay with high valuations and rightly so, but valuations are getting expensive at the index level.

Starting Valuation Makes a Huge Difference on Nifty Returns…
…A 15 Year Historical Dataset Suggests Negative Returns Ahead for the Nifty 50

Starting Valuation Makes a Huge Difference on Nifty Returns

But P/Es Adjusted for Lower Bond Yields Are Not as Alarming

But P/Es Adjusted for Lower Bond Yields Are Not as Alarming

Our Asset Allocation Model Is In Neutral

Our Asset Allocation Model Is In Neutral

And Unlike 2015, Earnings Growth Is Still In an Uptrend

And Unlike 2015, Earnings Growth Is Still In an Uptrend

Unlike Previous Quarters, this Earnings Season Is Off to a Slow Start

Unlike Previous Quarters, this Earnings Season Is Off to a Slow Start

A Negative Start to the Earnings Season Is a Move Away from Recent Trends…

An interesting analysis came out of a recent discussion with a client. Over the past few quarters, earnings reports have shown a consistent pattern. Earnings start out strong in the first ten days of reporting season, peak around day 20 and then the quality of earnings reports drops dramatically. Stands to reason.

Unfortunately, earnings are off to a disappointing start this quarter. In our opinion, all three majors – Infosys, TCS and Reliance Industries – have delivered lacklustre results.

A Healthy Monsoon So Far & a Benign CPI…

A pickup in monsoon rains is improving the outlook for inflation and interest rates, as the CPI rose slightly to 5.77% in June. The monsoon rains have covered the entire country, and healthy crop sowing levels are being reported across regions in India, amidst a rise in reservoir levels.

More Good News: Exports Have Picked Up…

Reversing 18 months of fall, India’s exports posted a modest growth in June, raising hopes that the worst may be over. Exports in June were $22.5 billion, 1.27% higher than $22.2 billion in the year ago period, while imports declined 7.3% to $30.6 billion.

So Has Industrial Production …

IIP for May-16 was at 1.2% against -1.3% in the prior month. The sequential improvement came from an improvement in consumer non-durables at -2% vs. -11% the previous month. Capital goods remained in the red at -12%. Consumer durables growth continues to be strong at 6%. 14 out of 22 industries reported positive growth.

Seventh Pay Commission Was Approved…

The Union cabinet approved the 7th Pay commission recommendations, including an additional allocation of INR 200 billion towards payouts on the earlier budget.

Government Finances on strong ground

Direct tax collections in the April-June quarter of the current financial year rose 24.8%. The government mopped up 30.8 % in indirect taxes.

More Money Coming to Infrastructure

The government is looking to provide an additional 250 billion for roads, rails and power in the upcoming session of parliament.

GST Bill Passage Looks Hopeful

Post the recent Rajya Sabha and state elections, the ruling coalition appears to have reached the magic number for passage of GST in the upcoming parliament session.

Globally, the Italian Banks & Deutsche Bank Loom as Potential Risks…

Hedge fund managers are comparing Deutsche Bank with Lehman. There is certainly cause for concern as both the Italian banking system and the large European banks pose systemic risk.

But Global Liquidity & Stimulus Are Back…

Central bankers have reacted strongly to Brexit and there is an avalanche of liquidity in global markets since the event. The Bank of Japan and the Bank of England are mulling stimulus packages. Markets are particularly excited about Bernanke’s visit to Japan. The official helicopter money experiment could possibly be about to begin in Japan.

Fixed Income

Good News: Foreign Investors Buy India Bonds

Indian bonds had their best week since March after foreign investors bought into debt. The benchmark 10 Yr yield ended at 7.27%, lowest since June-13. Overseas investors invested $745 Million (INR 50 Bn), the biggest weekly jump since Oct-15.

The Decline in 10 Year Yield Is Great News for the Economy

The Decline in 10 Year Yield Is Great News for the Economy

One-year interest-rate swaps slid to 6.43% during the week, the lowest level since September 2010, as the RBI’s liquidity infusion measures continue to boost interbank liquidity. The improving cash supply and pickup in demand caused the rally in bond yields across the yield curve.

Technical

After a brief pause in the previous week, the Nifty50 continued its uptrend closing at 8541 up by 2.61% for the week.

FIIs have been net buyers in both cash market (Rs.4061cr provisional) and in index future (Rs.4132) during the week. Now July’15 highs of 8654 will be the immediate level for the index. Also 8600 and 8700 strikes have the highest open interest in calls, suggesting index could find resistance in this region. Hence the Nifty is likely to continue its rally towards 8654-8700 zone on the upside where some profit might be expected. In put options, 8400 strike has the highest open interest, which will act as the base for the market. Also technical support is seen around 8350 levels for the Nifty. Hence market has good support zone in the region of 8400-8350 zone, where market can be expected to find support in case of any decline.

Outlook

Valuations are stretched for the index.

Further, from our proprietary models perspective, the rally is looking weak as well on a near term basis.

As we have stated often, we are not optimistic about the market’s prospects on a forward looking basis. On the other hand, investing is not as simple as a P/E number.

So, from our PMS model portfolio perspective, we follow the prudent man principle. Our fundamental premise is to protect portfolios and limit downside volatility, and that drives our philosophy. After a long unabated and profitable rally, the prudent choice is to protect profits. Some additional conclusions can be reasonably put forward:

The Nifty 50 Index is unlikely to deliver impactful returns over the next 12 months

Starting point makes a large impact in returns. With Nifty valuations in the higher echelons, and 3 large companies whiffing this quarter already, we are not fans of the index.

In a continuation of 2015, we expect index and individual stock returns to diverge massively

Many investment managers had great years in 2015. We think H2 2016 and beyond is a challenging time for the Nifty 50. However, we have firm conviction in quality growth stock portfolios managed by active managers that managed for absolute return.

First Quarter FY Earnings will determine the course of the market…

A repeat of 2015 appears unlikely unless earnings disappoint. With the government in the mix, and lots of other positives, we are reasonably comfortable that there is enough happening and earnings will not disappoint enough to warrant a sell off.

The bottom line though appears to be that earnings performance this quarter will drive the future direction of the market.

Stocks That Deliver Will Continue to Be Handsomely Rewarded

The corollary to the above is that stocks that deliver growth will be bought while those that disappoint will be punished.

Focused Vs Diversified Funds

It is an active manager’s market. We are of the opinion that active investment managers focused on absolute returns will outperform funds that aim to track the index.

Focused funds with purchases at reasonable valuations and ideally focused on domestic markets with incremental global growth are our preferred areas.
Quality and Patience remain the key to long term wealth creation

Quality and Patience remain the key to long term wealth creation

Quality growth and patience will ultimately prevail. That above all is the key to wealth creation.

Growth Will Offset Valuation

All things being equal, we would rather be in stocks delivering growth than not. Growth addresses valuation. Growth at a reasonable price is our holy grail.

Asset Allocation

The economy does not appear to be at risk of keeling over. Global liquidity is back in an uptrend. Known risks are being addressed. Domestically, the government is actively investing and moving forward with reforms.

Earnings results will determine our future course of action.

In debt assets, we remain comfortable in accrual funds and select preference shares.

Upcoming Earnings

Upcoming Earnings

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