Indian Market Economic Outlook perspective Mutual Fund Debt Equity Gold Environment

2. Market and Economic outlook –Market and Economic outlook –
April 2013

3. Executive summary-Economy
◌ः While Wholesale Price Inflation (WPI) inflation has
softened to below 7%, Consumer Price Inflation (CPI)
remains in double digits.
◌ः Index of industrial production showed positive growth in
January, but there is no sign of a sustained recovery.January, but there is no sign of a sustained recovery.
◌ः Owing to high CPI and high current account deficit (CAD),
RBI has signaled a pause in rate cuts after the 25 bps cut
in repo rate on March 19.

4. Executive summary-Economy
◌ःHigh CAD has emerged as a major point of
worry for policymakers and market
participants.

5. Executive summary-Politics
◌ःUPA’s strength has been reduced further
after the DMK’s withdrawal. Getting reforms
related legislation passed may become more
difficult.difficult.
◌ःAs the government gets into election mode
later this year, its commitment to fiscal
prudence may take a back seat.

6. Executive summary-international
◌ः As the US economy improves, quantitative easing may be
tapered. Will affect liquidity flows into emerging markets
(EMs) like India.
◌ः As US market becomes more attractive, flows into EMs
may be affected.may be affected.
◌ः The crisis in Cyprus showed that even a crisis of minor
magnitude can snowball. If it leads to a risk-off
environment, that could reverse the FII flows coming into
India.

7. Executive summary-Markets
◌ः The market has stayed range-bound this month. Mid- and
small-cap indexes have fallen more than the Sensex.
◌ः FII inflows in March were less than half compared to
January and February.
◌ः Market is worried about bad economic data, winding down
of QE, political weakness at the Centre, and so on.
◌ः Among positives, commodity prices have softened and
valuations have become more attractive.

8. The Economy

9. CPI inflation: still in double
digits
◌ः Headline CPI inflation for February 2013 moved up to 10.91% (y-o-y) from
10.79% in the previous month.
◌ः The index rose 0.63% month-on-month (m-o-m) in February, which was
the fastest m-o-m increase since October 2012.
◌ः The rise in CPI inflation was the result of return of food inflation. Food◌ः The rise in CPI inflation was the result of return of food inflation. Food
inflation had eased in the last few months due to seasonal factors.
◌ः Under food items, the major contribution came from cereals and protein
products.
◌ः The next big contribution came from transport and communication
followed by housing.

10. CPI will moderate –
with a lag
◌ः According to a note from Morgan Stanley, high CPI is symbolic of the
ills that have afflicted the Indian economy.
◌ः The government’s policies have encouraged consumption without
improving supply.
◌ः Now the government has begun to go down the road of fiscal◌ः Now the government has begun to go down the road of fiscal
consolidation. As the government reduces its fiscal deficit, CPI will
decelerate.
◌ः However, inflationary expectations have become so deeply
entrenched that it will take time for CPI to moderate.
◌ः High CPI will keep short-term rates elevated (prevent rate
cuts), something that the market doesn't like.

11. WPI inflation: lower compared to
CPI
◌ः WPI for February 2013 came in at 6.84%, higher than the
6.62% in January 2013.
◌ः WPI rose despite a favourable base effect.
◌ः WPI rose 0.6% month-on-month (m-o-m).
◌ः Year-on-year primary articles rose 9.7%, fuel and power◌ः Year-on-year primary articles rose 9.7%, fuel and power
10.5%, and manufactured products 4.5%.
◌ः Both primary articles and fuel power rose m-o-m.
◌ः Only manufactured articles declined 0.1% m-o-m.
◌ः All three broad categories within primary articles rose: food
articles (up 0.2% m-o-m), non-food articles (1.6% m-o-m) and
minerals (0.9% m-o-m).

12. IIP: marginal recovery
◌ः The index of industrial production (IIP) posted positive
growth in January after having declined for six out of
10 months in FY13.
◌ः IIP rose 2.4% y-o-y in January 2013 whereas it had◌ः IIP rose 2.4% y-o-y in January 2013 whereas it had
contracted 0.5% in December.
◌ः IIP rose 2.2% m-o-m in January vis-a-vis the 1.1% m-o-m
fall in December.

13. IIP over last 13 months
4.1
8.3
4
6
8
10
IIP (y-o-y) %
1.82
1.1
4.1
-3.5
-0.9
2.4
-1.8
0.1
2.7
-0.4 -0.1
-0.6
2.4
-6
-4
-2
0
2
4
Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13
IIP (y-o-y) %
IIP has seen negative growth in a number of months in the recent past.

14. IIP-component wise
Y-o-Y M-o-M
Overall IIP 2.4 -0.5 2.2 -1.1
Mining -2.9 -3.4 1 2.7
Electricity 6.4 5.3 0.1 2.1
Manufacturing 2.7 -0.7 2.8 -1.6
Use-based
Basic 3.4 1.8 -0.3 1.1Basic 3.4 1.8 -0.3 1.1
Intermediate 2 0.7 1.3 0.8
Capital goods -1.8 -0.6 5.5 2.4
Consumer goods 2.8 -3.6 3.6 -1.9
Durables -0.9 -8.2 1.2 -10.1
Non-durables 5.3 -0.4 5.3 3.6
Some positivity in January due to electricity and manufacturing.
Negative growth in durables points to weakening consumption.

15. IIP data may not improve soon
◌ःDespite some positivity in January
IIP, growth outlook continues to be weak.
◌ःThe improvement in January IIP data may
not sustain.

16. RBI cuts rate, signals a pause
◌ः RBI reduced repo rate by 25 basis points from 7.75% to 7.50%
on March 19. Reverse repo rate now down to 6.50%.
◌ः Cash reserve ratio (CRR) left unchanged at 4%.
◌ः Why did RBI cut the repo rate?
◌ः One, Q3FY13 GDP growth rate came in at decade-low◌ः One, Q3FY13 GDP growth rate came in at decade-low
4.5%, compared to 5.3% in Q2FY13.
◌ः Recovery in GDP growth likely to be gradual.
◌ः WPI inflation has moderated in recent times. Core inflation
is down.
◌ः Government's measures aimed at fiscal consolidation
provided RBI room to go in for a small cut.

17. Will rate cuts continue?
◌ःThe central bank was cautious about future rate
cuts. Why?
◌ःFood inflation remains high. Administered fuel◌ःFood inflation remains high. Administered fuel
prices have been hiked in recent times. Likely to
push inflation upward.
◌ःWide divergence between CPI and WPI. While WPI
has softened, CPI continues to be in double digits.

18. ◌ःCurrent account deficit (CAD) is high. If interest
rates are cut, it would result in more consumption,
leading to higher imports and worsening of CAD.
◌ः
Will rate cuts continue?
◌ःHence RBI indicated there is limited room for
further cuts.
◌ःMost economists expect interest rates to be cut by
another 50 bps in FY14.

19. Will banks reduce lending rates?
◌ःDespite cut in repo rate by the central bank, banks
may not lower their lending rates.
◌ःWith deposit growth slowing down, several banks
have raised their deposit rates in recent times.
◌ः
have raised their deposit rates in recent times.
◌ःWith banks' cost of funds rising, it will be difficult
for them to cut lending rates.
◌ःMany banks in difficulties due to high NPLs. Hence,
can’t afford to lower rates.

20. High CAD poses a risk
Oct-Dec
2011
Oct-Dec
2012
%age
change
Current-account deficit -19,954 -32,546 63.11
of which
Merchandise trade
balance -48,704 -59,604 22.38
Invisibles 28,750 27,059 -5.88Invisibles 28,750 27,059 -5.88
of which
Software services 15,806 15,901 0.60
Private Remittances 16,208 15,670 -3.32
Capital account deficit 7,680 31,761 313.55
of which
FDI 4,963 2,526 -49.10
Equity inflows 1,898 8,781 362.64
Loans 1,602 10,630 563.55
Other capital 4,703 4,544 -3.38

21. High CAD poses a risk
◌ः The current account deficit for the December 2012
quarter came in at a very high 6.7% of GDP.
◌ः This happened because merchandise trade balance
(imports less export) has grown by 22.38% y-o-y.
◌ः On the other hand, invisibles (combination of software◌ः On the other hand, invisibles (combination of software
earnings and private remittances) declined 5.88% year-
on-year.
◌ः Of the two components of invisibles, software services
rose 0.60 per cent but private remittances declined -
3.32 per cent.

22. High CAD poses a risk
◌ः Next, let us look at the capital account.
◌ः FDI, which represents stable inflows, is down -49.10% y-o-y.
◌ः Equity inflows, which are unstable, have grown 362.64%.
◌ः Even external loans have grown rapidly by 563.55% y-o-y.
◌ः Thus, India's current account deficit is being fuelled by hot money◌ः Thus, India's current account deficit is being fuelled by hot money
inflows.
◌ः If at any time these flows decline (say, due to the normalisation of
monetary policy in the West or due to the creation of a risk-off
environment), financing the CAD will become difficult.
◌ः The rupee could see another bout of rapid depreciation.

23. Worst of CAD probably behind us
◌ःAccording to a note from Morgan
Stanley, however, the worst of CAD is
probably behind us.
◌ःThe trade deficit should improve from the◌ःThe trade deficit should improve from the
next quarter, helped by the government's
fiscal restraint.
◌ःSoft crude prices may also help.

24. UPA strength reduced
post DMK pullout
◌ः The DMK pulled out of the UPA coalition in protest against the
government's position on US-backed UN resolution on war crimes
carried out during Sri Lanka's civil war.
◌ः The DMK had for long been putting pressure on the Indian
government to protect Sri Lanka's minority Tamil population.
◌ः The government survived owing to outside support from the◌ः The government survived owing to outside support from the
Samajwadi Party and the Bahujan Samaj Party.
◌ः The pullout has left financial market participants jittery.
◌ः Getting reforms-related legislation passed will become even more
difficult. Reforms are also expected to take a back seat owing to
state elections followed by the general election next year.

25. The equation in Lok Sabha
post DMK pullout
Who has how many seats in Lok Sabha
Party No. of seats
Congress 203
NCP 9
Rashtriya Lok Dal 5
J&K National Conference 3J&K National Conference 3
IUML, AIUDF, BPF, Kerala Cong. 5
Others 6
UPA 231
Outside Support 49
Samajwadi Party 22
Bahujan Samaj Party 21
Rashtriya Janata Dal 3
Janata Dal (Secular) 3
Total (with outside support) 280
Total no. of Lok Sabha seats 540

26. Will fiscal consolidation continue in
a pre-election year?
◌ः According to Morgan Stanley, history suggests that
government expenditure always rises in a pre-election
year.
◌ः Therefore, the market is sceptical about the
government's ability to achieve the 4.8% fiscal deficitgovernment's ability to achieve the 4.8% fiscal deficit
target for FY14.
◌ः However, according to Morgan Stanley, the worst of the
fiscal deficit and the current account deficit are
probably behind us. The note adds that a falling twin
deficit is good for stocks.

27. International scenario

28. US economy improving
◌ः According to Mohammed A El-Erian, CEO and co-CIO of
PIMCO, the United States' economy is healing, and doing so in
an accelerated fashion.
◌ः Most U.S.-based multinational companies are on a solid footing.
◌ः Smaller firms are gradually recuperating.
◌ः Banks have rebuilt their capital cushions and reduced dubious◌ः Banks have rebuilt their capital cushions and reduced dubious
assets.
◌ः More and more households are re-establishing healthier balance
sheets, especially as employment picks up.
◌ः The US budget deficit is on a downward trend, helped along by
higher revenues and lower pressure on spending (payments to
jobless have fallen).

29. Will QE continue?
◌ः Members of the US Federal Open Market Committee
(FOMC) have begun to debate the wisdom of continuing
with the QE program.
◌ः Many members favour ending, or at least tapering, the
program.program.
◌ः Currently the US central bank purchases $ 85 billion
worth of bonds from the open market every month.
◌ः Earlier the QE programme was expected to end only
when there was significant improvement in the labour
market. But now there are indications that it may end
earlier.

30. Will QE continue?
◌ः If the central bank continues with the QE program for too
long, it may result in an inflationary spiral that may
become difficult to control. Sharp buildup of inflationary
expectations may occur.
◌ः Excessively loose monetary policy also leads to excessive◌ः Excessively loose monetary policy also leads to excessive
risk taking in financial markets.
◌ः If interest rates begin to rise, the value of bonds held by the
central bank would erode, resulting in capital losses which
could wipe out the paid-up capital of the US Fed.
◌ः In his testimony to the U.S. Congress, Fed Chairman Ben
Bernanke said he's in favour of continuing with QE for the
moment.

31. Will QE continue?
◌ः So an abrupt end to the QE program may not happen. But the
size of QE could be reduced in the near future.
◌ः The US Fed’s policies have forced several other central banks
(BoJ, ECB, etc) to also follow loose monetary policies (to aid
their own economies but also to prevent their currencies from
appreciating). If US Fed winds down QE, others will follow suit.
their own economies but also to prevent their currencies from
appreciating). If US Fed winds down QE, others will follow suit.
◌ः This has implications for India.
◌ः Given its massive current-account deficit, the country has
become excessively dependent on short-term money flows to
bridge its current-account deficit.

32. Growing attractiveness of US
market
◌ः Another risk to the Indian economy arises from the growing
attractiveness of the US market.
◌ः According to a recent article by Akash Prakash, CEO of Amansa
Capital (in Business Standard), emerging markets have
significantly underperformed the S&P 500. In the last two
years, the MSCI emerging markets index is down nearly 10%
significantly underperformed the S&P 500. In the last two
years, the MSCI emerging markets index is down nearly 10%
while the S&P 500 is up 20%.
◌ः As more and more investors believe in the growing
attractiveness of the US markets, at some point inflows into
the Indian markets will be affected.
◌ः The reallocation of assets from the US market to emerging
markets, which we have seen in the past, could reverse.

33. Cyprus: crisis contained
◌ः Cyprus became the fifth country within the Eurozone to negotiate
a bailout.
◌ः In this second deal to bail out Cyprus, a € 10 billion ($ 13 billion)
loan was made to the country. This has reduced the probability of
Cyprus exiting the Eurozone.
◌ः Bank of Cyprus, the largest bank, will be restructured.◌ः Bank of Cyprus, the largest bank, will be restructured.
◌ः Laiki Bank, the second-largest bank, will be wound up.
◌ः These banks got into trouble because they had invested a lot of
their money in Greek bonds.
◌ः Savers with accounts below € 100,000 have been spared.
◌ः Losses will be borne in the following order: shareholders, junior
bondholders, senior bondholders, and finally, uninsured depositors.

34. Repercussions of the deal
◌ः The collapse of Cyprus's oversized banking sector, which along with
tourism was the mainstay of the economy, will cause an economic
slide. It is expected that Cyprus's economy may shrink by 10-15% in
2013 and 5% in 2014.
◌ः Capital controls have been imposed on depositors so that there is
no run on the banking system.no run on the banking system.
◌ः The decision to punish larger depositors means that a lot of money
that is currently deposited in Cyprus will go elsewhere (one third
of Cyprus's deposits are Russian).
◌ः People will also fear depositing money in weaker banks within
peripheral Europe.

35. Repercussions of the deal
◌ः This will make it harder to keep sick banks alive in a
crisis.
◌ः If and when a bank run starts, depositors will head for
the exit earlier and faster.
◌ः What is needed in Europe is a unified banking system
with fiscal backstop. It also needs a joint deposit
insurance scheme. Only this will break the link between
weak banks and weak governments. But Europe is
lagging behind in these matters.

36. Repercussions of the deal
◌ः From the creditors' viewpoint, the era of all-encompassing
bailouts is coming to an end.
◌ः Hereafter private investors will have to bear losses instead of
being bailed out by euro zone taxpayers.
◌ः◌ः The Finns, Dutch and Germans don't want greater pooling of
liabilities. They want the troubled Mediterranean countries to
adopt reform measures and come out of trouble.
◌ः However, Northern countries need to design bailout packages in
such a way that they do not impose unnecessary hardships.
They must also delay adopting austerity measures at home at a
time when other Eurozone economies are still recovering.

37. Impact on India
◌ः The big risk that India faces is that any flaring up of risk
in Europe could create a risk-off environment that may
lead to lower FII inflows, or even cause outflows from
India.
◌ः This would make it difficult for India to fund its CAD
and lead to another bout of rupee depreciation.
◌ः The Indian equity markets, which are very FII-
dependent, would also decline.

38. The Market

39. Market outlook
Asset Class Current
Levels( as of Feb
28, 2013)
Summary View Why Risk to our View
Equity Nifty: 5,647.75 Markets will be
under pressure,
Bad economic
data; government
If RBI cuts rates
aggressively or
Sensex: 18,835.77
under pressure,
especially mid- and
small-cap stocks
data; government
weakened; US
market becoming
attractive. Absence
of positive triggers.
aggressively or
Q4FY13 results
show considerable
improvement.

40. Index Watch
Index
1-month
return (%)
YTD
return(%)
Sensex -0.14 -3.8
BSE Mid-Cap -2.55 -14.66
BSE Small-Cap -6.47 -22.12
BSE Auto -4.44 -13.28
BSE Capital Goods -1.82 -17.97BSE Capital Goods -1.82 -17.97
BSE Consumer
Durables -1.08 -8.98
BSE FMCG Sector 4.41 -0.45
BSE Healthcare 2.53 -1.94
BSE IT 1.94 21.1
BSE Metal -3.41 -22.54
BSE Oil -3.72 -2.44
BSE Power Index -5.59 -18.05
BSE PSU -5.56 -12.54
BSE Tech 0.1 13.44
Figures as on March 28, 2013

41. FII inflows fall, MF outflow
continues
Month FII investment
MF
invest
ment
January 22,230 -865
February 22,122 -1,496
March* 10,399 -1,767March* 10,399 -1,767
*Upto March 26; all figures in Rs
crore
• FII inflows in March were less than half the
level in January and February.
• Mutual funds continued to be net sellers even
in March.

42. High dependence on FII inflows
◌ः The Indian economy has become very dependent on foreign
inflows to fund its current account deficit.
◌ः If FII inflows ebb, either due to QE ending or the creation of
a risk-off environment due to the European situation flaring
up again, the rupee could once again depreciate sharply.up again, the rupee could once again depreciate sharply.
◌ः With the rupee declining, the possibility of FIIs making a
profit declines further. This would create a vicious cycle,
leading to more pull-outs.
◌ः The high dependence of Indian markets on FII money would
lead to the decline of equity markets.

43. High dependence on FII inflows
◌ः This year India has already received about $ 10 billion
of inflows, yet the Indian equity market is among the
worst performers in Asia year to date.
◌ः Since January 2012, India has received over $ 35 billion
of FII inflows.of FII inflows.
◌ः It has received a disproportionate share of the flows
coming into Asia.
◌ः If these flows stop or reverse, it would have a very
negative impact on the Indian market.

44. Why are market participants
worried?
◌ः Pessimism has once again increased within the market.
◌ः Both the mid- and small-cap index are down quite a bit year-to-date.
Reasons:
◌ः Slew of bad data: GDP, CAD, CPI have all got market participants
worried.
◌ः
worried.
◌ः Political worries: Will reforms continue with the government
weakened after DMK’s pullout? Will fiscal consolidation continue in a
pre-election year?
◌ः Will QE continue?
◌ः Will FII inflows continue?

45. A few positives
◌ः Among the positives, valuations have become attractive. Valuations are
approaching buy territory, as in the summer of 2012.
◌ः Commodity prices are not rising.
◌ः India’s growth cycle is at an inflection point.
◌ः Bad data seems to have touched its nadir, including the investment rate and◌ः Bad data seems to have touched its nadir, including the investment rate and
exports, according to Morgan Stanley.
◌ः According to Morgan Stanley, the earnings cycle appears to be turning. Broad
market earnings have reached a trough and may move up now, albeit
gradually.
◌ः So far the level of global liquidity remains high. This is favourable for Indian
stocks.
◌ः Bad sentiment is a good contra-indicator for stock returns.

46. Thank you