index EQUITY MARKET OUTLOOK : THE YEAR OF REFORMS 2018: THE YEAR AHEAD; FOCUS ON FUNDAMENTALS AND CORPORATE EARNINGS

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1 OUTLOOK 2018

2 index FOREWORD EQUITY MARKET OUTLOOK : THE YEAR OF REFORMS 2018: THE YEAR AHEAD; FOCUS ON FUNDAMENTALS AND CORPORATE EARNINGS GDP GROWTH OUTLOOK: GRADUAL RECOVERY KEEPING MACRO STABILITY IN CHECK MONETARY POLICY OUTLOOK: POLICY RATES LIKELY TO REMAIN ON HOLD; INFLATION DATA HOLDS THE KEY CURRENCY OUTLOOK: MILD DEPRECIATION IN `/$ LIKELY; LEVERS EXIST TO CONTROL CURRENCY VOLATILITY OUTLOOK ON CRUDE OIL PRICES SECTOR OUTLOOK ACTIONABLE INTELLIGENCE: EQUITY DEBT MARKET OUTLOOK : THE YEAR OF PING-PONG YIELDS 2018: ON TO CALMER, SMOOTHER TIDES INTEREST RATE OUTLOOK DEBT INVESTMENT STRATEGY ACTIONABLE INTELLIGENCE: DEBT

3 foreword Dear Friends, As we close 2017, we are in an interesting situation. The fiscal deficit is increasing due to lower tax collections. The crude oil price is on the rise. Domestic interest rates have moved up more than 100 basis points without any uptick in Policy rates. IPOs supply is at all time high. And yet, our equity markets keep testing new highs will be a year of consolidation. We are unlikely to see disruptive reform like demonetisation or GST in the run up to election. These will allow economy to benefit from the past reforms. The economy will continue to face the hurdle of over valued Rupee till fundamentals prevail over flows and high real interest rates till transmission of lower rates is achieved. Volatility will be order of the day for bulk of CY Headwinds are building up in the form of higher crude oil prices, lower GST collections, fiscal slippage, high real interest rates and deteriorating current account deficit. Market towards 4 Q CY 18 will also witness uncertainties related to 2019 general election. Valuations which are priced for perfection are getting supported by domestic flows on the hopes of earnings recovery. The low base effect of Dec 16 and March 17 quarterly results can push earnings growth to double digit for Dec 17 and March 18 quarter. However by than momentum should pick up to push earnings growth to double digit without base effect. It will be fair for Investor to moderate return expectations in CY 2018 and be ready for volatility. It is also likely that stock picking will deliver return rather than broad sector call. One big theme which is worth relying not only in next year,but in years to come, is disruptor versus disrupted. We are seeing technology and other forces creating disruption in business environment and sooner than later, it will start getting reflected into markets as well. In every single company, in every single sector, you will have to ensure that you are on the side of disruptor rather than disrupted. Not that every single disruptor company will be able to give you return. But if you are on the side where bulk of the companies are disruptor, your chances of outperforming market increases significantly. So the big theme for 2018 and onwards will be disruptor versus disrupted. In manufacturing, 3D printing and artificial intelligence is disrupting traditional models of manufacturing. In services, robotics is disrupting human way of providing services. So there is no sector which is outside the influence of technological and other forces of disruption. One will have to be very careful in evaluating future business prospect as many disrupted companies will get extinct like Dinosaur. when we are paying 20 times forward earning, clearly, we are taking into account next 20 years cash flow and a terminal value. And, if disruption is not going to be absorbed by the company, then they may not remain in existence over that period of time. So it is not sector specific, company specific, it is across the economy. You need to have companies in your portfolio which are cognisant to disruptions. You want companies in your portfolio which are taking appropriate steps to ride on the wave of disruption, rather than remaining subdued and getting disrupted. From mutual fund industry standpoint, we have our tasks cut out for next year. We have to manage investor expectations. While a majority of investors are coming reasonably well informed about the Volatility of returns and need for long term investment horizon, a minority indeed is coming looking at the past performance. We have to caution them about potential lower nominal returns since equity markets are little above fair value valuations. Many investors tend to view mutual funds as equity funds, and we need to market debt funds as well as we have done for equity funds, especially for retail investors. This will be a challenge especially when last 12 months savings account has given more return than a bond fund. We need to stress on the need for asset allocation and longer-term investment horizon. We need to reinforce the message of regular investments, especially to investors in semi-urban and rural areas so that they can share the benefits of equity returns. We have to expand the distribution network by enrolling new distributors. The gap between the number of insurance agents and mutual fund distributors needs to narrow down substantially for the funds industry to sustain its reach. There is a need to develop models for small-ticket investors, and empower smaller distributors through technology for better analytical skills. We must drive home the fact that mutual funds remain a low-cost, value-for-money product for the common man. The foundation has been laid for rapid growth in the years to come. But we need to keep on evolving to add value to our customers. Wishing you all a Very Happy and Prosperous 2018! Nilesh Shah 1

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5 2017: the year of reforms INTRODUCTION In the seventh decade of India s independence, India stands on the cusp of a major economic revolution coupled with strong demographic dividend which could lead to unprecedented growth in future. A greater access to the internet and mobile connectivity along with an improving physical infrastructure, India s Gross Domestic Product (GDP) has witnessed a massive 10x growth in the last 25 years. As India sets it eyes on to become the second largest economy by 2050, the year of 2017 will mark itself as the year of reforms which acted as a strong foundation for years to come can clearly be termed as the year of reforms. Reform measures such as GST (Goods and Services Tax), the Insolvency and Bankruptcy Code (IBC) and the flagship schemes like Direct Benefit Transfer (DBT) were some of the major initiatives of the year started with the economy grappling with the after effects of demonetization. This was followed by the implementation of GST, which is by far the biggest tax reform that the country has seen. While there has been some temporary disruption in activity on account of GST, we do believe that supportive global growth, strong consumption demand (including revival in rural demand) and improving corporate profitability would spur growth in progressive regulations, have all supported this shift in savings behaviour. We also believe that over time as the GST infrastructure and rates stabilise, better compliance would ensure that there is an improvement in the tax- GDP ratio in our country which would help us move further along the path of fiscal consolidation. In line with the shift of savings towards financial assets, the markets have received tremendous support from Domestic Institutional Investors (DIIs) who were net investors to the tune of USD 14 Bn in Foreign Institutional Investors (FIIs) too supported the markets with net investment of USD 7.5 Bn into the Indian equity markets (data till Dec 28, 2017). Another big development in 2017 were the steps taken to expedite the banking sector stress resolution. Large corporate Non Performing Loans (NPLs) have been plaguing the banking sector resulting in eroding balance sheet strength. RBI (Reserve Bank of India) has Donald Trump becomes 45th President of USA Goods and Services Tax rolled out decided to refer some of the large corporate delinquent accounts to the NCLT (National Company Law Tribunal) under the Insolvency and Bankruptcy Code in order to find a time bound resolution to the NPLs was also the year of macro stability with most macro indicators remaining largely under control. Even while Real GDP growth was impacted by the effects of Demonetisation as well as GST implementation, other indicators such as CPI inflation, Current Account Deficit and interest rates were largely benign. The stable macro trends along with growing comfort on political stability and the continuation of the reforms agenda has led to a significant run up in the markets in 2017 even while earnings growth remained subdued. Ratings agency Moody s also upgraded India s sovereign rating to Baa2 from Baa3 (the last rating upgrade by Moody s was in Jan 2004). The pace of reform initiatives in the country continues to remain strong and the Moody s sovereign ratings upgrade is a recognition of the same. The large cap Nifty Index rose 28.73% and the Nifty Free Float Midcap 100 rose 47.26% in Direct Benefit Transfer for fertiliser subsidies FEB AUGUST NOVEMBER GST implementation has resulted in two large structural thematic shifts in India which are still playing out: (a) shift from the unorganized to the organized space and (b) a shift in savings from physical to financial assets. Favourable demographics combined with macro stability and initiatives to educate investors, as well as JAN JULY OCTOBER Union Budget RBI cuts Repo rates by 25 bps Insolvency and Bankruptcy Code Ordinance 2017 passed, Announcement of Bank Recapitalisation, Moody's upgraded India's ratings after 14 years 3

6 2018: the year ahead; focus on fundamentals and corporate earnings 2018: back to basics; focus on fundamentals As we enter the New Year 2018, as is customary, we spend some time looking back at the year gone by and also attempt to gaze into the crystal ball to understand what 2018 has in store for us. The theme this 2018 is back to basics with a focus on fundamentals and disciplined investing. In this regard the quote from Benjamin Graham seems very apt. One of the key concerns in 2017 was that the upmove in the markets has not been supported by strong earnings growth. While earnings growth has been muted for the last few years, we now think that the trend is about to reverse and corporate earnings are set for a recovery and such a recovery would be one of the main pre-conditions to the market sustaining current valuations. This earnings recovery would in our opinion be led by the macro polices and reforms agenda, a boost to infrastructure spending, export growth supported by global growth revival, a robust consumer demand (including improvement in rural demand) and a nascent recovery in private capex. When we talk of earnings recovery, a recovery in overall capital formation cycle would be a key factor apart from growth in consumption. While the key driver for capex in the economy would continue to be public spend, the private capex cycle should also benefit from three years of low average lending rates, better corporate profitability, easier availability of credit from the banking system, higher equity raising from a buoyant market, more FDI into manufacturing and infrastructure and a renewed focus on housing. Public capex growth is likely to remain healthy with a focus on roads, rural development and affordable housing. Apart from the factors mentioned above, the pace of resolution of NPLs and the repair of the balance sheets of corporate private sector banks and PSU banks would play a role in the revival of private sector investments in India. In this regard, the plan to infuse Rs 2.11 Trillion of capital into Public sector banks through a mix of recapitalisation bonds, capital infusion as planned in the budget and fresh raise from the market, stands in good stead. Over time as the resolution of big ticket NPLs gather pace, the cycle of low capital and low growth could be broken, resulting in a pick-up in credit growth. While 2017 was the year of reforms, in 2018 the focus of the Government will be on consolidation and building on reforms like GST, bank recapitalization plan, bankruptcy and insolvency process and nurturing the economy back into a higher growth path in a preelection year. In this context we would also await the recommendation of the Committee on Direct tax reforms with the focus on improving tax buoyancy and compliance. The later part of 2018, will see many states coming up for elections (8 state elections are slated to be held). In our base case, we build in a fairly stable political scenario leading up to the General Elections in Against this backdrop we expect the Nifty to report ~15% earnings growth in FY19E. With improving corporate earnings, we too would continue to follow our investment philosophy of Successful investing professionals are disciplined and consistent and they think a great deal about what they do and how they do it. - Benjamin Graham Growth at a Reasonable Price (GARP) with an aim of investing in companies which have the potential to report earnings growth higher than the market, a strong balance sheet position and stable management. We would continue to urge investors to invest through mutual funds in a systematic manner for the medium to long term keeping in mind individual risk profile and return expectations. KEY RISKS Sharp and sustained rise in oil prices is a key risk to the near term growth story for India Supply of paper: An acceleration in the supply of paper in a bunched up manner could impact market performance Long bond yields are unlikely to retrace to lower levels in a hurry and therefore any sharp and sustained spike in bond yields could impact the cost of capital. Any political instability as a result of the heavy election calendar of

7 gdp growth outlook: gradual recovery keeping macro stability in check We expect real GVA (Gross Value Added) growth in FY18e to be ~6.5% before improving gradually to ~7% in FY19E as many of the GST and demonetisation related disruptions normalize out. GDP Gross domestic product We expect consumption, both urban and rural, to be the main drivers even as gross fixed capital formation is driven largely by public spend. Q2FY Q2FY Q2FY Q2FY Q2FY High frequency indicators as well as some of the indicators of rural demand are pointing to signs of recovery. Two-wheeler sales, tractor sales, diesel demand, rural wage growth, demand for consumer non-durables and usage of cash all point towards an improving rural economy. The monsoons in 2018 would however remain the key monitorable factor for a sustained improvement in rural demand. Source: Bloomberg Table 1 : GDP growth outlook (%, GVA) Real GVA FY16 FY17 FY18E FY19E Agriculture & Allied The lagging investment cycle has been a cause of concern as private sector capex remains muted. In this regard, the steps taken so far for the resolution of banking system stress would aid in cleaning up bank balance sheets over the next months and could help in the revival of investment activity through better availability of funds, albeit at a slow pace. Industry Services Real GVA Source : CSO; Kotak Estimates

8 monetary policy outlook: policy rates likely to remain on hold; inflation data holds the key The key focus for RBI s monetary policy is to keep inflation under check and to ensure that CPI (Consumer Price Index) inflation remains close to the medium term target of ~4%. It is likely that inflation stays elevated in H2FY18 on the back of hardening food prices and the pass through impact of the HRA (House Rent Allowance) hike post the implementation of the recommendations of the 7th Pay Commission. We expect CPI inflation to average ~4% in FY18E (March end inflation likely to be ~5%) and between 4.7-5% in FY19E % 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% CPI Core CPI 4.9% 4.88% Given this backdrop, we expect that policy rates would be kept on hold for the medium term as the central bank (RBI) would monitor domestic CPI inflation, trends in fiscal deficit and the outcome of the policy actions by the US Federal Reserve. Sep-12 Source: MOSPI Sep-13 Sep-14 Sep-15 Sep-16 Sep-17 In terms of liquidity, the stance of the MPC (Monetary Policy Committee) remains neutral. The excess liquidity in the system which had peaked post demonetisation, has been coming off with increase in currency in circulation. The expectation is that liquidity would remain marginally in surplus in FY18 while moving closer to neutral levels by Q1FY19. RBI would however continue to manage liquidity through the Liquidity Adjustment Facility (LAF) and would also use open market operations (OMOs) if the need arises. YEAR FII Equity + Debt (` in Cr.) 2,56,669 65,277 DII Equity (` in Cr.) 29,780 66, ,514 37, ,96,040 91,353 Source: Bloomberg 6

9 currency outlook: mild depreciation in `/$ likely; levers exist to control currency volatility The central theme for CY17 has been a relatively broadbased global recovery after having experienced global disinflation shocks in With growth staging some degree of a comeback, we should see some near term USD dollar strength in H1CY18 amid a relatively more active Fed than the rest of G4 central banks and on tax reforms progress. We estimate FY18E CAD (Current Account Deficit)/ GDP to be at 1.8% and ~1.9-2% in FY19E (from 0.7% of GDP in FY17). However, despite the widening of the CAD, it is likely that the overall BoP in FY18E would continue to remain in surplus on the back of capital flows. We however do factor in some slowdown in flows in the latter part of FY18 as real interest differentials reduce putting some pressure on debt flows. factor in some weakness in the INR. The direction of the INR movement would continue to be USD determined which in turn would be a function of GDP growth, inflation and policy rate movement and the balance sheet tightening undertaken by the US Fed. The pace of the narrowing of the real interest rate differential would also have an important bearing on the movement of the currency. forex reserves in India now stand in excess of USD 400Bn which could be used to counter any sharp currency movement. This together with strong policy headwinds and a vigilant RBI would likely ensure low INR volatility. Emerging markets cross currency chart; % change YoY against USD 15.0 We expect the INR/USD to move in the range of 63 to for the rest of FY18 and also build in a mild 2-3% depreciation for FY19E. INR/USD has appreciated ~6% 5.0 (Dec 19, 2017, YoY basis). However, this has been in line with the strength seen in most of the emerging - market currencies against the USD. From here on we (5.0) (10.0) Korea Malaysia Thailand Mexico Taiwan S.Africa Singapore India China Indonsia Brazil Philippines Turkey Source: Bloomberg; Change w.r.t. to Dec 19,

10 outlook on crude oil prices We expect oil price to be range bound between USD55-65/bbl and average at ~USD60/bbl for FY19. Oil demand growth is expected to be steady at ~1.5mn bpd with steady oil price. Brent crude Increase in oil prices from the lows and higher than USD50-55/bbl will result in increase in shale oil production from US which will put a cap on the upside for oil price. The extension of production cuts of 1.8mn bpd by OPEC and few other large non-opec producers like Russia up to end of 2018 will be downside support to the prices. Risk on the upside if there is deterioration of geo-political situation in Middle East particularly that in Saudi Arabia, Iran and Iraq which will increase the risk premium on oil price. Dec Source: Bloomberg Dec Dec Dec Dec

11 sector outlook BANKING AND FINANCIAL SERVICES BFSI has emerged as a large sector in the Indian context with many subsets. Within this space, we are structurally positive on retail private sector banks. The key theme supporting our view is the shift in market share in loans and deposits towards these banks. This structural change in the banking system could continue over the next few years aiding superior profitability which would help support valuations. With some signs of resolution of large ticket corporate NPLs, the corporate private sector lenders would likely benefit as credit costs moderates and growth in corporate lending resumes. However, while the initiation of the resolution process through the bankruptcy code is a key positive, the pace of such resolution could remain muted resulting in elevated credit costs in the near term for these banks even as incremental slippages reduce. product segments, exposure to rural segments wherein in demand is showing signs of revival and a diversified borrowing profile. We anticipate a structural shift towards financial savings which started as a consequence of the demonetisation drive to continue. BANK Given this background, Life insurance companies could see improvement in new business premium growth. Life insurance companies which have better distribution franchises and strong banc-assurance tie ups would benefit. With structural improvement in persistency together with higher growth, New Business Premium (NBP) margins are also likely to improve resulting in better profitability. General Insurance companies are also in a sweet spot currently with better pricing trends and improving underwriting profitability. ` We would prefer better capitalised corporate lenders/ larger PSU banks which also have a robust retail liability franchise. NBFCs have had a good run in CY17 as they benefitted from lower cost of borrowings and higher growth. Incrementally as we see liquidity in the system moving from excess to neutral, it is likely that the cost of funds for these entities would rise. Hence, one would need to focus on those NBFCs which have pricing power in their 9

12 sector outlook FMCG FMCG sector is likely to see the recovery in the first half of calendar 2018 with rural growth showing some early signs of recovery off late. A low base courtesy the demonetisation and GST impact will also ensure an optically higher growth for the first half. Discretionary spends are likely to see continued uptrends premiumisation is likely to take a faster route to growth. GST implementation will also help in the organised players gaining some share from the unorganised segment as the price differential between their offerings reduces. The higher pay-outs from the government on account of the increased allowances will also keep the service class having surplus money to spend. We also expect large scale benefits for the poor towards the later part of the year as the general election nears. Thus the FMCG sector is poised for a good INFRASTRUCTURE Infrastructure built-out is clearly amongst the top priority of the Government, both Centre and State, as reflected in heightened approval/order in Roads, Railways, Urban Infrastructure, Airports, Housing, etc. Recently, Cabinet approved ambitious Bharat Mala project, enhancing NHDP programme. Certain large ticket size infrastructure projects like Navi Mumbai Airport, Mumbai Trans Harbour Link (MTHL) have also been awarded. On the Urban Infrastructure front, there is a meaningful activity on Metro projects in all major towns with Mumbai taking lead in project award and construction. Recently, Hyderabad Metro was inaugurated by PMO. Other long term projects like DFC, NamameGange, DMIC (Delhi- Mumbai Industrial Corridor), River inter-linking, and expansion of regional airport infrastructure would offer sizable growth opportunity to players in the space. We would prefer to play construction theme vs asset owners given better business profile, low capital intensity, better asset turn and relatively lower risk profile. 10

13 sector outlook AUTOMOBILES We remain positive on the automobile sector over the medium to long term as the sector growth has a direct correlation with the economy growth outlook. In contrast to last year, where urban growth led to the sector revival, we expect rural growth to take the front seat this time around. Two normal monsoons, slight inch up in minimum support prices, higher spends on rural areas by government are all likely to result in better growth in rural India. We expect the tractor industry to see good growth continuing into 2018 as well as rural focused utility vehicles to see an uptick. We also expect the industry to see increased focus towards electric vehicles and that will also keep up the excitement/nervousness in the sector high. Passenger vehicles segment should see a continued growth in the compact sports utility segment as well as more offerings in the mid segment sedan market. CEMENT We remain positive on the prospects of the cement industry from a medium to long term perspective. Cement demand which has been languishing between 4-5% CAGR range in last four years will likely improve to 7-8% CAGR over the next three years. This will be largely led by increased thrust of government on infrastructure spend. While urban real estate market continues to remain sluggish, demand from affordable housing projects and Housing for All scheme in urban/rural areas will result in strong cement demand traction. Cement industry utilizations have bottomed out in FY17 and we expect a structural shift upwards led by declining pace of capacity additions coupled with demand pick up. Pricing power is also likely to return for the industry as incremental demand will be higher than incremental supply from FY18E onwards and consolidation due to increased M&A deals in industry. This in our view could lead to a structural improvement in margins for the industry was a challenging year due to increase in power and fuel prices which the industry has managed to pass on through strong pricing. Going forward volume driven pricing growth will be the key variable to watch out. cement 66.77% Utilisation Demand (mnt) Source: IIFL Estimates 67.58% Utilisation Demand (mnt) 64.97% Utilisation Demand (mnt) 64.75% Utilisation Demand (mnt) 66.00% Utilisation Demand (mnt) Effective Effective Effective Effective Effective Capacity Capacity Capacity Capacity Capacity 11

14 sector outlook PHARMACEUTICALS CY17 has been challenging for the Pharma sector due to continued pricing pressure in US as well as muted growth in India. Pricing pressure due to increased competition and buyer consolidation and negative action by USFDA has impacted growth and profitability of Indian players in US. Growth in the Indian market has been impacted due to inventory destocking because of GST implementation. We expect that CY18 would see very gradual improvement for Indian players in the US market as key facilities are expected to come out of warning letters and improvement in ANDA (Abbreviated New Drugs Applications) approvals due to implementation of GDUFA (Generic Drug User Fee Amendment) timelines. Growth rate in Indian market is expected to reach earlier levels of about 12-13% for CY18. We expect players with USFDA compliant facilities and large number of pending ANDAs to do better than peers. We expect that players with higher exposure to India compared to peers would be better placed. OIL & GAS We expect oil price to be range bound in USD55-65/ bbl and average at ~USD60/bbl for FY19. Oil demand growth is expected to be steady at ~1.5 mn bpd which is also positive for the refining sector. Capacity addition will keep pace with demand growth, which will help refining margins to sustain at current levels in next 6-12 months while on medium term horizon of 1-2 years, margins can further strengthen due to lack of any major capacity additions. Gas sector is likely to see some stronger push from regulatory side particularly on inclusion on natural gas under GST, pipeline tariffs revision and award and revised framework for new city gas distribution circles as the Govt. is looking to further increase the share of natural gas in India s energy mix. While domestic natural gas prices have bottomed out and are likely to increase further (based on formula using combination of international gas prices), it will still remain far cheaper than alternate fuels. LNG prices showed surprising strength in 2H2017 after weak 1H2017 but going forward we expect LNG prices to move lower due to LNG liquefaction capacity starts in US and Australia for next 2-3 years. We continue to remain positive on OMCs as we expect refining business to have healthy margins and there is scope for further re-rating with marketing freedom staying and strong domestic demand growth continuing. If petroleum sector is brought under GST it will be further positive but in our view chances of that happening in 2018 are very remote. We are also positive on gas utilities as domestic demand will be stronger due to lower gas prices, higher gas availability from regasification capacity additions and also domestic production growth and Govt. policies favouring gas usage. 12

15 sector outlook METALS We find risk reward unfavourable in this sector, particularly in ferrous sector, as the profitability of companies is largely dependent on the policies and economic situation in China which at times become unpredictable. While there is support to domestic steel prices due to safeguard and anti-dumping duties, the underlying demand growth is weak at 4-5% and hence, fortunes of steel cos. will hinge on external factors such as market conditions in China. Capacity cuts in China for winter have supported the prices but restarts of these capacities post winter can normalize the prices again. Non-ferrous sector is relatively better placed due to constraints on supply. Aluminium prices will have cost support due to higher alumina and energy prices and proposed capacity cuts in China if effected will give further strength to the prices from current level of USD 2000/t which can sustain longer. Zinc prices had a sharp run in the past 1.5 years due to mine closures and that may now remain steady at the current high levels of ~USD 3000/t. TECHNOLOGY The technology sector has witnessed single digit USD revenue growth in 2017 which has in turn resulted in muted earnings growth for these companies. The sector has been facing headwinds which are both cyclical and structural in nature. Looking into 2018, from a cyclical demand perspective especially in North America (which is one of the largest geographies for Indian IT firms), it is likely that demand would start showing some signs of pick up. Herein, BFSI as a vertical holds the key. Structurally the sector faces challenges as the nature of IT services shifts from traditional application development and maintenance work to more digital, cloud, analytics and consulting led projects. In this respect, IT firms are seeking to reinvent themselves and acquire new capabilities even as growth in the traditional areas slows down dragging down overall growth. Automation is also the name of the game given pricing pressure. IT firms so far have done a fairly commendable job of maintaining margins through various cost control measures even as revenue growth stays muted. In this scenario, we acknowledge that valuations in the sector are attractive and most of the companies generate significant cash flows and earn high ROEs. However, given that growth revival would take place only at a slow and steady pace, our focus would be on companies which have a higher proportion of revenues coming from new age digital projects and have been able to carve a niche out for themselves. 13

16 actionable intelligence: equity key theme remarks Large Cap play on buying sectoral leaders that benefit from improving investment climate Kotak 50 Diversified/Multicap focus on sectors that are likely to benefit the most across market cap Kotak Select Focus /Kotak Opportunities Fund Infrastructure revival True-to-label fund recent thrust of government to revive the infrastructure theme Kotak Infrastructure & Economic Reforms Fund Through SIP in Midcap oriented scheme Kotak Emerging Equities Fund ELSS Equity allocation with ability to reduce tax outgo Kotak Tax Saver Fund Balanced benefit from debt and equity allocation Kotak Balanced Fund we recommend investors to invest through sip/stp with a 5 years horizon 14

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18 2017: the year of ping-pong yields Year 2017 was a roller coaster ride for the fixed income markets. The 10-yr benchmark sovereign yield moved from 6.40% levels at the start of the year to 7.39% levels by the year end, i.e. a rise of almost 100 bps (i.e. 1%). The policy changes and the resultant market interpretations too were quite mystifying through the year. The RBI Monetary Policy Committee (MPC) at its February 2017 meeting decided to hold the rates and changed its stance from accommodative to neutral. The MPC reasoned that the banks were flush with liquidity post demonetization and the committee was focussed on maintaining inflation within the targeted range. There was a sudden reversal in the yields post-april With month-on-month CPI numbers slowing down and reaching a 5-year low of 1.54% in June 2017, markets built up an expectation of rate cut in the June and Aug 2017 RBI meetings. This led to almost 50bps (0.50%) downward movement (read rally) in bond yields. 10 year gilt (in %) This rally did not sustain long as RBI MPC s commentary continued to be perceived as hawkish in both the meetings even with the announcement of 25bps rate cut in August This, coupled with RBI s unabated bonds sales under Open Market Operations (OMO) caused a major sell-off in the bond yields, Sep 2017 onwards. In FY18, till date, RBI has already sold bonds worth Rs. 90,000 crores through OMO. The MPC s decision dashed the market expectations of a rate cut and instead, triggered a sharp selloff across the yields spectrum. Dec Dec Dec Dec Source: Bloomberg 16

19 2017: the year of ping-pong yields Despite positive events like India s credit rating upgrade from Moody s, positive outlook from S&P and cancellation of RBI s OMO sale, the sell-off in bond yields continued. RBI s hawkish commentary and rising inflation numbers (CPI 4.88% in November 2017); the US Fed s December rate hike and a guidance of three more hikes in 2018; hardening crude prices; expectations of fiscal slippage all these factors eclipsed the positive developments and continued to cause a sell-off. Amid all this gloom, the silver lining was Foreign Institutional investors (FIIs) who poured in a record INR 1.36 trillion in fixed income which is higher than the cumulative flows from CY ! Indian economy has undergone large-scale structural changes in 2017; these changes will reap benefits in the long run. But in the interim, these changes have caused jitters and, to an extent, over-reaction in the Indian bond markets. We believe India s macro-economic story is evolving and with most of the pessimism already discounted by the bond markets. FED rate Federal funds rate we do not expect to see any grave or adverse impact on the bond yields in Dec Dec Dec Dec Dec Source: Bloomberg 17

20 2018: on to calmer, smoother tides A much-awaited credit rating upgrade from Moody s and positive commentary from S&P s were welcome steps and are expected to have positive structural impact on key factors including interest rates, in the coming year. A positive impact is already being seen in the form of a stable and appreciating INR. This rating upgrade will likely take away good amount of uncertainty risk premium from interest rates (in differential terms) and INR over a period of time. The larger concerns for debt markets in 2018 continues to be fiscal deficit and rising CPI. Key drivers of interest rates: A. FISCAL DEFICIT B. GDP AND GROWTH C. BANKING LIQUIDITY At the beginning of this year, the government had announced its focus on fiscal consolidation and given a target of 3.2% fiscal deficit in FY18, with a glide path of 3%. But in October 2017 itself, government spending reached 96% of its fiscal deficit target (vis-à-vis 80%, same time last year). This was partly due to shortfall in expected GST revenue. However, the government recently announced that spending for FY18 would exceed the budgeted expenditure by Rs. 73,000 crores. This is likely to cause the fiscal deficit for FY18 to slip to 3.5% (±0.2%), with an expectation of 3.2% (±0.2%) fiscal deficit target in FY19. Also, GST implementation is a structurally positive step which is likely to reap benefits as we progress into Achieving the desired efficiency through GST may well set India on the path to becoming a mature economy, in the long run. The market views on the pace of economy / earnings recovery continue to remain diverse. Although there is a general acceptance of the various structural reforms undertaken by the government (i.e. bank recap bonds, GST, etc.), market conviction in growth and capital expenditure continue to be low. The recent uptick in inflation, instead of being driven by growth in demand / consumption, was driven by rising food and fuel prices. RBI has already lowered the GDP growth target for FY18 from 7.3% to 6.7% - which still seems a tad ambitious. Although GDP growth improved from 5.7% in the June 2017 quarter to 6.3% in September 2017 quarter, it would need to see a sharp jump in Q3 & Q4 for it to be at 6.7% for the whole year. Such a sharp jump seems difficult. The banking system is likely to remain neutral to positive on liquidity. Despite that, the repo window will continue to be operational as it goes with RBI s monetary policy stance. We expect the repo rate to remain at 6%. 18

21 2018: on to calmer, smoother tides E. INFLATION D. GLOBAL IMPACT On the global front, the FOMC and ECB have started normalising their policy by hiking rates and unwinding their balance sheets gradually. The economic impact of their actions will be seen over the course of With developed economies lacking inflation, the next year may see moderate growth rather than acceleration. A look at the current yield curve of US Treasury bonds shows a flattening yield curve (5-yr US treasury 2.25% and 10- yr US treasury 2.5%). We expect this flattening to continue and eventually over the course of next 4-5 quarters result in an inversion of the yield curve. Though the US Treasury yield curve may be pointing towards recession, the Fed dot plot shows that 3 rate hikes are still on the table for next year. A growing developed economy will help our exports, thereby making our macro stronger. CPI Inflation rose from 3.58% in October 2017 to 4.88% in November 2017 (15-month high). A rise in food and fuel prices and a second order impact of the implementation of House Rent Allowances under the 7th Central Pay Commission primarily caused this uptick. The food prices increased to 4.4% in Nov from 1.9% in Oct 17 and fuel prices rose 7.2% from 6.1% in Oct 17. Going forward, we expect the inflation to further spike up in December 2017, before cooling off in Q4 FY18, rising again in Apr-Jul 2018 quarter and then cooling off. This is under the assumption that crude prices shall remain range-bound in the $60-$70 / barrel levels. The OPEC nations have extended their production freeze until June However, oil prices may %YoY 10 7 remain controlled due to US shale production and due to the likelihood of certain countries like Russia preferring to opt out of the production freeze agreement. We do not expect a sustained rise in inflationary pressures through the year Though the headline CPI number may touch the 6% mark due to base effect and HRA impact, it is likely to cool off subsequently. The only risk is due to crude oil prices, which may change the equation. With most of the large, global economies focussing on harnessing renewable sources of energy, we do not expect the high crude prices to sustain for long. In fact, there exists a possibility that inflation may surprise on the down side, as indicated by Bloomberg estimates below: Inflation to Drop Back Below RBI s 4% Medium-Term Target CPI Inflation 12-Month Avg. Rolling CPI Inflation RBI s 4% Medium-Term Target BE Estimate 4 1 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 *CPI projections include impact of higher housing rent allowance for central government employees Source : Ministry of Statistics and Programme Implementation, Bloomberg Economics 19

22 interest rate outlook The year gone by has displayed excessive pessimism with respect to bond yields and has also discounted negative news multiple times. We expect a more muted impact on rates in We base our interest rate outlook for 2018 on the premise that crude prices will remain range bound within $60 - $70 / barrel. With crude remaining range-bound, the RBI may overlook the rise in inflation driven by higher prices of food and fuel and settle for a long pause in interest rates for the bulk of CY However, the current yield curve seems to suggest that the market has already discounted one rate hike. then the trajectory could lead to softer rates. 10 yr bond yields are likely to remain elevated at the current levels until either inflation shows a peak or monsoon augurs well for the inflation trajectory in the remaining year. If there are no negative surprises for the developed economies, then we are conservatively priced on the curve and can deliver superior return across the curve depending on an investor s risk appetite. In a scenario where the past year has been hostile for bond yields, but the future may be more toned down, the perceived risk seems much higher than the real risk. With most events already discounted for and crude remaining range-bound we do not expect to see significant sell-off in bond yields in We go into the New Year with an expectation of a long pause by RBI. From the fiscal deficit point of view we expect this year to end with a fiscal deficit of 3.5% (±0.2%); we expect the government to announce a glide path of 3.2% (±0.2%) for the fiscal deficit in the coming year. If the deficit target for the next year stays between 3.2% - 3.5%, the same should augur well for market sentiments. Fiscal Deficit The yield curve is likely to remain steep till the time we have clarity on peak inflation. The budget shall provide the much needed fiscal clarity for the coming year. With each inflation data-point, the trajectory may change; but if the fiscal picture is around 3% - 3.2% as promised and if the headline inflation undershoots, FY Source: Bloomberg FY FY FY E FY E( 0.2)

23 debt investment strategy STRATEGY #1: ULTRA-SHORT TERM FUNDS - FOR CONSERVATIVE INVESTORS The short end of the yield curve is already steep and has already priced in a lot of negatives. Thus, further steepening is unlikely. For instance, to get the same yield as a current 6 Month Commercial paper (CP), 3 month CP will have to trade at 8% after 3 months, which we assign a very low probability. (Average of 6.5% & 8% = 7.25% which is the current 6 Month CP yield) DATE/ YIELDS 01-Sep Dec-17 Spike in yields Thus, ultra-short term funds have the potential to provide alpha over liquid funds with a 6-12 month horizon. Funds to consider Kotak Treasury Advantage Fund; Kotak Low Duration Fund; Kotak Corporate Bond fund. 3 MONTHS HDFC 6.40% 6.50% 10 bps STRATEGY #2: SHORT-TERM FUNDS - BETTER RETURNS POTENTIAL FOR LOW RISK INVESTORS The spike in 6-month yields and uncertainty over RBI action has also pushed the 1 year 3 year rates higher and is pricing in a lot of negatives making the curve attractive. 6 MONTHS HDFC 7.00% 7.25% 25 bps SPREAD 60 bps 75 bps DATE/ YIELDS 01-Sep Dec-17 Spike in yields 1 YEAR PSU 6.75% 7.00% 25 bps Thus, the steep curve, significant spike in yields and very low credit risk in this space makes it attractive for investors with a month horizon. Active fund management also has the potential to generate alpha over FMPs with a 36 month horizon. Funds to consider Kotak Bond Short Term and Kotak Banking & PSU Debt Fund STRATEGY #3: ACCRUAL FUNDS EARNING OPPORTUNITIES FOR MODERATE RISK INVESTORS The recent sell-off in bond yields resulted in a parallel shift in the yields of AAA and sub-aaa assets. With a long pause on rates by RBI and bank MCLR rates remaining unchanged, we expect a spread compression in the yields of AAA and sub-aaa assets. This, coupled with rating upgrade opportunities provided by an improving economy will allow investors in sub-aaa assets to earn from capital appreciation. 3 YEAR PSU 6.9% 7.35% 45 bps SPREAD 15 bps 35 bps For investors who have a month horizon and a moderate appetite for volatility and credit risk, accrual funds can create an alpha over short-term funds. 1 YEAR NBFC 7.10% 7.40% 30 bps 3 YEAR NBFC 7.35% 7.70% 35 bps Funds to consider Kotak Income Opportunities Fund and Kotak Medium Term Fund. SPREAD 25 bps 30 bps STRATEGY #4: SYSTEMATIC TRANSFER PLAN (STP) IN DURATION FUNDS FOR INVESTORS WHO CAN WITHSTAND VOLATILITY We believe that most of the negatives are priced in, due to uncertainty. Any positive developments on fiscal, inflation & PSU Bank recap in the medium to long term would be a big positive for markets. Since sentiments are likely to remain subdued, we recommend investors to consider partial allocation towards duration funds but through the STP route till March Funds to consider Kotak Bond Fund and Kotak Gilt Fund 21

24 actionable intelligence: debt segment scheme horizon Conservative Investors Ultra Short Term Funds Kotak Treasury Advantage Fund; Kotak Low Duration Fund; Kotak Corporate Bond Fund 6 months 12 months Investors with appetite for moderate volatility and low credit risk Short Term Funds Kotak Bond Short Term; Kotak Banking & PSU Debt Fund months Investors with appetite for moderate volatility and moderate credit risk Accrual Strategy Kotak Income Opportunities; Kotak Medium Term Fund months High Volatility Active duration Kotak Bond Fund; Kotak Gilt 36 months (Participate through STP till Mar-18) 22

25 Disclaimer: This material should not be construed as an offer to sell or the solicitation of an offer to buy units of Kotak Mahindra Mutual Funds. We are not soliciting any action based on this material and is for general information only. Before acting on any statement made or advice or recommendation in this material, clients should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. Investors should read relevant Fund information document and understand the investment objective, risk of such investment before investing. Past performance does not indicate the future performance of the Funds of the Fund. Name of the Scheme This product is suitable for investors who are seeking* Riskometer Kotak Mahindra 50 Unit Scheme Kotak Select Focus Fund Kotak Emerging Equity Scheme Kotak Balance Fund Kotak Opportunities Kotak Tax saver Fund Kotak Infrastructure & Economic Reform Fund (formerly known as PineBridge Infrastructure & Economic Reform Fund ) long term capital growth Investment in portfolio of predominantly equity & equity related securities long term capital growth Investment in portfolio of predominantly equity & equity related securities generally focused on a few selected sectors long term capital growth Investment in equity & equity related securities predominantly in mid & small cap companies. Long term capital growth Investment in equity & equity related securities balanced with income generation by investing in debt & money market instruments long term capital growth Investment in portfolio of predominantly equity & equity related securities Long term capital growth with a 3 year lock in Investment in portfolio of predominantly equity & equity related securities long term capital growth long term capital appreciation by investing in equity and equity related instruments of companies contributing to infrastructure and economic development of India Kotak Gilt Investment Kotak Bond Kotak Low Duration Fund Kotak Medium Term Fund Kotak Banking and PSU Debt Fund Kotak Bond Short Term Kotak Treasury Advantage Fund Kotak Income Opportunities Fund Kotak Corporate Bond Fund income over a long investment horizon Investments in sovereign securities issued by the Central and/or State Government(s) and / or reverse repos in such securities. income over a long investment horizon investment in debt & money market securities Regular Income over short term Income by focusing on low duration securities Income over a medium term investment horizon Investment in debt, government securities & money market instruments with a portfolio weighted average maturity between 3-7 years income over a short to medium term investment horizon Investment in debt & money market securities of PSUs, Banks & government securities income over a medium term horizon investment in debt & money market securities income over a short term investment horizon investment in debt & money market securities Income over a medium term investment horizon Investment in debt & money market securities regular income over short term income by investing in fixed income securities of varying maturities and credit * Investors should consult their financial advisers if in doubt about whether the product is suitable for them Mutual Fund investments are subject to market risks, read all Fund related documents carefully. 23

26 summary As India s growth engine becomes stronger, challenges present themselves in the mask of opportunities. A land of golden sparrow is ready to reach new highs with its laurels resting on young, dynamic and efficient wings, which will steer not just domestic growth but also global growth.