India Insights Monthly update on Indian markets

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1 India Insights Monthly update on Indian markets Summary August 2017 On 2 August, at its third bi-monthly monetary policy meeting, the RBI s MPC cut the policy repo rate by 25bps to 6%, on the grounds that upside risks to inflation have either reduced or not materialised Headline inflation rebounded in July driven by easing food price deflation and a rise in core inflation following the implementation of GST and housing rent allowance (HRA) hike for central government employees, although the latter had limited impact PMI data for July came in lower due to the transitory impact of the new tax structure that led to a cutback in production and weakness in domestic demand Indian stocks broke their nearly uninterrupted seven month long rally to give up some ground in the first part of August, prompted by a number of factors, including lackluster corporate earnings announcement and disappointing economic data on various fronts Earnings review: Still banking on a recovery? Asset quality concerns weighed on Indian banks in August after a spate of disappointing earnings once again highlighted the ongoing bad loans issue that has haunted the sector for several quarters now Non-performing assets (NPAs) at banks moved up to 10.3% of loans in the June quarter, compared with 9.6% in the previous financial year, net interest margins (NIMs) contracted sharply and net interest income growth was negative Non-performing assets (NPAs) at banks moved up to 10.3% of loans in the June quarter, compared with 9.6% in the previous financial year State-owned banks, which account for around 70% of all lending in the system, are currently reeling under more than $150 billion in bad debt, thus hampering credit growth in India. Stressed loans at these public sector banks rose to over 15% of total loans in the June quarter (see chart on page 2) Analysts expect the sector to stay under pressure in the coming quarters amidst worries about defaults on agricultural loans following the announcement of farm loan waivers in several states. Additionally, banks have also flagged emerging risks from the power sector loans as states seek to renegotiate power purchase agreements At the same time, credit growth at state-owned banks is expected to remain subdued amidst capital adequacy concerns and competition from private banks in the retail banking space This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target.

2 Earnings review: Still banking on a recovery? (cont d) Earlier in August, Reserve Bank of India Governor said that public sector banks will need more capital to resolve bad loan problems weighing on their balance sheets Outside of banking, earnings in many other sectors also fell short of expectations as the impact of demonetisation and GST implementation weighed on companies In the past few years the RBI has played a more active role tackling the bad loans issue plaguing the Indian banking system including the asset quality review it undertook in In June 2017 it identified 12 of India's biggest loan defaulters and asked creditors to pursue bankruptcy proceedings against them, under the new bankruptcy regime However its efforts have fallen short and the challenge of cleaning up banks balance sheets has been made more complicated by inadequate capitalisation of many state-owned banks. Earlier in August, Reserve Bank of India Governor Urjit Patel said that public sector banks will need more capital to resolve bad loan problems weighing on their balance sheets Additional capital could be raised either by getting funds from the market, through the government diluting its stake in state-run banks, through additional government capital infusions, or the sale of non-core assets and mergers among lenders In June, Moody's said that the 11 Indian state-run banks that it rates could need up to $15 billion in equity capital by March 2019, far above the $3.2 billion rupees the government plans to inject into state banks by then Outside of banking, earnings in many other sectors also fell short of expectations in the June quarter as the impact of demonetisation and Goods and Services Tax (GST) implementation weighed on companies. Sectors including materials, consumer discretionary and consumer staples were particularly affected during the run up to the GST rollout as it resulted in restocking, supply chain disruptions and compressed margins There are concerns that this setback may push the long-awaited earnings recovery back by a few more quarters and this could likely be reflected in market valuations which are currently at above average levels Stressed loans have risen in the June quarter Source: Credit Suisse, HSBC Global Asset Management as of August 2017 Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies.

3 Equity market Indian stocks broke their nearly uninterrupted seven month long rally to give up some ground in the first part of August. The market has since then clawed back some gains but is still around 3% (Sensex) below the all time high it scaled a few weeks ago The correction was prompted by a number of factors, including lackluster corporate earnings announcement and spike in inflation data which mitigated hopes for yet another rate cut in the near term Despite the recent weakness in the market, Indian stocks have returned more than 29% (as of 18 August) in USD terms since the beginning of the year Looking ahead, the government has forecasted GDP growth at % in the current financial year with risks to the downside The correction was prompted by a number of factors, including lackluster corporate earnings announcement and spike in inflation data which mitigated hopes for yet another rate cut in the near term. Disappointing macro data on other fronts also contributed to the negative sentiment amongst investors The escalation of tensions between North Korea and the United States also drove down shares in the Indian market along with the rest of the region. However, the stand-off between India and China in Doklam (Donglang) region, which has continued for more than two months now, had limited impact on sentiment While friction between India and China over their long shared border has been ongoing for decades now, intensifying rhetoric from both countries has dominated news headlines in recent weeks. The probability of further escalation is still seen as being low as both countries have much to lose in the event of a full-blown conflict. There is hope that both sides may still focus on their deepened economic ties and resolve their differences through dialogue. The leaders of both countries will meet at the upcoming BRICS summit which will be held in Xiamen in September Other news that made headlines in August includes the resignation of the CEO of India s second largest IT services firm, who cited a long-running feud with the founders of the company over corporate strategy as his reason for his for stepping down. The announcement sent the stock into a tailspin and has raised questions about the company s ability to meet growth targets in future Despite the recent weakness in the market, Indian stocks have returned more than 29% (as of 18 August) in USD terms since the beginning of the year. Fund flows have been driven by domestic mutual funds, while foreign institutional investors have steered clear of the Indian markets in recent weeks amidst rising valuations Investors are now looking towards the upcoming IPO pipeline, which likely includes several blockbuster issuances by insurance companies, to provide further boost to the market. Till July this year, 15 companies have raised nearly $2 billion through the IPO route, which the highest amount raised in first seven months of the year since If the IPOs planned for the rest of 2017 materialise, then that would make it the best year for the Indian equity primary market in terms of amount raised Looking ahead, the government has forecasted GDP growth at % in the current financial year with risks to the downside in its mid-year survey of the Indian economy, which was released in August The survey also expects CPI inflation to remain below the RBI s medium-term target of 4% even by March 2018 and makes an argument for further rate cuts as real rates in India remain high when compared with emerging market peers Source: Bloomberg, HSBC Global Asset Management as of August 2017 Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies.

4 Sector Views Sector Consumer Discretionary Financials Industrials Real Estate Materials Information Technology Consumer Staples Telecom Healthcare Energy Weighting Overweight Overweight Overweight Neutral Neutral Source: HSBC Global Asset Management as of end-july 2017 Sector focus Indian healthcare stocks tanked amidst the global rout in pharmaceutical names, prompted by falling prices of generic drugs While prices of generic drugs have been under pressure for several years now, worsened financial performance of related companies has led to a broad-based sell-off in pharma stocks Indian pharmaceutical companies which have a larger exposure to the US market took a hit in the June quarter with their revenues falling sharply amidst continued erosion of prices Intensifying competition in the sector has also taken a toll as Indian players who produce bulk drugs are witnessing a margin squeeze The recent sell down has made pharma stocks seem relatively attractive on a valuation basis, particularly when compared with other sectors that have rallied sharply this year However, analysts predict continued cuts to pharma company earnings estimates as the downward pressure on drug prices will likely stay in place and we could potentially witness some consolidation in the sector Chart in focus Healthcare stocks have accelerated their decline in 2017 Source: : Bloomberg, HSBC Global Asset Management as of August 2017 Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies. Source : NPCI as of June 2017

5 Fixed income On 2 August, at its third bimonthly monetary policy meeting, the RBI MPC cut the policy Repo rate by 25bps to 6% from 6.25%. Currency In the first 7 months ending 31 July 2017, net FPI debt inflows have been INR 1,149 billion vs. an outflow of INR 80 billion for the same period in India s core inflation moderated in Q2 % Y-O-Y On 2 August, at its third bi-monthly monetary policy meeting, the RBI s MPC cut the policy repo rate by 25bps to 6%. The cut was made on the grounds that some upside risks to inflation observed earlier have either reduced or not materialised. Such factors include inflation projections, a moderation in core inflation over the last three months, a smooth roll out of GST and a favourable monsoon season. Industrial production growth contracted 0.1% y-o-y in June from an upwardly revised 2.8% in May (1.7% earlier), which was below expectations. The supply side was weak with mining output growing by a meagre 0.4% y-o-y (vs 0.2% in May) and electricity output growth slowing to 2.1% (from 8.3% in May). On the demand side, both consumer durables and capital goods output contracted, while infrastructure goods output grew at a muted 0.6% Looking ahead, the MPC sees headline inflation a little above 4% (excluding the HRA impact from the 7th Pay Commission) by 4QFY2018, and reiterated its commitment to its medium term durable inflation target of 4% The MPC has also outlined three key developmental steps to strengthen the fixed income market as well as to improve financial intermediation. These include the introduction of the tri-party repo for corporate bonds; study transmission of policy rates into lending rates, and the establishment of a public credit registry. From a strategy standpoint, we maintain overweight duration in INR government bonds given a balanced inflation outlook and any further rate cuts are data dependent. We could look to add state government bonds on a selective basis, given good spreads in a stable environment. We continue to hold highly liquid corporate bonds which provide a reasonable carry in a stable interest rate environment. We could selectively add Non-banking Financial Companies (NBFCs) in the 3-4y space for carry. In the first seven months ending 31 July 2017, net FPI debt inflows have been INR 1,149 billion vs. an outflow of INR 80 billion for the same period in As of 31 July 2017, the INR has appreciated by 5.82% year-to-date against the USD and has added to foreign investors gains Despite a possible marginal widening of the Current Account Deficit (CAD), market consensus still expects the basic balance i.e. CAD plus FDI to be positive this year, which together with portfolio flows should keep the INR on an appreciating bias. Given improving economic fundamentals, narrowing inflation differentials and strong FX reserves, we expect the INR to be more resilient and to remain range bound going forward INR continues to be one of the better performing Asian currencies Source: LHS, Bloomberg, as of 31 July RHS, HSBC Global Asset Management, as of 16 August Investment involves risks. Past performance is not indicative of future performance. Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies.

6 Data watch Indicator Latest data Consensus data Previous data Analysis PMI (Composite) - Manufacturing - Services 46.0 (Jul) 47.9 (Jul) 45.9 (Jul) NA 52.7 (Jun) 50.9 (Jun) 53.1 (Jun) The plunge in PMIs reflected the transitory impact of GST implementation that led to a cutback in production and weakness in domestic demand, while the new export orders stayed in the expansionary territory. We expect normal business activity to resume after firms adopt the new tax structure. The large rise in services PMI output prices and fall in manufacturing PMI output prices may reflect the impact on the effective tax rate for services vs. manufacturing. Industrial Production (IP) (% yoy) -0.1 (Jun) (May) Manufacturers destocking and GST-related uncertainty weighing on domestic demand both capital and consumer goods led to the decline in IP, while infrastructure/construction activity held up. The manufacturing PMI suggests further IP weakness in July due to GST disruption, which is likely temporary. Local passenger vehicle (PV) sales (units) 298,997 (Jul) (+15.1% yoy) NA 198,399 (Jun) (-11.2% yoy) The rebound was driven by restocking by dealers after GST implementation, after a steep decline in June dispatches. August data may give greater clarity to the strength of demand in the retail space, especially at the onset of the festival season (end-august). Lower pricing of vehicles in certain segments and a good monsoon could be positive for demand in the coming months. Exports (USD) (% yoy) Imports (USD) (% yoy) 3.9 (Jul) NA 4.4 (Jun) The further deceleration in export growth was largely driven by weakness in pharmaceutical products and labour-intensive categories, such as gems & jewellery and textile and readymade garments, which may have reflected the impact of INR appreciation. Engineering good exports remained robust (Jul) NA 19.0 (Jun) The lower import growth could reflect the supply-chain disruption due to the transition to the GST. Jewellers reduced their imports after restocking in June, while the yoy growth in gold imports eased further. Oil and commodity imports held up. Non-oil non-gold import growth - a proxy for domestic demand decelerated to 11.6% yoy from 16.7% in June but maintained a solid pace. Trade Balance (USD) -11.4bn (Jul) NA -13.0bn (Jun) Despite narrowing for a second month, the trade deficit is likely to widen in FY18 on higher imports due to a recovery in domestic demand. Inflation (% yoy) - CPI - WPI 2.36 (Jul) 1.88 (Jul) (Jun) 0.90 (Jun) The rebound in headline CPI inflation was driven by eased food price deflation (vegetables; in particular tomatoes) and a rise in core inflation, largely led by higher prices in some categories such as pan, tobacco & intoxicants, housing, health, and household goods & services, etc. These likely reflected effects of implementation of the GST and housing rent allowance (HRA) hike for central government employees, although the latter s impact was rather mild. Overall, headline CPI inflation is likely to rise gradually in the coming months towards the RBI s 4% medium-term target, partly due to the base effect as food prices normalise and the HRA impact becomes more visible. However, the near-term inflation outlook remains benign amid modest demand-pull pressure curtailing the second-round effects of supply-side cost push (e.g. HRA) onto core, a normal monsoon, INR appreciation YTD, and largely neutral GST impact. Repo rate (%) Reverse repo rate (%) Marginal standing facility (MSF) rate (%) (2 Aug) (7 Jun) The rate cut came on the back of lower-than-projected CPI inflation trajectory, especially deceleration in core, as well as the smooth roll out of the GST and normal monsoon rainfalls. The MPC maintained its neutral policy stance and expected inflation to rise from current lows. It remained cautious about the inflation outlook, particularly how much of the disinflation is transitory versus structural and from the implementation of HRA hikes and GST. It also flagged fiscal slippage risks from worsened state finances. The future policy direction continues to be data dependent, but the door for further easing remains open. GDP at market prices (quarterly, % yoy) Gross valueadded (GVA) at basic prices (quarterly, % yoy) 6.1 (Jan- Mar) 5.6% (Jan- Mar) (Oct- Dec) 6.7% (Oct- Dec) Growth slowdown likely partly reflected the lagged impact of demonetisation. The cash shortage led to a contraction of construction GVA and a drop in real estate and manufacturing GVA growth on the supply side. On the demand side, it led to a contraction in fixed investment growth and slowdown in private consumption, despite a rise in government spending. However, nominal GDP growth picked up to 12.5% yoy from 10.4% in the December-quarter. The GST implementation pose some risks to post-demonetization growth recovery, but the impact is likely to be transitory and not broad-based. High-frequency data suggest consumption, public investment, and exports still drive growth. Current Account Balance (CAB) (quarterly, balance in USD and % of GDP) -USD3.4bn -0.6 (Jan- Mar) -USD6.3bn -USD8 bn -1.4 (Oct- Dec) Source: Bloomberg, HSBC Global Asset Management, as of August 2017 Indicates improved data on month-on-month/quarter-on-quarter/year-on-year basis Indicates worsened data on month-on-month/quarter-on-quarter/year-on-year basis Indicates no change in data on month-on-month/quarter-on-quarter/year-on-year basis The narrowing of CAD largely reflected seasonality, with a lower merchandise trade deficit, slower investment outflows and higher remittances helping offset a smaller services trade surplus. CAD narrowed to 0.7% of GDP FY17, the lowest seen since FY05. It is likely to widen in FY18 on higher goods trade deficit, but should remain within sustainable levels with robust FDI inflows. Management accepts no liability for any failure to meet such forecasts, projections or targets. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies.

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