Equity View With an eventful year 2015 coming to an end, at the very outset, we wish everyone a very happy and prosperous New Year- 2016. Key highlights: We believe that 2016 can be a year of immense possibilities for equity markets in India. Earnings recovery: Key driver of equity market performance in 2016. Earnings downgrades for FY16 likely to abate; FY17E earnings growth of ~15-16% achievable; volume growth to provide operating leverage. Improvement in household savings led by financial savings: structural driver for Indian equity markets. GDP growth: On the path to steady recovery; FY17E real GDP growth at 7.8-8% (7.3% in FY16E). Scope remains for 25-50bps further cuts in policy rates; Inching up of CPI inflation largely on the back of fading base effect. Currency: India shines among emerging markets; depreciating bias to remain; FY16E INR/USD to average 65; 67.5-68 in FY17E. India 2016: A year of immense possibilities 2015 was a rather eventful year for Indian equities with its fair share of ups and down. It is now time to look ahead and crystal gaze into 2016. We believe that 2016 can be a year of immense possibilities for equity markets in India. While much has been written and debated about the India story one cannot ignore the fact that today India's macro stabilisation is now on a much stronger footing. This is at a time when most of the world is grappling with slower growth and myriad other imbalances. This paves the way for the Government to increase focus on policy measures, which would translate into sustained economic recovery. A word of caution though; even as India will continue to be the fastest growing large economy in the world, given the external and some domestic headwinds, economic recovery would be slow but steady. Against this backdrop we examine what we believe would be the key themes for 2016. 1. Earnings recovery: Driver of equity market performance While 2015 was a tepid year for the equity markets, we do believe that the benefits of on-going reforms is likely to translate into a slow but steady earnings recovery. The key to market performance in CY16 in our view is corporate earnings trajectory. Earnings expectations for FY16 have been significantly cut, leading to a de-rating of the markets. However, it now does appear that the pace of earnings downgrades is close to its peak and FY17E earnings growth should settle at around ~15-16% levels on a realistic basis. In this context, we note the following: In FY16, earnings growth when adjusted for Sun Pharma, Lupin, IDFC, Tata Motors, Metals and Oil& Gas would be around 12-13% instead of the likely headline number of 6-7%. Hence, after adjusting the one offs, the asking rate for earnings growth for FY17 does not appear very challenging. With GDP growth expected to improve in FY17, we are hopeful of a volume recovery. Further, the current global construct is favourable for India macros. Low commodity and oil prices together with global liquidity would help keep India's Balance of Payments (BoP) and fiscal deficit under check. With operating costs remaining benign, any growth recovery would result in significant operating leverage for Indian corporates. RBI has cut interest rates by 125bps in CY15 in an effort to boost the economy and kick start the investment cycle. As banks accelerate the process of monetary transmission (with the introduction of the new base rate regime), we believe that India's cost of capital (COC) will also progressively reduce. The consequent expansion in the ROCE-COC spread could be one of the drivers of the next leg of re-rating in Indian equities. Given these expectations, the market is currently trading at valuations which appear comfortable at ~15.5xFY17E EPS (Nifty, on a free float basis). However, we could see some downside risks from rise in credit costs in the banking sector and a further sharp fall in commodity prices could increase capital outflows and risk aversion. A reduction in corporate tax rate, which is not factored in our estimates, may boost earnings.
2. Improvement in household savings led by financial savings: Structural driver for Indian equity markets The improvement in financial savings of households would be one of the key drivers for equity markets in 2016. Gross Household financial savings rate stood at only 9.8% of GDP in FY15 and this would in our view improve over the next 10 years and would lead to not only better deposit mobilisation but also see better inflows into equity as an asset class through investment in mutual funds and life insurance. The government's thrust on financial inclusion and curbing black money and the RBI's focus on positive real interest rates are the key factors that in our view would result in a higher proportion of household savings being allocated to financial savings as opposed to physical assets. 3. GDP growth: On the path to steady recovery We expect economic activity to start picking up from H2CY16 as the government's efforts to address some of India's legacy investment issues start taking effect. While the accuracy of the GDP data as per the new series has been oft debated, the trends in the real GDP growth points towards a slow but steady recovery (H1FY16 growth at 7.2%) in FY16/FY17. Signs of nascent recovery in manufacturing and investment growth (on the back of public spend, easing interest rate cycle and proactive policies to improve investment appetite) appears encouraging and the monthly IIP (Index of Industrial Production) data supports this view. Recovery would be mainly led by urban consumption (boosted by the payouts under the 7th Pay Commission), government spending on infrastructure and lower bank lending rates. However, the impact of poor monsoons on agriculture output will manifest in Q3FY16 and exports weakness is persisting for longer. The good news is that the initial forecasts point towards the possibility of a normal monsoon in FY17 which bodes well for agricultural GDP growth. OUTLOOK: we estimate real GDP growth in FY16 to be at 7.3% on a Gross value added basis (GVA, FY15-7.2%) and FY17E growth at 7.8%-8%. Table 1: India's real GDP growth (GVA basis), % growth Real GVA FY13 FY14 FY15 FY16E FY17E Agriculture & Allied 1.2 3.7 0.2 1.8 2.5 Industry 2.4 4.5 6.1 7.0 7.3 Services 8 9.1 10.2 9.4 9.8 Real GVA 4.9 6.6 7.2 7.3 7.8 Source: CSO, Kotak estimates, GVA- Gross Value Added 4. Interest rates: Scope remains for some further cuts While the US Federal Reserve has embarked on a policy tightening cycle with the first rate hike on December 16, 2015, the policy stance of most other central banks around the world remains accommodative as many of these economies grapple with deflation. We believe that even after the 50bps cut in policy rates in September 2015 (125 bps cut in policy rates cumulatively in CY15), RBI has the head room to cut rates by another 25-50bps in CY16. The rise in CPI inflation in India as per the latest data (5.41% in November '15) should be viewed in light of the fading base effect and we expect that CPI inflation would not exceed RBI's targeted rate of 5.8% in January 2016 and would average ~5% in FY16. For FY17, our expectations is for average CPI inflation to range between 5-5.5%. Banks have started transmitting the cut in policy rates by lowering their base rates and RBI has announced the new methodology for base rate (calculated on marginal cost of funds) for incremental loans which could lead to some further lending rate cuts. This together with the persistent slack in economic activity would give the confidence to RBI to continue with cutting policy rates even as the longer term target of bringing down CPI inflation closer to 4% remains intact.
5. Currency: India shines among emerging markets; depreciating bias to remain While the Indian currency has depreciated against the USD by 4.7% in CY15 (till Dec 22, 2015), the pace of the depreciation has been gradual and has not resulted in any significant volatility in the currency markets. Despite the fall, India remains better placed than many emerging economies which have seen sharp currency depreciation. Chart 1: Cross currency movement against the USD (CTYD) Source: Bloomberg; Data till Dec 22, 2015 However, even with the strong showing of the INR in comparison to other emerging market currencies, we do believe that our currency would have a depreciating bias against the USD in 2016 due to: While the INR has depreciated against the USD, it has appreciated against many other currencies which is reflected in the overvaluation of the INR in REER terms (Real Effective Exchange Rate). Exports continue to de-grow: Export growth was down 18.3% YoY while imports fell 17.3% YoY for April- November 2015. Our view is that the INR/USD would average 65 in FY16 with a likelihood of another ~3.5-4% depreciation in FY17 resulting in the INR averaging ~67.5/USD in FY17E. However, like in 2015, we do not see any sharp volatility in the currency markets as RBI has managed to build a sizeable war chest in the form of forex reserves (USD 351Bn) which may hold the currency in good stead.
Debt View The factors affecting the debt market performance remained in line with expectations of the market. Following is the summary of key changes in certain parameters from the previous month. Key Events Items Nov-15 Oct-15 Change Reverse Repo 5.75% 5.75% Nil Repo 6.75% 6.75% Nil CRR 4% 4% Nil SLR 21.50% 21.50% Nil Mibor Overnight 7.03% 6.84% 19 bps Call(O/N) 6.68% 6.75% -7 bps CBLO 7.04% 6.69% 35 bps 1 yr T Bill 7.23% 7.20% 3 bps 10 G Sec 7.76% 7.79% -3 bps 5 Year AAA 8.30% 8.25% 5 bps USD/INR 66.33 66.81-48 paise Source: RBI; ICraonline. Headline CPI for November 2015 rose to 5.41% from 5%. The core inflation was at 4.6% from 4.50%. WPI inflation for the November month came at -1.99% from -3.81% (negative for 13th month in a row). US Central bank raised interest rates by 25 bps for a first time in nearly a decade taking its target range for federal fund rate to 0.25%-0.50%. It also said the policy stance remained accommodative and pace of future hikes would be gradual. Market reaction to long-impending rate hike was relatively benign due to fine calibration of market expectations by the Fed. India's exports declined for the 12th month running in November to $20 billion from $21.4 billion a month earlier, whereas imports have also decline to $29.8 billion from $31.1 billion on October. The trade deficit for November was at $9.7 billion. Rupee has outperformed other EM currencies. Rupee has appreciated 0.51% against dollar in Dec month due to better macro-economic profile and reform-oriented government ECB's Draghi announced a modest reduction in the deposit rate paid on reserves held at the central bank - which is already negative but falls further from -0.2% to -0.3% - and a six-month extension of the end-date for the ECB's 60bn-a-month quantitative easing (QE) programme. Despite conciliatory noises in early December, India's legislative reforms remained stalled for the rest of the month, with both GST and Bankruptcy Bill not seeing the light of day; Government is confident of pushing through these in the Budget session. Performance of 10 Year Gilt Inflation Source: - Bloomberg
Despite policy rate cut of cumulative 125 bps in CY15, 10yr yields have fallen by only 10-15 bps. This is mainly because of the concerns on fiscal & inflationary pressures due to 7th pay commission recommendations, leading to G-sec supply pressure Current spread of ~100 bps between overnight rate and g-sec yields is too wide for an easing policy. We believe that the current markets are oversold and present an investment opportunity for the long term investors Outlook Long Term Curve : 10 year yields are at pre-rate cut levels in Jan 2015; we believe most of the negatives are priced in While RBI is still in accommodative mode and likely to cut further when space emerges and will keep ample liquidity in the market, 100 bps spread between 10 yr and overnight rates is very attractive With muted credit growth and high positive carry of ~100 bp, we expect demand for G Sec to remain good. However it may remain volatile due to events such as budget. We expect 10 yr to trend lower around 7.40% band by March 2016 as bulk of supply is behind us With inflation expected to fall well below the targeted 5% by Jan 2017 and RBI's indicated real interest rate of 1.5-2%, we expect further rate cut of 50 bps in next 18 months. We would recommend duration funds with a 18 month view. Short-Term Curve (3m -24 m): Currently the yield curve is steep and we expect it to remain steep due to uncertainty on the rate cut front As rate cut expectation increase on the back of declining inflation, we expect yield curve to flatten. Gold View For the month, spot gold closed at $1162.25 per ounce, up $ 6.60 per ounce or 0.63%. During the month the US Federal Reserve hiked interest rates for the first time in nearly a decade on December 16, signaling faith that the US economy had largely overcome the wounds of the 2007-2009 financial crisis. Gold has lost value for three straight years, starting in 2013. That is the longest streak of annual losses for the metal since 1996. A rise in the dollar which has gained 9.1% in 2015, also weighed on dollar-denominated metals, making them less appealing to buyers using other monetary units. Gold had a bad year frankly. This was not a surprise as most of the commodities fell globally as dollar posted a strong performance. The likelihood of reversal in the zero interest rate policy of US Fed was the primary catapult for US Dollar's performance. As a consequence, the yellow metal is about to close the year at around US$ 1070 per ounce level. A decline of almost 11.2% on yoy terms. Even in Rupee terms, the metal has fallen by around 5.62% and is trading at around Rs 25144 levels. We believe that gold's understated performance is likely to continue since the possibility of further rate hike in US Fed rate in 2016 remains high. At that, the co-related commodities such as crude oil are also expected to remain subdued in the following year. For that reason, we continue to advise our investors to remain marginally invested in gold and only to the extent so as to anchor the portfolio against any systemic risk in the financial sector. Disclaimer : The information contained in this document is extracted from different public sources. Kotak Mahindra Asset Management Co Ltd does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. All reasonable care has been taken to ensure that the information contained herein is not misleading or untrue at the time of publication. This is not a sales literature and all the information is for the information of the person to whom it is provided without any liability whatsoever on the part of Kotak Mahindra Asset Management Co Ltd or any associated companies or any employee thereof.