Annual Report for the year 2016-2017 2016 The year of Surprises! The year gone by has been full of surprises and proved most of the market participants wrong in the projections that they have made for the financial markets. The key theme for global markets emerged from political events like Brexit and the US elections. Antiglobalization and protectionist parties have triumphed over the status quo, sending jitters across the financial world. Key events that influenced the global markets this year are: Analyst contact: Rakesh Chelapareddy rakesh.chelapareddy@karvy.com +914033216636 Deepak Agarwal deepak.agarwal@karvy.com 1. January to June 2016: a. The brutal fall in markets marked the beginning of an eventful year. Fueled by slowing economic activity and a depreciating currency in China, there was a flight to safety as investors began to price in another recession. b. Another cause for concern was the falling crude oil prices which bottomed out at $26.21 a barrel, fueled by slowing demand and a supply glut in the oil industry. MSCI World index and MSCI EM index c. Negative interest rates in Japan were announced in the end of January that led to a sharp fall in interest rates across the developed world. 2. June to December 2016: a. The Brexit Shock: As markets begin to rebound from the lows of Jan, another shock verdict from UK rattled the financial markets. Britain voted to leave the European Union, resulting in a weaker Pound and government yields, leading to a revival of quantitative easing from the Bank of England. This was followed by an Italian referendum in December and another antiestablishment verdict has taken the markets by surprise. b. Trump and the after effects: Donald Trump winning the US elections was expected to be a negative event for the global markets but that expectation was short-lived and lasted for a few hours as investors appreciated the idea of fiscal stimulus, tax cuts and lower levels of regulations. British Pound fall from 1.49-1.2150 c. OPEC Deal to cut production: In a landmark agreement, OPEC nations agreed to a production cut, lifting oil above $50.00/barrel. Crude oil falls bottoms out at $26.21 and rebounds to $55.00 after the OPEC production cut. 1
Annual Report for the year 2016-2017 The Indian roller coaster: The Indian markets had a fair share of volatility in the year 2016. Indian rupee moved in the range of 66.04-68.85 with multiple factors affecting the currency pair. Indian equity markets (nifty index) rebounded from the lows of 6825.00 seen in the beginning of the year to make a year high of 8969 in September this year. In this report we would like to limit the coverage to macro factors that have played a key role in the influencing the price action. The reforms that have arrived: The year gone has had many new initiatives that have helped shaped the outlook for the Indian economy. The Indian government led by Prime Minister Modi has taken some bold steps that helped deliver much needed reforms. Introduction on the GST (Goods and Services Tax) bill in the parliament and passing of the same, introduction of the Bankruptcy code and the most daring of all these reforms was the demonetization move that was announced in the month of November. The positive momentum is expected to continue in the reform front but with the elections in many key states next year and with the fallout from the demonetization move would hinder any plans for aggressive regulatory and monetary reforms. Growth in the Indian economy has been on track with the Q3 GDP data showing that the Indian economy has grown at a rate of 7.3% yoy, improving from the 7.1% yoy in Q2 16-17. Manufacturing and industrial production have not shown similar increase in the same time period and with the current demonetization move, we are expecting a slowdown in the coming two to three quarters. Indian GDP with consensus projection (Source: Bloomberg) Indian GDP with quarterly consensus projection (Source: Bloomberg) 2
Glance at the numbers: Fears of a drop in activity after the demonetization move by the government have seen little light but it is too early to gauge the impact at such an early stage. The manufacturing PMI for the month of November was reported at 52.3 as compared to a recent high of 54.4 in October. Services PMI too recorded a drop in the previous month but these falls are at an alarming rate at least for the time being. Consumer discretionary spending has seen a decline in the last one month. Decline has been reported in the sales of two wheelers, consumer electronics, clothing and real estate ventures where most of the transaction is done in cash. The demonetization move has hampered the unregulated labour market where employers were unable to pay employees for lack of cash and this trend has been common in rural areas, which has impacted the demand from these sectors. Reduction in demand has seen a drop in prices with the inflation data indicating a modest drop in the month of November. Wholesale price inflation at 3.2% yoy for the month of November as compared to 3.4% in October and consumer price inflation has been reported at 3.6% for November as compared to 4.2% in October. Major impact has been witnessed in the food price as the demonetization has taken a toll on the demand with supply remaining elevated. Going ahead, we can expect inflation to rebound as the move would impact supply in the near term. To add to the inflationary pressure, rise in the global oil prices will lead to rise in inflation in the near term. Drop seen in manufacturing, services and industrial production (graphs below). 3
Inflation expectations for the year ahead A brief note on monetary policy: In the recent monetary policy announcement, the Reserve Bank of India has left the interest rates unchanged at 6.25%, against a market expectation for a rate cut of 0.25%. Expectations remain high for further loosening in the near term, to boost demand that is likely to be affected after the demonetization announcement by the government of India. Fiscal policy is also poised for a hit as lower demand and business activity would impact the indirect tax revenues. Introduction of the GST (Goods and Services Tax), at least by September will add to the troubles of the industry in the near term and will impact tax revenues for the government. We expect the RBI to remain focused on containing inflation and with this aim; aggressive rate cuts might not be possible. Another round of easing in the February meeting cannot be written off as falling growth after the demonetization exercise needs to be tackled by some monetary easing. 4
What lies ahead for the Indian Rupee? Indian rupee remained one of the most resilient currencies of the EM space. Though the Indian currency has made an attempt to breach the life time high near 68.85 (last seen in 2013 during the taper tantrum) in the month of November, markets were quick to reverse the losses and Rupee stabilized near 68.00/$ going into the year end. The key reasons for the depreciation in the Indian rupee were global rather than domestic. A stronger US dollar which was a result of the optimism arising out of the expectations for aggressive fiscal stimulus from the Trump administration once he takes office and a hawkish US FED which has increased the interest rates for the first time in a year and projected another three rate hikes in the year ahead. On a REER (Real effective exchange rate) basis, Indian rupee continues to remain stable with limited depreciation against other trade partners excluding the US. This would be a cause of concern as sharp depreciation of India s competitors currency would leave them with an advantage when it comes to exports. This could mean that the government would likely support gradual depreciation of the Indian Rupee to help continuing export growth. Indian rupee among least volatile currencies in the EM space (Source: Bloomberg) The role of the Indian central bank has to be commended which has been successful in managing the volatility of the Indian currency. The central bank is likely to remain active on the currency front as volatility is expected to remain high. With the forex reserves continuing to remain high which stood at $367bn in the month of November, expect the RBI to defend the Indian rupee against high levels of volatility. Forex Reserves (Source: RBI, Bloomberg) Indian Exports (Green) and Imports (Red) (Source RBI, Bloomberg) 5
We predict further depreciation in the year ahead With the Trump presidency beginning on the 20 th of January and the possibility of a sizable fiscal stimulus package, would drive the demand in the US higher leading to an inflationary boost in the US and prompting the FED to tighten quicker than expected. The result of these actions would lead to a stronger US dollar and higher US treasury yields in the year ahead, which will lead to further pain for the EM currencies and we can expect another bout of depreciation for the Indian rupee. From the domestic point of view, the effects of demonetization are likely to be seen in the coming quarters. Uncertainty surrounding future policy and a reduction in growth would reduce the appeal for the Indian markets. We have witnessed an outflow of funds in the recent months and a combination of international as well as domestic factors would continue to fuel redemptions in equity and bond space which in turn would have a bearing on the Indian rupee. Recent comments from the Indian prime minister about investors in stock markets need to pay for the development of the country has led to the speculation about introduction of long term capital gains in the Indian equity markets. If this step is taken, it will take a hit on the market sentiment and will lead to flight of capital from the Indian equity markets. The upcoming budget would be a possible avenue for such announcements and can accelerate the depreciation of Indian rupee. Overall, expect a volatile journey for all of the next year. There are limited scenarios for the Indian rupee to appreciate aggressively and we expect 66.00 to act as strong support for the pair in the year ahead. On the upper side, 70/$ would act as a near term resistance but strong external forces can propel the USDINR price above this level as well with 72/$-74/$ being a tail risk price. Key international themes for the year ahead US Markets are expected to zoom higher after the proposed fiscal stimulus package is announced. Other major economies would not be able to catch up with the US and will continue to stimulate their respective economies with further easing. Policy Divergence will play out with the US continuing on its path to tightening. We expect the US to raise its interest rates 3 times or even surprise markets with an additional hike. On the other hand, ECB and BOJ will continue with the quantitative easing programs and this will take the US dollar to new heights in 2017. USDJPY will comfortably breach the 120.00 mark and head towards 125. Eurozone to remain vulnerable, we expect the Euro to remain under pressure as uncertainty from the elections in France, Germany and the Netherlands would keep investors on tenterhooks. Inflation will remain below the ECB target and will force the central bank to continue with the stimulus program. We expect EURO to breach parity against the US dollar. UK is likely to come out successful from the Brexit chaos. After a stormy 2016, following the Brexit referendum, we believe that the UK government would be successful in achieving a soft Brexit and this would be supportive for Pound. Discussions are already going on to facilitate trade before the Article 50 is invoked in March next year. We expect the British Pound to remain supported near the 1.20 level and stabilize near the 1.25-1.28 range. Oil price to trade higher as the production cut comes into effect and we also expect demand to pick in the year ahead. Price is likely to edge towards the $60 mark with the $40-$45 acting as a strong support. Growth across the globe will remain sluggish but investor sentiment will be higher and demand for stocks will remain. EM countries will struggle to perform while countries dependent on commodity exports will outperform their peers. 6
A view based on Technical Analysis: Key events highlighted on the chart Technical Chart for USDINR SPOT 7
Technical Outlook: The weekly chart of USDINR (SPOT) was in strong uptrend since June 2013. The pair kept trading above the channel line creating higher tops and bottoms in since 2013. The USDINR pair is having strong uptrend in the upward sloping regression channel line from 17 th June 2011 till date marked by the yellow upward sloping regression line with a median line in the centre of the channel. During this period, the pair has taken support multiple times near the upward sloping channel median line marked by green arrow (1)58.20 (2)61.30 (3)66.04 suggesting demand (aggressiveness of bulls) near the support line and with supply coming in at the upper channel zone marked by red arrow where the pair made a 52 week high of 68.87(25th Feb 2016) and reversed from this level, forming a bearish engulfing pattern in following weeks confirming the supply zone of channel resistance. The Pair continued this correction to 66.04 near the previous swing low of 65.96 and could not close below the Fibonacci 23.6% (connecting high 68.88-58.20low) levels suggesting demand from the bulls. On 08 th November 2016 after the demonetisation news and Donald trump election, the pair touched the supports at regression line. Then it reversed with a bullish candle going on to make new highs of 68.87 near the medium term median line, suggesting the importance of the regression line. For the year ahead we expect the trend to continue for the pair with major support at 66.00 (major swing low) and the pair is likely to trade in the regression upward sloping channel continuing along its long term appreciation trend in the channel. In the long term charts, MACD continues to remain in positive territory, confirming the possibility for the pair to test upper median channel line at 70. Conclusion: Overall we expect Indian rupee to trade in the range of 66.00 70.00 with a tail risk possibility of a break above the 70.00 mark. The USDINR pair should stabilize near the 69.00/$ mark by the year end. Recommendation for 2017: We would recommend any corporate with an exposure to USDINR outflows to hedge (40%-60%) of exposure at current price and utilize any dips near 67.00-66.50 to hedge their remaining exposure. Exporters are advised to hedge only the near term exposure as per the recommended levels and utilize the higher levels to hedge their remaining exposure in the 69-70 range. Exporters with long term exposure where the forward/future prices are quoting above the Rs70/$ mark should start utilizing the higher premiums to start hedging. Diverging monetary policy expectations if played out will diminish the interest rate differential and lead to lower forward premiums in the year ahead. 8
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