Monthly Fixed Income View & Monthly Equity View - July 23

 

Markets in wariness

The domestic bond market in June showed a divergent view from that in the month of May. The market turned increasingly cautious and gave up the hope of rate cut anytime soon. 

Global factors too turned against the bond market as resilient economy and strong labour market data compelled the US Fed to turn hawkish.

Most of the month witnessed gradual upward movement in the yields with the 10-year government bond yield grinding higher from 6.99% on 31^st May 2023 to 7.11% on 28^th June 2023.

Short term money market rates remained relatively flat with 2-3 months treasury bills trading in a tight range between 6.70% - 6.76% for most part of the month. The yield on the AAA rated 3 months- PSU commercial papers (CPs) too remained in a tight band trading between 6.90%-6.95%.

There was an upward shift in the yield curve during the month, where yields in the 3-5-year segment and even the ultra-long-term segment of 30-years saw hardening of ~17-20bps. The yield curve also steepened slightly during the month from a relatively flattish curve back in May, on account of increased liquidity and the longer end of the yield curve enduring the impact of hawkish turn in the US monetary policy.

The shift in views from ‘optimism’ in May to ‘caution’ in June was in response to a mixed bag of positive and negative cues, both domestic and global.

RBI delivering another pause but with caution:

The RBI continued its pause on rate hikes in the June policy, expressing its intentions to assess the cumulative impact of the 250bps rate hike so far.  

However, “Monetary policy needs to remain in ‘brace’ mode” said Dr. Patra and the minutes too reiterated the MPC's focus on lowering  inflation to the4% target over the medium term.

Given the CPI inflation is forecasted to remain significantly above the 4% goal for entire FY24, there is no room for the RBI to reverse the monetary policy direction anytime soon.

Liquidity continues to be in large surplus:

The banking system liquidity as measured by net borrowing/lending under the RBI’s liquidity adjustment facility, moved from ~₹ 0.42 trillion on 28^th April 2023 to around ₹ 1.25 trillion on 30^th June 2023.

The main contributors to this increase in liquidity surplus were - (1) government bond maturities to the tune of ₹ 1 trillion, (2) RBI’s buying of foreign exchange, and (3) deposits of ₹ 2000 denomination currency notes after the RBI announced its withdrawal from circulation.

The total value of ₹2000 banknotes received back from circulation since the announcement on May 19, 2023, is ₹2.72 trillion as of 30^th June 2023. This indicates that ~76% of the ₹2000 banknotes in circulation as on 19^th May 2023, have since been returned of which about 87% is in the form of deposits and the remaining around 13% has been exchanged into other denomination banknotes.

The RBI did acknowledge that deposit of ₹ 2000 denomination currency notes will add to the already high liquidity surplus in the banking system. However, they chose not to deploy any durable liquidity absorption tool to reduce the excess liquidity. Instead, resorted to conducting variable rate reverse repo (VRRR) auctions of various tenors to absorb the excess liquidity temporarily.  

In our opinion, overall liquidity condition will remain easy at least for the next three months. we would expect liquidity surplus to drain out during the second half of the fiscal year as cash withdrawals tend to pick up during the high activity festive season and elections. Until then, there could be some decline in short term money market rates.

Global hawkishness:

The outcome of the June Fed policy was a consensus pause but FED policy members released FED dot plot (FOMC members’ future expectation of Fed fund rate)  which increased the dot plots for 2 further rate hikes. The not so weak macro-economic data and sticky inflation may lead the Fed to be hawkish and is likely to keep rates higher for longer which we believe may add more holes to the now weakening US economy.  

The hawkish Fed dot plots and mixed macro-economic data trends contributed to the volatility in domestic as well as global bond yields. The 2 year and 10 year US treasury yields have jumped to 4.95% and 3.95% respectively. As per the CME Fedwatch the probability of a rate hike in the July FOMC meeting has now increased to 89%. This should keep global rates elevated in near term.

However, from more structural point of view, elevated interest rate for extended period is making the financial markets increasingly vulnerable to event risk like the one seen in March 2023 when regional banks in the US faced turbulence.  

Inflation in comfort zone but has an upside risk:

The headline CPI inflation for May was at 4.25% YoY, mainly led by lower food inflation while core CPI (ex-food, fuel) remained sticky at 5.15% YoY.

Most parts of India experienced a delayed onset of monsoon, thereby affecting the sowing pattern during the period. However, the CPI is likely to remain sub 5% for Q1FY24 and average around 5% in full year.

While favorable base effects will remain in play for another few months, it continues to have an upside risk from monsoon-related uncertainties.

Outlook:

Given a volatile global economic scenario and lingering risks to domestic inflation, the near-term outlook is slightly clouded and highly data dependent. The market is now sensitive to cues for direction with a slightly stronger indication of an upward movement. Also, given the yields have been gradually moving upward amid uncertainties around rainfall, global hawkishness, and looming clouds of recession in the US, there is a high possibility of yields moving higher from current levels in near term. However, the upside on yields should be limited to 10-20 basis points given the overall domestic macro backdrop is favorable.  

In line with our near-term cautious view, we maintain a slightly lower portfolio duration in our actively managed bond fund as a tactical position. We would look to add duration on every uptick in bond yields.

Notwithstanding the near-term concerns, we maintain our constructive outlook for long bonds in medium term. With bond yields hovering above 7.10%, much of the government bond yield curve is offering a reasonable positive real yield.

Investors with over 2-3 years investment horizon should allocate to dynamic bond funds which tends to benefit in this kind of interest rate environment.

Investors with shorter investment horizon and low risk appetite should stick with liquid funds.

Equity Outlook – July 2023

The S&P BSE Sensex rose by 3.6% in the month of June supported by strong FPI flows and reasonable macro. FPI flows have strengthened amidst India’s relative preference following weak recovery in China. S&P BSE Midcap Index & S&P BSE Small cap Index increased by 6.4% and 6.9% respectively. Moderating inflation and MPC’s decision to pause rate hikes also supported the rally. Mid and small cap companies had a relatively higher benefit from the moderation in input costs compared to larger peers. All sectoral indices advanced during the month in line with broader market trend. Healthcare, Auto, Capital Goods and Realty were sectors which advanced to a higher extent. Few pharma companies bagged product approvals aiding a better revenue visibility. Auto sales are progressing reasonably well. Rationalisation of subsidies has reduced the sales mix in favour of conventional engines benefiting the traditional auto players. Capital goods sector is benefiting from healthy order inflows and moderation in input prices. Residential absorption across top cities is showing healthy growth benefiting the listed developers.

Global indices followed a similar trend on investor hopes of a potential reversal in rate cycle and normalisation in global macro environment. S&P 500 advanced by 6.6%, broader MSCI EM index advanced by 3.8% and MSCI World Index advanced by 6.1%.

In terms of flows, FPI flows remain strong as India has a reasonable macro environment amidst the global uncertainties. Weak recovery in China is also helping the relative preference for India. FPI (Foreign Portfolio Investors) inflows for the month of June stood at USD 5.7 bn. DIIs (Domestic Institutional Investors) were buyers to the tune of USD 687 mn. Indian equities saw block deals to the tune of over $10 bn so far in 2023 compared to $ 14 bn in the whole of 2022. This is indicative of strong appetite for Indian equities.

Quantum Long Term Equity Value Fund (QLTEVF) saw an increase of 4.7 % in its NAV in the month of June 2023. This compares to an increase of 4.3% in it’s Tier-I benchmark - S&P BSE 500 and 4.0% in it’s Tier-II Benchmark - S&P BSE 200. Auto and financials were major contributors to the outperformance. Cash in the scheme stood at approximately 6.9% at the end of the month. The portfolio is valued at 12.8x consensus earnings vs. the S&P BSE Sensex valuations of 17.5x based on FY25E consensus earnings; thus, displaying value characteristics.

Should Investors be wary of incremental investment at current levels?

PMI-Services and PMI-Manufacturing indices continues to be in the expansion zone at 58.5 and 57.8 respectively in June. As indicated by the PMI survey, employment expanded over the month indicative of reasonable demand expectation by companies. Provisional figures for Q1-FY24 reported by banks and NBFCs show a healthy credit demand for most companies. GST collections and auto sales are also showing a healthy trend. Monsoon is turning out to be better than initial fears of a large deficit due to El Nino. Corporate earnings cycle and macro environment continues to be conducive for a broad-based growth. There is a reasonable chance of normalisation in global macro over the course of next year which could further stimulate the current uptrend in corporate earnings. Nifty EPS growth indicated by consensus estimates corroborates a similar story.

Nifty EPS Growth
FY19-FY23 (CAGR)	13.1%
FY24E	16.7%
FY25E	14.5%

Source: Bloomberg; FY24 and FY25 are based on consensus estimates

Indices across market caps are trading marginally above long-term average valuations. Given the recent rally in mid and small caps, risk reward looks favourable in the large cap category. Quantum follows a liquidity filter of a minimum average daily turnover of $ 1 mn over past one year, leading to a large cap tilt in the portfolio. The liquidity filter is to ensure that the reported NAV (Net Asset Value) reflects the realisable value even during times of market down turns. The following graph shows draw downs (Fall from previous peak) across indices since Jan-2004. The small cap and mid cap indices which has a higher proportion of illiquid names has had larger draw downs and longer recovery times (Time to recoup losses).

Source: Bloomberg; Data as of July 6, 2023

The stable domestic macro environment and favorable corporate earnings cycle doesn’t indicate the possibility of a material correction in the broader markets. However, a deterioration in global macro, deficit monsoon leading to a spike in inflation or uncertainty around 2024 general elections could lead to short term volatility. Investors can consider making incremental investments in a staggered manner.