2015 Review & 2016 Outlook: Fund Managers

At the start of 2014, very few would have predicted that Equities as an asset class would have one of its best years. The mood was of despair and helplessness, saddled with a government broiled in corruption scandals and a PM perceived to be inactive and silent, with a risk of multiparty weak coalition forming a government post elections. But markets have a way of surprising people and surprise it did, with the BSE Sensex giving a return of 31.4% on a total return basis. Broader indices like the BSE 200 and BSE 500 have rallied even higher, driven primarily by a historical electoral result and by perception that we finally have a government in place which is pro-business and will deliver on key reforms. Whether the government will actually deliver, only time will tell but valuations have set a high benchmark and market participants continue to wait and watch.

The other key driver of rally in Indian equities has come fortuitously for India. High crude prices the Achilles heel of the India story, one of the primary architects of high inflation as well as widening current account deficit, suddenly collapsed to multi-year lows, lowering both inflation as well as current account deficit, giving the new Indian government much needed fiscal space to put its house in order and indeed the new government has taken measures of deregulating the oil & gas sector. How long this environment of low crude prices lasts is anyone’s guess but the longer it does, the greater the time available for net importing countries like India to build a solid macroeconomic base for sustainable long term GDP growth.

Despite favorable macro tailwinds at the ground level the recovery has been weak, with the Index of Industrial Production growing at barely 2% for H1FY14 (April –Oct 2014). The private sector in India remains in a deleveraging cycle, saddled with excess debt, while government spending has remained constrained due to a weak fiscal situation as tax revenues are lower than projected. Both the drivers of capex cycle are currently in a state of forced austerity, in such a situation it would be naïve to assume that the collapse in capex cycle (the primary reason for the economic slowdown) would revive overnight and India will quickly get back to 8%+ GDP growth witnessed between 2005-2009.

‘In the country of the blind the one eyed man is king’- with the exception of India all the other countries forming part of the famous BRICS quartet saw deteriorating macros in 2014, and so FII’s continued to divert flows into India which offered hope of faster economic growth, accelerated reforms as well and a stable political setup at least for the next four years. For CY14 FIIs have been net buyers to the tune of USD 16.5 bn. The bigger story has been the comeback of the Indian retail investor via mutual funds as domestic mutual funds bought equities to the tune of USD 3.5 bn in CY14. Whether this is astute timing by the retail investor or just a function of overzealous marketing teams of mutual funds using the rally to launch new products to collect AUM, only time will tell (we fear it could be the latter).

Globally the environment remains concerning, in our view, a significant portion of the developed world and indeed the developing world could be facing deflationary risk and low growth in 2015. The biggest risk to emerging markets remains what happens to flows once the US starts tapering. The world has seen a brief episode of what such a risk can do in Aug of 2013 (collapsing markets as well as currencies, India was particularly hit badly). Since then India is in a much stronger macroeconomic position to withstand such a risk, but we are in unchartered territory, and have limited capability of foreseeing future events. Risks remain and a careful approach is well advised.

The year 2015 could be an important one in terms of the economic history of this country. It could be the year where we see passage of key reforms which lay the foundations of the sustainable long term economic growth. The markets certainly believe so; hence the strong rally in 2014, despite weak company earnings. Expectations remain elevated and delivery is awaited, any disappointment could see markets correcting. The reforms may or may not come but we remain hopeful of the long term India story; we believe India has enough quality entrepreneurs building sustainable businesses irrespective of government action or inaction. Investors would be better off ignoring all this noise and focusing on fundamentals alone. A stock specific approach focusing on company’s long term earnings potential evaluated against its risk is better. Everything else is best ignored.

Data Source: Bloomberg

Debt markets started the year on a bad note with RBI hiking repo rate by 25 basis points in the month of January 2014, due to high Consumer Price Inflation (CPI). Consumer price inflation had been above 10% levels for the last quarter of calendar year 2013, and core inflation reading above 8% levels. The RBI in January also accepted the Urjit Patel Committee report, which had recommended taking the CPI inflation as the nominal anchor instead of Wholesale Price Inflation (WPI) for monetary policy. It also suggested a intermediate glide path to target CPI inflation of 8% in January 2015, 6% in January 2016 and subsequently 4% (+/- 2%) as the acceptable level of CPI inflation.

The Debt market remained weak in the first quarter, as the initial estimates by SKYMET and other international weather bureau predicted drought-like conditions in India. Now with the RBI targeting CPI inflation, which has almost 50% weightage to food items, the market worried about further rate hikes on a monsoon failure. Also, the estimated borrowing programme was around Rs 5, 27,000 Crores, which converted into average weekly borrowing program of Rs 15,000 crores. The ten year Government security yield moved above 9% levels in early April, with the State government and AAA corporate bonds trading around 9.50 and 9.70% levels.

The BJP government’s landslide victory in the Lok Sabha elections led to buoyancy in the equity markets and stabilized the Rupee in the 58 to 61 band against the dollar. The stability of the rupee led to the FIIs investing USD 25 billion this year in the debt markets to take advantage of higher interest rate differential and stable currency prevailing in the Indian market compared with the developed markets. The RBI purchased around 50 billion of USD in the spot and forward markets, to control rupee appreciation and keep the rupee competitive on a relative basis, as the dollar strengthened by more than 10 to 15 percentage against developed market currency.

Oil prices remained elevated in the early half of the year due to the Middle East crisis, but Chinese slowdown and increased supply of shale gas from U.S. led to Brent crude oil falling from 110 to 80 dollars. Further fall in oil prices came when the OPEC cartel refused to reduce supply to match reduced demand. Crude oil supply was excess of 3 to 4 million barrels per day compared to demand, which led to Brent crude oil falling from 80 to 60 dollars per barrel. Iron ore prices fell from a high of 107 dollars to 68 dollars per ton. Commodity prices fell due to slowdown in Chinese real estate sector which led to copper, coal, steel and other metals prices falling to 3 to 5 year lows. Agriculture prices were also soft in the global market due to excess production. India being a net importer of crude and coal is seen as a beneficiary of the global commodity price falls. The fall in oil prices has ensured that the government has allowed diesel to be freely priced and has since seen a drop of more than INR 5/- in retail diesel price. India’s oil subsidy is expected to halve this year against the budgeted number.

India’s Inflation started moderating as vegetable inflation came down and due to global fall in commodity prices. The government released 5 million tons of wheat and rice from PDS to control food inflation. The governments also increase the minimum export prices of onion to USD 300 per metric ton, to increase supply of in the domestic markets.

Indian CPI inflation fell from a high of 10.04% in December 2013 to a low of 4.38% in the month of November 2014, whereas WPI inflation in the month of November, 2014 stands at Zero levels due to fall in fuel , cotton and metal prices. RBI in its credit policy in December, 2014 has indicated that it is neutral on achieving its CPI inflation target of 6% by January 2016 as against in its previous policy where it had indicated it may end up with CPI inflation of 7% in month of January 2016 and thus indicated chances of rate cut in early 2015. It also mentioned that the yields on Certificate of deposits, G sec, AAA Corporate bonds fell by 50 to 100 basis points during the year and spread between corporate bond and G Sec fell from 80 basis points to 50 basis points during the year. The ten year government bond (G-sec) yields fell from a high of 9.11% levels to a low of 7.77% in the month of December 2014.

Outlook for the next calendar year

We expect RBI to be cautious and look through the base effect of CPI inflation which has contributed to inflation remaining low. Also, given the high expectations of the Equity markets from the Budget, we expect RBI to keep rates on hold, till the Budget. The budget is expected to be presented in the last week of February and the government has committed to a fiscal road map of reducing the fiscal deficit to 3.6 % of GDP. But more than that, the RBI would want to see concrete steps from the government in increasing investments and boosting GDP growth. With the Kharif production in India at 120 million metric tons lower than last year, it may lead to higher prices of food items in the coming months.

Also, next year, in our view the Federal Reserve is expected to increase its policy rates, as the U.S. economy unemployment rates is now at 5.8% levels and full employment as defined by the Federal Reserve is 5.5% levels. However, the Federal Reserve is not expected to reach its inflation target of 2% in the next year; it has not been able to reach CPI inflation for the last 25 months due to lower commodity, lower oil prices and global slowdown in China and the rest of the world. We expect Fed to start hiking by June 2015 and the RBI would also have to take this into consideration.

GDP growth is expected to be around 5.5% for FY 15 as per midterm review of the economy, and there could be a slippage of 1.10 trillion in revenue collection. The government is expected to rationalize expenditure to keep the fiscal deficit under check. The rupee is also expected to trade in a band of 60 to 65 against the dollar as the real effective exchange rate in our view is overvalued by 10% levels as the dollar index is traded above 89 levels.

In our view, RBI is expected to cut repo rates by 75 to 100 basis points in the next calendar year to support growth. However, the sequencing of rates cut could be in the later part of the calendar year, as RBI gets more clarity on impact of the Budget, monsoon and expect path of interest rates hikes in the U.S.

Data Source: Bloomberg, RBI

Gold prices are little changed from levels where they started the year. Although a flat closing with its fair share of ups and downs, broadly speaking gold held well this year given that dollar gained more than 10%, commodities collapsed and equity markets surged. The likely reason is that much of the rhetoric surrounding tapering and rate increases was already in the price. Demand from physical/bargain buyers and geopolitical tensions in Ukraine and around the Middle East helped gold stay closer to the $1200 an ounce mark.

After the big sell off in gold in 2013, its price has since been consolidating for much of the year in a range with pivots at around the $1200 an ounce levels. A mix of opposing factors seems to be resulting in a range bound market. Physical demand and geopolitical jitters have ensured bids under gold. Whereas, the Fed’s ending of asset purchases coupled with rising expectations on rate increases have been a worry for gold markets.

A stronger dollar has kept gold price under check. However, a very strong dollar will also not be desirable from a policymaker's perspective. While the U.S. economy remains relatively better off, there are risks abroad. With Euro-zone likely to fall into recession, China slowing down, Japan in recession and Russia also likely to fall into recession, global trends can drag down US growth. If this is used as an opportunity by US policymakers to renew QE, gold and all other asset classes will surge as it will signal a renewed currency war.

As far as the rate increases are concerned, the markets have been running ahead of expectations. Rate increases by the Fed would require a really strong economy or high inflation. The economic data remains a mixed bag at best with no clear sign of a sustainable high growth. There is an argument that the recent decline in oil prices will increase savings and spending in the U.S economy. To the contrary, much of the job creation that has aided the recovery has been in or surrounding the energy sector as the shale expansion played out. There will surely be slowdown as much of it will start looking unviable in lower oil price environment. Also the boom surrounding the high yield credit has been for funding the shale boom. All of a sudden, the economic recovery may find itself on a slippery slope.

On the other end of the spectrum, central banks of Japan, Europe and China have been adding liquidity and have shown commitments to do more if deemed necessary. Markets have been carefully evaluating the diverging economic policies in different parts of the globe and its impact on currencies and gold. The big macro issues like the economic uncertainties and structural imbalances remain in place especially in the older industrialized nations. The European Central Bank is dithering about how much to expand its balance sheet with asset purchases, while the Bank of Japan has been on a quanto easing spree with bigger arrows each time the economy seems slipping. Even, China has joined the easing band wagon with rate cuts and liquidity measures. Private and public debts in advanced economies are still high and rising – and are potentially unsustainable, especially in the euro zone and Japan.

Outlook:
In our view, Gold prices could be under some pressure in the short term as the market anticipates the Federal Reserve raising interest rates. Fed would resist raising rates until they see a risk of runaway inflation or until there is a significant improvement in labour markets. The increase in rates would cause strains on the asset markets and threaten the anaemic housing recovery, both of which have been thriving on cheap liquidity. Even it would cause strains on government coffers to service public debt. If there is any moderation of expectations surrounding rate increases, the recent downward pressure on gold should be alleviated. As the market figures out that Fed will stay behind the curve and do only little and keep real rates negative for much longer, gold should start moving northwards. On the other end, the fragile economic recovery will witness further strain as the Fed embarks on its necessary exit process. Unfortunately, the US economy is now so rife with speculative activities and mal-investments that could cause a downturn by any attempt by the Fed to 'normalise' its monetary policy. The potential for underlying weak economic growth is simply another factor that could keep a bid in place for gold.

The policy divergence among the major central banks is on the verge of being very pronounced. That will have a far bigger impact on global markets. When the U.S has ended asset purchases and is contemplating rate increases, the other economies continue their money printing. Europe is working its way into an outright deflationary recession. Markets are looking for more action from the ECB and not just words. Draghi is pondering a trillion dollar package to pull the eurozone out of the deflationary rift. Will he be able to garner enough support to override German objections and will it be enough to avert deflation given the Japanese experience. What further do we see if Greece defaults again? China has been adding liquidity on first signs of crisis. The Swiss have made deposit rates negative in a bid to keep their currency from appreciating. Japan has been adding to its liquidity arrows which seem to be growing bigger each round. The widening policy divergence among major central banks is going to have a major impact on currencies and create the real potential for a currency war.

There are a number of massive financial, economic and political imbalances that have caused all of the problems. There still exist serious imbalances and problems in many countries, including excessive private and/or public debt, the unsustainable divergence between record corporate profits and steadily declining wages, rising inequality, and mispricing of asset markets at best. None of these issues have been dealt with effectively. The underlying structural issues are still there. The central bank and the government are experimenting with Keynesian demand-boosting strategies. This is likely to undermine consumer confidence going forward when the realisation dawns that these ill conceived notions do not have any favorable impact beyond the short term. Gold generally tends to perform very well during periods of declining confidence in the financial system, be it relating to the underlying strength of the economy and/or the currency.

The combination of high debt and rising inequality broadly across the globe is leading us nowhere. It’s worsening the prospects of growth and leaving us on a path of stagnation. The unconventional policies of the central banks have only been able to boost asset prices increasing the inequalities. The reflationary efforts of central banks have only given rise to more asset bubbles. In the short run Keynesian economic policies work, but the end result is that they create bubbles. In 2000 we had a tech bubble. In 2005/06 we had a real estate bubble. In 2008 we had a bubble in oil and commodities which led to runaway inflation but all eventually turned into a recession. Years of simulative policies in Japan haven’t been able to bring back growth. Such unconventional policies of central banks leads markets in a belief that the central bank would provide asset markets all the support and that it would never decline in value significantly leading to higher and higher bids for the asset creating a bubble. But eventually the notion on which the market is functioning isn’t true in any form and the bubble bursts leading to unintended consequences for other asset markets and the economy as a whole.

The explosive growth in central bank balance sheets can result into unpleasant long-run consequences of generating high inflation and can derail financial stability. Policymakers who got us into this mess are unlikely to navigate us out of it as exit processes lack a clear road map and therefore could be indeed confusing for the current state of highly sensitive markets. The unintended consequences of such unconventional polices on asset markets would probably be felt at the time of unwinding. Meanwhile, if the global economy is indeed trapped in a subpar growth environment and looming deflationary threat, then it will likely translate into central bankers getting further aggressive in building ever-greater balance sheets with ever-greater negative consequences down the road. This could be incredibly bullish for gold.

We still continue to see the world remain awash in easy money and an unconventional and aggressively loose monetary setting; this remains bullish for gold over the long term. Although, near term challenges remain as we see the markets running high expectations on U.S recovery and potential rate increases leading to a strong dollar. All the easy money infused by central bankers across the globe makes its way to risk assets especially equities that continue to get expensive by the day. However, over the medium to long term, we could see the economy showing visible signs of distress as a result of lower money on the table. Given the policy mindset, it would not be surprising to see further unconventional policy response on any signs of unsettling of asset markets; this will act as a likely trigger for gold prices to move upwards. Until then, gold prices would likely consolidate further and trade sideways in the near future. We do not know whether gold has hit the bottom or when it would. Somewhere in the middle of next year seems to be the probable timing when gold prices may start moving higher as all the mist surrounding U.S recovery and the potential rate increases and the magnitude of it should be clear. Any re-pricing of economic and political risks would bring investors back to gold.

Lower gold prices are providing investors with an opportunity to build up their allocations as it looks obvious that uncertainties still loom large in the global arena and central banks are in crisis mode. An allocation to gold in such uncertain times is important. If concerns surrounding monetization gains momentum, this could trigger another broadly based loss of risk appetite, investors would no doubt want to increase their gold holdings. We reiterate that one of the main reasons to own gold is just the sheer fact that it is one of the good portfolio diversification tools and thereby helping you to reduce overall portfolio risk.

Data Source: Bloomberg, World Gold Council