)
The US Federal Reserve (Fed) left its overall monetary policy unchanged and provided breathing space for global asset markets. However, within no time, political squabbles in the US over fiscal policy are taking the country to the brink yet again, although we very much doubt that the government will default on its debt obligations.
With the on-going fiscal tiff combined with modest growth recovery and low inflation, we believe it unlikely that the Fed will start to scale back quantitative easing (QE) at its upcoming policy meeting.
If tapering doesn’t start in October, it would seem unusual for the central bank to start tightening policy just before the Christmas shopping season, which would then make early 2014 the most likely time for a Fed move.
Domestic growth momentum continues to be slow, owing to a sharp drop in investment activity combined with weakened government and private spending. However, from here on consumption-led demand is likely to pick up with the expected improvements in agricultural output.
The government’s push to revive investment demand in the last six months could help revive economic activity over the next two to three quarters. However, we need a strong and stable policy regime for a sustained recovery in economic activity to revert to earlier trend growth; this is only likely after the elections in 2014.
The Indian rupee has appreciated sharply by around 6.5% since September, owing to the RBI’s measures and improved outlook for trade deficit. These should support the rupee and lessen the impact of the Fed scaling back QE.
Should there be fiscal slippage, in the absence of any other credible measures to restrict the deficit, the only option would be to cut planned expenditure again, which would be counter-productive for growth.
Inflationary concerns resurfaced yet again, led by food and fuel inflation, but the RBI appears to be focused on managing core consumer prices (CPI) in its policy framework. This measure rose to 8.2% against the repo rate of 7.5%, making the case for another 25 to 50 basis points of repo rate hikes to turn real rates positive.
However, over the medium term the inflation outlook appears stable with a downward bias owing to recent currency appreciation and the expected rise in grain production. Currency stability will support liquidity provision by the RBI, which will favourably impact short-term yields. As a result, we maintain a positive stance on shorter-dated bonds.
Against this macro backdrop, we expect equities to be range-bound between 5,600 and 6,100 (Nifty) as most headwinds are priced in and possible tailwinds are still some distance away. The Nifty is trading on a P/E multiple of 13.3, based on 12-month forecast earnings. This is below the 10-year average of 13.8.
Earnings momentum looks set to remain weak for at least another two quarters given weak demand and companies’ lack of pricing power. Foreign portfolio flows have totalled $2.2 billion since September. However, given the overhang of global events (like fiscal tiff and QE scale-back) we don’t see this yet as a secular reversal of flow trends.
We continue to prefer large-cap stocks over mid-caps as we find the risk-reward more favourable for large firms currently. Among sectors, we continue to favour consumer staples, healthcare and information technology.
We have upgraded consumer discretionary and utilities to neutral from underweight because of attractive valuations and supportive earnings momentum led by improvements in the sector-specific macro outlook. We are cautious on financials given the surge in credit costs and compression in interest margins with the protracted slow down.
The weak domestic economic outlook and fast-changing currency dynamics underscore the need for portfolio diversification in global equities. The outlook for China has improved recently following positive data surprises.
The Chinese market is expected to be resilient in the event the Fed starts scaling back QE, with authorities able to maintain policy flexibility to deal with any slowdown in growth. The on-going improvements in key macroeconomic data from the US and better-than-expected earnings augur well for US equities.
The author is CIO, RBS Private Banking, India
