Equity & Debt Strategy

Equity & Debt Strategy

Equity Market Update

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Summary:

Global indices – earnings growth & valuations

Global Overview:

2016 looks to be a challenging year

Global GDP growth projected to be above 3%, downside risks given weak US GDP in first quarter (0.5%) , and shocking jobs data for the last month.

Global earnings growth shows deceleration (CY14: 4.9% & CY15: -0.6%)

Dollar Index has retreated from the highs, but is range bound without much downward bias

China is stabilizing , fears of Yuan depreciation have diminished, capital outflows have shown signs of reversal but commodities are pulling back on massive speculation.

Key points of debate:

Britain’s exit from EU, and if it happens what is the potential impact on the global financial markets?

The probability of US Fed Action amid weak jobs data and slower economic growth and options for the fed.

The resolve of the world powers in the G7 to work together on improving economic prospects through Fiscal, structural and monetary measures given domestic compulsions

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Global Growth:

U.S. & U.K. to drive global growth in CY16

Global GDP growth is projected to be

above 3% for the next two years. Hopes are Eurozone will continue to grow in

CY16. U.K. is expected to maintain growth momentum in CY16.

US kept up the growth momentum in CY15. CY16 and CY17 are likely

to see growth of 2% or above.

Source: Bloomberg

China & India are likely to grow at 6-8% in

CY16-17. S. Korea could grow at ~2.5 -3% & Japan at

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India:

Sector Performance

Sector-wise Performance (May’16)

• May’16 saw a rally in the market with Nifty (+4.0%) & Sensex (+4.1%) posting good returns.

• For May’16, Capital Goods (+9.6%) & Banking (+5.2%) were the biggest gainers, while Healthcare (-2.2%) & Oil & Gas (-0.4%) posted lowest returns.

• Other sectors which performed better than Nifty/Sensex in May’16 were: Auto (+4.8%), Realty (+4.7%) & FMCG (+4.5%).

• Other sectors which performed worse than Nifty/Sensex in May’16 were: Consumer Durables (-0.2%), Metals (-0.1%), Power (+1.4%), Teck (+1.7%) & Infotech (+2.2%).

• On YTD basis, Healthcare (-9.8%), Power (-4.4%) & Oil & Gas (-2.4%) have given the least returns, while Metals (+7.5%), Realty (+5.7%) & Infotech (+4.7%) & Auto (+4.6%) have given the best returns.

• On YTD basis, Nifty (+2.7%) and Sensex (+2.1%) have posted positive returns.

India:

Indices Performance

• Good corporate results, forecast of above normal monsoon, strong US home sales data, government’s approval on the National Capital Goods Policy & the passage of bankruptcy bill in Rajya Sabha drove the rally in the market. Though weak Chinese factory data, changes in the India-Mauritius tax treaty, disappointing CPI & IIP data weighed on the market at the start of the month.

• FY17 started positively with Sensex and Nifty Indices posting 2.1% and 2.7% returns on YTD basis, respectively. On the other hand, CNX Mid Cap index was down 0.8% and BSE Small Cap index was down 5.9%.

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Valuations:

India remains expensive vis-a-vis other emerging markets

India earnings as expected has picked up from the lower base, with fourth quarter results being better than the consensus

expectations

Despite better growth ,India looks slightly expensive vis-a-vis its peers in EMs.

However, there is expectation of good monsoon and if govt. is able to push GST reform, then from FY17E perspective, India may look only moderately expensive.

-20% 0% 20% 40% 60% 80% Ap r-05 N ov -05 Ju n -06 Jan -07 Au g-07 Ma r-08 Oct-08 Ma y-0 9 De c-0 9 Ju l-10 Fe b -11 Se p -11 Ap r-12 N o v-12 Ju n -13 Jan -14 Au g-14 Ma r-15 Oct-15 Ma y-1 6 De c-1 6

MSCI India Premium vs MSCI World (1-yr FW Basis)

Source: Kotak Institutional Equities Source: Kotak Institutional Equities

Macros:

GDP

IMF sees India as the fastest growing amongst major economies with GDP growth of ~7.5%, compared to 7.2% in FY15. Monsoon is expected to be above normal, there is good possibility of wider distribution

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Macros:

IIP

April IIP growth at (-) 0.8% much lower

than ours and

consensus expectation. Manufacturing sector growth at (-)3.1%

Capital good growth at (-)24.9%; Consumer goods growth at (-)1.2% Consecutive six months of negative capital goods growth does not instill confidence in the private capex cycle recovery.

Macros:

Inflation (CPI)

May CPI inflation increased to 5.76% after 5.47% in April.

The increase in the headline print was largely on account of food inflation, which increased to 7.6% after 6.4% in April, with broad-based increases.

While there are upside risks emanating from higher crude prices and 7CPC implementation, KIE expects price pressures on volatile food items to ebb in the subsequent months.

Core inflation, however, softened marginally to 4.48% from 4.69% in April.

Kotak Economic Research continues to monitor the monsoon outturn and retain their call for a 25 bps rate cut in 2HFY17.

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Macros:

Inflation (WPI)

WPI inflation registered second consecutive positive reading, after almost 1.5 years of contraction. May WPI inflation printed 0.79%, after 0.34% in April.

Notably, food inflation mirrored the trends shown in CPI inflation, picking up sharply to 7.88% after 4.2% in April, helped by sequential pickup across the board, primarily vegetables (14.4% mom), pulses (7.0%) and egg, meat & fish (1.5%). Non-food primary goods articles eased to 4.5%.

As the base effect wanes, Kotak Economic Research expects FY2017 WPI inflation to average 3% against (-)2.5% in FY2016.

Core inflation, on the other hand, has remained in the negative territory, printing (-)0.43% in May from (-)0.75% in April. Core inflation is expected to turn positive from 2QFY17 and average1.4 % in FY2017 against (-)1.5% in FY2016.

Macros: Monsoon

IMD forecasts above normal monsoon in FY17

IMD maintains monsoon rainfall at 106% of LPA

July and August likely to receive rainfall of 107% and 104% of LPA

North-west, central and south peninsula to receive rainfall 813% above LPA; north-east at 6% below LPA

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Flows:

Foreign & Domestic net investments

• After huge inflow in March for the Emerging Markets , April ,may witnessed moderation in FII Flows ,In June so far we have witnessed some positive momentum.

• The capital outflows from China have stabilized , lower volatility in currencies have led to some stability in the EMs.

• Moderation in Dollar index, and weak economic data from US suggest fed to hold on June rate hike which will be positive for the flows.

India Sectors:

Earnings growth & valuations

• FY17E to FY18E earnings growth is expected to be in a range of 12-20%; Q4 results were better than expectations and suggest very low probability of downgrade.

• Focus on sectors which are likely to report earnings growth above that of Nifty on a CAGR basis between FY16 & FY18E. These are:

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India Valuations:

Trading close to 10 yr averages

On one year forward earnings, Sensex (26396) trades at~ 17x (i.e. on June ’17E EPS of Rs.1520)

KIE EPS estimates: FY16: Rs.1290 (1289) FY17E: Rs.1484 (1502)

Consensus EPS :

FY17E: Rs.1646 (1725)

We continue to maintain our our PE range to 15x-to-17.5x. This is mainly on the back of positive leading indicators. However if the GST reform materialize the range is expected to move to 15-18x

India Earnings:

Q4 preview

The earnings of the Sensex companies have grown at 7.5% ahead of our expectation of 6.7%. the growth ex-energy was higher at 10.1%

Net profits of the BSE-30 Index excluding banking companies were 8% ahead of expectations .

Banks reported very high loan-loss provisions in 4QFY16 pertaining to fresh impaired assets.

Adjusted EBITDA of the BSE-30 Index increased 14.5% yoy versus our expectations of 12.3%

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India Equities:

Outlook

• G7 meeting was successful with concluding statement :“we commit to strengthening our economic policy responses in a cooperative manner and to employing a more forceful and balanced policy mix, in order to swiftly achieve a strong, sustainable and balanced growth pattern.” Thus guidance is amply clear for more international cooperation including fiscal cooperation hence lowering of risk in terms of the market volatility

• With the disappointing GDP and Jobs data ,the US Fed is likely to go slow on the rate hikes; this move is likely to provide stability to the emerging market currencies in the medium term.

• ECB reiterated commitment to continue QE for an extended period of time, if required .

• The Bank of Japan has suggested that policy makers will not hesitate to expand monetary stimulus in order to achieve their 2% inflation target.

• Thus, the accommodative monetary policy adopted by most of the influential central banks is likely to continue.

• The extraordinary expansion in the balance sheet of the central banks could be a structural risk, however we do not see it materializing in the short term.

• The domestic monsoon is expected to be above normal; this along with Government capex, 7th _{CPC, and focus on the}

rural sector is likely to contribute to the recovery process in India.

• The initial quarterly numbers suggest low probability of downgrades in FY17.

Key risks:

Mainly stems from global factors

• The risk of Brexit has gone up with more surveys indicating lead of “leave campaign”.

• Confidence in policy traction is slipping amid concerns about the ability of overburdened monetary policies to offset the impact of higher economic and political risks.

• The US has been witnessing fragile recovery which is reflected by volatile data points . A sharper correction in the Chinese or any other major economy could have negative spill over effect on the US growth.

• Emerging markets run the risk of broad-based selling if the US Fed moves contrary to expectations and decides to

consistently raise rates in CY16 & thereafter faster depreciation of the yuan or increase in the geopolitical tensions could lead to higher volatility.

• Fall in the global trade has been a major risk for the trans-border flow of liquidity and global growth. Earnings downgrades is a global phenomenon due to currency movements and fall in global trade.

• China is in the midst of shifting from investment to consumption driven economy. This is leading to medium term slowdown in their economy, this coupled with excessive leverage could be potential source of global commodity and currency volatility.

• The crude and other commodity prices have stabilized to some extent , any return of the volatility could derail the stability in the markets .

• On the domestic front we might witness some currency volatility on FCNR related expectations of tightening of liquidity, the risk of monsoon being lower than expectation also remains a major risk.

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Strategy:

Continue to remain Neutral

• On the global front we are witnessing signs of risk to expected growth of ~3.5%.

• On the domestic economic front, Monsoon is expected to drive the rural economy, further leading indicators like diesel sales, MHCV and LCV sales, air traffic, direct and indirect taxes, electricity, cement and construction equipment production etc. are pointing to economic recovery.

• The recent Rajya Sabha elections points to increased probability of GST reform.

• The government capex spending is likely to positively affect industrial sector. But private capex continue to lag.

• With signs of economic revival, expectation of better monsoon, and the Q4 result numbers being better than expectation suggest the risks of downgrades have reduced considerably.

• However at this point we are not changing our conservative stance and expect Sensex EPS for FY17E at Rs.1484 & that of FY18E at Rs.1750.

• Assigning the forward PE of 17x (slightly below last 10 years average) our Sensex target would work out to 30500 an upside of approx. 15% from current levels of 26396

• On the immediate downside, we expect the market to take support at 15x, which works out to Sensex levels of ~22,800, which is approx. 14% downside from current levels.

Equity MF Strategy

 Recommended allocation within equity mutual funds is as under:

- 100% Large Cap allocation

- This allocation to Large caps can also be taken through Opportunistic Funds which currently have a bias towards Large cap

Debt Market Update

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RBI policy: Pause on rates and focus on liquidity easing

• RBI expectedly kept the policy rates unchanged but emphasized on its aim to reach neutral banking system liquidity over a period of time. With the recent inflation resurgence, RBI reckoned considerable uncertainty around the inflation outlook, but maintained the forecast unchanged from April policy.

• RBI highlighted upside risks to inflation such as –

(1) pickup in food inflation beyond the seasonal effects (especially in items such as pulses and sugar), (2) sticky services inflation and

(3) reversal in commodity prices

• On growth, RBI retained the real GVA growth projections for FY2017 at 7.6%, premised on improving consumption demand and some private capex crowding in of public investment.

• The immediate policy focus will continue to be on better transmission of past rate cuts and assessment of domestic liquidity backed by RBI’s new liquidity management framework. On the policy strategy with regards to managing volatility around the period of upcoming FCNR (B) maturities during September-December, RBI reassured of its readiness to offset any INR liquidity shortfall, or do FX intervention, if needed

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Liquidity

• As of June 09, 2016 banking liquidity deficit was Rs 31.999 Cr compared to Rs 1 lakh crore for month of May

• The pace of OMO purchases ( Rs 70,014 crore FYTD of net OMO purchases compared to Rs 52,324 crore in FY16) in July-August is likely to fade given the expected easing in system liquidity on the back of seasonal payback in CIC, RBI’s dividend declaration to the government and likely Rupee liquidity through FX intervention.

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Govt surplus cash balance (Rs. bn) Total systen liquidity deficit (Rs. bn)

Macros:

CPI

• CPI inflation continued to move higher in May led by increase in food prices. May CPI inflation increased to 5.76% after 5.47% in April (Kotak Estimate: 5.7%, consensus estimate: 5.6%). The increase in the headline print was largely on account of food inflation. A favorable monsoon can keep a lid on the speculative pricing and help in keeping inflationary pressures at bay.

• Core inflation, however, softened marginally to 4.48% from 4.69% in April

• Our inflation trajectory mostly mirrors that of RBI, with the 4QFY17 inflation expected to average 4.8%, and end-FY2017 inflation around 5% mark

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Ten Year G-sec & Repo Spread above historical average

10 Year G-sec spread over Repo is currently trading at 98 bps against average of 79 bps over last 10 year.

10 Year AAA PSU Spread over G-sec

10 Year AAA PSU Bond spread over G-sec is marginally below historical levels. Current spread at 86 bps against average spread of 88 bps in last 5 years. Corporate Bond spreads could widen on account of supply and possibility of FII selling Source : Bloomberg

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Global Rates

• Spread between Indian ten year G-sec and US 10 Year Treasury currently at 5.81% substantially above historical average spread of 4.96% in last 10 years; thus giving Indian Bonds enough cushion even if US rates were to go up.

SDL Yield – Attractive Spread

Source: CCIL, Bloomberg

SDL’s trading at spread of 60 bps over G-sec

Spread over 60 bps existed only 27% of the times in last 5 years Median spread between SDL & G-sec is 46 bps

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 7 7.5 8 8.5 9 9.5 10 03 -01 -11 03 -03 -11 03 -05 -11 03 -07 -11 03 -09 -11 03 -11 -11 03 -01 -12 03 -03 -12 03 -05 -12 03 -07 -12 03 -09 -12 03 -11 -12 03 -01 -13 03 -03 -13 03 -05 -13 03 -07 -13 03 -09 -13 03 -11 -13 03 -01 -14 03 -03 -14 03 -05 -14 03 -07 -14 03 -09 -14 03 -11 -14 03 -01 -15 03 -03 -15 03 -05 -15 03 -07 -15 03 -09 -15 03 -11 -15 03 -01 -16 03 -03 -16 03 -05 -16 G-Sec SDL Spread

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CP’s at attractive spread over CD

CP’s are getting traded at 1.15% over CD’s against five year average of 44 bps

Themes to invest in Bond Market in Current Environment

 Possible volatility due to FCNR outflow during the September-November period– We would recommend not to invest in long duration as there could be some volatility on account of FCNR outflows. Post the event we would review the strategy on long bonds

 The risk of maturity mismatches will cause swings in FX reserves and hence INR liquidity

 Limited scope for rollovers as ~85% of FCNR deposits were from leveraged funds

 Long bonds yield movement would be dependent on pace of RBI OMO during that period

 Attractive Absolute Yield & Spread –Invest through State Development Loan’s (SDL’s) for Held to Maturity

 Attractive Yield– Play thru High Yielding Funds/ FMP’s (allocation based on investor risk profile)

 In last 1 months high yield funds have underperformed duration strategy.

 Rate cut by RBI has not impacted the yields in the credit segment significantly thus the segment could do well going ahead.

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Risks

 CPI overshooting RBI’s projection

 Unwinding of positions by FIIs in Indian Debt / Equities

 Any major geopolitical risks and disruption in crude supplies could hurt India.

 Sharp reversal in direction of global commodity prices leading to widening of fiscal deficit

 Sudden changes in global monetary policies

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