Choppiness likely as Euro zone crisis continues

Equity market update

In the month of May 2010 too, the Indian equity markets (BSE Sensex) oscillated in a narrow range of 16,000 and 17,400, thus depicting a consolidation. However, when seen from its previous month’s (April 2010) close the equity markets ended in a negative terrain (-3.5%). This indecisive movement, with a negative bias was on account of the escalating Euro zone crisis, real estate led price bubble in China and double digit inflation concerns in India.

BSE Sensex vs. FII inflows

(Source: ACE MF)

The graph above also clearly depicts that as the Euro zone crisis escalated, the Foreign Institutional Investors (FIIs) continued to press the panic button in the month of May 2010, in order to cover losses in the European markets, by booking profits in the emerging markets. FIIs turned net sellers in Indian equities to the tune of Rs 9,437 crore, as compared to being net buyers in equity to the tune of Rs 11,477 crore in the month of April 2010.

The Index of Industrial Production (IIP) number for March 2010 (declared in the month of May 2010), also reported some slow down, which eventually did not appeal to the FIIs. The IIP for March 2010 slowed to 13.5% (from 15.1% in February 2010) over the last year's figure of -2.3% in March 2009, on account of fading of the overall base effect. However, according to the quick estimates released by the Central Statistical Organisation (CSO), the IIP numbers also did reveal the following positives:

• Strong manufacturing growth - The manufacturing index, which is the principal component of the IIP, grew by 14.3% over the last year (March 2009).
• Growth in sectoral output - Output of capital goods grew over the last year (March 2009) by 27.4%, followed by growth of 12.7% in the output of intermediate goods. Similarly, the output of consumer durables and consumer non-durables also grew by 32.0% and 3.30% respectively.

What should equity investors do?

In our opinion, as the Euro zone crisis takes it course, the fear of the unknown will infuse nervousness in the minds of investors. The unknown factors could be:

• Impact of the huge debt levels of some European countries and their ability to pay
• Impact of the spending cuts.
• Impact on bond prices
• Quantum of write downs which banks will have to take in their books and their ability to maintain their credit ratings

In such a scenario, this nervous feeling will creep into investor sentiments thus making equity markets choppy in the near term. However, from a long-term perspective, we believe that India has a strong story to tell to the world, on account of the following reasons:

• Robust GDP & IIP numbers signalling economic growth
• RBI’s prudence by following a calibrated exit path from the accommodative policy, which intends to control spiralling inflation without choking economic growth
• India Inc’s promise to churn out strong earnings
• IMD’s forecast of good monsoons this year
• Domestic nature of the Indian economy - not being too export reliant, which lowers India’s exposure to such global risks

We therefore recommend investors to stay invested and invest more in a phased manner during such choppy times in the equity markets, as these are opportune times to invest in funds which are driven by strong investment processes and fundamentals. One should not look at the immediate index levels, as they do not matter for a long-term investor.

Debt market update

The 10-Yr G-Sec yield did not gallop during May 2010. Infact, it softened by 55 basis points on account of expectation of a lower fiscal deficit fueled by a huge boost to government revenues as streamed by the 3G auction in the telecom sector and on the back of a bleak chance of an intermediate policy rate hikes by the Reserve Bank of India (RBI) before its first quarter review of the monetary policy 2010-11, scheduled for July 27, 2010.

The short term rates remained stable for the better part of the month but started inching up in the last week, on expectations of liquidity tightness in June. Short term mutual fund schemes (Liquid and Liquid Plus funds) faced redemption pressures from telecom companies and banks as they withdrew money in order to fund their 3G auction related obligations thus leading to a rise in short term yields. Short term yields have risen by almost 1.0% to around 5.5% levels.

We expect liquidity to remain tight for the substantial part of the month as 3G auction payments, bond auctions and advance tax payments will suck out liquidity. We therefore expect short term rates to increase by another 50 basis points across the curve, as mutual funds would be stressed to meet redemptions leading to forced liquidations.

The prospect of lower fiscal deficit and probability of inflation cooling down between 5.0% - 6.0% by December 2010 (as quoted by the Finance Minister), will do good for the longer tenor bonds as long term rates would reduce.

However, having said that, one has to be careful about the trend in oil prices. If oil prices increase, it may flip the story – it may actually bring in an inflationary situation in the economy. Moreover, it would weaken the Rupee, as imports in value terms would increase and thereby worsen trade deficit and hamper (increase) fiscal deficit, as higher subsidies will be provided for compensating the petroleum companies for retailing fuel at below production costs. There is economic sense in increasing fuel prices but currently it seems political compulsions are stalling the process

What should debt investors do?

In our opinion, any intermediate policy rate hikes by the Reserve Bank of India (RBI), before its first quarter review of monetary policy 2010-11 (scheduled for July 27, 2010) looks unlikely. But, in order to make policy rates more normalised and more relevant to the current economic growth and inflation, we believe that RBI will continue to adopt the calibrated exit path from the accommodative policy by increasing policy rates by 25 basis points at each step.

As short term rates are expected to rise, (for the reasons mentioned above) it would be prudent for investors with a short-term horizon (i.e. 3 months or less), to invest in liquid funds or liquid plus funds for the next two months. On the other hand medium term investors with a time horizon of 6-12 months can invest in floating rate funds.

Investors should wait before allocating their money to Fixed Deposits (FDs), as a further increase in deposit rates is expected from the banks. One year FDs would be attractive only above 7.5% so as to obtain real growth, after factoring in inflation. One year bank FDs are currently available at 5.0% to 6.5%.

Gold Update

(Source: World Gold Council)

In the month of May too, gold prices increased further and once again pierced the U.S. $ 1200 per ounce mark, thus now being close to its all time high (U.S. $ 1,226 per ounce) in December 2009. It thereby also indicates that the consolidation in gold prices seems to be ending, and once again gold is becoming bold, due to the burgeoning crisis in the Euro zone.

For the month of May 2010, prices as measured by the London AM Fix leapt higher by 3.23%, as the U.S. dollar strengthened. But it seems that markets have realised that the recent U.S dollar strength is more because of the problems faced by the Euro zone, than on the dollar’s own merit.

In the Indian markets too, gold prices ended at Rs 18,407 per 10 grams (on May 31, 2010), up by 8.1% from its previous month’s close (Rs 17,030 per 10 grams). This increase in gold prices is again nourished primarily by the Euro zone crisis, depreciation of Indian Rupee against the US dollar and the local demand for the precious metal due to the ongoing marriage season.

What should investors do?

We believe that gold as an asset class is an excellent diversification tool for investors. Also, gold is the classic safe haven in times of prevailing global economic uncertainty. Gold is seen today as an “insurance policy”, on account of the rising concern about “currency devaluation”, ‘’sovereign debt crisis” and “inflation”. Hence in such situations, we suggest that investors should gradually keep allocating to gold and make the most of any declines by increasing allocations to this asset class.

At Personal FN, we recommend that every investor should have a minimum of 5%-10% allocation to gold. Invest in gold with a long term perspective with a time horizon of 10 to 20 years.

Address questions or comments to: research@personalfn.com

please write to services@personalfn.com

For Debt Market Update, the inputs were taken from the Fund Manager - Fixed Income of 'Quantum Mutual Fund'."

For Gold Update, the inputs were taken from the Fund Manager - Commodities of 'Quantum Mutual Fund'."

For private circulation only. This note is being circulated to clients of Personal FN's investment solutions services and subscribers of Personal FN's premium services.

Disclaimer:This newsletter is for Private Circulation only and not for sale, is only for information purposes and Quantum Information Services Limited (PersonalFN) is not providing any professional/investment advice through it and, does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to an offer to buy or sell financial products, units or securities. PersonalFN disclaims warranty of any kind, whether express or implied, as to any matter/content contained in this newsletter, including without limitation the implied warranties of merchantability and fitness for a particular purpose. PersonalFN and its subsidiaries / affiliates / sponsors / trustee or their officers, employees, personnel, directors will not be responsible for any direct/indirect loss or liability incurred by the user as a consequence of his or any other person on his behalf taking any investment decisions based on the contents of this newsletter. Use of this newsletter is at the user’s own risk. The user must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary. PersonalFN does not warrant completeness or accuracy of any information published in this newsletter. All intellectual property rights emerging from this newsletter are and shall remain with PersonalFN. This newsletter is for your personal use and you shall not resell, copy, or redistribute this newsletter, or use it for any commercial purpose.