The sharp bounce back in Index of Industrial Production (IIP) witnessed in October 2012 proved to be ephemeral. The data released for the month of November 2012 shows a slump in the factory output which shrank by 0.1% month-on- month. However, it has risen by about 1.0% year-on year basis. Manufacturing industries which constitute nearly 76% of the index showed muted growth. Mining activity decelerated and depicted negative growth of 5.5%. On the other hand, Electricity sectors which grew by 2.4% restricted the fall in IIP Index to 0.1%.

There was a downward revision in the IIP growth (from 2.3% to 2.0%) registered in August 2012. This has been the second downward revision so far.
 

IIP Growth- Topsy-Turvy Continues

(Source: CSO, PersonalFN Research)  

The following constituents of IIP Index affected the growth numbers
 

• Manufacturing index, which constitutes nearly 76% of the industrial production index, failed to maintain the momentum in growth it demonstrated in October 2012. As many as13 out of 22 industry groups (As per 2-Digit NIC-2004) in the manufacturing sector have witnessed fall in the growth. However, these 13 industries collectively form only 27% of IIP (36.3% of manufacturing index). Among industries which performed poorly, "Other Non-Metallic Mineral Products" and "Motor Vehicles, Trailers and Semi-trailers" are the major industries in the manufacturing index with significant weight of 5.7% and 5.4% respectively. While former showed a negative growth of 7.5% the later grew at negative 18.7%. Growth in some major sectors such as Base Metals (+7%), Chemicals (2.5%) and Textiles (4%) helped curb the hard landing.
  
  There has been an upward revision in numbers reported for October 2012 but manufacturing growth for the month of August 2012 has been revised downward for the second time.
   
• Consumer goods index posted 1.0% growth in the month of November 2012. Although the growth may appear lacklustre, it has not fallen in the negative territory despite the higher base effect. Continuing their outperformance over non-durables (which witnessed a growth of 0.3%), sector of consumer durables has grown at 1.9%. There have been 2 upward revisions in the growth numbers reported for August 2012 October 2012
   
• The capital goods index dipped again posting a negative growth of 7.7%. This shows that 7.5% growth demonstrated by the sector in October 2012 was mostly on account of low base effect and not as a result of pick-up in activity. Growth numbers for the month of August 2012 have been revised downward for the second time.
   

Our View:

There has been a lull in the manufacturing activity primarily caused by high cost of borrowing and fewer capex plans by corporate. Lately, the government has introduced a slew of reforms which has boosted the business sentiment. WPI inflation for the month of November 2012 has been 7.24% which is the lowest reading in FY 2012-13. Cooling inflation and deceleration in IIP growth may prompt RBI to cut policy rates by 25bps or 0.25% at third quarter review of monetary policy which is scheduled on January 29, 2013. This would be supportive to growth and IIP may show improvements going forward. Recently Government has imposed a safeguard duty on electrical insulators imported from China at the rate of 35% for 1 year which will reduce to 25% thereafter. This is considered to be a positive for power equipment makers. Such policy initiatives taken with a view to provide level playing field to the domestic industry may result in robust performance of manufacturing sector.

What should equity investors do?

Going forward, it remains to be seen whether FIIs would continue to exude confidence in 2013 as well, because India's current account deficit is widening (it was at a record high of 5.4% of GDP in the September 2012 quarter) and fiscal deficit could also fail to achieve the target of 5.3% GDP; although the Government is quite ambitious on its path of fiscal consolidation. Due to ballooning deficit, rating agencies have warned of axing India's sovereign ratings and if this situation continues or worsens, it would not be too long before they rate India as "junk". Stating that the Government is likely to miss its fiscal deficit target for the current financial year, rating agency Fitch said India may face a credit ratings downgrade in the next 12-24 months. Standard & Poor's had also warned that India still faced one-in-three chance of downgrade in its sovereign rating to junk grade over the next 24 months citing high fiscal deficit and debt burden. "A downgrade is likely if India's economic growth prospects dim, its external position deteriorates, its political climate worsens, or fiscal reforms slow," the S&P had said in a statement.

It is noteworthy that India is encountering a slowdown in economic growth rate due to negative ripples seen earlier from the global economy and to near to high policy rates seen so far. The recent IIP data for November 2012 at -0.1%, has proved that October 2012's sharp impulse was a mere positive statistical effect and to an extent supported by festive season.

Thus far sticky inflation over the comfort zone of the RBI has induced the central bank too to maintain its anti-inflationary stance. Recently, RBI Deputy Governor, Dr K.C. Chakrabarty said, "Definitely today the policy rate is 8.0%. Inflation should come not come down to 3.0% to review the rate but that is depending on the macro economic situation." Thus the RBI is looking at the current macroeconomic situation besides inflation before taking a call on reducing interest rates. Dr. Chakrabarty has also added that 7.0% inflation is definitely not the comfort zone, and the RBI has at many occasions said that it should be around 5.0%. In the 3rd quarter mid-review of monetary policy the central bank has hinted at reducing policy rates in support of economic growth; but we think that since inflationary pressures yet exist, the policy rate cut may not be very aggressive - it could be a 25 basis points (bps) reduction.

At present the global sentiments are conducive for the markets. With the U.S. Senate approving the last minute deal to avert a fiscal cliff, confidence has been imbued into the global economy. The Senate passed the legislation, which would make taxes remain steady for the middle class and rise at incomes over U.S. $4,00,000 for individuals and U.S. $4,50,000 for couples - levels higher than President Barack Obama had campaigned for in his successful drive for a second term in office. As far as spending cuts are concerned, they are totalled at U.S. $42 billion over two months. In the Euro zone too with bailout package doled out for Greece (€40 billion, aimed at bringing an immediate 20% reduction to the country's debt) and Spanish bank loans restructuring approved (expected to inject around €37 billion into the Euro zone), worries over the Euro zone debt crisis too have receded for the time being. China too is showing signs of economic recovery with better manufacturing data (HSBC China manufacturing Purchasing Managers' Index rose to a final reading of 51.5, an upward revision from the preliminary 50.9 result) being reported due to news business flows. FIIs have exuded confidence thus far into our equity markets by being net buyers to the tune of Rs 5,772 crore (until January 07, 2013), and the BSE Sensex too has ascended by about 1.4% since the beginning of the new calendar year.

But we think, hereon the markets would be watchful of:
 

• Political scenario in India (ahead of 2014 general elections)
• Ballooning fiscal deficit
• Widening CAD
• Manufacturing data
• Services sector growth
• Economic growth rate
   

While the Government may make an attempt to pronounce a populist Union Budget 2013 and try to elevate sentiments, it could in the long-term be damaging for our fiscal position. Also with recovery in China, FIIs may not shy away from turning their focus on Chinese equity markets. Moreover recovery in China could also stoke-up commodity prices leading to inflation in India.

Thus in the background of the above, we recommend investor to stagger their investments to mitigate risk. While in investing in equity mutual funds, we recommend one to opt for the SIP (Systematic Investment Plan) mode of investing, as it will enable you to mitigate the volatility through rupee-cost averaging and power your portfolio with the benefit of compounding. However, while selecting mutual funds for your portfolio, prefer the diversified equity funds which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years.

What should debt investors do?

Going forward, since inflationary pressures are evident for about of couple of months, RBI would have reasons to remain cautious in its monetary policy stance. But taking into account once again a contraction in IIP (-0.1% in November 2012), the markets are factoring a 25 bps (0.25%) cut in repo from RBI in its 3rd quarter review of monetary policy 2012-13 (scheduled on January 29, 2013). Anything in excess of that would protract the current rally in Government securities. Going forward if the RBI reduces rates and shows consideration for growth, long-term debt funds may perform even better. It is noteworthy that the liquidity deficit in the system and expectation to see a rate cut by RBI has given rise to investment opportunities at both the ends of the yield curve, where long-term debt funds are likely to perform better.

However the Indian debt markets would be careful over what the Finance Minister's Budget 2013 budget speech pronounces. If the Budget 2013 is populist, the Indian debt markets may witness upticks in yields once again as such a budget would put further pressures on India's fiscal deficit.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 month, or liquid plus funds for next 3 to 6 months horizon. However, investors with a short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

The present scenario also seems comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can now hold some exposure to pure income funds. Since longer tenor papers could become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an investment horizon of say 2 to 3 years. However, one may witness some volatility in the near term as there is always an interest rate risk associated with longer maturity instruments.

Fixed Maturity Plans (FMPs) of upto 1 year may for some more time yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity. You can consider investing your money in Fixed Deposits (FDs) as well, before the interest rates offered on them are reduced further. At present 1 year FDs are offering interest in the range of 7.50% - 9.00% p.a.

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