Over the last 3 months, the rupee has depreciated 4-5% against the US dollar. The rupee has remained largely steady against the US dollar over the last few years, which is contrary to long term trends. Theory says that the rupee should depreciate against the dollar over long periods of time at a rate of about 3-4% p.a. which is in line with the inflation differential between the two countries. Since 1993 the rupee has depreciated against the dollar by roughly 3% p.a.

However, this expected depreciation of the currency is not a smooth affair and is punctuated by volatility, largely on account of factors like the current account deficit and the capital flows into the country. The largest component of the current account deficit is the trade deficit which is the difference between the total goods and services exported by a country and the total goods and services imported by the country. Remittances and other transfers make up the rest. India’s trade deficit this year (including invisibles, a large item of which is IT services exports) is estimated at $48 bn. This is up sharply from $15bn last year though short of the record USD $88bn in FY2013. One of the important factors affecting the trade deficit is that oil prices are up sharply in recent months, due to higher global growth and a curtailment of supply by producers. Brent oil futures, which were trading at about $50-55 a year ago, have climbed into the mid-70s and this causes some strain on India’s trade deficit. Traded good exports grew at 10% last year but imports grew a higher 20%. Oil imports are up 25.5% and non-oil imports are up 17.9%. The other factor affecting India’s current account is that ‘invisibles’ which consist largely of IT services exports and remittances, has shown a slowdown in growth after showing remarkable growth in earlier years.

The current account deficit is normally bridged by capital inflows – FDI and FII. FDI inflows have bumped up in the last few years from the roughly $20bn levels 5 years ago to about $40bn levels currently. FII equity flows which have ranged between $10-$20 bn over the last many years, slowed down to a roughly $2bn pace in FY2018. FII Debt flows have been strong at roughly $20 bn. On the whole, capital inflows continue to be stable.

In 2013 the Indian rupee witnessed a lot of volatility and touched the 68 to the dollar mark. Since then, the rupee has done rather well and has actually appreciated marginally over a 5 year period – the last time one remembers such a long steady period for the rupee is during the 2004-2007 period when emerging market flows were very strong.

One way to gauge the valuation of the rupee with respect to its trading partners, is to look at the REER, or the Real Effective Exchange Rate data, which the RBI publishes regularly. The most frequently observed readings of the REER on 36 Currency Trade based weights are somewhere between 99 and 120 over the last 10 years. In December, 2017 the reading was at 122.6 and was at 117.4 as on March, 2018. The higher the value of the REER the more overvalued we can expect the rupee to be and this may be exerting some pressure on the rupee.

A depreciating rupee has twin effects – it benefits exporters and increases the cost of imports thus also feeding into inflation. From our portfolio perspective, since we have some IT services companies and pharmaceutical exporters in the portfolio, we believe the portfolios are sufficiently protected against any major weakness in the rupee, and are even likely to benefit.

The Nifty closed the financial year, FY2018, with a 10.25% gain – in many senses this has become the average return of the Nifty in recent times. The Nifty has compounded at 6% pa on a 3 year basis and about 12% pa on a 5 year basis. It is worth remembering while comparing returns over any period, to try and keep in context the valuations at the beginning and end points and the environment that they represent. The 3 year return is low because it is on the base of the strong rally in the Nifty in the year ended 31-Mar-15, when the Nifty was up 27%.

When one looks out at longer time frames, the 10 year return on the Nifty is 7.9% pa while the 20 year return stands at 11.6% pa. It is important to note that once you are analysing 20 year and longer duration returns, the starting and end point valuations are less relevant in determining the final result. Some under valuation or overvaluation at either the start point or end point gets neutralised by the long period over which the return is being calculated.

It is interesting to compare the returns generated by the Nifty over the years to the growth in nominal GDP over the same period. To give a context, the typical GDP growth number which one normally reads about is the ‘real GDP’ growth, which closely represents the volume growth in GDP. Real GDP has been averaging 7.0-7.5% pa growth over the past several years. Nominal GDP, on the other hand represents the Rupee growth in GDP – which includes the ‘real GDP’ and the increase in selling prices of products, or inflation. Nominal GDP for the year ended 31-Mar-18 (estimates) has grown at 10.1% pa over a 3 year period and 10.7% pa over a 5 year period. Over the 10 and 20 year periods the nominal GDP growth is 12.8% pa and 12.5% pa respectively. The lower inflation in recent years may be one of the reasons for recent numbers to be lower than long term averages.

We have seen that the return from Nifty has been close to the rate of growth of nominal GDP over long periods of time. Revenue growth of a collection of large companies tends to converge with nominal GDP growth, which in turn reflects the intrinsic value growth of these companies, and therefore the long term expected stock market return. Note that we are using nominal GDP – i.e. GDP not adjusted for inflation because we are comparing it to Nifty values which are also not adjusted for inflation.

The above analysis of long term Nifty returns, particularly the 20 year growth numbers, should give us some sort of anchor as to what to expect in terms of market returns over long periods of time. From that perspective, the year that went by, was close to an average year. There has been some conversation lately that the market is over-heated. While this is partly true with respect to mid-caps and small caps, when one looks at the Nifty returns over 3 years (6%), 5 years (12%) and 10 years (8%), we see the numbers are fairly close to their long term averages. This implies that the returns of the large caps which represent the Nifty, have been in line with historical norms and do not exhibit a great amount of exuberance, as is being feared by some investors. It is important to have realistic expectations of what returns the equity market can deliver and this can help avoid making mistakes while investing.

The month of February saw all global markets hit by a bout of volatility as equity indices across the globe saw cuts of 7-10% within a week and a half. The cause for this volatility seems to be the fact that the US 10 year bond yield spiked to very near 3.0% from about 2.1% in Sept-17. One of the factors feeding into this spike in US bond yields is the strong labour market which is now beginning to feed into higher wages and hence higher inflation for the economy as a whole. What may have also spooked the US markets is that the US budget deficit is set to go up significantly to $1 trillion for the coming financial year. So, while the market has till now been focused on the tax cuts and the benefits to corporate America, the recent volatility has shifted attention to the resultant higher fiscal deficits going into the next few years. In any case, interest rates have been kept artificially low since the mortgage crisis a decade back, and at some stage we need to start facing up to reality.

In India too, the 10 year bond yield has climbed from 6.5% in Sep-17 to 7.7% now, though the yield on 1 year bonds has moved up from 6.4% to only 6.8% in the same period. Bond funds with long duration have seen negative rates of return over the past few months, on the back of this move (bonds fall in value as interest rates increase). It has been tough times for fixed income investors in India over the last few months. The spike in bond yields also affects the balance sheet strength of an already fragile set of Indian PSU banks, as they have to recognize mark to market losses because of this move.

This sharp move in the 10 year bond yield in India has taken many market participants by surprise. One plausible explanation for the sharp move is that while the government may not account for the 2.11 lakh crore recapitalisation of the PSU banks in its book, the market has seen through that and is factoring the bank recapitalisation along with the fiscal slippage (fiscal deficit in the financial year ending Mar-19 is now projected to fall to 3.3% instead of 3.0% earlier) of the Indian government.

Interest rates have a twin effect on stock prices. At one level, the cost of borrowing goes up for corporates and this has an impact on the interest cost that corporates have to bear, and thus an impact on corporate earnings. Also interest rates for consumers go up, which can have an impact on consumer demand at the margin. Interest rates also affect the PE ratio of stocks, because when we discount future earnings back to today, the formula has the discount rate in the denominator, which is directly impacted by interest rates. As a result, a rise in interest rates should have a negative impact on the PE for stocks.

Rising interest rates can to some extent cap the Price to Earnings expansion we have witnessed in India over the last few years. In any case, PE ratios in many pockets of the market had gone up way beyond historical levels, on the hope of rapid earnings growth. We expect the market to scrutinise earnings coming in over the next few quarters very closely. The case for PE expansion seems limited from here and the market would need to see sustained earnings increases to sustain momentum in the equity market.

There is an expectation among investors, both domestic and international, that the Indian GDP is on a long term high growth path. Over the last decade, India has moved from a $ 1 trillion GDP to $ 2.2 trillion currently. In this period, India has moved from being the 12th largest GDP to now being the 6th largest. The Prime Minister recently spelt out a vision to reach a $ 5 trillion GDP by 2025. However, sentiment at the ground level is more sanguine. The average business seems far less optimistic, given the economic slowdown over the last 5 years. Volume growth has been muted (less than historical averages) for many businesses, and overall revenue growth has also been slow, with price increases difficult to come by. The capital goods cycle is yet to gain any traction, with several industries sitting on surplus capacity. The banking sector is grappling with the historical bad debt situation, which is preventing banks from lending adequately to the economy.

In all this picture of economic gloom, we are seeing the first signs of an uptick in corporate earnings performance as evidenced by the quarterly results over the last 2 quarters. The performance of many bellwether companies has been good, even after factoring in that the growth is being compared to the December 2016 quarter, which was affected by demonetization. Moreover, many companies are also guiding for improved performance going forward as well. This suggests that the economy may be getting over its demonetization and GST blues and could be heading back to its normal 7-8% real GDP growth phase. This would be aided by the NPA resolution and bank recapitalization which is under way. In addition, in some of the core industries, we have seen the gap between supply (over supply had built up) and demand beginning to reduce. As demand converges towards supply, we should see the capital goods cycle recovery kick in. We should warn here that it is early stages yet and one will need to observe corporate performance for a few more quarters before we can firmly conclude that the economy is getting its mojo back.

The Indian equity market, on the other hand, seems to be pricing in a firm economic recovery – the valuations are on the higher side, and the mood is buoyant, thanks to the strong domestic inflows into equities. The capital raising environment for companies is also quite strong, with nearly $ 20 billion of fresh capital being raised, either directly into companies or through offer for sale. A strong capital market, can partly catalyze the economic recovery, by contributing the risk capital required for the capacity build up in the economy. The government also needs to do its bit, by investing larger sums into infrastructure projects, both in rural and urban areas.

Given where the market is, at the moment, it is important for these green shoots of economic recovery, to take roots and grow. If we don’t see the next couple of quarters building on the strength over the past couple of quarters, we can see markets give up some steam. Valuations are getting exaggerated in some areas of the market and some sort of correction or consolidation of the market would perhaps be healthy as well.