October 2009: Reversal in RBI policy

Equity markets finished the month on a very weak note, down 7.3% for the month. Much of the fall was witnessed towards the end of the month and we are seeing strong signs of weakness in equity markets since the recovery began earlier this year. We have increasingly been believing that a large component of cash in the portfolio is the right choice, and because of that our portfolios are broadly not affected much due to the fall in the markets. Many of the portfolio stocks stood up relatively well compared to the market, as there was a distinct shift towards the more defensive sectors.

The sharp sell off in the equity markets has been led by 2 reasons. Firstly, with the increasing risk of inflation, the RBI finally decided to start pulling the plug on the loose monetary policy. The loose monetary policy stand since Oct 2008 was from a combination of low interest rates, low CRR & SLR, certain special provisions targeted at some sectors and some relaxation in accounting policies. In addition, the Finance Ministry had also reduced excise duties and service tax rates. The RBI signaled a reversal in stand by removing most of the special provisions and some stricter accounting norms. It has also clearly stated that it will not hesitate to further tighten liquidity, if inflation continues to rule high. We believe the crutches would get taken away from the patient as the doctor starts to believe the patient can stand on his own. You know what would happen to equity prices, if there is less money available in the system.

We believe this is just part of the reason for equity market weakness. Globally, over the past few months, one has been seeing the US Dollar weaken against all major currencies. As a result, there was a significant shift in investments away from the US markets towards emerging markets likeIndia. It is likely that the USD will start to strengthen in the coming days, which should lead to a slow down in foreign inflows. This can cause significant changes to equity markets in India.

The FIIs hold about 16 per cent of the Indian markets, whereas the domestic Mutual Funds hold just about 3 per cent of the market. Apart from company promoters, the FIIs have the largest impact on Indian markets and any change in the FII appetite towards equities can lead to large changes in equity prices. FII flows towards India is influenced by a combination of attractiveness of equity prices and expectation on currency strength.

Current quarter corporate results season continued to be very mixed, with some sectors like FMCG, Pharma, auto and IT coming out with stronger than expected results. On the other hand, we are definitely starting to see margin pressure across several sectors. The last 3 years has seen significant investments in several sectors and as a result over-capacity is building up in the economy. On the other hand, the current operating profit margins of companies in these sectors are well above historic averages. If one were to believe in history, one may see margin erosion in several sectors where competitive conditions are increasing. One cannot assume the current earnings to be sustainable in several pockets of the economy. Even after the recent correction in equity prices, valuations of large companies are not attractive as yet.