With the significant fall in commodity prices over the last 2-3 months and its resultant impact on both CPI and WPI expectations have grown that RBI will cut policy rates in the December policy. These expectations have also grown with the dismal growth numbers coming out of the Indian economy where growth seems to be faltering and the IIP for the second quarter likely to show virtually no growth. The fall in agricultural product prices, especially issues related to cash crops like Sugarcane, Rubber etc as well as a lower increase in MSP’s this year is also likely to put Rural growth under pressure in the near term.
The results season till now also has been quite moderate, more towards disappointing with results across the board coming in below expectations or just about meeting expectations. The only silver lining is that with the decline in input prices margins have held up and could see some uptick going forward.
RBI action is likely to be on the SLR front rather than a cut in the policy rates. Raghuram Rajan has repeatedly said that Monetary Policy is directional and once a step is taken towards easing, stopping or reversing that will be extremely catastrophic from angle of the credibility of the Central Bank. The second major point that RBI has said is that the current decline in inflation is largely due to the decline in global commodity prices and the base affect of last year, where vegetable price inflation had shot up between June to November last year. As the low base wears off we could again see an uptick in inflation. Foodgrain production has been low this year due to the erratic monsoon and prices of several key vegetables like Potato, Pulses , Dry Fruits as well as Fruits remain strongly elevated. Although we have not seen any spike in food prices, on an overall basis there hasn’t been much decline too. Overall the supply side response from the Domestic angle is still a long way off.
The other major factors which will keep the RBI wary in the near term is the fact that it is difficult to say whether the fall in crude prices is durable and will last given that there are countries like Libya which could see a sudden stop in production any time. The RBI has also warned on unhedged Forex exposures both related to Capital as well as by importers. Strong capital flows and not an improvement in the Trade Deficit has kept the INR stable at a time where we have seen most Emerging Market currencies fall 8-20%. A strong US Dollar combined with lower yields in India and a weakening currency could lead to sudden capital outflows especially from the Debt markets.
Banks have continued their rent seeking behaviour. Deposit rates have come down and liquidity eased significantly. The cost of funds for banks have come down due to this. However despite extremely slack credit growth banks in India refuse to cut lending rates inorder to boost lending. Net Interest Margins in India for banks are among the highest in the world with some Private Sector Banks reporting margins as high as 5%. This needs to come down. I still remember at the time when RBI was cutting policy rates a couple of years back, banks refused to cut rates citing tight liquidity. Today liquidity is very easy, so why not cut rates? This requires no action from RBI’s side.
It is clear that the next action of RBI will be that of cutting rates. The question is just of timing. Will it start in 3 months or six months? My guess is that if global commodities remain weak for the next 3-4 months we could see the rate cuts being front ended in the year 2015. However a spike would postpone the action. However the possibility of a cut in SLR has increased substantially. On one hand it releases funds that banks can potentially lend into the economy, secondly it will reduce the downward pressure on Govt bond yields which have been falling to RBI’s discomfort. The cut in SLR could also be of a significant magnitude. Repo rate cut should be ruled out for now.
MARKETS
I had expected the markets to correct from the 7900 levels mainly due to the expected upmove in the US Dollar as well as increasing risks of a global stock market correction. We did see a correction in global markets and most EM’s also corrected 8-15% from the top. However the positivity due to the new government combined with falling commodity prices has continued to keep the Indian markets buoyant and after a shallow correction the markets have moved up sharply.
So does this mean that we abandon the view. I find it so weird that just because markets move up people expect me to become bullish. Anyone who knows me knows I am the biggest long term India bull. However we cannot ignore short term factors. Results largely have been disappointing, FM Arun jaitley has himself accepted lately that revival is a long haul and Global risks remain. Just because BOJ and ECB have announced money printing the risks have not moderated. Current markets reflect Euphoric conditions where the belief that markets will not correct is so high that I can see that in response to my cautious views on Twitter and FB. This is reflected in the way global markets moved after BOJ announced an additional QE of $ 90 billion over one year and Global Market Capitalisation went up by $1.5 Trillion.
Any correction will provide potential entry points at justifiable valuations. The kind of stocks that will do the best in 2015 will also be different from stocks that did well this year. However I will talk of that more towards the end of the year.
My view has been a 10% cut from the top. Earlier that was at 7100-7200 for the Nifty. Now it could be 7400-7500.