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Alpha Edge June, 2016 - The guessing game

Dear Investor,


The markets have almost gone up 17% from Feb lows and in the last three months we have seen a spectacular rally in equities. This is the time when equities are back to new ‘recent’ highs and so are the analysts with their prediction of a ‘new bull run on its way’ and even higher targets. But given the scenario, it requires a brave soul to completely believe that. Even though the domestic economy seems to be recovering slowly, markets are expected to follow global cues in the short term, as foreign institutional investors with deep pockets play a major role in the markets here, and they take their cues from the global economy which is weak at the moment. This, leads us to the question ‘whether this rally will sustain’?

June is the month of two key global events taking over and a lot of confusion along with it. Brexit & Fed rate hike. Brexit is one animal that the markets have not been able to figure out, but consensus believes that if it happens it would result in a much higher volatility as compared to status quo. Going by the general opinion polls, it seems like a close contest with voters slightly leaning towards a Brexit. With regards to Fed, the general tone has become more aggressive towards a rate hike, with probabilities of a rate hike as early as June increasing. However, the markets don’t seem to be factoring a rate hike based on the data points trickling in. Hence, an actual rate hike may temporarily unsettle the markets globally. Whereas, we believe, the situation for Fed is all the more complicated thanks to global events like Brexit, China slowdown and Brazil, which is suffering from one of the deepest economic recession in a long time along with an extremely difficult political situation. With many reasons for concern about the global economy and with likely US domestic uncertainty ahead of the U.S. presidential election, one has to ask, what is the Fed’s rush to hike interest rates now?  

Back home we saw ‘cheer’ in terms of the GDP numbers that came in at 7.9% for Q4FY16. The data, however, seems to be inconsistent with few high frequency indicators like the IIP, which was barely positive in Q1. Our concerns about the quality of the numbers continue. Concerns over measurement aside, momentum does seem to be improving and combined with recent legislative gains in the recent state elections, provide reassurance that the economy is headed in the right direction. A normal monsoon, which seems to be a certainty, would be the major game changer for the economy which is suffering from aftermath of two consecutive drought season.

As far as the latest earnings are concerned, we have seen better numbers this quarter compared to previous quarters led primarily by margin expansion. More companies have beaten estimates, but that is also a function of low expectations for the quarter. The numbers look much better minus banks which are marred by NPA issues and affected by higher recognition of bad loans. These days, good news seems to travel faster in to prices. Recent headlines such as ‘worst over for earnings’, ‘good monsoon’, ‘global commodity prices reviving’, rate hike fears abating etc. have quickly percolated into valuations which once again indicate that such good news has been discounted. Hence, based on valuations we are little cautious for shorter term and believe there is less probability of valuations expanding from here, unless we see more good news specially in terms of earnings surprising on the upside. It would be prudent to invest in a staggered manner in equities until people play ‘The guessing game’ on Brexit, Fed rate hike or earnings recovery.

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