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Re-fueling Volatility - Alpha Edge, May 2018

In the March edition of our newsletter, we shed light on the multiple signs of the potential dangerous curves ahead in the equity markets, and in April about the breather in the form of a market rally which would probably be ‘The First Pit Stop’. Accordingly, post the correction seen in March, markets recovered in April. We believe that the factors such as a strong dollar, impending global trade wars, hardening of the US bond yields and a resilient Oil will ‘Re-fuel volatility’ in the days to come.

Globally, Oil prices gained and may continue to do so as the Organization of the Petroleum Exporting Countries (OPEC) and non-OPEC countries are likely to continue with output cuts until inventories return to their normal levels. Oil supply disruption in an increasingly hostile environment in Venezuela also contributed to the price movement. Higher commodity prices had elevated concerns on inflation while the 10-year US treasury rate is hovering near 3%. Further, trade friction and sanctions by the US could lead to higher prices not only for oil and metals but at some stage other goods that are hit with tariffs too. This has led to a cautious stance from the FIIs towards Emerging markets and therefore EM currencies in general have witnessed increasing pressure.

On the domestic front, India’s Trade deficit widened to a 5 year high. For a net oil importing county like India, a sustained rise in crude oil price would have adverse macroeconomic implications. Higher oil prices will weaken the economic growth, push up inflation and deteriorate the twin deficits (current account deficit and fiscal deficit). This may have an adverse impact on the Indian G-Sec yields. Rising commodity prices and cost of capital will add pressure on margins of Indian corporates.

The Q4 FY17-18 result season hasn’t been encouraging so far. We will have to wait and watch for the entire earnings season to unfold to have a concrete conclusion. However, we believe there is scope for valuations to rationalise. The current risk-reward ratio seems to be unfavourable for equities from a shorter-term perspective, while the earnings in the medium term are expected to be good. The outcome of the Karnataka elections is another key event which will have to be closely observed and its impact assessed.

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The first pit stop! - Alpha Edge, April 2018

Earlier in March, we brought your attention to the multiple signs of the dangerous curves ahead in Equity markets. March turned to be just that. An action-packed month that started with Mr. Trump’s Trade war announcement followed by CBI taking noticeable action against fraudulent banks. We also saw the U.S. Fed raising interest rates while the Bank of Japan's chief hinted at a possible exit from its ‘ultra-easy’ policies. These events have led to an increase in volatility and have caused the markets to continue their downtrend after the swift fall in February.

We presently believe that the current breather in markets is probably a first pit, “The First pit stop” to further lower levels during the year ahead. This pause will help participants to evaluate the changing trade dynamics and likely perception of investors, domestically and globally.

Globally, US-China trade war needs to be closely watched as China has hit back, though mildly, through a US $ 3 bn tariff. The move may not look significant prima facie, but is effective as it aims to hit The President’s voter base, namely the farmers. If the tensions between these two giants escalate, we surely can see a lot of collateral damage globally. But that is a big if, considering that all Governments know the fragile states of their economies.

Its likely that global trade has slowed down in the last quarter, which can be interpreted by Baltic Dry Index that has dropped more than 40% since mid-December. This index is reported around the world as a proxy for general shipping trade which symbolizes the epicenter of global trade, that of movement of basic raw materials.

On the domestic front, apart from the global worries, asset quality issues for Public sector banks have only deepened, coinciding with political uncertainty from impending elections, deteriorating trade balance due to higher oil prices and deteriorating fiscal policy environment. These key concerns need to be meticulously observed.

We have seen a reasonable correction in the last two months, but the valuations are still high and are some distance away from being called as fairly valued. The recovery in earnings is very critical for such rich valuations to sustain. Hence, we continue to retain our cautious stance on Equities and suggest measured exposure towards them if at all.

 Happy navigating the many pit stops that lie ahead this year. Strict adherence to asset allocation is the only way out.


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The pendulum has swung! - Alpha Edge, March 2018

You know the street signs that grab your attention on the road and appropriately lead you to take caution? Multiple signs, similar to the ones mentioned above, have been reminding us of the dangerous curves ahead in the equity markets. We experienced an eventful February full of critical announcements and news flows ensuring the return of volatility as global markets, including India, retreated.

In the month of January, we released our Alpha Edge report titled ‘Remember the pendulum’, where we highlighted the prospects of change in market direction and correlated it to the movement of a pendulum. Our view still remains the same, that we are likely to see sustained periods of volatility ahead. Now, the pendulum seems to have swung.

Globally, markets were broadly weaker in February. Higher-than-expected US wage data initially put the bond markets under pressure - as investors priced in the potential for a more proactive Federal Reserve - before worries spread to equity markets. Rising rates, inflation and talks of trade wars have caused market participants to re-evaluate their views on the overall state of markets.

Indian equity markets underperformed their emerging market peers in February. Domestically, markets have become increasingly reactive to news flows, which were probably ignored earlier. Another major development has come from the banking sector where an alleged fraud at state-controlled Punjab National Bank has raised concern over the wider sector. Over the last year, even though India has been a part of the global markets rally, it has not really been a part of the global economic recovery. This has led to valuations stretching to near historic levels. The latest earnings season and high-frequency indicators are suggesting some bit of recovery finally being underway. However, the higher expectations built around the recovery over the last three years pushed the valuations to the extent that has left little or no room for further price appreciation.

Higher inflation, domestic rate hike fears, fiscal slippage, political uncertainty and the upward movement of global bond yields, will continue to act as an overhang on multiples. 
Hence, we continue to retain our cautious stance on equities from a short-term point of view.


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Free lunches...No more! - Alpha Edge, February 2018

The time has come for the earnings to stand up to expectations. As there is probably no room for sentiments led PE expansion. The quarterly results of the top 50 companies seem to indicate that the coast could be clear on the earnings front and indeed they have been better than expected. All that we now need to await is whether this was on a low base of post demon dip in Q1, 2017. The next quarter will, therefore, be the all critical quarter that proves that the tide has really turned on the earnings front.

Globally, January month was dominated by good news such as better than expected job market report, which showed unemployment shrinking and wages rising. However, this good news of higher wages compounds the pressure on the US Federal Reserve to raise interest rates, so as to tame inflation and prevent the economy from overheating. As things stand at least 2 to 3 hikes seem to be on the cards.

Given a decade of ultra-low interest rates, any quickening of pace in rate hikes or expectations about it, trigger the kind of fear that comes with a paradigm shift. A shift that makes fixed income look attractive incrementally, calling for a possible reallocation from risk assets to ‘safer assets’. A distinct possibility given how far valuations have reached across the world. If this narrative gains ground, what was witnessed during the first week of February, maybe a trailer of things to come. Perhaps, the time for “Free lunches” may have gone and an increasing earnings momentum alone can support the markets from here on. Especially in India

Domestically, India certainly participated in the global equity market rally but not completely in the global growth momentum. The expectations from the Union Budget was that it will focus on growth initiatives and less on structural reforms which were the focus of previous versions of the Union budget. The budget clearly did not disappoint, as it gave due importance to all sections of the economy and tried to enhance the ease-of-doing-business while keeping its focus on infrastructure development. However, the imposition of LTCG on equity shares and units of equity oriented mutual funds has triggered a short-term perception disruption in the equity markets coinciding with volatility from a global sell-off.

Even though we have seen around 6% correction from the recent peak, the valuations are still high and do not look reasonable post this correction. The recovery in earnings is very critical for such rich valuations to sustain.  The Q3 FY18 results have been in-line, however, fag end of the result season needs to be watched closely. The way to go about it is to stagger fresh investments, as markets could give enough opportunities to invest throughout the year. 


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Remember the Pendulum - Alpha Edge, January 2018

Wish you and your family a happy new year. Hope you had a good time welcoming it.

Readers familiar with Citadelle’s approach to markets would have concluded us to be very factual and objective by nature. It was a conscious choice in order to see through the smog of market noise by way of news, its interpretation and the grandstanding that follows in the name of conviction. We look to laws of nature in inspiring us and guiding us. And for now, the object of contemplation is the working of a pendulum. Which also reminds us of a famous quote by Jason Zweig.

The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The Intelligent Investor is a realist who sells to optimists and buys from pessimists.― Jason ZweigThe Intelligent Investor

Ever noticed how at a certain point to the extreme, the pendulum is in a state of suspended animation. For a moment you can neither be sure whether it is going to go further ahead, pause or retreat. This point is associated with no more kinetic energy that helps it move further and all gravitational energy that makes it retreat. We may be reaching such a point where the sentiment led valuation momentum is approaching zero and earnings become the only gravitational focus. Liquidity has been the length of this pendulum that may have allowed it to swing too far, but then even an elastic rope has a finite length.

We do believe that earnings will improve even if on a low base and we do believe that valuations will revert to mean for sure by a decisive combination of price and time correction. 2018 seems set to be a roller coaster. Be prepared.


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