2017 INDIA INVESTMENT OUTLOOK January 2017

2017 INDIA INVESTMENT OUTLOOK

WHAT’S INSIDE

1 | THE YEAR GONE BY 2 | EQUITY MARKETS IN 2016 3 | EQUITY MARKETS – OUR OUTLOOK FOR 2017 4 | FIXED INCOME MARKETS IN 2016 5 | FIXED INCOME MARKETS – OUR OUTLOOK FOR 2017

The Year Gone By To say that the year 2016 went by without much ado would be a complete misnomer, for there would have hardly been a dull moment in the past 12 months. From concerns around hard landing of the Chinese economy to Brexit event to a rise in the negative yield-bearing assets globally to the stupendous demonetization drive in India to the US presidential election victory of Donald Trump, the year has been action-packed to say the least. •

On the macroeconomic front, while there was a sharp recovery in the global crude oil prices (23%), consumer price index (CPI) inflation remained benign and twin deficits remained contained. Metals rallied in 2016, bouncing back from the 2015 lows and on expectation of a revival in Chinese demand. Weak credit growth during the year further aggravated by demonetization move, posed headwinds for the Banking sector. Discretionary spending showed a negative growth trend in Nov-Dec period on muted demand on account of the note ban move.

•

FPI (Foreign Portfolio Investors) flows into Indian equity markets for CY2016 stood at a 5-year low of USD 2.90bn (INR 187.82bn). Further, FPIs remained net sellers to the extent of USD 6.5bn (INR 442.97bn) into fixed income markets during the year. Interestingly, DIIs (Domestic Institutional Investors) ploughed in INR 372bn into Indian equities during the year surpassing the net flows from FPIs.

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On the equity market front, a slowdown in the Chinese economy, UK’s vote to exit the EU, weakness in global trade growth, policy normalization by the US Federal Reserve, rise in global commodity prices and the US elections weighed on the market movements during the year.

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Indian fixed income markets which started the year on a cautious note, had a lot to cheer in 2016 especially post demonetization. The steep drop in 10-year benchmark yield by around 113 bps during the year stands out amongst developed and emerging markets. 2017 INDIA INVESTMENT OUTLOOK | 1

Equity Markets in 2016 Equity Indices performance in 2016 Cyclicals outperform defensives

DMs and commodity centric EMs gain in 2016

Domestic indices performance 2016

Domestic indices performance 2016

S&P BSE Metal

Russia RTS

36.65

S&P BSE OIL & GAS S&P BSE PSU

12.88

S&P BSE Auto

15.32

FTSE 100

14.43

Dow Jones

7.97

S&P BSE Bankex

7.35

Nifty Free Float Midcap 100

7.13

38.93

Jakarta Composite

9.39

S&P BSE MidCap

52.22

Brazil Bovespa

27.17

13.42

Taiwan Taiex

10.98

S&P 500

9.54

Reuters/Jelferies CRB Index

9.29

S&P BSE 200

3.95

MSCI Emerging Markets

Nifty 500

3.84

Nasdaq

8.58 7.50

S&P BSE 500

3.78

S&P/ASX 200

6.98

S&P BSE Fast Moving Consumer Goods

3.29

Xetra DAX

6.87

Nifty 50

3.01

MSCI AC World Index

5.63

CAC 40

4.86

S&P BSE Sensex

1.95

S&P BSE SmallCap

1.77

S&P BSE POWER

1.53

S&P BSE Capital Goods

-3.28

S&P BSE REALTY

-5.98

S&P BSE Consumer Durables

-6.34

S&P BSE Information Technology S&P BSE TECK

-8.00 -9.16

S&P BSE Healthcare-12.88

KOSPI

3.32

MSCI AC ASIA ex JAPAN

2.88

MSCI AC Asia Pacific

2.33

S&P BSE Sensex

1.95

Nikkei

0.42

Hand Seng

0.39

Singapore Straits Times

-0.68

FTSE Eurotop 100

-0.88

SSE Composite-12.31

Source: Bloomberg

Cumulative FPI flows at 5-yr low; DII flows surpasses Inflows INR Cr

Cumulative FII, DII inflows CY2016

BSE Sensex

FPI - INR 187.82 bn

28000 40000 27000

30000

26000

20000

25000

10000

24000 DII - INR 372 bn 23000

-20000

22000

01/Jan 14/Jan 28/Jan 10/Feb 24/Feb 09/Mar 22/Mar 06/Apr 22/Apr 05/May 18/May 31/May 13/Jun 24/Jun 08/Jul 21/Jul 03/Aug 17/Aug 30/Aug 14/Sep 27/Sep 10/Oct 25/Oct 07/Nov 21/Nov 02/Dec 15/Dec 28/Dec

-10000

Cumulative FPI inflows

Cumulative Domestic Institutional inflows

Commodity trends in CY2016

29000

50000

0

Resurgence in global commodities in 2016

BSE Sensex

70%

61%

59%

60% 50% 40% 30%

23%

20% 10%

9%

17%

14%

0% Gold

Brent Crude Aluminum

Zinc (S/Met.ton)

Copper (S/lbs)

Steel

Source: CDSL, BSE India, Bloomberg

• A slowdown in Chinese economy, UK’s vote to exit the EU, weakness in global trade growth, policy normalization by the US Federal Reserve, rise in global commodity prices and the US elections weighed on the Indian equity markets during the year.

• Despite global events impacting risk sentiments during the year, domestic positives supported the market such as normal monsoons, a rise in the area under cultivation for winter crop (YoY 5.9% by December), moderating inflation and implementation of 7th pay commission which are expected to boost consumption.

• Commodities rallied in 2016, bouncing back from the 2015 lows and on expectation of a revival in Chinese demand. 2017 INDIA INVESTMENT OUTLOOK | 2

Equity Markets Our outlook for 2017 Major themes to impact Indian markets in 2017 include resurrection in consumption demand, growth led by policy reforms, move towards digitization, monetary stance of global central banks and economic policy decisions. The impact of demonetization may weigh on consumption demand and on the growth of various industries in the near term, dragging down the GDP growth for FY17 by 50 bps. The approval of promulgation of the Special Bank Notes (SBNs) (Cessation of liabilities) ordinance by the President of India could likely bring about a gain to the government on account of allowance given to the RBI to extinguish its liability towards unreturned SBNs. We expect the impact of this currency replacement program to be short lived as new notes come into circulation (45% back in circulation as on December 17th). Additionally, this move should help to increase the share of formal economy and digital economy. Improvement in consumption demand is expected to be a major theme for 2017 supported by a gradually rising rural wage level, implementation of the 7th pay commission, lowering of interest rates in the Indian economy and continued government spending.

Anand Radhakrishnan Chief Investment Officer Franklin Equity – India

Fiscal deficit dropped by 52.3% YoY in Nov on pick-up in tax receipts (direct and indirect) even as non-tax revenue was down. However the achievement of fiscal deficit target for FY17 would warrant a tradeoff between government spending to counter the slowdown from demonetization and expectation of a fall in tax revenue in H2FY17. Policy reforms led growth – Interest subvention of 3% and 4% for housing loan announced in December 2016 may boost low cost housing segment. Post the fixation of tax structure by the GST council, GST law now awaits implementation in 2017. This simplification of tax structure along with reforms pertaining to land, labor, infrastructure sectors and modification in FDI policy could contribute to sustainable growth over medium term. Global factors including commodity price movements, economic policies of the new government in the US and monetary policy stance of global central banks could have a bearing on capital flows to emerging markets like India. A likely rise in inflation pressure in the US from wage rise and expansion in the economy should elicit future interest rate hike actions by the US Federal Reserve in 2017. Global growth rate is likely to improve, led by the US and other emerging economies in 2017 which could benefit the Indian export oriented sectors. That said, India’s lower linkage to global economies makes the domestic macro factors and fiscal trends the key catalysts to determine growth. Improving fiscal situation, inflation rate, exports growth, rising FDI flows point towards fundamental stability in the economy which augurs well for long term equity investing. Domestic corporate earnings volatility may increase as corporates attempt to tide over the impact of currency replacement program. Earnings for FY17 are expected to be lower than estimate with EPS growth likely at around 10%. Consensus earnings growth for FY18 is expected to be healthy at high teens. The fundamental strength of the economy and attractive valuation levels of the market (1 year forward P/E for BSE Sensex at 14.7x, moderate levels implying low risk) present a positive outlook for equity. Periods of interim weakness in equity market should be considered as investment opportunities for long term investors. We recommend a systematic investment in diversified equity funds & hybrid funds to benefit from the current volatility and participate in the growth potential of Indian equities.

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Fixed Income Markets in 2016 Rebound in the global crude oil prices

CPI inflation remained benign

Fiscal Deficit under control

Deposit Growth picks up post CRP*

INR depreciated vis a vis US dollar

But, Foreign Exchange Reserves remain robust

Source: Bloomberg, PPAC, CGA, Morgan Stanley (MS) Research estimates, CMIE, RBI, MS Chartbook – December 2016 *CRP stands for Currency Replacement Program

• On the macroeconomic front, while there was a sharp recovery in the global crude oil prices (23%), consumer price index (CPI) inflation remained benign and twin deficits remained contained.

• The banking system has been flooded with liquidity post the announcement of Currency Replacement Program (CRP). Subsequently, deposit growth has picked up post CRP.

• The rupee has depreciated close to 3% against the dollar. We believe RBI’s reasonable foreign exchange reserves may provide some cushion against Rupee depreciation in 2017.

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Fixed Income Markets Our outlook for 2017 Although bond markets started off 2016 on a subdued note, the sharp drop in 10-year benchmark yield by around 113 bps (most of it came after demonetization) led to softening of bond yields across the curve. •

We believe that slowdown in growth (aftermath of demonetization) and expected soft inflation could probably leave room for rate cuts by the RBI, which could augur well for duration strategies in 2017.

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There were credit concerns on individual companies during 2016, however, improving credit ratio seems to indicate that we broadly appear to be in a credit upgrade cycle, though it could take time for credit cycle to pick up. Anticipated fall in the lending rates post the currency swap exercise (increase in bank deposits) would help to bring down cost of capital for Indian companies, which in turn may bode well for the improvement of the credit environment and thus benefit accrual strategies.

The liquidity in the banking system has improved post demonetisation which would henceforth result in lower deposit and lending rates. • Given the cash rich nature of our economy, we could see some slowdown in the overall economic activity thereby weighing on the GDP growth.

Santosh Kamath Chief Investment Officer Fixed Income - India

• The trade-off between 1) likely positive impact of demonetization in form of lower interest rates over medium to long term and 2) pick-up in macroeconomic growth, once the consumption gathers momentum, will be instrumental in shaping up the direction of interest rates in 2017. CPI inflation which had been muted in 2016, fell to a two year low more recently due to softer food inflation. • Given the good monsoon season and expected slowdown in consumption post currency replacement program, we believe that March’17 inflation could undershoot RBI’s target of 5%. • Conversely, the RBI seems to be concerned about inflationary risks. In its Dec monetary policy review, the RBI surprised by leaving policy rates unchanged stating that growth pain on account of demonetisation is ‘transitory’ and that there is enough demand in the system to make it worry over inflation. Going ahead, the RBI will assess durability of the fall in inflation for implementing further interest rate cuts. The rupee has depreciated close to 3% against the US dollar, however, it was among the better performing emerging market currencies in 2016. While higher crude oil prices and expectations of stronger U.S. growth coupled with earlier and more aggressive interest rate hikes in the US may impact INR, however, contained twin deficits, improving domestic macroeconomic indicators and RBI’s reasonable foreign exchange reserves may provide some support. Although India is in a relatively better position among the emerging economies, there are risks which can weigh on the Indian bond markets. • Faster than expected raise in interest rates by US Federal Reserve, rising political uncertainty in Europe and OPEC’s deal on production cut could spike up the oil prices, impacting the global bond markets. • Meanwhile, at home the actual economic impact of the currency swap program will become clear in 2017 and the date of implementation of the goods and services tax (GST) could be pushed ahead. The infusion of fresh deposits in banking system (post demonetization) is likely to shore up demand for G-Secs by banks, which could eventually augur well for bond prices. We recommend investors (who can withstand volatility) to consider duration bond/gilt funds for medium to long term horizon. Although, the lack of growth in private sector capex has delayed the pick-up in credit cycle, our corporate bond funds continue to offer reasonably high portfolio yields providing higher accrual income opportunities for the short-to-medium term.

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Note: We have relied on third party data which, we believe to be correct but, we do not offer any assurance as to the accuracy or the correctness of the same and would not accept any liability for any loss or damage arising directly or indirectly from action taken, or not taken, in reliance on material or information contained herein. The information contained in the above commentary is not a complete presentation of every material fact regarding any industry, security or the fund and is neither an offer for units nor an invitation to invest. This communication is meant for use by the recipient and not for circulation/reproduction without prior approval. The views expressed by the portfolio managers are based on current market conditions and information available to them and do not constitute investment advice. Past performance may or may not be sustained in future.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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