Connect for the Month of March 2007 - Birla Sun Life Mutual Fund

M a r c h 2 0 0 7
Market Outlook
EQUITY MARKET
Equity markets remained volatile over last month owing to tightening liquidity and higher inflation. Union Budget expectations and state election results added to the
confusion.
As the month closed, the Finance Minister, Mr. Chidambaram cleared the dust laying all speculations to rest. Key
positives in the budget include strong focus on infrastructure (urban & rural), agriculture and education. The budget
provides for increased (+30-32%) spending on 'Bharat Nirman', rural electrification and higher outlay for the Rural
Infrastructure Development Fund. Social spending allocation has also been raised by 36% for improvement of
general education, public health and social security. Agriculture push remains with outlay on irrigation raised by
55% in addition to promise of reforms in fertilizer subsidy delivery mechanism.
The government also maintained the pace of trade liberalization with reduction in peak rate of customs duties from
12.5% to 10% on non-agricultural imports. As has been the case with earlier budgets, service tax net has been
further widened to include more services. However, direct tax rates have not been tinkered with even after record
tax collections. In fact, Education Cess stands increased by an additional percent while dividend distribution tax
has been raised to 15%. This clearly indicates the FM's disposition towards using revenue growth to maintain fiscal
discipline in comparison to expenditure control.
The budget did not contain any positive surprises for the corporate sector. Certain measures, viz. imposition of FBT on ESOPs, differential excise duty on cement
producers (arguably directed to cap cement prices) cannot be termed progressive. Though, there has not been
a significant impact on corporate earnings, certain tax proposals could negatively impact earnings for few
companies in some sectors viz., 15-25% for Construction sector on account of withdrawal of 80IA benefit, 15-
20% for Mining sector due to imposition of export tax on iron ore and 2-5% on IT sector from application of MAT.
In terms of fiscal situation, Centre's own performance has been quite satisfactory as it adhered to fiscal
discipline and managed to restrict the fiscal deficit to 3.6% of GDP, thanks to 38% growth in Net Tax Revenue to
the Centre for the Apr-Dec'06 period.
Advance Estimate numbers suggest that the growth in Agricultural sector is at 2.7% as against 10.0% in
Industrial sector and 11.2% in Services. Undeniably, the slow growth in agricultural sector is a worrisome
aspect in current state of affairs. With almost two-third of the population dependent on this sector, low growth
has serious implications in terms of widening income disparity. Moreover, we have already seen the impact in
terms of food article inflation rise to double-digit levels on account of supply-side problems in such essential
commodities. Finding short-term solutions to this problem, which affects millions of consumers, is a difficult task. Massive investments are needed to augment
agricultural supply chain given that a substantial part of agri-produce in India is spoilt or wasted. Gains from these investments would directly add to supplies
Inflation has been an area of concern to most Central Bankers who have resorted to liquidity tightening in order to moderate it. The global liquidity tightening could lead
to reassessment of risk appetite of investors and consequently impact flows to the various markets. Commodity markets were the first to experience volatility on this
account.
Lately, global equity markets have also started feeling the jitters as Bank of China raised reserve ratio by 50 bps to 10%; Bank of Japan also recently raised interest
rates by 25 bps to 0.50%. Japanese Yen also appreciated from 121 to 116 recently.
Indian corporate earnings have shown robust growth in first nine months as exhibited by 34% rise in Sensex earnings. Going forward, the Sensex EPS is estimated to
be Rs. 811 for FY08E even after a downward revision on account of impact of tax measures introduced in the budget. Although there could be short-term fluctuations in
the Indian equity markets, sectors directly linked to India's consumption and development prospects should do well over the longer term.
DEBT MARKET
Domestic Bond Markets
Confluence of many unfavourable factors like surprise CRR hike, inflationary concerns, spike in global oil prices and pre-budget jitters swayed yield movements. The
rise in yields was more pronounced at the short-end of the curve, the 91-day commercial paper reference rate rose sharply from 9.35% to 10.75%. The yield on the 10-
year benchmark paper spiked to an intra-month high of 8.12% before closing the month at 8.00%. It had closed at 7.73% in January.
With several economic data pointing towards record growth, high inflationary risks restrained market activity early in the month despite improving cash surpluses. Even
though the RBI's hawkish stance to combat inflation kept traders vigilant, its instantaneous action of hiking the CRR (Cash Reserve Ratio) to rein in inflation and loan
growth caused to heavy selling. Market momentum was further hit by the above-trend inflation (consistently above the 6.00% mark), which raised beliefs of another
round of monetary tightening. Value buying, with bonds at multi-month lows, however helped yields come off highs. Furthermore improving systemic liquidity, import
duty cuts and downward revision in fuel prices offered some respite. The Fed Reserve Chairman Bernanke's dovish remarks on diminishing inflation concerns further
supported the market. Speculations of bond market friendly budget and lower borrowing programme due to buoyant revenue collections also added to the optimism but
worries of a fresh round of monetary tightening from the central bank to contain quickening inflation and anxiety ahead of the Budget announcements sustained
pressure on yields. Concerned by accelerating inflation, the Reserve Bank of India hiked the cash reserve ratio (CRR), the second time in two months, by 50 basis
points, to 6% in two stages, the first on February 17 and the second on March 3. The impact of the hike on the economy is well evident with many banks having
announced an increase in their deposit rate and prime-lending rate (PLR). The PLR hike is expected to lead to a slowdown in retail credit growth, and thus will help bring
the inflation down.
Union Budget 2007-2008
Union Budget, highlighted robust growth prospects and further fiscal consolidation through phased removal of certain tax exemptions, measures to slow down inflation,
initiatives for agriculture sector aimed at addressing supply side constraints, infrastructure and the social sector. The net borrowing programme, though largely in line
with market expectations, failed to enthuse the bond market, as revised estimates for the current year are higher than the market expectations despite buoyant tax
revenues. Total market borrowing is estimated at a net Rs. 1.09 trillion for 2007-08, 2% up from Rs. 1.07 trillion in 2006-07. The government raised the annual ceiling for
market stabilization bonds (MSS) that are used to absorb excess cash in the banking system. The ceiling increased to Rs. 800 billion for FY 08, from Rs. 700 billion in
the current year.
Outlook for bond markets
Bonds are expected to remain subdued ahead of the fiscal year-end. While the plethora of fiscal and monetary measures from the government and the central bank to
tame inflation and to address overheating concerns in certain sectors is likely to provide a lid on inflation in the coming months, pressure on interest rates could continue
for some time. Besides inflation, liquidity will also be closely tracked due to the quarterly tax flows and year-end demand. At this stage, investors can consider locking in
funds at the higher short-term yields by investing in fixed maturity plans, floating rate and liquid funds.
4
Commodity 3 Months Returns (%)*
Aluminium 3M -2
Copper 3M -14
Zinc 3M -25
Nickel 3M 21
Crude Oil -3
Natural Gas -14
* 01-Dec-2006 to 02-Mar-2007
Equity Markets 2 Months Returns (%)*
India (BSE Sensex) -7
USA (S&P 500) -2
Nikkei 0
Hang Seng -3
Taiwan -2
Korea -1
Brazil -5
UK (FTSE 100) -2
* 01-Jan-2007 to 02-Mar-2007