The Nifty Index rose 2% in September. Mid-cap and small-cap indices continue to outperform large-cap and were up 3.6% and 4.1%, respectively. Sector-wise, PSU (+11%), Power (+7%) and Metals (+6%) gained the most. None of the sectors closed in the negative. Globally, India (2%) was among the top-performing markets, along with the UK and Philippines, which were up 2.9% and 2.4%, respectively, while Thailand, Russia, and S&P 500 declined 6%, 5%, and 4.6%, respectively. September FOMC hawkishness saw US yields breach the 4.6% mark (10Y), and Crude touched $95/bbl, the highest it has been this year, Dollar index (DXY) also made fresh highs of 107. Despite global challenges, India’s Bond index inclusion supported sentiments. FPIs sold US$1.8 bn of Indian equities in the secondary market, whereas DIIs bought ~US$ 2 bn worth of shares. After some lull, September rainfall activity improved, and cumulative rainfall during monsoon season 2023 so far was 94.0% of its long-period average (LPA).

High-frequency data for September held on to the gains and improved a tad on a sequential basis. GST collection for Sept (reflecting activity in Aug) grew by 10.2% YoY. PMI manufacturing moderated somewhat to 57.5 in September from 58.6 in August. Credit growth remained largely steady at 15.1% in Sept vs. 14.9% in August (adjusted for HDFC merger). Growth in rail freight moderated, while power demand clocked double-digit growth for the second consecutive month. In autos, two-wheeler sales rose while passenger vehicle sales decelerated. Services PMI accelerated yet again to a 13-year high of 61 in September from 60.1 in August. Air passenger traffic continued to improve sequentially. Vaahan Registration (proxy for retail sales) rose by 20.4%YoY in September from 7.7% in August. The CMIE unemployment rate dipped to a 4-month low of 7.1% in Sept.

Risk-off sentiments in the global market increased materially in September thanks to the uncertainty on the direction of interest rates amidst the US Fed’s continuing ‘higher for longer’ narrative, concerns about the US Govt shutdown, and labor unrest in the form of strikes by the UAW and the US healthcare workers and rising oil prices. Fixed income market weakness was palpable as yields across the curve moved up sharply. As we write, oil prices have cooled off and the US Govt shutdown has been averted for now. Notwithstanding, our inference of incoming data suggests continuing disinflation and moderation in inflation expectations in the US and Eurozone, which are currently being overlooked in the context of recent Fedspeak that seems to have convinced markets of elevated interest rates for longer. Besides, even the Chinese economy appears quite resilient in the face of continuing headwinds from the property market. However, there is likely to be a prolonged wait period for more data that supports the disinflation narrative in the developed world, and for more signs that suggest slowing economic activity in the US that will help dictate when rates will begin to be cut next year and by how much. We also await a possible re-defining of the target inflation band by the US Fed.

On the domestic front, India’s inflation picture saw improvement as headline inflation eased to 6.8% in Aug from 7.4% in June as food inflation moderated and core inflation remained steady. We expect inflation prints to come down further until the end of CY23, driven by a more broad-based reduction in food inflation. This is likely to hold RBI in a pause mode for longer with interest rate cuts, if any, likely to be synchronous with global rate cuts in 2024.

While broader market returns have been considerably strong in the recent few months, and that can open up the possibility of a modest pullback, we choose to not lose sight of the unfolding economic cycle and its strength in India, which, in our view has just taken roots in the past 12 months. Broader market returns (small and midcaps) of the past 2 years is 15-16% compared to >20% CAGR returns in past cycles of economic expansion. We therefore advise investors with a 2–3-year horizon, to stay the course and deploy incremental capital gradually, noting the sharp surge in recent months. We reckon conditions are also gradually building up for a probable recovery in consumption demand as the drag of inflation and interest rates recess, leading to better affordability.

On balance, our conviction on a strong economic cycle unfolding in India, therefore, over the next 4-5 years stands. We believe this will widen investment options in the market. We maintain that India equity is clearly emerging as one of the most attractive investment destinations when seen from a 3–5-year time scale.

The Global backdrop remained challenging during the month. US FOMC paused on policy rates but sounded more hawkish than market expectations as it guided for “Higher rates for Longer. ECB delivered a dovish 25 bps rate hike with a low likelihood of further rate hikes. Elevated food prices on El Nino fears and crude oil prices crossing USD 95 per barrel due to tight demand-supply dynamics stoked inflationary fears. The huge fiscal supply in the US remained an overhang. The dollar strengthened sharply against major currencies, as reflected in the Dollar index crossing 107.

Global rates remained highly volatile and further hardened, with many developed countries witnessing multi-year highs. US 10 yr G-Sec hardened by more than 50 bps and crossed 4.70% levels as the expectations of a fast rate cut cycle unwounded. Emerging market rates also witnessed a rise in market yields, though to a lesser extent.

Domestic rates were relatively less impacted on the back of positive sentiments as Indian sovereign bonds got included in the first ever global bond indices of JP Morgan Emerging Markets Bond. G-Sec borrowing calendar for 2HFY24 also came in line with market expectations with a borrowing program of Rs 6.55 trn (FY2024BE borrowing of Rs15.4 trn).

Outlook

Global factors have worsened over the last month as market rates in many developed countries remain on an upward trajectory, putting pressure on currencies. Elevated crude prices have further added to the concerns. US FOMC future policy action is data dependent, and incoming data on growth/inflation/jobs continues to stow mixed trends. The domestic rate environment has also become relatively more challenging with inflation concerns led by volatile food prices, incrementally higher current account deficit, and a slowdown in FPIs inflow due to global uncertainties.

Amidst a challenging backdrop, MPC, in its October policy, maintained a pause on policy rates while still retaining its stance as “withdrawal of accommodation” to keep its guard high against any domestic inflation worries. Indication of G-Sec Open Market Operations (OMO) Sales for liquidity management has spooked the market and clearly indicated MPC’s resolute to reach a 4% inflation target. 1QFY25 projected inflation at 5.2% points to a delayed rate cut cycle. While the MPC was more hawkish than expected, we believe the MPC will maintain a long pause at current policy levels as Inflation is expected to maintain its downward trajectory over the next few months. Instead, MPC may actively use its liquidity tool, including OMO sales, to anchor inflation expectations.

With the negative market reaction of 10-15 bps across the yield curve post MPC due to OMO sale overhang, domestic rates have surged back to the 2023 beginning levels with 5 – 10 year G-Sec now in the range of 7.35% - 7.40%. We believe India’s current fundamental situation is much better than that in early 2023, and the recent surge in market rates provides an attractive entry point to investors, especially in 2 to 5 year duration segment. While the near-term volatility may remain high as the market waits for a direction on RBI’s liquidity management coupled with global factors, any large upside in yields is expected to be limited on the back of India’s inclusion in global bond indices. Inclusion in the JP Morgan index alone can prompt an inflow of more than USD 25 bn over the next 2 years, thereby lowering market yields and also supporting the currency. It may also open doors for inclusion in other global debt indices. The timing couldn’t have been better as the global backdrop has become more challenging with elevated rates, surge in crude prices, and currencies under pressure. Nonetheless, active fund management is critical as uncertainties may emanate from domestic inflation, fiscal supply, and global backdrop, which may influence various yield curve segments differently. The credit environment remains healthy, and selective AA / AA+ rated exposure can be explored at fair credit spreads.