Market Outlook

January 2017

Two months since Demonetization…

Impact on economic activity: CSO revised down its FY17 growth estimate

Source: Morgan Stanley, SBIMF Research

Impact on Economic activity- Mixed Data points Agriculture: Rabi Sowing unaffected

-5.7 -4.6

-7.4

-0.3 -0.6

0.4

1.7 2.8 2.8

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0N

ov 1

1

Nov

18

Nov

25

Dec

2

Dec

9

Dec

16

Dec

23

Dec

30

Jan

6

% c

hang

e fr

om n

orm

al o

f co

rres

pond

ing

wee

k

… but both manufacturing and services PMI showed contraction in December

IP growth surprised on the upside due to inventory restocking post Diwali…

Source: Antique, JP Morgan, CLSA, SBIMF Research

Impact on Economic activity- Mixed Data points

Credit growth slowed – reflecting the impact of both fewer credit off-take and clearing of old loans Currency in circulation has dipped by 9 trillion

18.0

9

CIC before demonetization (Rs. Trillion) CIC as of 6th Jan

4.00

9.00

14.00

19.00

Jan-

13

Apr-

13

Jul-1

3

Oct

-13

Jan-

14

Apr-

14

Jul-1

4

Oct

-14

Jan-

15

Apr-

15

Jul-1

5

Oct

-15

Jan-

16

Apr-

16

Jul-1

6

Oct

-16

Credit % y-o-y-LHS

Nov-16, (Rs Bn) YoY

Dec-16, (Rs Bn) YoY

Gross tax revenue 1144.0 54.6 2064 5.6

Corporation tax 149.2 164.3 970 -4.6

Income tax 167.8 40.7 450 41.7

Customs duty 205.3 20.0 175 -14.4

Excise duty 329.2 43.4 315 25.5

Service tax 219.3 44.3 154 0.0

Direct tax collection improved, indirect tax collection fell

Source: SBIMF Research

Grow th Last 3 yrs average Last 3 mth average November grow thNon-Food Credit 9.9 7.4 4.8Agriculture & Allied Activities 14.6 13.1 10.3Industry 5.8 -1.4 -3.4Services 10.0 11.6 7.1Personal Loans 16.2 17.3 15.2Priority Sector 12.3 8.5 5.8

Softer credit print was seen across all sectors

Impact on economic activity- Mixed Data points

0

5

10

15

20

25

30

35

40

45

50

Dec-

06Ju

n-07

Dec-

07Ju

n-08

Dec-

08Ju

n-09

Dec-

09Ju

n-10

Dec-

10Ju

n-11

Dec-

11Ju

n-12

Dec-

12Ju

n-13

Dec-

13Ju

n-14

Dec-

14Ju

n-15

Dec-

15Ju

n-16

Dec-

16

(New

pro

ject

s as %

of G

DP, t

raili

ng 4

Q)

New investment projects at all time low… Production in core industries unaffected

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Jun-

05

Jan-

06

Aug-

06

Mar

-07

Oct

-07

May

-08

Dec-

08

Jul-0

9

Feb-

10

Sep-

10

Apr-

11

Nov

-11

Jun-

12

Jan-

13

Aug-

13

Mar

-14

Oct

-14

May

-15

Dec-

15

Jul-1

6

Performance of eight core Industries (% y-o-y, 3mma)

Equity Market Outlook

Global equity market snapshot: 2016

Source: Bloomberg, SBIMF Research

• Nifty (3%) under performed most of the global markets during the year.

• Brazil/Russia/Pakistan/Indonesia happen to the best performing markets globally YTD.

• Sri Lanka/China/Philippines were amongst the laggards.

• India underperforms the MSCI Emerging markets index in 2016.

Performance 2016 (local currency returns)

-12 -10 -2

0 0 1 3 5 7 9 10 11 13 14 15 22

41 46

52

(20)

(10)

0

10

20

30

40

50

60CH

INA

SRI L

ANKA

PHIL

IPPI

NES

HAN

G SE

NG

JAPA

N

KORE

A

NIF

TY

FRAN

CE

GERM

ANY

MSC

I EM

S&P

500

TAIW

AN

DOW

JON

ES UK

INDO

NES

IA

MSC

I EM

- EU

ROPE

BRAZ

IL

PAKI

STAN

RUSS

IA

Indian stock market snapshot: 2016

Performance in December 2016

Source: Bloomberg, SBIMF Research

• Nifty/Sensex was up be a feeble 3% and 2% respectively in 2016.

• Metals emerged as the top performers.

• Pharma and IT have been the worst performing sectors.

• Mid-caps (8%) outperformed but Small-caps (2%) was in line with the Sensex returns.

-13 -8 -6

-3

2 2 3 3 4 4 7 8 9

13

27

37

(20)

(10)

0

10

20

30

40PH

ARM

A IT

REAL

EST

ATE

CAP

GOO

DS

SMAL

L CA

P

SEN

SEX

NIF

TY

FMCG

BSE

100

BSE

500

BAN

KEX

MID

CAP

AUTO PS

U

OIL

& G

AS

MET

ALS

Source: Antique, SBIMF Research,

Earnings: What is the risk?

• Profits for Indian companies have been weak in FY15 and FY16 on the back of weak export and domestic demand, stressed balance sheet, high real interest rates, fall in global commodity prices (affecting the commodity related companies), delayed investment cycle and relative appreciation of rupee vis-à-vis the trading partners.

• The earnings narrative was expected to change in FY17 and there were were visible signs of a cyclical uptick. In fact, The market rally and the subsequent rerating between 4QFY16-2QFY17 was driven primarily

• by the stabilization of the earnings trajectory which led to a belief that after five years, FY17 could finally see a revival in earnings growth (at least 10-12% in FY17, followed by 16-18% growth between FY18-19).

• Markets expected a boost in earnings from moderating interest rates, favourable base for select cyclicals like metals and PSU banks and growth in consumption on account of normal monsoon after two consecutive years of drought and from 7th Pay Commission pay-outs.

• The earnings narrative has now changed significantly post

demonetization. While it is difficult to predict earnings with any degree of uncertainty given the many moving parts, there is very little doubt that growth slowdown will lead to earnings cuts, especially in consumption driven sectors which was at the forefront of earnings growth over last 5 years.

• Needless to say, global factors like global bond yields, capital flows and

currency movement will also weigh in. Second, the phase of commodity cost tailwinds – which drove margin expansion over FY14-16 – is now behind as commodity costs have bottomed out. This could pose downside risks to margins in an environment of demand compression.

For FY17, earnings were expected to grow by as much as 14%. Both FY17 and FY18 expectations is likely to be revised downward post the demonetization exercise

95 128

175 207

239

283 247

284

330 351

385 427

391 403

460

-20%

-10%

0%

10%

20%

30%

40%

0

50

100

150

200

250

300

350

400

450

500

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

e

Nifty EPS (RS.)% y-o-y (RHS)

Source: Bloomberg, Morgan Stanley, SBIMF Research,

Corrections in Indian Equity Valuations

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

27-Dec-00 27-Dec-03 27-Dec-06 27-Dec-09 27-Dec-12 27-Dec-15

MSCI India's P/E prem. wrt MSCI EM

India’s valuations relative to other EMs have come-off in recent months …

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0% MSCI India ROE Relative to EM

…while the relative RoE continues to strengthen

Liquidity: DII inflow cushioned the market

Source: Antique, NSDL, SBIMF Research

FIIs have been net sellers in last three months of 2016

DIIs, on the other hand, pumped in US$ 5.2bn in last quarter

-20

-10

0

10

20

30

40

50

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

India: Net FII Debt Investment (USD bn)India: Net FII Equity Investment (USD bn)

-10000-8000-6000-4000-2000

02000400060008000

May

-13

Aug-

13

Nov

-13

Feb-

14

May

-14

Aug-

14

Nov

-14

Feb-

15

May

-15

Aug-

15

Nov

-15

Feb-

16

May

-16

Aug-

16

Nov

-16

Equity Investment Debt Investment

USD mn

Overall FII flow in Indian equity has been muted in 2016

-3.4 -3.5

-6.3

-1.3 -0.7

-4.7

-2.2 -2.7

-0.4

0.3

-1.0

5.0 4.1

2.0 0.9

0.4

-1.3

5.2

Sep-

12

Dec

-12

Mar

-13

Jun-

13

Sep-

13

Dec

-13

Mar

-14

Jun-

14

Sep-

14

Dec

-14

Mar

-15

Jun-

15

Sep-

15

Dec

-15

Mar

-16

Jun-

16

Sep-

16

Dec

-16

Market outlook

• 2014 was a rousing bull market followed by a consolidation in 2015. In contrast, calendar 2016 has been a complete roller-coaster starting with a disastrous January, building up to an almost-new-high by September and falling back again thanks to concerns about FII outflows and economic impact from demonetisation.

• The year, nevertheless, ended on a positive note with the BSE Sensex up 1.9% for the year, the BSE Midcap way higher at 8.0% and the BSE Small-cap ending up at 1.8%; no clear pattern across the cap curve with the midcaps outperforming and the small-caps underperforming the large cap Sensex.

• Relative performance across emerging markets was disappointing to say the least; India ranked 16th among MSCI emerging markets.

• FII flows started off negative and recovered substantially only to end the last quarter negative, meaningfully; MF flows were a mixed bag in the first half but picked up substantially in the second while Insurance was largely negative. Overall, DII buying cushioned the impact of FII outflows.

• For the year, Materials and Utilities were the best performing sectors and IT and Healthcare were the worst.

• On fundamentals, earnings continue to disappoint, yet again, with FY17 likely to end at low single digits. Though valuations have seemingly corrected with the market, the demonetization seems to have hit the economy negatively in the short term and has unsettled the growth expectation build up.

• We remain cautiously optimistic, with all eyes on the Union budget and policy unveiling by Donald Trump administration. The structural growth drivers for India remain firmly in place.

Valuations are at 16 times on 1 year forward earnings

Source: Bloomberg, SBIMF Research

7.0

9.0

11.0

13.0

15.0

17.0

19.0

21.0

23.0

25.0

Dec/

05Ju

l/06

Feb/

07Se

p/07

Apr/

08N

ov/0

8Ju

n/09

Jan/

10Au

g/10

Mar

/11

Oct

/11

May

/12

Dec/

12Ju

l/13

Feb/

14Se

p/14

Apr/

15N

ov/1

5Ju

n/16

Sensex 1Y fwd PE

Mean: 16

+1 SD

-1 SD

Debt Market Outlook

Global rates snapshot for 2016: Change in the trajectory

• There has been a subtle shift in the direction of global bond

yields over the last three month with markets doubting the incremental effectiveness of additional QE/Monetary easing on aggregate demand.

• With the election results in the US, expectations of ramped up government spending, higher growth and a tighter pace of Federal Reserve rate hikes have led the dollar to soar to 13-year highs and bond yields to rise higher.

Source: Bloomberg, SBIMF Research

10 Year Gsec Yield (% mth end) 2014 end 2015 end 2016 end

3m Change (in bps)

% change in 2016 (in bps)

Developed market US- 10 year 2.17 2.27 2.44 85 17Germany- 10 year 0.54 0.63 0.21 33 -42Italy 1.57 1.35 1.82 82 47Japan- 10 year 0.33 0.27 0.05 14 -22Spain 1.61 1.77 1.38 50 -39Switzerland 0.32 -0.06 -0.19 36 -13

-0.50.00.51.01.52.02.53.03.54.04.5

Jan-

10M

ay-1

0Se

p-10

Jan-

11M

ay-1

1Se

p-11

Jan-

12M

ay-1

2Se

p-12

Jan-

13M

ay-1

3Se

p-13

Jan-

14M

ay-1

4Se

p-14

Jan-

15M

ay-1

5Se

p-15

Jan-

16M

ay-1

6Se

p-16

US- 10 year Germany- 10 year Japan- 10 year

70

80

90

100

110

120

130

Jan-

2001

Au

g-20

01

Mar

-200

2

Oct

-200

2

May

-200

3

Dec

-200

3

Jul-

2004

Feb

-200

5

Sep

-200

5

Ap

r-20

06

No

v-20

06

Jun

-200

7

Jan-

2008

Au

g-20

08

Mar

-200

9

Oct

-200

9

May

-201

0

Dec

-201

0

Jul-

2011

Feb

-201

2

Sep

-201

2

Ap

r-20

13

No

v-20

13

Jun

-201

4

Jan-

2015

Au

g-20

15

Mar

-201

6

Oct

-201

6

DXY Index- monthly average

Dollar Index has moved above 100 after nearly 13 years

Bond yields moved up significantly since October

Barring India and Brazil, emerging markets bond yields are rising

Source: Bloomberg, SBIMF Research

10 Year Gsec Yield (% mth end) 2014 end 2015 end Sep-16 Oct-16 Nov-16 2016 end

3m Change (in bps)

% change in 2016 (in

bps)

Emerging Market

Brazil 12.4 16.5 11.6 11.4 11.8 11.4 -18 -511

China 3.6 2.8 2.7 2.7 2.9 3.0 32 20

India 7.9 7.8 6.8 6.8 6.2 6.4 -38 -132

Indonesia 7.8 8.7 7.0 7.2 8.1 7.9 89 -78

Korea 2.6 2.1 1.4 1.7 2.1 2.1 66 0

Malaysia 4.1 4.2 3.5 3.6 4.3 4.2 65 0

Philippines 3.9 3.9 3.9 3.9 4.5 4.6 69 69

Russia 9.4 9.6 8.2 8.6 8.8 8.4 21 -126

South Africa 8.0 9.8 8.7 8.7 9.0 8.9 25 -85

Taiwan 1.6 1.0 0.7 0.7 1.2 1.2 52 19

Thailand 2.7 2.5 2.1 2.1 2.7 2.6 55 16

Among emerging markets, Brazil and India saw the sharpest fall in bond yields

India Rates Snapshot for 2016: massive softening was seen

• The withdrawal of the high denomination notes as legal tender led to massive deposits of money at bank branches. Given the ceiling on withdrawal of cash, the liquidity in the banking system rose sharply. At the same time, growth disruptive effects of demonetization led markets to expect deeper rate buts in the economy. Improved liquidity and rate cuts expectations led to softening of yields across the curve.

• Indian bond yields have softened massively with 10-year G-sec touching a low of 6.10% in November end, though the yields moved up post December 9 MPC meet to trade at 6.44% by end of the year. Money-market rates, too, softened on the back of anticipation of improvement in liquidity.

• Crude oil prices rose 9.1% over the month, but rose 47.8% YTD. Rupee depreciated by 2.7% in 2016.

Source: Bloomberg, PPAC, SBIMF Research; NB: **Crude oil price is average $/barrel for the month, rest of the data are % month end; *Corporate bond rate is for AAA rated bonds ,*** Refers to PSU Banks CD rate; # INR and Oil price changes are % change

Oct-16 Nov-16 Dec-16 m-o-m change (in

bps) Change in

2016 (in bps) 1 Yr T-Bill 6.44 6.05 6.33 -15 -90 3M T-Bill 6.37 5.95 6.20 -12 -95 10 year GSec 6.79 6.25 6.44 -28 -132 3M CD*** 6.58 6.15 6.28 -34 -93 12M CD*** 6.93 6.48 6.63 -23 -108 3 Yr Corp Bond* 7.48 7.03 7.29 -23 -104 5 Yr Corp Bond* 7.52 7.16 7.37 -22 -102 10 Yr Corp Bond* 7.65 7.20 7.58 -26 -84 1 Yr IRS 6.35 6.00 6.19 -7 -89 5 Yr IRS 6.35 6.07 6.26 -18 -70 Overnight MIBOR Rate 6.24 6.51 6.25 16 -78 INR/USD 66.8 68.4 67.9 -0.8# 2.7# Crude Oil Indian Basket** 49.2 44.5 52.7 9.1# 47.8#

Reasons for falling Domestic Bond-yields in 2016

Change in the Liquidity Stance of RBI, increased OMO purchase

Source: RBI, SBIMF Research; NB: Data as of 12th January 2017

Banking system in comfortable liquidity since June 2016

-4000

-2000

0

2000

4000

6000

8000

10000

Banking System Liquidity (Rs. Billion)

+1% of NDTL

-1% of NDTL

Comfortable liquidity since

546

-634

523

1105

-800-600-400-200

0200400600800

10001200

FY14 FY15 FY16 FY17 YTD

Net OMO Purchase (Rs. Billion)

RBI conducted OMO purchase of Rs. 1,105 billion in FY17 (YTD)

Change in RBI’s Liquidity Stance from deficit to neutral:

• The Reserve Bank’s liquidity framework was changed significantly in September 2014 and the central bank had kept the system in an ex ante deficit mode on average, with a liquidity shortfall equivalent to 1% of banks’ NDTL. The rationale has been that the banking system would borrow from the Reserve Bank’s liquidity facilities, ensuring that the repo rate guided short term money market rates and thereby was effective as the policy rate.

• In April 2016, RBI remarked that the provision of short term liquidity does not substitute fully for needed durable liquidity, though durable liquidity can substitute for short term liquidity needs. Also, the past rationale for keeping the system in significant average liquidity deficit no longer is as compelling, when the policy stance is intended to be accommodative. And hence RBI moved to progressively lower the average ex ante liquidity deficit in the system to a position closer to neutrality.

• The change in liquidity stance led the Banking system liquidity to move in a comfortable zone since June 2016. Post demonetization, banks’ liquidity shot up further as the pace of withdrawal of currency has been much less than the pace of deposit

Increased OMO purchase by RBI: • To move towards the neutral liquidity system, RBI conducted

an aggressive OMO purchase of Rs. 1,105 billion in FY17 thus creating an increased demand for central government securities.

Accommodative stance from RBI supported by comfortable inflation

Source: RBI, SBIMF Research; NB: Data as of 12th January 2017

RBI delivered additional 50 bps cut in 2016

CPI remained comfortable since August 2016

RBI gave 50bps cut in Repo rate, remained accommodative:

• Helped by the fiscal consolidation path and contained inflation, RBI delivered two rate cuts of 25bps each in April and October taking the Repo rate to 6.25% by the year end.

• The stance remains accommodative helping the bond yields to also fall lower.

FY17 inflation target of 5% looks achievable • CPI started to considerably soften since August 2016 making

5% FY17 target comfortably achievable.

• Near normal monsoon after two years of deficit rainfall and active food price stabilization strategy by government of India, significantly eased the food price pressures.

• Food inflation peaked at 8% in July and then glided south to 2% by year end.

• Despite the rising global commodity prices and hence rising input cost, the muted demand scenario led the output prices to remain contained (weak pricing powers of retailers).

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

Jan-

12

Apr-

12

Jul-1

2

Oct

-12

Jan-

13

Apr-

13

Jul-1

3

Oct

-13

Jan-

14

Apr-

14

Jul-1

4

Oct

-14

Jan-

15

Apr-

15

Jul-1

5

Oct

-15

Jan-

16

Apr-

16

Jul-1

6

Oct

-16

CPI % y-o-y

CPI target range 4% + 2%

6.00

6.50

7.00

7.50

8.00

8.50

9.00

9.50

Jan-

11

Apr-

11

Jul-1

1

Oct

-11

Jan-

12

Apr-

12

Jul-1

2

Oct

-12

Jan-

13

Apr-

13

Jul-1

3

Oct

-13

Jan-

14

Apr-

14

Jul-1

4

Oct

-14

Jan-

15

Apr-

15

Jul-1

5

Oct

-15

Jan-

16

Apr-

16

Jul-1

6

Oct

-16

10 year GSec yield (mth end, %) Repo Rate (mth end, %)

Average spread between G-sec and Repo in last 10 years: 75bps

Muted Credit growth and finally the demonetization

Source: RBI, SBIMF Research; NB: *Oct 2016 figures of 500 &1000 notes are SBIMF’s estimate

Credit growth extremely muted Low Credit deposit growth

• Low demand for bank credit kept the banks demanding for higher quantum of G-sec than their SLR requirement

• Demand for G-sec by the banks increased further post demonetization due to surplus liquidity in the banking system

Demonetization • Demonetization led to 86% of currency in circulation losing legal

status overnight.

• Loss of ‘medium of exchange’ led to significant disruption in economic activity which led market to expect much lower growth in the near term.

• At the same time, some of the perishable food items loss demand due to lack of cash and hence the prices of these food items fell significantly.

• Demonetization is expected to strengthen fiscal balance sheet either by better tax compliance, or higher penalty payments or by some gains in RBI’s balance sheet the last argument is gradually losing significance).

• Some amount of cash deposited with the banks is expected to remain permanently in the banking system thus improving their liquidity.

• Combination of adverse effect to growth, contained inflation, strengthened fiscal situation led markets to expect rate cuts by RBI. Hence yields went low in weeks immediately after demonetization.

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

Jan-

13

Mar

-13

May

-13

Jul-1

3

Sep-

13

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-1

4

Sep-

14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-1

5

Sep-

15

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-1

6

Sep-

16

Nov

-16

Bank Deposit (% y-o-y) Credit % y-o-y-LHS

86% of Indian currency loses legal status overnight*

0.6 0.8 1.1 1.5 1.9 2.5 3.2 4.0 5.0 6.0 7.5 8.6 9.7 10.8 12.2 14.2 15.2

2.2 2.5 2.8 3.3 3.7 4.3 5.0 5.9 6.9 8.0 9.5

10.7 11.8 13.0

14.5 16.6 17.8

0.0

5.0

10.0

15.0

20.0

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

2009

-10

2010

-11

2011

-12

2012

-13

2013

-14

2014

-15

2015

-16

2016

-17

(Oct

)

500 and 1000 rupee notes (in Rs. Trillion)Smaller denomination notes& coins (in Rs. Trillion)Total Currency in Circulation (in Rs. Trillion)

What lies ahead in 2017- Themes to watch

Interplay of Global and Domestic Factors

Global factors Global Bond yields movement: Global rates “low for longer”’ to ‘’ low forever’’ to

questions over incremental effectiveness of monetary policy experiments

Role of fiscal policy actions to revive demand- Trump effect

Divergence in global monetary policy stance- US Fed & other central banks

Commodity price outlook and currency market dynamics- OPEC policies , Strong Dollar

Domestic factors:

Durable Impact of currency note legal tender cancellation- Growth & Inflation- uncertain

Structural improvement in liquidity- Positive

Fiscal Policy – Short and Long term impact- Short term uncertain. Long term positive

External account, Commodity, Currency and Capital flow dynamics- global linkages

The full impact of demonetization on growth is not known as yet

Source: RBI, SBIFM Research

Liquidity Impact: Can be recouped to a large extent once currency

flow normalizes

Wealth effect: Can adversely impact select sectors. In long run, distributional wealth effect may

lead to neutral impact on growth

Income effect: Consumption lost because of underlying incomes taking a hit may not necessarily be recouped. Can have adverse

spiral effects and may take longer to correct

Growth impacts

Selective

• Demonetization has disrupted the business activity significantly, specifically for sectors which thrives on cash as a medium of exchange. Affects the ability to pay wages and make purchase orders for sectors.

• Financial services , on the other hand, will see positive impacts due to influx of low-cost deposits. Expectation of fiscal stimulus will also provide a boost to demand in related sectors.

• Net short-term effect is likely to be negative and to that extent, it can dilute the impact of consumption boost that market anticipated from the rolling out of 7thPay commission and improvement in rural income due to better harvest.

• In the long run, both GST implementation and curbing of black money are structurally positive for growth. However, in the near-term, it is not known how long will the disruption to growth lasts.

• Stronger disruption to growth may lead RBI to subtly shift its focus to growth

CPI inflation: Impact mildly deflationary

Source: CSO, SBIMF Research

• Latest Inflation print (3.4% in December) depicted considerable softening in prices primarily due to fall in fruits and vegetable.

• Demonetization is likely to cause temporary fall in inflation due to reduced cash availability and hence reduced spending. This has lowered the prices perishable food items and may keep the prices of discretionary goods and services (16% weight in CPI basket) under check. However, the effects may be transitory and a large portion of CPI basket may remain unaffected from demonetization (with apprx 45% food, 10% fuel and light and 10% housing rentals.

• FY18 Outlook: Average CPI inflation has been declining every year since FY13 and 5% FY17 target of RBI looks comfortably achievable. However, going sustainably below 5% to 4% is going to be challenging as a) core CPI has remained sticky at ~5%, b) global commodity prices are firming up, c) food prices still depend on vagaries of monsoon, d) the uncertain impacts of GST still looms, e) 7th Pay commission effects is yet to fully unfold, and e) government is gradually turning more supportive to rural economy via MGNREGA and higher MSPs. That said, both government and RBI is extremely mindful of inflation and take pro-active measures to keep it under check. RBI will closely watch these developments before embarking on further rate cuts.

CPI Inflation softened considerably to 3.4% in December …due to fall in food prices

-4.0-2.00.02.04.06.08.0

10.012.0

Jan-

14

Mar

-14

May

-14

Jul-1

4

Sep-

14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-1

5

Sep-

15

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-1

6

Sep-

16

Nov

-16

Core CPI (CPI ex food ex fuel)

CPI Food

CPI: Transport and communication

% y-o-y

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

Jan-

12

Apr-

12

Jul-1

2

Oct

-12

Jan-

13

Apr-

13

Jul-1

3

Oct

-13

Jan-

14

Apr-

14

Jul-1

4

Oct

-14

Jan-

15

Apr-

15

Jul-1

5

Oct

-15

Jan-

16

Apr-

16

Jul-1

6

Oct

-16

CPI % y-o-y

CPI target range 4% + 2%

Fiscal position: Even as Long term positives emerge

Source: CSO, SBIMF Research

7.1 7.3 7.1 7.4 7.2 7.2 6.5 7.0 7.0

8.8 9.5 9.9 10.1 9.7 9.4 10.8 10.6 10.2

15.2 16.0 16.2 16.8 16.1 15.9 16.3 17.1 17.1

02468

101214161820

Centre State Total

Tax Collection (as % of GDP)

1316 16

20

2528 29

3640

0

5

10

15

20

25

30

35

40

45

Indonesia India Thailand Mexico Korea Australia Turkey Brazil Euro zone

Tax

to G

DP

, %

• Fiscal health of the economy will definitely see an improvement due to both these measures of GST implementation and

curbing the black money, though it may be marginally negative in the short-term due to implementation cost and reduced business activity.

• In the long-run, demonetization, along with other measures such as GST implementation, DBT, Real estate regulations , PAN card requirement for higher denomination transaction will create a background which reduces the scope of evading taxes (and hence black money size in India)

• We are likely to see a massive improvement in revenue collection, whether it be through better tax to GDP ratio, through penalty payments (for black money) or through profit transfer from RBI (though it is looking bleak at the current juncture due to return of most of 500/1000 rupee notes back into the system).

Banking system Liquidity to see sustained improvement

Source: RBI, SBIMF Research

• Currency Leakage has picked up pace in last two years which has been out-of-sync with the pace of economic growth. High currency leakage, on the margin, leads to tightness in the banking system liquidity.

• Liquidity has gone large shifts in Q3 FY17 to surplus zone. Currency in Circulations plunged by Rs. 7.4 billion, net of replacements up to December 2. Deposits in banking system surged in parallel.

• RBI implemented variety of measures to suck this surplus liquidity. Incremental CRR of 100% was implemented for a fortnight, variable reverse repo window was scaled up, oil bonds issued by government was allowed as eligible securities under LAF and limits on securities under market stabilization scheme (MSS) was scaled up from Rs. 0.2 trillion to Rs. 6 trillion on November 9. Cash Management Bills under MSS has been issued to the tune of Rs. 5.6 trillion as of 13th January.

• Some of the cash is likely to permanently stay in the system as bank deposits even after conditions normalizes and hence lead to a permanent improvement in banking system liquidity.

8.0

10.0

12.0

14.0

16.0

18.0

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16

Growth in Currency in Circulation (% y-o-y)

Currency leakage from the banking system accelerated in last two years

Return of currency to the banks without a parallel withdrawal led to drastic improvement in liquidity

-4000-3000-2000-1000

0100020003000400050006000

6-Ap

r-15

6-Ju

n-15

6-Au

g-15

6-O

ct-1

5

6-De

c-15

6-Fe

b-16

6-Ap

r-16

6-Ju

n-16

6-Au

g-16

6-O

ct-1

6

6-De

c-16

Banking System Liquidity (Rs. Billion)

+1% of NDTL

-1% of NDTL

Banks lending rates seen falling due to availability of low cost deposits

Loan growth remains soft while deposit growth surged further

Source: CMIE, RBI, SBIFM Research

MCLR has fallen by 25bps in November

• Buoyed by the demonetization drive, the deposit portfolio surge further by Rs. 5.3 trillion in November. Banks’ deposit growth thus increased to 16% y-y, highest in past few years and much higher compared to 1H FY17 growth of 9.5%.

• Some of the cash is likely to permanently stay in the system as bank deposits even after conditions normalizes and hence lead to a permanent cheaper source of funds for banks. Banks have already reduced their deposit rates for varying tenors due to the comfortable liquidity.

• Over the next couple of months, banks' lending rates is likely to come down due to fall in deposit rates and due to competitive pressure created by rate cuts announced by some of the banks.

• Weak near term credit demand can support bonds, until the working capital demand shifts to banking channels from the cash based channel. While we anticipate some of the informal lending demand to come to the formal banking system, a big jump in credit growth will depend on pick up in capital spending cycle.

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

Jan/

13

Apr/

13

Jul/1

3

Oct

/13

Jan/

14

Apr/

14

Jul/1

4

Oct

/14

Jan/

15

Apr/

15

Jul/1

5

Oct

/15

Jan/

16

Apr/

16

Jul/1

6

Oct

/16

Bank Deposit (% y-o-y) Credit % y-o-y-LHS

8.58.68.68.78.78.88.88.98.99.09.0

01-A

pr-2

016

15-A

pr-2

016

29-A

pr-2

016

13-M

ay-2

016

27-M

ay-2

016

10-Ju

n-20

1624

-Jun-

2016

08-Ju

l-201

622

-Jul-2

016

05-A

ug-2

016

19-A

ug-2

016

02-S

ep-2

016

16-S

ep-2

016

30-S

ep-2

016

14-O

ct-2

016

28-O

ct-2

016

11-N

ov-2

016

25-N

ov-2

016

Dec.

9, 2

016

Dec.

16,

201

6

MCLR (Overnight) in %

Commodity prices snapshot 2016

Source: Bloomberg, SBIMF Research; NB: Data as of 6th December

Commodity prices saw a broad based rise in 2016, barring corn, wheat and uranium

-100.0 -50.0 0.0 50.0 100.0

UraniumWheat

CornCoffee

PlatinumCotton

GoldAluminium

WTIGas Oil

SoybeansBrent

Heating OilSilver

GasolineCopper

Natural GasSugarNickel

PalladiumTin

ZincIron Ore

Coal

% change 2016

Currency

Source: Bloomberg, SBIMF Research

Indian rupee has been relatively less volatile and depicted marginal depreciation bias since 2014 at a time when most other Emerging Market currencies depicted large swings on either side

-17.2 -17.0

-6.5 -6.3 -5.4 -4.3 -2.6 -2.6 -1.3

0.5 1.7 2.35.7

12.6

-30-25-20-15-10

-505

1015

Turk

ey L

ira

Mex

ican

Pes

o

Chin

ese

renm

inbi

Polis

h Zl

oty

Phili

ppin

e Pe

so

Mal

aysi

an R

ingi

tt

Indi

an R

upee

Kore

an W

on

Hun

garia

n Fo

rint

Thai

Bah

t

Taiw

anes

e D

olla

r

Indo

nesi

an R

upia

h

Colo

mbi

an P

eso

Afric

an R

and

Russ

ian

Roub

le

Braz

il Re

al

% change in 2014 % change in 2015 % change2016

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Jan-

11

May

-11

Sep-

11

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16

Avg volatility of EM currency (ex India) Indian rupee volatility

FX intervention by RBI has increased in last 3 years compared to 2009 to 2012 period

0.010.020.030.040.050.060.070.080.0

FX Intervention (in US$ bn) (purchase + sell)

Currency outlook

Source: CMIE economic outlook, SBIMF Research

Indian currency has strengthened against its trade partners

• Over the last three months dollar has strengthened and bond

yields across the globe has rallied rapidly.

• India has been an exception to see bond yields falling massively at a time when even emerging markets rallied by anywhere between 50-100bps. This has narrowed down India’s interest differential vis-à-vis similar US treasury papers by at least 100 bps in last three months across the yield curve.

• Thus, Indian rupee, which has been a story high carry and low volatility, will see some loss of attractiveness on the former.

• Nearly US$ 80bn of foreign currency reserves has been amassed by the Indian central bank, at a time, when most other emerging markets dipped into their reserves. This provides some muscle power to the RBI to contain the rupee volatility. I

• While rupee depicted marginal depreciation against dollar, it strengthened against its trading partners in last three years.

• Outlook: Looking ahead, in the event of depreciation in other emerging market currencies, rising crude prices and strengthening dollar, we do envisage continued depreciation in rupee next year. -543

-135-35 -8 -3 -2

0 3 5 6 24 25 4085

-600-500-400-300-200-100

0100200

Chin

a

Russ

ia

Mala

ysia

Turk

ey

Braz

il

Philip

pine

s

Sout

h Af

rica

Thail

and

Colo

mbi

a

Mex

ico

Indo

nesia

Taiw

an

Kore

a

Indi

a

Reserves accretion between Aug 2013 to Dec 2016 (in USD bn)

Substantial build-up in Indian FX reserves will enable RBI to manage currency volatility

Rate Outlook

Source: RBI, CSO, SBIFM Research

4.00

5.00

6.00

7.00

8.00

9.00

10.00

Jun-

05

Mar

-06

Dec-

06

Sep-

07

Jun-

08

Mar

-09

Dec-

09

Sep-

10

Jun-

11

Mar

-12

Dec-

12

Sep-

13

Jun-

14

Mar

-15

Dec-

15

Sep-

16

Repo Rate (mth end, %)

Very little data at present to validate significant additional policy

easing .

Liquidity improvement would enable improved transmission to lending rates & bring down system wide rates.

Data dependency of additional easing increases in the current context.

Changing external dynamics and Fx moves are material considerations that shape policy stance apart from visibility of a durable softening in CPI to 4%, durability of demand slowdown and fiscal stance for FY18

Comfort in meeting March 17 CPI target and near term subdued

readings could keep market expectations intact for a 25 bps easing in Q1CY17.

Improvement in fiscal position over next few years would be structurally positive for bond markets

This would support a case for continuation of an accommodative monetary policy stance and lower market rates

There has been a shift in the direction of global bond yields over the last month with markets doubting the incremental effectiveness of additional QE/Monetary easing measures on aggregate demand.

With the election results in the US, there has been a further rise in treasury yields across the developed markets, increase in long term market implied inflation expectations and curve steepening.

Within the emerging markets too, barring India, yields have risen in all the key markets in last three months.

Exuberance driven by easier near term liquidity and hopes of policy easing have led to domestic yields getting disconnected entirely from global trends as well as markets under-pricing near term risks arising from weakness in currency as well as some uptick in commodity prices. Consequently, the central bank’s decision to leave the repo rate unchanged contrary to market expectations of 25-50bps of rate cut led to an immediate negative reaction from the market, with yields moving up by about 20-30bps.

The recent demonetisation of high value notes can have major medium-long term positive structural effects such as: a) potential additional government tax revenues from better compliance over the coming years, b) increase in tax/GDP ratios seen in conjunction with GST and c) reducing the role of cash economy and additional access to formal financial sector.

While fiscal situation can improve significantly over medium term, the market can also take comfort from near term weakness in headline CPI.

In this environment, the trend for a medium term easing in market yields remains intact driven by incremental news flow on potential benefits to government revenues over the medium term.

In the very short term, global yield volatility , shifting expectations of US Fed stance and lack of OMO’s /higher net supply will keep the markets volatile.

Market Outlook

Source: RBI, Bloomberg, SBIFM Research

6.00

6.50

7.00

7.50

8.00

8.50

9.00

9.50

Jan-

11M

ay-1

1Se

p-11

Jan-

12M

ay-1

2Se

p-12

Jan-

13M

ay-1

3Se

p-13

Jan-

14M

ay-1

4Se

p-14

Jan-

15M

ay-1

5Se

p-15

Jan-

16M

ay-1

6Se

p-16

10 year GSec yield (mth end, %) Repo Rate (mth end, %)

Average spread between G-sec and Repo in last 10 years: 75bps

Thank you

Disclaimer

This presentation is for information purposes only and is not an offer to sell or a solicitation to buy any mutual fund units/securities. These views alone are not sufficient and should not be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions and estimates included here constitute our view as of this date and are subject to change without notice. Neither SBI Funds Management Private Limited, nor any person connected with it, accepts any liability arising from the use of this information. The recipient of this material should rely on their investigations and take their own professional advice.

Mutual Funds investments are subject to market risks, read all scheme related documents carefully. Asset Management Company: SBI Funds Management Private Limited (A joint venture with SBI and AMUNDI). Trustee Company: SBI Mutual Fund Trustee Company Private Limited.

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