• The MPC met in the first week of August. While all the policy rates remained unchanged, the stance on a continued accommodative policy met with a dissent from one member of the MPC. The MPC also changed the average inflation forecast for the year from 5.30 % to 5.70 % marking a large upward move in the inflation. Separately RBI also announced larger Variable Reverse Repo rate auctions through the quarter, aimed at normalizing the liquidity in the banking system. The debt markets sold off after the policy and yields moved by around 10 bps
• We think the dissenting voices within MPC may increase with inflation remaining a concern and the RBI would first move towards normalizing the liquidity deluge in the banking system
• We remain apprehensive of a gradual rate rise as we move through the year. We believe that the markets may stop coat tailing the RBI, and may remain apprehensive of a commodity prices rise induced inflation and a larger borrowing program
• The possibility of a bear flattening of the yield curve exists with long term rates rising lesser than short term rates
• We also believe that AAA credit spreads are very tight and the probability of spreads to increase in the near future remains a distinct possibility
• Liquidity being in sustained surplus mode, the extreme short end of the yield curve may remain stable

Indian markets continued the broad-based rally in July with the Small Cap and Mid cap indices performing better than the Nifty 50 that ended almost flat. The markets were driven by the increasing retail participation in equity markets, both directly as well as through mutual fund schemes while foreign portfolio investors (FPIs) were net sellers during the month. On the sectoral front, metals and information technology (IT) outperformed Nifty 50 while auto and energy counters underperformed Nifty 50.

Globally, the equity markets continue to remain in positive zone, with exception being China and Hong Kong. Optimism over economic recovery owning to vaccination leading to normalisation of services activity in USA and Europe boosted the sentiments. Meanwhile, US Federal Reserve’s (Fed) in its July policy meeting maintained the status quo citing current high inflation as being transitory and kept its policy guidance on rate hike in CY23 intact. Over and above the expansionary monetary policy by Fed, the fiscal support by the US government also supported the economic recovery in the post covid world. Unemployment benefits and/or pay protection plan in USA has helped majority American citizens get income support and maintain their living. The income support plan in USA is due for review and revision in September 2021 and the revised terms would be keenly monitored. Among other global indices, China and Hong Kong markets fell sharply in July 2021 as policy actions taken by Chinese government on regulating education companies as well as newly listed company Didi pulled down the tech-platform companies.

In India’s context, we would monitor RBI’s policy action as inflation remains high and any move towards tightening can hurt economic recovery prospects. This was evident in the past when monetary easing supported the mid and small cap segment in general while tightening hurt them. This is critical especially in the backdrop of a super-normal rally in mid n small caps. From the covid lows in March 2020 as well as in past 1-year, Nifty Smallcap 100 Index rallied 212% and 110%, respectively, while Nifty Midcap 100 Index ended up 153% and 80% as well. Considering the sharp rally amidst the delayed recovery due to covid, small cap and mid cap index as an aggregate appear more expensive than the large cap indices like Nifty or Nifty 100.

On Covid front while vaccination drive remains a focus, there are early reports about emergence of delta variants of covid in western world. Clearly the hopes of economic recovery and market sentiments are based on successful post-vaccination normalisation and not factoring third wave of covid.

While the monetary policy response on rate hike seems well communicated, the negative surprise can arise from tapering of the incremental liquidity by Fed. The fiscal policy support in USA (direct payment and unemployment benefits) has achieved what years of easy monetary policy by Fed could not do, create inflation. Yes, there are other factors like Chinese Yuan appreciation, supply disruption and commodity price that too contributed to inflation. But the demand generated by fiscal support has a relevant role and hence policy decision on further continuation of unemployment benefits remains to be evaluated.

The earnings season for Q1FY22 has been good till now though the base effect makes any comparison with FY21 is not very relevant. FY22 as of now is likely to be a replay of FY21 where economy normalised during Q3 festive season. Perhaps a fiscal policy support is needed to boost economy towards double digit growth.

While the power of asset allocation to equity in past 12-15 months has been seen, the power of market cycles in terms of capitalizations has crucial role to play. What started as a large cap driven recovery in passed leadership baton to mid cap and then to small caps. The economic cycle of growth and corporate earnings, navigate across market capitalization driven by policy actions on both fiscal and monetary front. We believe this re-emphasises the need to be flexible in choosing companies across market capitalizations. Yes, there are clearly Risks (Uncertainty) in Markets and its relationship with expected Returns. Large Cap, Mid Cap and Small cap as a segment, play a critical role in a portfolio construction for investors and they may always choose to manage it themselves or choose to entrust to mutual funds who have the flexible approach.

Investors with lumpsum investments style could have an asset allocation strategy (equity as a % of portfolio) to try and benefit from greed and fear phases. Alternately, the strategy could be to really stick to longer term outlook rather than focusing on 1-2 years volatility. For investors with SIP investments such phases are not so relevant as investor is still in accumulation phase for wealth creation over the 5-7 years. SIP may be a good alternate to avoid the behavioural traps during the extreme phases of markets. We maintain that investors use SIP as part of core investment philosophy and use the lumpsum route during the extreme phases to top-up on their SIPs during the fearful times amidst the volatility

For investments in debt oriented products:

• We believe that the investors with a shorter investment horizon may continue investments in ultra-short term and low duration funds
• For a medium to long term investment horizon and with a suitable risk appetite, an allocation to Short Term Fund and Dynamic Bond Fund merits attention.

For investments in equity oriented products:

• Our view is that volatility may continue and SIP may be a good way to increase equity market allocations
• Investors looking to invest for a medium to long period, can consider SIPs or STPs into focused, multicap or hybrid funds based on risk appetite.
• Investors looking for a better return opportunity and with a suitable risk appetite, may consider part allocation in mid cap fund as well.