The New Year has been kind to investors in emerging markets, as equity prices as well bonds prices have recovered from their Post-Trump lows in December 2016. Indian equity markets have been able to beat the winter blues and march higher, inspite of a steady stream of outflows from the FPI community. A negative bias from FPIs, coupled with a reserve accumulation from RBI has ensured that Indian Rupee remains one of the weakest currencies in the emerging market basket, after Turkish Lira and Mexican Peso. There is no surprise there, as we had pointed out in December that after a large scale sale from its reserves, RBI would be eager to accumulate some of foreign currencies in Q1 2017. Past data have shown that it is RBI who makes or breaks the Rupee. During quarters when RBI is on a spree to divest its currency chest, Rupee remains in the top quartile in the EM basket and vice versa.

Domestic investors in India continue to pour money into the equity markets, and that helped it recover back to levels seen before US elections. It is US equities and bounce back in commodities that pulled the EM equities higher and higher EM equities, ensured that FPIs, who are still negative on Indian stock market refrain from aggressive selling, and that in turn allowed domestic money to push up stocks higher. Post demonetisation, markets have gone from shock to pessimism to surprise and now towards euphoria. Economic data flow indicated an economy which was losing momentum even before demonitisation kicked in. Since then, economic data has become too distorted to draw much of inference. However, that has not stopped the enthusiastic fundamental or macro person to jump into the business of extrapolation. There is a growing demand from the community of investors and media to makes sense of the financial markets through the inadequate lenses of macroeconomics and corporate fundamentals. This has compelled our community to indulge in the meaningless pursuit of finding meaning amongst a whole array of distorted data post demonetisation.

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Since 2008-09, globally, cycles in financial markets have not only become shorter to the dislike of a fundamental oriented research analyst but also become less attached to the cycles in the macro economy. Infact, the cycles of positive and negative economic trends have themselves become short. All in all we have been delivered an analytical nightmare. A technical analyst may have been navigating these water better, as the scope of his work which entails analyzing existing trends, rather than forecasting it, is better suited for modern times. The fundamental analyst who has exhibited a more consistent streak of more rights, than wrongs, has been the one who has been able to adapt to the new normal.

Coming back to our Indian economy. We are in an important week for news/data watchers. Union Budget will be presented this week. Like an annual rituals financial and media community is busy peddling list of Mr. FM should do and should not do. Non-financial industry bodies are not far behind. India loves to celebrate and Union Budget has become our national pastime. How will all these affect financial markets? I have no clue. However, let us consider what happened over past three years. In 2014, pre budget trend in stock market and bond market continued, after usual volatility post Budget. However, in 2015, trend reversed from upward to downward but in 2016, it reversed from downward to upward. Hence, take your pick what will the direction of markets post Budget. However, I would say this. This is going to be a complex budgeting exercise, where short to medium term horizon is quite fuzzy, though medium-long term path appears a lot clear. The reason I say this is because of the following:

Union Budget has to factor in the impact of a mid-year implementation of GST.

GST rates are not known and even the exemption list is not finalized, so how would government arrive at a full year target on indirect taxes?

Demonetisation and GST are steps towards formalizing the economy. A more formal economy would ensure better tax compliance, better protection of workers rights and better formal credit penetration in the economy. However, these are long term goals which can surely be achieved through smart implementation. But they will cause short to medium term disruptions in the economy. Be in less of money flow into real estate and hence further deceleration of real estate sector. A weak real estate will have knock on effects on investments, employment and consumer sentiment and balance sheets of financial companies. It can even impair balance sheet of corporates through backdoor. They will have adverse impact on revenues of state governments, who are dependent on the sector to meet their financing needs.

I also believe that too much of deliberate ignorance is peddled in the name of analysis. One such area remains the expectation that government somehow has a magic wand to fix the economic growth trajectory over the short to medium term. We know it but now should stop forgetting it, that since liberalization, the role of public sector in the economy has become smaller. In fact it was an intended effect of liberalization, that to reduce the role of government, who is seen as an inefficient allocator of resources, and increase the role of private sector. Therefore, to now expect the same government can materially alter the course of deceleration in the economy, is just being naïve. Take for instance, the fact government institutions like NHAI and Railways finding it difficult to utilize the resources to significantly boost capital formation in the economy. The problem is no longer adequate capital at a reasonable rate but it is lack of capacity to execute. It takes long time to build execution capacity. Therefore, economy would need that kind of time to see the capital formation increase significantly.

Before I conclude, I would take you through my expectation on some of the key financial markets. In USDINR, there is a dead heat on between USD bulls and bears. The pair is caught within a range of 67.90 and 68.30 on spot. I hope the range resolves post Budget. In case of a sustained break of 67.90 can open doors towards 67.30/40 levels. At the same time, in case of a sustained break above 68.50 can cause a test of 68.90/69.00 levels of spot. One can look at long convexity based option strategies for the next few weeks. After Rupee, it is the turn of Indian bonds. Indian 10 year would be affected by what is presented in the Union Budget, especially number of gross fiscal deficit. A number closer to 3.5% can be positive for yields but a number closer to 3.00% would negative.