Download Portfolio Managers` Commentaries

Templeton Equity Funds
Mark Mobius
Overview
Having started the period on a positive note, global equities, including emerging market companies,
began a downward trend in June. Extreme risk aversion led to a drying up of liquidity, tight credit
conditions, problems for companies based on highly leveraged finance models, and high volatility in
global stock markets.
Markets, however, started to recover in March 2009, as investors began to focus on the fundamentals
and attractive valuations of individual companies. This led markets to recuperate some of the losses
recorded in the earlier part of the period. Recognizing the severity of the credit crunch, governments
globally implemented fiscal stimuli to support their domestic economies and ease liquidity
conditions. For the 12-month period, however, the MSCI Emerging Markets index was still down
46.9% in US$ terms. Part of this decline was due to weakness in domestic currencies as the US dollar
benefited from funds seeking a safer haven.
Eastern European markets were especially affected as investors became concerned about the financial
state of European banks and their Eastern European subsidiaries. Asian markets outperformed their
emerging market counterparts as regional economies continued to record relatively higher growth
rates than their counterparts. Asia’s high foreign reserves, huge consumer base and significant
economic presence provided investors with reasons to remain positive on the region’s potential. In
Latin America, Chile was among the top performers while Mexico underperformed due to its close
economic ties with the U.S. economy. South Africa was one of the best performing markets during the
reporting period due to the government’s stimulus package, lower interest rates and easing
inflationary pressures. The gateway to the African continent, South Africa also remains an attractive
investment destination due to its abundant natural reserves and attractive valuations.
During the period, the Indian market underperformed its emerging market peers with the BSE Sensex
30 index recording a decline of 51% in US$ terms. A shift in investors’ profile towards less risky
assets, tightening liquidity and cautiousness ahead of the general elections in April-May 2009 led
Indian equity prices to lag the region. Subsequent to the elections, however, the Indian market
significantly outperformed its counterparts with a 37% return in May 2009 as investors cheered the
election results.
Political and Economic conditions
The Indian economy grew 4.1% y-o-y in the first quarter of 2009. This brought growth for the fiscal
year 2008/9 to 6.7%. This compared to 9.0% for the year ended March 2008. Key drivers of growth
included government spending, private spending and investment. Government expenditure surged
21.5% y-o-y while private consumption increased 2.7% y-o-y. Gross fixed capital formation rose 6.4%
y-o-y, an increase from the 5.1% rise in the previous quarter. Despite recording slower growth, India
remains one of the fastest growing major economies globally.
Inflation remained a major concern in the first half of the period with consumer prices reaching a 16year high of 12.9% in August 2008. High food and oil prices coupled with rising salaries were the key
culprits. This led the Reserve Bank to tighten its monetary policy to curb inflationary pressures. The
benchmark interest rate was increased by 125 basis points (1.25%), while the cash reserve ratio was
raised by 125 basis points (1.25%).
In latter part of the period, however, the Bank switched to an expansionary monetary policy to
improve liquidity, which dried up as a result of the global financial crisis. Key policy actions included
a 400 basis points (4.0%) reduction in the benchmark interest rate, a reduction in the cash reserve
requirement ratio to 5.0% from 9.0% and the provision of additional liquidity support via the
Liquidity Adjustment Facility. Inflation also steadily fell, reaching its lowest in about 30 years.
The government and Reserve Bank of India continued efforts to support the domestic economy in
2009. Prime Minister Manmohan Singh increased its budgeted spending by US$4 billion to US$60
billion for the last few months of the fiscal year 2008/9 to rejuvenate the economy. The economic
stimulus package included plans to recapitalize state banks easing overseas borrowing regulations by
local infrastructure and real estate companies and opening the corporate bond market to more foreign
investment. The government also relaxed foreign direct investment (FDI) restrictions, cut excise duty
and service tax rates, to ease household expenses, and proposed higher spending on education,
healthcare and employment. A fiscal deficit of 6.0% was estimated for the current fiscal year ending
March 2009 and 5.5% for the following year.
In the area of trade, India is expected to sign a free trade agreement with the Association of Southeast
Asian Nations (ASEAN) bloc later this year. India and Egypt have also been exploring ways to
expand cooperation in the energy sector, while India and Singapore agreed to double bilateral trade
by 2012.
Politically, the incumbent United Progressive Alliance (UPA) (led by the Congress party) won the
general elections with the alliance winning 261 of the 543 seats. The Bharatiya Janata Party (BJP),
Congress’s main opposition, won 116 seats, its lowest in 20 years. President Pratibha Patil
reappointed Manmohan Singh as prime minister.
Outlook
We believe that the longer-term outlook for emerging markets remains positive due to their relatively
strong fundamental characteristics and faster growth than their developed counterparts. Fiscal
measures and easing monetary policies undertaken by governments and central banks globally
should also help rejuvenate economic growth in emerging markets. We expect emerging markets to
play key roles in 2009 and beyond.
We believe that the longer-term outlook for India markets remains positive due to its relatively strong
fundamental characteristics and faster growth than its developed counterparts. Fiscal measures and
easing monetary policies undertaken by the government and Reserve Bank should also help
rejuvenate economic growth in the domestic economy. Demographics will also play a key part in the
country’s future. India has the second largest population in the world and thus represents a huge
consumer market as well as a strong labor force. Infrastructure development is another area which
could also contribute to the recovery of the economy.
The overwhelming victory of the Congress-led UPA in the general elections should ensure a stable
government for the next five years. Focus should now shift to the implementation of reforms with the
first major event being the Union Budget in July.
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Franklin Equity Funds
Sukumar Rajah, Chief Investment Officer – Equity
Market scenario
The year 2008 is likely to be remembered as a defining period for the global financial sector,
particularly in US and Europe. The de-leveraging since the start of 2008 culminated in unprecedented
measures including massive government bailouts, aggressive rate cuts, forced mergers, bankruptcies,
deposit guarantees, large-scale liquidity injections by central banks and restrictions on short selling.
This led to a metamorphosis of the financial landscape accompanied by synchronized policy
measures across the globe. Many equity markets, especially in the emerging markets space have
bounced back sharply since the lows in March 2009, helped by a return in optimism and also
expectations of ‘de-coupling’.
The ongoing de-leveraging has triggered a negative feedback loop as shrinking bank balance sheets
have impacted credit offtake and the spending cutbacks by both corporates/consumers has led to a
demand contraction. The ensuing fall in production and rise in unemployment is exacerbating the
demand slowdown. The result is a broad-based decline in economic activity and a particularly sharp
drop in global trade and manufacturing activity. While there are some signs of stabilization, it might
take few more quarters before we witness clear signs of a turnaround.
India
The global events accompanied by a sharp fall in risk appetite led to indiscriminate pull out from
emerging markets, including India. This along with a cyclical slowdown in the domestic economy
weighed heavily on Indian equity markets. Mid and small cap stocks underperformed large-caps.
Real estate, metals and consumer durable sectors which had registered strong gains in FY08, posted
sharp declines. FMCG and healthcare sectors, typically considered to be defensive plays benefited
from increased investor interest.
At the time of writing this report, broad market indices have rebounded sharply from the lows helped
by increased foreign fund flows, positive election outcome and improved macro-economic
environment.
Economy
After three consecutive years of 9% or more growth, the Indian economy slowed down significantly
in FY09 on the back of monetary tightening undertaken in the first half of 2008, cyclical step-down
from above trend growth and ripple effects from the global financial crisis. However, the slowdown
was modest when compared to performance of the global economy and some of its Asian peers. The
economy grew by 6.70% in FY09 helped by growth in private consumption, sustained increase in
services sector and government stimulus.
Economic data (exports, industrial production, tax collections etc.) reflected the near-term headwinds
for the Indian economy – difficult credit conditions, demand slowdown and cyclical factors. The
slowdown is more dominant in the industrial segment. However, as we have been saying, the threat
to Indian economic growth remains relatively limited due to two factors - lower share of exports and
the high share of services sector in the Indian economy.
This clearly sets the Indian economy apart from its peer group countries that rely on an export-driven
economic model dependent on manufacturing. Typically economies go through the manufacturing
phase before services dominate. However, the Indian economy made this transition much faster
compared to other regional economies. In addition, the rural economy remains largely unaffected by
the overall slowdown that has impacted the urban centres.
Corporate India
The ongoing de-leveraging and shift in macro-economic environment led to deceleration in earnings
growth rate in the last fiscal. Large foreign institutional outflows from equity markets resulted in a
sharp decline in valuations and made it difficult for companies to access the equity route for raising
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funds. This alongside high cost of borrowings and discerned bank lending impacted investment
growth and weighed on earnings of companies operating in the capital goods and infrastructure
space. Consumer businesses benefited from the uptick in rural demand on the back of varied rural
initiatives including the increase in minimum support price.
Broadly, corporate balance sheets remain in good shape with low leverage compared to the past. As
market conditions improve, we are likely to see increased primary market activity by companies
looking to reduce debt levels or raise capital to meet ongoing expansion. With the Government
facilitating foreign debt buyback and opening up credit/ swap lines for beleaguered segments of the
economy, the pain may be limited for companies having sizeable foreign debt component. In the last
few years, there was excess capital flow into certain sectors that will have to undergo
restructuring/consolidation, due to the macro-economic changes. Companies deriving a large part of
their earnings from exports may continue to report subdued growth, given the weak demand
environment.
Despite the near-term challenges, over a 3-5 year period, we expect Corporate India to deliver
earnings growth of about 12-18%. Well-managed companies with a long and established track record
across market cycles are likely to navigate through the current challenging times better and emerge
stronger.
Outlook
From a fundamental perspective, economies like India, with relatively lower dependence on exports
remain attractive over the medium to long term horizon and are likely to weather the current global
uncertainty better. Slow growth in leading developed economies means that economies that rely on
domestic demand and are growing fast, offer better investment opportunities and have a better
chance of attracting new capital over the longer term.
From a structural point of view, factors such as high dependence on domestic consumption and
investment mean that the economy is capable of generating strong growth over the medium-to-long
term. The high savings rate and sustained increase in per capita incomes over the last few years offer
support to economic expansion. India’s banking system is more conservatively run with relatively
low share of securitized debt. The monetary and fiscal stimulus is expected to provide fillip to growth
over the medium term.
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Income Funds
Santosh Kamath, Chief Investment Officer – Fixed Income
Global markets
Global bond markets underwent a volatile period in FY09 as yields spiked after the unraveling of the
credit and financial crisis. The drying up of liquidity in global inter-bank markets following a crisis of
confidence resulted in the TED spread (difference between the 3 month US T-bill rate and LIBOR), a
measure of liquidity indicating banks willingness to lend money, touching historical highs in October
2008. Some of the emerging market countries and developed economies witnessed pressure on their
currencies and economies, leading to an enlarged role for IMF. Policymakers and central banks across
the globe adopted aggressive monetary easing and liquidity injections, to boost growth and unfreeze
credit markets.
The sharp decline in global energy/commodity prices provided central banks with additional
flexibility to deal with the economic slowdown. With policy rates close to zero now, central banks in
developed economies have undertaken quantitative easing (QE). These measures along with
increased safe haven buying have helped treasuries gain. However, the monetary and fiscal
expansion has resulted in concerns over the sovereign balance sheets and at the time of writing this
report, benchmark yields in many countries have started to move up.
Domestic markets
The spike in headline inflation prompted monetary tightening by RBI in the first half of last fiscal year
and this pushed up yields. However, the trend reversed in the second half of the fiscal as RBI cut rates
aggressively and boosted systemic liquidity to mitigate the impact of the global credit crisis and boost
domestic growth.
Yields: The sharp fall in systemic liquidity and jump in credit costs led RBI to reduce policy rates
significantly. Yields were lower across the curve on an annual basis and the yield curve steepened
with spreads between the 1-year and 30-year dated securities expanding to 262bps from 85bps in
March 2008. Corporate bond spreads over gilts which had risen sharply amidst the risk aversion
normalized towards close of year.
Liquidity: Systemic liquidity came under pressure as the credit crisis intensified and corporates
increased their reliance on domestic credit resources amidst volatility in the overseas markets. RBI
intervention in the forex markets further exacerbated the situation. Various liquidity measures
including a 400bps cut in cash reserve ratio (CRR) helped call rates ease from their double-digit levels.
Government borrowings, however, increased significantly to accommodate the increased public
spending and slowdown in tax flows.
Forex: Increased risk aversion leading to FII outflows and dollar strength weighed on the rupee. The
currency depreciated from highs of about Rs.39/$ to close the year at Rs.50/$. During the year, forex
reserves fell to $252 bln from $309.7 bln as RBI intervened in the forex markets to stem rupee
weakness as well as due to currency revaluation. In the current fiscal, rupee has partially reversed
losses on the back of improved global sentiment and weakness in the dollar.
Macro:
Headline inflation, as measured by year-on-year variations in the wholesale price index (WPI), fell by
more than half from its intra-year peak of 12.91% in August 2008 to sub - 1% by March 31, 2009. Nonfood credit growth (y-o-y) peaked during October-November 2008 but witnessed sustained
deceleration thereafter.
India's fiscal deficit for FY09 was higher than the revised budgeted estimates by about Rs.3,600 crore.
The deficit is pegged at about 6% of GDP and the increase in fiscal deficit reflects the fiscal stimulus
measures and decline in revenues. For FY10, the Centre’s budget deficit is estimated to touch 5.5% of
GDP.
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The downtrend in exports combined with sustained foreign portfolio outflows weighed on India’s
Balance of Payments (BoP), which registered a deficit of $17.9 bln in the December-end quarter
compared to a deficit of $4.7 bln in the previous quarter. The capital account balance turned negative
(first time in over a decade) on higher FII outflows. The trade balance narrowed to $36.3 bln from
$38.5 bln in the previous quarter due to fall in imports.
Policy:
In recent years, RBI was faced with the task of managing strong FII flows along with a sharp increase
in inflationary pressures due to global commodity prices. This prompted tightening of liquidity and
interest rates to dampen inflation and ensuring adequate credit growth along with quality. The latter
is important when we look at the deeply indebted households/economies in the developed world
and some countries in Asia, and the bursting of the housing bubble. Today Indian banks are typically
devoid of the excesses witnessed in the western banks.
However, the macro economic conditions in India as well as the world changed significantly in 2008
and this warranted aggressive monetary easing. The sharp fall in global energy and commodity prices
provided RBI with additional flexibility. RBI announced a slew of measures including a 425 bps cut in
repo rate and 275 bps reduction in reverse repo rate. This helped in bringing down liquidity pressures
and provided succor to certain segments of the economy that were being impacted by the credit
squeeze.
In its most recent policy review, the central bank shifted focus on the relatively low transmission of
the stimulus by emphasizing on the need for banks to lower prime lending rates. The last cut in
reverse repo brought the rate below the administered savings rate, thereby forcing banks to lend
more. Also the policy statement indicated a clear emphasis on increasing credit flow to the economy
and cushioning the impact of higher government borrowings via various channels (OMO, MSS, etc.).
RBI has lowered the projections for money supply, deposit/credit growth and inflation for the
current financial year.
Outlook
Globally, given the structural changes underway in some of the major economies, the pace of global
economic recovery may be slow. Overall, monetary policy focus will continue to be on reviving
economic growth. At the same time, central banks will look to manage the government borrowing
programme and alleviate supply pressures. Another point to watch would be the timing and the exit
strategies that need to be employed by central banks when withdrawing monetary stimulus; should
the economies stabilize.
In India also growth expectations have tempered, but given limited percolation of rate cuts through
the economy, the emphasis of monetary policy is likely to be on effective transmission of policy
signals and improvement in credit flow. Fiscal consolidation is one of the key challenges facing the
new Indian government. Any increase in government spending as part of efforts to revive economic
growth could further dampen the already weak fiscal position.
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