HDFC Standard Life Insurance

Debt markets Update June, 2011

May Highlights
In its Annual Monetary Policy announced at the beginning of the month, RBI raised the Repo and Reverse Repo rates by 50 bps, the first time it has hiked rates aggessively since the beginning of the rate hike cycle 13 months ago. o In addition to the aggressive rate hikes, the tone of the policy was hawkish as the RBI asserted that inflation control was its prime focus even at the cost of a slowdown in growth in the short term. o The other notable step taken in the policy was the increase in the Savings Bank rate by 50 bps, as an interim step in the path towards de-regulation of the SB rate. o The RBI also crystallised the over-night liquidity operations to a corridor of 200 bps, bound by the Reverse Repo rate at the lower end, Repo rate at 100 bps over the Reverse Repo and a special Marginal Standing Facility (MSF) for banks at 100 bps over Repo. These spreads will remain constant in future. Industrial production in March rose by 7.3%, as manufacturing sector growth picked up sharply to 7.9%. Capital goods index was much above trend-path, leading to a reversal in the yoy growth to 12.9% in March from negative numbers in the past three months. Consumer durables sector growth fell to 12.3% for March from 23.5% in February, probably indicating some effect of monetary tightening. April inflation moderated to 8.66%, mainly on a favorable base effect from April 2010 when it had peaked at 10.88%. The steep upward revisions to past inflation data continued this month as well, with the February WPI revised to 9.54% from the provisional estimate of 8.31%, an increase of 123 bps. The recent petrol price hike will add approximately 6-10 bps to the inflation in the coming months, while further pressure could arise out of likely price increases in diesel, LPG and kerosene. GDP growth in 4QFY11 slipped to 7.8% from 8.3% in the previous quarter as industrial sector growth slowed to 5.3%. Services sector growth rate remained unchanged from the last quarter at 8.6%. Growth for FY2011 came in at 8.5% as the 1QFY11 was revised up to 9.3% from 8.9%. Agriculture sector on the back of a good monsoon in FY2011 saw 4QFY11 growth at 7.5% after 3QFY11 was revised up to 9.9%. With record output in food grains, agriculture growth in FY2011 was at 6.3% against 0.6% in FY2010, much of it coming on the back of base effects. On the other hand, industrial sector saw a steady decline in growth from 11.3% in 1QFY11 to 5.3% in 4QFY11. Bond yields saw a sharp uptick in the month as the aggressive rate hikes and the sticky inflation soured sentiments. The 10-year bond which was trading at 8.12% at the end of the previous month, saw a high of 8.46%, before easing to 8.41% by the end of the month.

Market Outlook High inflation is the key factor affecting the path of bond prices in the near term. RBI struck a very hawkish note in its Annual Monetary Policy, as it was willing to trade off growth in the short term for cooling the inflationary pressures in the economy. The markets seem to be pricing in further rate hikes in the coming months along with continued tightness in liquidity. Hence, the short end yields are expected to stay elevated till the RBI feels confident of relaxing its grip on the liquidity in the system. Short end yields have once again scaled the peak levels seen in March, with the 1-year Bank CD yields breaking into double digit territory. The current levels offer attractive carry yields and additional duration gains may be possible, when markets start pricing in a less hawkish Monetary Policy stance. The expectations of inflation staying elevated in the near future, primarily due to high crude oil and energy prices, have soured sentiments at the long end of the curve as well. Against this backdrop, the fears of a glut in supply of GSecs due to the Governments ballooning deficit, are also affecting the markets. The impact of high Oil prices, is felt on the level of expected inflation as well as the Governments oil subsidy burden. Both these factors are negative for bond prices. We expect oil prices to be the near term driver of bond yields. If Oil prices rise further from current levels, we expect bond yields to rise as well. However, if oil prices ease from the current levels, due to any growth scare or increase in risk aversion, we expect bond yields, too, to ease.

HDFC Standard Life Insurance

June 2011

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks. - Benjamin Graham

Equity markets
Indices BSE Sensex S&P CNX Nifty BSE 100 BSE Mid Cap BSE Small Cap
Source: Bloomberg

31st May 2011 18,503 5,560 9,721 6,910 8,236

29th April 2011 19,136 5,750 9,992 7,094 8,715

1 Month Return (%) -3.31 -3.29 -2.71 -2.59 -5.50

1 Year Return (%) 9.20 9.32 7.52 1.10 -3.64

Indian markets fell in line with global markets in the month of May amidst weak global data, persistent high inflation and relatively high crude oil prices. Global indices were lower by 0.2% to 5.8% during the month of May thus reversing all the gains of April. SENSEX and NIFTY declined by 3.3% each respectively in May on the back of ~US$1.2bn Foreign Institutional Investors (FIIs) outflows in equity. The broader market in India outperformed the main indices and mid cap index ended lower by 2.6%, while BSE100 index was lower by 2.7% during the month, exceptionally small cap index underperformed the main indices and was down by 5.5%. FIIs were net sellers in the secondary market during the month of May. FIIs sold net Rs.51.6bn worth of Indian equities in cash market whereas domestic mutual funds bought net Rs.4.4bn worth of stocks during the month of May. For the month of May sectors like FMCG, Healthcare, Consumer durables, Capital Goods, Realty and IT outperformed the key benchmark indices, whereas sectors like Auto, Metals, Banks, Oil & Gas and Power underperformed.
Macro Economic Data

Inflation for April came at 8.66% compared with 8.98% for the previous month. Inflation was marginally higher than market expectations (8.46%) as the MoM rise in manufactured products was again higher at 1.04% (this is after a 1.4% MoM rise over previous month). There has been a revision in past index as there was an error in the new WPI series and the series has been revised from April 2004. As a result of this correction March provisional inflation increased from 8.98% to 9.04%. The index of industrial production (IIP) growth surpassed all expectations at 7.3% in March 2011 from 3.7% reported in the earlier month. February IIP was revised upwards to 3.7% from 3.6%. The IIP growth for March 2011 was much better than expected due to the phenomenal MoM increase in the capital goods index that jumped by 78% over the previous month. Capital Goods posted positive growth after three months of negative growth. Capital goods during March rose by a robust 12.9% compared with a contraction of 18.4% last month. However, production in the consumer non-durables segment went down 1

HDFC Standard Life Insurance

marginally at 5.7% during the month under review. It had expanded by 1.5% in the same period a year ago. Consumer durables segment grew by 12.3% in March as against 32.6% in the same month of last year. Intermediate goods grew at 5.4% in March 2011 against 13.5% in the same period last year. Mining growth plummeted to 0.2% in the month under review from 12.3% in the same month last year. Electricity segment grew at 7.2% in March 2011 as against 8.3% in March 2010. India Meteorological Department (IMD) has predicted normal monsoons for FY12. As per the first forecast for the 2011 monsoon season (June to September) released by the IMD, rainfall for the country as a whole is most likely to be normal. IMD estimates total rainfall at 98% of the Long Period Average (LPA) with a model error of +/-5%. In another key event during the month of May, RBI in its Annual Monetary Policy Review on 3rd May signaled an end to the calibrated approach and stated its priority to control inflation at the cost of growth. Following were the highlights of the hawkish policy: Repo raised by 50 bps to 7.25%. Reverse Repo raised by 50 bps to 6.25%. The weighted average overnight call money rate will be the operating target of monetary policy of the Reserve Bank. Hiked savings bank rate to 4.0% from 3.5% with immediate effect CRR and Bank Rate unchanged at 6.0%. FY12 GDP projections at around 8.0% (7.4% - 8.5%) FY12 credit growth projection at 19.0%, Deposit Growth at 17%. FY12 Money Supply growth projection at 16.0%.

The baseline projection for WPI inflation for March 2012 is placed at 6 per cent with an upward bias. Liquidity growth declined with YoY M3 growth at 16.8% (as on fortnight ended 20th May11) compared to 17.6% in the same period previous month, mainly due to sharp fall in demand deposits with the banks.
Commodities (USD) Gold Silver Crude Oil Copper Primary Aluminum Lead Nickel Tin Zinc
Source: Bloomberg

1 Month Return (%) -1.8 -20.5 -9.0 -1.1 -3.3 1.2 -12.1 -12.8 0.8

One Year Return (%) 26.3 109.4 38.8 32.8 30.9 36.3 10.5 56.6 17.0

Precious commodities like Gold, Silver came off their peaks during the month of May. Most Industrial commodities like Copper, Nickel and Tin corrected during the month. While Lead and Zinc remained flat during the month. Crude Oil corrected significantly by 9%.

HDFC Standard Life Insurance

Indian Rupee depreciated by 1.4% against the US dollar during the month, more than reversing the appreciation in the previous month. The dollar gained against most global currencies due to risk aversion on resurfacing Euro zone debt problems. Further, there were capital outflows from the equity markets which aided INR weakness. We expect manufacturing growth going forward to remain modest as lower base effect is waning. We believe that reported inflation in India is likely to remain sticky in coming months as the end consumer demand remains robust and outlook on most commodities remain strong. Therefore, we feel that RBI is likely to raise rates and keep tight system liquidity. The global situation remains mixed despite improvement in monthly data from USA. Peripheral Eurozone continues to remain weak. We believe that high government debts world over is complicating the outlook for the near and medium term growth in these economies. Infact on 18th April Standard & Poors (S&P) cut its outlook on the triple-A rating of U.S. debt to negative, saying the path from large deficits remains unclear. This coupled with sluggish employment growth and the austerity measures to contain the fiscal deficit are leading to muted outlook on these economies. We could see some pressure on risky assets in general and equity markets in particular. However, given higher sustainable growth in emerging markets, the asset allocation will continue to favor emerging markets like India and we continue to expect healthy FII flows in CY2011. The market valuations are reasonable at about 15.3x FY12 estimated earnings for SENSEX, which are building in about 18% EPS growth over FY11. We believe that estimates are optimistic and could see downward bias going forward. The valuation gap in mid cap and large cap stocks has narrowed as midcap stocks have outperformed the large cap stocks during the month. We are incrementally more comfortable with the valuations and remain positive on the earnings growth in the longer term and believe that growth in India is secular. Barring the global risks especially crude prices, we remain optimistic on the markets.