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Is continuing negative NAVs of equity MFs a risk to the broader market?

Share Written By
Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

24 Sep 2018

Last month, net sales of equity mutual funds were down 71% compared with the prior year, proving that equity MF flows are indeed cyclical.  But the bigger question to ask now is whether the sustenance of negative NAVs of equity MFs pose a risk to the broader market? The answer is, yes.

In August, equity- and equity-linked mutual funds saw their net sales declining to Rs59bn, down 71% from the peak of Rs204bn witnessed in August 2017. This aggregate sales number includes equity, arbitrage, and ELSS funds. From March until August this year, average net sales were Rs89bn – half of the average during the GST dislocation period.

These all indicate that investor appetite for MFs has peaked out around early-2018. This could be true for direct investment of retail investors as well.

Traditionally, net sales of equity MFs have demonstrated a stronger correlation with the performance of the overall market but only a modest negative correlation with G-sec yields (-0.11), underpinning our view of the self-fulfilling nature of flows from retail investors. Further, the demonetization and the GST dislocation had created idle liquidity which eventually found its way to the market and created a valuation distortion, especially in the mid- and small-cap space.

Available data validate our thesis of bi-directional causality between MF flows and equity market valuation, and we have observed that the three-month lag correlation between net sales of equity MFs with mid-cap and benchmark indices was high at 0.80 in the past two years.

When it comes to net financial savings of households, net of financial liabilities, the FY18 number of 7.1% of disposable income is just a modest increase considering that in FY17 it had declined to 6.7% due to the demonetization shock. Note that in FY16, it stood at 8.1%. Ironically, data reveal that the portion of currency in households’ financial assets jumped to 2.8% of disposable income in FY18, higher than the pre-demonetization level of 1.6% (FY16).  Adding to this trend, gross financial assets, excluding currency holdings, actually declined to 8.3% of disposable income, much lower than the pre-demonetization average of 9.3%.

With the strong pace of growth in mortgage lending at more than 20% p.a, higher than both disposable income and consumption growth, households’ net financial savings were much lesser than that of physical assets such as real estate — about 43% in financial assets vs. 57% in physical assets.

In essence, the data on financial savings of households is counterintuitive to the prevailing notion of financialization in India after the demonetization. 

Taking into account the lackluster profit growth of Indian corporates and high combined revenue deficit of state and central governments (3% in FY18 vs. 2.3% in FY17) as well as moderate growth in household savings rate to 16.4%, overall India saving rate continued its decline and stood at 28.4% for FY18 vs. 26.6% in FY17 — a conclusion that is also evident from the decline in investment rates and the rising current account deficit inferred from FY18 GDP numbers.

Net net, there is little evidence of a structural rise in financial savings of households.

The sustainability of the recent catch-up rally in the broader market after a 17-20% decline earlier this year seems to be difficult. Although the mid-cap index trailing PE declined to 39x in August from 51x in December 2017, compared with the benchmark Sensex and Nifty, it’s still a premium of 56%. It could go back to an average discount of 12-15% that existed before May 2014 instead of a premium.

Interestingly, the fall in the mid-cap index has mirrored the decline in net sales of equity mutual funds, while large-cap indices were relatively less affected by the fall in retail participation.

To conclude, going forward, retail investors’ risk-taking appetite will likely remain modest due to macro headwinds including higher risk-free rates, moderating global liquidity, INR depreciation, and uncertainty ahead of the 2019 general election. This could affect valuation multiples generally, and could possibly reverse the cyclical improvement in earnings growth achieved on currency depreciation and better consumption demand.  

Last month, net sales of equity mutual funds were down 71% compared with the prior year, proving that equity MF flows are indeed cyclical.  But the bigger question to ask now is whether the sustenance of negative NAVs of equity MFs pose a risk to the broader market? The answer is, yes.

In August, equity- and equity-linked mutual funds saw their net sales declining to Rs59bn, down 71% from the peak of Rs204bn witnessed in August 2017. This aggregate sales number includes equity, arbitrage, and ELSS funds. From March until August this year, average net sales were Rs89bn – half of the average during the GST dislocation period.

These all indicate that investor appetite for MFs has peaked out around early-2018. This could be true for direct investment of retail investors as well.

Traditionally, net sales of equity MFs have demonstrated a stronger correlation with the performance of the overall market but only a modest negative correlation with G-sec yields (-0.11), underpinning our view of the self-fulfilling nature of flows from retail investors. Further, the demonetization and the GST dislocation had created idle liquidity which eventually found its way to the market and created a valuation distortion, especially in the mid- and small-cap space.

Available data validate our thesis of bi-directional causality between MF flows and equity market valuation, and we have observed that the three-month lag correlation between net sales of equity MFs with mid-cap and benchmark indices was high at 0.80 in the past two years.

When it comes to net financial savings of households, net of financial liabilities, the FY18 number of 7.1% of disposable income is just a modest increase considering that in FY17 it had declined to 6.7% due to the demonetization shock. Note that in FY16, it stood at 8.1%. Ironically, data reveal that the portion of currency in households’ financial assets jumped to 2.8% of disposable income in FY18, higher than the pre-demonetization level of 1.6% (FY16).  Adding to this trend, gross financial assets, excluding currency holdings, actually declined to 8.3% of disposable income, much lower than the pre-demonetization average of 9.3%.

With the strong pace of growth in mortgage lending at more than 20% p.a, higher than both disposable income and consumption growth, households’ net financial savings were much lesser than that of physical assets such as real estate — about 43% in financial assets vs. 57% in physical assets.

In essence, the data on financial savings of households is counterintuitive to the prevailing notion of financialization in India after the demonetization. 

Taking into account the lackluster profit growth of Indian corporates and high combined revenue deficit of state and central governments (3% in FY18 vs. 2.3% in FY17) as well as moderate growth in household savings rate to 16.4%, overall India saving rate continued its decline and stood at 28.4% for FY18 vs. 26.6% in FY17 — a conclusion that is also evident from the decline in investment rates and the rising current account deficit inferred from FY18 GDP numbers.

Net net, there is little evidence of a structural rise in financial savings of households.

The sustainability of the recent catch-up rally in the broader market after a 17-20% decline earlier this year seems to be difficult. Although the mid-cap index trailing PE declined to 39x in August from 51x in December 2017, compared with the benchmark Sensex and Nifty, it’s still a premium of 56%. It could go back to an average discount of 12-15% that existed before May 2014 instead of a premium.

Interestingly, the fall in the mid-cap index has mirrored the decline in net sales of equity mutual funds, while large-cap indices were relatively less affected by the fall in retail participation.

To conclude, going forward, retail investors’ risk-taking appetite will likely remain modest due to macro headwinds including higher risk-free rates, moderating global liquidity, INR depreciation, and uncertainty ahead of the 2019 general election. This could affect valuation multiples generally, and could possibly reverse the cyclical improvement in earnings growth achieved on currency depreciation and better consumption demand.