Strictly Confidential. For Team Members’ use only. 1

Economic Outlook

-Asset Class wise Strategy

Outlook 2017 – Monetary Policy● RBI is expected to cut rates by 25-50 bps in 2017.

● An expected slowdown in growth and fall in inflation post Demonetization are likely to create room for RBI to go for rate cuts in order to support growth.

● This could lead to a bull steepening of the yield curve as short term rates fall faster than long term rates.

Drivers – ● Slowdown in economic growth

● Lower inflation below RBI’s March 2017 target of 5%

● Weak credit growth

● Strong deposit growth & surplus liquidity in banking system

● Disintermediation by bond markets – businesses issuing bonds / NCDs

Risks – ● Crude oil prices sustaining above $55 per barrel

● More than 2 rate hikes by US Fed in CY2017

● Non-adherence to FRBM roadmap (Fiscal expansion) in Union Budget 2017

Outlook 2017 – Growth● Real GDP Growth is likely to slowdown in the 2nd half of FY2017; Recovery likely in 2nd and 3rd

quarters of FY18

● Private Consumption has seen demand postponement and not demand destruction; Recovery depends on pace of re-monetization or digitization

● Government spending to remain elevated

● Investment growth to remain weak as capacity utilization remains low

Drivers –

● Union Budget – government spending – quantum and quality

● Drop in interest rates & accelerated lending by banks reviving demand

● Re-monetization process

● Shift of transactions from informal to formal economy

● Policy reforms – GST, Land & Labour Reforms

● Improvement in global trade (early signs visible) leading to rise in exports

Risks –

● Deeper than expected impact of Demonetization & slow pace of re-monetization

● Failure to revive MSME & Construction sectors & consequent rise in bank NPAs

● Monsoon in 2017 plays spoilsport

Outlook 2017 – Inflation● Inflation likely to remain low due to slowdown in growth & disinflationary impact of

Demonetization

● CPI inflation likely to remain below RBI’s target of 5% for March 2017

Drivers –

● Slower growth

● Disinflationary impact of Demonetization

● Supply chain reforms by government in the Farm produce sector

● Low capacity utilization and consequent weak pricing power of manufacturers

Risks –

● Weaker currency to increase input costs of manufacturers by way of imported inflation – India is a net importer of energy and industrial metals

● Core (ex-food & fuel) inflation has remained sticky at around 5%; if food and fuel prices recover, it may push headline CPI higher

● Rise in crude oil and global commodity prices consequent to recovery in US

● Fiscal expansion & sharper than expected rise in MSP of agri-products

● Short term inflationary impact of GST if GST is implemented w.e.f. April 2017

Outlook 2017 – Fiscal, Trade and Current A/c Balances● The best of Fiscal, Trade and Current Account Deficit may be behind us

● Fiscal deficit to expand in FY18 if global commodity prices rise and government raises spending to counter slowdown

● Trade & Current Account deficit to be impacted by weaker export growth and higher oil and global commodity prices

Drivers –

● Rise in oil prices after OPEC and non-OPEC members cut production

● Rise in global commodity prices amid fiscal expansion in US and consequent recovery in US growth

Risks –

● Oil prices do not sustain beyond $55 per barrel as shale oil supply comes in above that (average breakeven price for US shale oil producers is $53-55 per barrel)

● Chinese economy slows down at a faster clip than expected capping demand for and prices of global commodities

● Weaker than anticipated recovery in US economy

Macro – Economic Data Releases● Growth has weakened in Nov and Dec 2016 post demonetization – PMI indices have

contracted in Nov & Dec, Industrial growth weakened in October and most micro

indicators such as Auto sales, Export growth and Cement output suffer. Core sector

growth slows but remains positive in Nov 2016

● Inflation – CPI inflation fell further to 3.6% in Nov’16 on lower food & fuel inflation

(2.1% and 2.8% respectively); Core CPI inflation (headline excluding food & fuel)

remained sticky at 5.0%

● Deficits - Trade Deficit widened to $13 billion in Nov’16 on rise in imports and fall in

exports; Fiscal Deficit was at 86% of Budgeted target in first 8 months (vs. 87% in

same period of last fiscal). However, in absolute terms, fiscal deficit for Apr-Nov 2016

period is the lowest in last 4 years. Current Account Deficit in Jul-Sep 2016 quarter

rose to $3.4 bn vs. 0.28 bn in Apr-Jun 2016 quarter. BoP saw a rise in surplus to $8.5

bn in Jul-Sep’16 vs. $7.0 bn in Apr-Jun’16 period on higher FDI inflows

● Foreign Capital Flows - FII flows remained negative in Equity and Debt in Dec 2016

as US Dollar strengthened and US Treasury yields rose; However, quantum of

outflows fell by half in Equities and declined marginally in Debt as compared to

Nov’16. FDI inflows rose to $14 bn in Q2FY17 vs. $7.6 bn in Q1FY17 and $7.1 bn in

Q2FY16

● Forex reserves – Despite FCNR-B repayments of approx. $22 bn in Oct-Dec’16

quarter and FII outflows, Forex reserves saw only a marginal dip to $360 bn

maintaining a healthy import cover of 11.5 months

● Liquidity – Liquidity in the banking system eased substantially as deposit growth

rose sharply, following Demonetization. Money market rates fell near reverse repo

rate temporarily, only to bounce back to repo rate after RBI intervened by bringing

in a 100% incremental CRR (reversed after a few days) for deposits mobilized

between Sep 2016 & Nov 2016 and issuing MSS bonds.

Macro – Economic Data Releases

Economic Indicators - SummaryGrowth Period Latest Previous period TTM average TTM TrendManufacturing PMI (Index) Dec-16 49.6 52.3 51.7 UpServices PMI (Index) Dec-16 46.8 46.7 51.8 UpIIP (% change YoY) Oct-16 -1.87 0.7 -0.5 downCore Sector (% change YoY) Nov-16 4.9 6.6 4.6 sidewaysGDP (% change YoY) Q2FY16 7.3 7.1 7.4 sideways

Inflation Period Latest Previous period TTM average TTM TrendCPI headline (% change YoY) Nov-16 3.6% 4.2% 5.1% DownCPI Food inflation (% change YoY) Nov-16 2.1% 3.3% 5.7% DownCPI Core inflation (% change YoY) Nov-16 5.0% 5.1% 4.9% sideways

Deficits Period Latest Previous period TTM average TTM TrendTrade Balance ($ million) Nov-16 -13009 -10161 -8091 ExpandingFiscal Balance (Rs. Cr) (FYTD) Nov-16 457996 483523 NA DownCurrent Account ($ million) Q2FY17 -3429 -277 -4061 Widening

Foreign Capital flows Period Latest Previous period TTM average TTM TrendFDI ($ million) Apr-Sep'16 21623 16633 NA UpFII flows - Net (Equity) - Rs. Cr Dec-16 -8176 -18244 1289 DownFII flows - Net (Debt) - Rs. Cr Dec-16 -18935 -21152 -3500 DownForeign Exchange Reserves ($ billion) 16-Dec-16 361 363 down

Interest rates & Yields As on Latest year ago changeRepo Rate (%) 28-Dec-16 6.25% 6.75% -50 bps10y G-Sec yield (%) 28-Dec-16 6.58% 7.76% -118 bpsCredit Growth (%) 9-Dec-16 5.80% 11.00% -520 bpsDeposit Growth (%) 9-Dec-16 15.90% 11.50% 440 bps

Equity Outlook

Equity - OutlookShort term Cautious, Medium to Long Term Positive

● A combination of expected slowdown in corporate earnings post demonetization and flight of capital post US Elections and Fed rate hike has led to correction in stock markets

● However, a healthier financial system, flow of domestic savings in capital markets, expansion in reported GDP numbers, lower lending rates and availability of easy credit shall lead to a phase of sharp economic growth going ahead. The next leg of the secular bull run shall be based on much stronger fundamentals.

● Lower interest rates tend to be positive for equities. A rise in demand coupled with lower interest rates shall be immensely positive for businesses with high operating & financial leverages

● A likely improvement in India’s credit rating and global ranking post the fiscal boost and increased transparency should lead to higher flows of foreign capital in equities

Markets Follow Earnings Growth

Source: Bloomberg, ICICI Prudential AMC

Earnings growth are likely to accelerate in next 2 years

Earnings Growth Drivers

Source: Bloomberg, ICICI Prudential AMC

High Operating Leverage, Gains in market shares and lower cost of capital to drive earnings growth in future

Equity markets may deliver good returns in next 3 years

Source: Bloomberg, ICICI Prudential AMC

Earnings Growth Drivers

Source: Bloomberg, ICICI Prudential AMC

DIIs counter FII selling in cash markets

Source: Internal Research

Source: Kotak AMC

• FIIs covered shorts in Index

Derivatives in Dec 2016;

built marginal longs in Index

Futures• DIIs (Mutual funds, banks &

Insurance companies) have

emerged as strong players in

domestic equity markets• FII selling in cash markets

has been countered

effectively by DIIs in CY2015

and CY2016

Investment StrategyValuations have just entered the “Invest Lumpsum” zone (see pic 1)Event based volatility is likely to be high in 2017 due to key events with large range if outcomes (see pic 2)We maintain a Neutral Allocation to Equities; Active Rebalancing should be done if the allocation dips below Neutral on any dip in marketsFresh Equity Investments should be made through Systematic Investment route (SIP or STP). Lumpsum investments to be made only on dipsPrefer Diversified Large Cap funds over Mid / Small Cap fundsConservative investors can invest in Asset Allocation Funds like Balanced Funds, MIPs, Equity Savings Funds, CPOFs and Dynamic Asset Allocation funds as they may give better risk adjusted returns.

Source: ICICI Prudential AMC

Source: Kotak AMC

Fixed Income Outlook

Fixed Income - Outlook● After bucking the global trend of rising interest rates and falling

sharply, Indian 10 year G-Sec yields rebounded in Dec 2016, after RBI negatively surprises markets by keeping rates unchanged in its Dec 2016 policy meet

● Low inflation and slower growth creates room for RBI to go for further rate cuts in 2017

● However, RBI’s ability to cut rates shall be limited by – 1. Anticipated rate hikes by US Fed in 2017 and consequent rise in global bond yields, 2. Rise in prices of crude oil and global commodities leading to higher inflation and rise trade and fiscal deficits, 3. A fiscally expansionary Union Budget 2017 as government may increase spending to boost growth

● Policy Transmission happening - SBI and other banks (including private sector banks) have cut MCLRs by 50-90 bps

● Given the cut in MCLR, the 12-36 month corporate bond yields are likely to compress with falling yields

Current and Fiscal Account are in pink of health…

But the best in Current Account Deficit (CAD) and Fiscal Deficit may be behind us… as Trade Deficit has already started rising

Falling CPI inflation and lower growth create room for rate cuts

However, a rise in crude oil prices and sticky Core CPI inflation can limit RBI’s ability to cut rates

10y G-sec yields rebound…

As FIIs book profits…

Liquidity turns from deficit to surplus…

… as deposit growth outpaces credit growth

Source: ICICI Prudential AMC

Debt Valuation Index

Fixed Income – Investment Strategy• 10 year G-Sec yields are likely to trade in the 6.2 to 6.8% range in the near

term• Risk reward in Long Duration is not attractive at this point in time. • Corporate Bond yields are high and spreads are wide and look attractive.

MCLR cuts to lead to spread compression• We remain Overweight on Accrual and Underweight on Long Duration,

maintaining a 70:30 allocation in favor of Accrual• Avoid Fresh investments in Long Duration schemes at these levels• Book profits in Long Duration Schemes near the lower end of the band at

6.2% and shift to Accrual Strategies / Schemes (Corporate bond funds, Income Opportunity funds, Medium Term funds) to benefit from higher accrual income

• Focus on Accrual Schemes having high credit quality• High yielding Fixed Income products like FMPs from Mutual funds, GoI Bonds

(Taxable) and NCD issues from AAA rated companies present a good opportunity for conservative investors to lock in high yields for long periods of time

Gold• Long term - Our Long Term outlook on Gold remains UNDERWEIGHT due to low

inflation, positive real rates in the Indian economy, rising yields in US, a rising US Dollar and a relatively stable outlook for the domestic currency (INR).

• Short Term - In Tactical Portfolios, our short term view on Gold shall be calibrated in line with our view on Indian Equities and the domestic currency (INR). We believe that the Government’s crack down on black money shall shift investor preference towards financial assets. Physical assets such as Gold and Realty are unlikely to see much investment demand in the near term. Our tactical view on Gold hence remains Underweight.

However, Gold sovereign bonds issued by Government of India remain an attractive investment option as it carries twin benefits – • Bond price linked to price of physical gold; Bonds to be listed on Stock Exchanges - Scope

for Capital Gains at the time of maturity / sale• Fixed Coupon of 2.5% to 2.75% p.a. payable half yearly on initial investment• Exemption from Capital Gains Tax on Redemption• Sovereign Guarantee both on capital invested and interest

EQUITY MUTUAL FUNDS• Large Cap – 40%; Flexi / Multi cap / ELSS – 30%; Midcap – 10%; Value Style – 20%

DEBT MUTUAL FUNDS

Investment Horizon (as per exit loads)

Fund Category

<3 months Liquid / Ultra Short Term debt funds

=>3m to <6m Low Duration Funds

=>6m to <12m Short Term debt funds / Arbitrage Funds

=>12m to <18m Short Term debt funds / Dynamic Bond funds / Income Funds

=>18m to <30m High yield accrual funds/ / Medium Term Funds / Dynamic Bond Funds / Income Funds

=>30m Corporate bond funds

Investment Matrix