Wednesday, December 18, 2013

2014 – Key factors to be watched

Thought for the day
“The superior man understands what is right; the inferior man understands what will sell.”
-Confucius (Chinese, 551-479BC)
Word of the day
Solipsism (n)
Extreme preoccupation with and indulgence of one's feelings, desires, etc.; egoistic self-absorption.
(Source: Dictionary.com)
Shri Nārada Uvāca
By rejecting the Adarsh panel report, has CM Prithviraj Chavan just seeded the AAP in Mumbai?

2014 – Key factors to be watched



Politics

Growth

Inflation

Rates

External trade

Fiscal conditions

Corporate performance
  
As suggested a day before, in our view 2014 will only be a prolongation of 2013. Contrary to the consensus, in our view we may not see break in any of the major trends until at least end of 3Q2014. We believe that both the corporate performance and macro fundamentals should continue to seek their respective trough for most part of 2014. Investors should carefully observe the following 7 factors to find clues for break in the trend.
#1 Politics
In past few months the emphasis on Indian politics by the investors and financial research firms has been unprecedented. In the background of policy paralysis seen particularly since 2H2010, most have pinned hope on a proactive and responsive administration post 2014 general election.
It is however pertinent to note that so far it remains a hope only. None of the opinion polls has projected a decisive government post general elections in summer of 2014. Most are just hoping that conditions will improve as NDA gathers more momentum post recent assembly elections.
Investors however need to understand five things clearly, in our view
(a)   The policy making at central level will remain suspended till May 2014 when the new government is likely to be formed. The first session of new Lok Sabha will be held only in July when the new government will get an opportunity to present the budget for FY15 and enunciate their priorities and programs for its full term 2014-2019.
(b)   Both public and private investment plans will likely remain suspended during 1H2014: public for want decision making and implementation of model code of conduct and private for want of clarity on the direction of new government’s policies and priorities.
(c)   As the process of election progresses further and electioneering intensifies, the market may become highly sensitive to news flow. Each opinion poll, political statements, realignment of political parties and group may cause high volatility and wild swings in the market.
(d)   As the market is already close to their high levels, the gains post election may not match the gains seen post 2009 elections.
(e)   If the current opinion polls hold true and a non Congress non-BJP government becomes a reality, the initial reaction of markets could be a sharp down move.
As stated earlier, in our view, the best thing that could potentially occur post 2014 elections is improvement in execution of existing plans, programs and projects. The implication in terms of industry performance would be better visibility of order flow for capital goods from 2015, improvement in working capital cycle. Improvement in capacity utilization level would depend on the correction in inventory level, pick up in consumption demand and higher government plan expenditure.
Expecting more than this would be fraught with risk and may lead to major disappointment.

#2 Economic growth




The consensus growth estimates points to a moderate recovery in economic growth in 2014. From sub 5% level in FY14, real GDP growth is expected to be in the range of 5 to 5.5%.
In our view, much more than the below potential quantity of the growth, it is qualitative aspects of the growth which are matter of serious concern. The structure of the growth as partly manifested in direction and constitution of growth remains weak and is expected to remain so for better part of 2014.
The recent RBI policy statement succinctly explained this aspect as follows
“the pick-up in real GDP growth in Q2 of 2013-14, albeit modest, was driven largely by robust growth of agricultural activity, supported by an improvement in net exports. However, the weakness in industrial activity persisting into Q3, still lackluster lead indicators of services and subdued domestic consumption demand suggest continuing headwinds to growth. Tightening government spending in Q4 to meet budget projections will add to these headwinds. In this context, the revival of stalled investment, especially in the projects cleared by the Cabinet Committee on Investment, will be critical”.
The current estimates of the modest recovery in growth are overwhelmingly dependent on the steady global growth environment and nature’s largesse in the form of favorable weather conditions.
In our view, for a structural improvement in the economy we need our manufacturing and construction sectors to grow at a much faster rate. Expected industrial growth of ~3% and service sector growth of ~6% cannot and will not lead to any material improvement in the structural weaknesses of the economy, e.g., high level of unemployment/underemployment, poor physical and social infrastructure, low tax to GDP ratio, lower social sector spending, especially education and health, declining private sector investment, persistent high burden of entitlements on the fiscal, etc.
All the indicators are highlighting that the modest recovery in growth will probably come from micro adjustments, like correction in inventory levels, higher capacity utilization, higher exports, and improvement in project execution etc.
This will not lead to any material improvement in employment conditions. On the contrary there are sufficient indications that many employers may actually further rationalize their work force to protect their margins. Historically, the work force rationalization in India, especially in manufacturing and construction sectors, has been more permanent in nature. Private consumption growth may therefore  remain constrained during 2014 also.
The investment environment is not likely to improve in any substantive measures. As with economic growth still much below potential, the output gap will continue to remain high; persistent high inflation will keep rates at elevated level; producers are not likely to gain much pricing power as the demand domestic environment continues to remain weak; balance stress will likely rise further unless lending rates come down materially.
In our view, it is pertinent to keep a watch on the periodic macro data. But it is often not appropriate to let these data lead a substantial change in the direction of investment strategy. A profitable investment strategy, in our view, needs to be based on medium to long term growth magnitude and direction.
Insofar as the current medium to long term growth trend in India is concerned, in our view, the trend growth decline that began from FY09 may not bottom before end of FY16, even if we accept the rather bullish estimates of government agencies.
The resumption of up move in medium term trend growth would only lead to a stable growth environment in the country and sustainable gain in equity prices, because a sustained growth over medium term would only-
(a)   bridge the output gap and create demand for investment;
(b)   lead to creation of productive employment opportunities;
(c)   provide fiscal leverage to government for increasing social sector spending and thus increasing the sustainability of growth;
(d)   lead to stability in prices as more capacities are added;
(e)   lead to sustainable monetary easing as fiscal condition improves; and
(f)     lead to rise in private income and savings, thus providing impetus to private consumption;
In our view, the potential growth of India under current circumstances is not more than 6%. Growing at 5-6% in the current direction would not lead to enough employment opportunities and strong consumption story will not remain sustainable. Agriculture, as we have seen in past couple of years is still “God” driven. Basing an investment strategy on God’s alone is not advisable in our view.


(Source: CSO, InvesTrekk Global Research
#3  Inflation
Both WPI and CPI have shown tendency to rise in recent past. It is more likely to exacerbate in 1H2014 as high base effect wanes, INR vs. USD bottoms out at elevated 60-61/USD levels; more administrative prices move closure to market price and wage inflation rises at faster pace led by rise in rural and public sector wages.
In our view therefore the current stagflation like conditions will persist for better part of 2014 with inflationary expectation persisting at higher level.
However, the lagged impact of RBI’s measures and further tightening, lack of pricing power in manufacturing sector and high output gap due to lower capacity utilization and somewhat lower food inflation would keep the inflation under check from running away in unmanageable territory.
The interesting factor to watch would be cereal inflation post implementation of National Food Security Act. In our view, the Food Security Bill, if implemented in right earnest could transform Indian agriculture from a mere self sustenance activity into a truly commercial activity thereby marking a meaningful shift of small and marginal farmers from cereal to cash crops or even non-agriculture activity.
With real yields to household persisting in negative territory household savings may deteriorate further. This may keep hurting the growth by further widening the savings – investment gap.

(Source: Yes Bank)
#4 Rates
In our view, higher risk, higher demand and lower supply should keep interest rates in Indian context relatively higher for next couple of years at the least.
Interest rates or cost/reward for capital is primarily a function of demand and supply of capital. The default risk associated with the demand for capital plays an important role in determination of rates. The benchmark or policy rates established by the regulators or central bankers theoretically play a critical role in determination of interest rate structure in an economy under normal economic conditions. However, in extreme cases policy rates may fail to transmit to the ultimate provider or user of capital.
Indian economy presently is passing through such extreme conditions. Therefore, policy rates established by RBI are not as effective as these should be under normal circumstances. The reason for this failure in transmitting the policy rates are varied and multiple. For example:
(a)   The default risk and therefore credit cost for banks has risen substantially in this period. Most of the credit demand is for re-financing of existing stressed loans or working capital loans. Thus increasing the risk premium.
(b)   Fiscal profligacy has kept demand for government borrowing higher whereas higher inflation and higher administered small savings rates have led to lower deposits growth (supply of funds).
(c)   Precarious BoP conditions have probably prevented the regulator from aggressively enforcing transmission, as lower rate could impact inflow of much needed foreign capital.
This read with (a) firming yields globally (b) persisting higher inflationary expectations and (c) constant need to defend INR by augmenting reserves through higher flows – implies that we may likely see the rates persisting at elevated level during 2014 also.
Benchmark 10yr yields currently at ~8.75% are therefore not likely to come down in any significant proportion next year. For all, these may actually firm up a little during later part of the year, if US Federal Reserve indeed indicates prospects of some tightening from 2015 onwards. Moreover, in recent times currency movement has become a key factor in determination of rates. With Fed already in “taper mode’, the tighter liquidity may potentially reverse the normalization of yield curve in 2Q2014.







(Source: Yes Bank)

#5 External balance

The Indian government and RBI successfully averted a disaster last summer by stemming the slide in INR by using some emergency measures. Keeping public sector oil marketing companies out of forex market for some time, attracting over $32bn through a temporary swap window, and most importantly curbing gold imports through official channels were the key measures taken.

Delay in QE tapering by Fed, better export demand due to better economic conditions & weaker INR, fall in fuel consumption due to higher prices, and fall in non-fuel imports due to poor domestic demand conditions also helped the government’s endeavor.

Consequently, the CAD conditions look much healthier as compared to a quarter ago. INR is also stable around 61-62/USD level.

In our view, the stability in INR and improvement in CAD is welcome; even though there is little evidence to suggest any structural improvement in the external balance of the country (Also see here). This temporary relief gives the government and RBI a window of opportunity to introduce structural adjustments in the economy. Given that QE tapering has already begun, the window is much smaller and warrants swift action.

In our view, given the political environment and impending elections, there are decent chances that we may again slip to face another crisis in summer of 2014. Tighter global liquidity, strong USD, removal of curbs on gold imports, and higher consumer demand and purchase of USD by RBI to augment the reserves and smaller inflows due to policy uncertainties ahead of elections may add to the pressure.

We believe that the current account deficit rise again to over 3.5% in FY15 and consequently USDINR equilibrium may shift upwards to INR65/USD level by the end of 2014.

#6 Fiscal deficit

Through a mix of deft accounting (postponing fuel & fertilizer subsidies and delayed IT/excise refunds), austerity (cut in public expenditure) and strict enforcement (tax collections) the incumbent finance minister may achieve the 4.8% fiscal deficit target for FY14.

Substantial rationalization of fuel subsidy is a major achievement. However, a strong government would be needed to sustain it. The incremental fiscal burden due to implementation of food security law is not clear yet, but on aggregate level it may not be unmanageable given most states are already providing food security.

A pickup in growth shall lead to better tax collections and better market conditions could enable sale of stakes in PSUs and capital raising by public sector banks.

Standing here at dusk of 2013, assuming noon of 2014 will see a stable government taking over, fiscal condition look stable though not as good as one would desire it to be. However, the assumptions are too many and somewhat optimistic.


#7 Corporate performance

In our view, in next few quarters investors should closely watch three factors in corporate performance – (a) improvement in capacity utilization; (b) leverage reduction; and (c) operating margin improvement.

Revenue growth through higher sales rather than price hikes; deleveraging by better working capital management and sale of non-core and stressed assets rather than debt restructuring and accounting jugglery, and cost optimization through automation and technology innovation rather than lower taxes and wage cuts would indicate sustainable improvement in corporate performance.

We believe that the bipolarity seen in earnings growth during FY13-FY14 should continue in FY15 also. Large corporates with global operations would continue to outperform the businesses totally focused on domestic market.

The earnings profile of large corporates with geographically diversified global business profile could help aggregate earnings numbers to show a better picture in FY15. Though, mid and small enterprise should continue to struggle and post sub-par performance. The financials therefore may not witness any marked improvement in asset quality. Besides, the urgency to kick start the stalled investment cycle may warrant the lenders to play a larger role in balance sheet cleansing process.

We feel consensus earnings growth of 16-18% for FY15 may not materialize due to still higher rates and constricted public spending. In our view, earnings growth should mirror the nominal GDP growth of 12-13%; mostly driven by large global corporates, consumers and energy companies benefitting from fuel price deregulation and other recent reforms.

As stated earlier, global businesses and energy may contribute bulk of the earnings, while domestic businesses especially SME continue to suffer under the twin pressure of lower margin and lower demand.

As on aggregate level margins in large corporates are close to lowest level in post crisis period and small businesses are incurring operating losses, 2014 could be a critical year. Given the high level of operating leverage, a slight improvement in the operating environment could provide a major boost to earnings and relieve financial stress. However, any further deterioration in economy due to whatever reason could lead to exponential rise in the stress level in financial system.

2014 being an election year, politics will dominant the business and investors’ sentiment for most part of the year. However, given that the new government will be in saddle only in June, any meaningful changes in economic policy may take effect only from 2HFY15. Therefore, any optimism in business confidence and therefore investment climate would be largely sentimental and may not reflect in data for FY15.
Overall, we see gradual improvement in business environment that would pave way for resurrection of investment cycle over next few years. Therefore hope and the numbers would drive the investors in equity.
 

Tuesday, December 17, 2013

2014 - Starting close to finish

Thought for the day
“If you're trying to summarize something for your 1-year-old, you put it in very simple terms. You only gradually complicate the explanation as they get older.”
-Emma Donoghue (Irish, 1969 - )
Word of the day
Turpitude (n)
Inherent baseness or vileness of principle, words, or actions; depravity.
(Source: Dictionary.com)
Shri Nārada Uvāca
Should Congress conserve resources for 2019 or spend all of it in 2014 itself?

2014 – Starting close to finish

Imagine the reaction of a 100m race participant, who is allowed to begin the race from 75m mark! Assured of victory will he be delighted? Much ahead of competition will he be complacent (remember the classic hare and tortoise fable)? Or will he feel depressed and opt out of competition?
Now imagine the reaction of a professional formula 1 driver, who is informed in middle of race that the priced money for the race has been reduced by 75%! Will he continue with the race with same zest? Will he take lesser risk in the remaining part of the race? Or will he choose to abandon the race midway?
In our view, the athlete may opt out of the race as the privilege of beginning from close to the finish line would hurt to his sense of competition and take the thrill of winning out of the competition. However, the car racer may decide to continue in the same zest, despite lower price money, because getting out midway could be riskier, and a win would still add to his confidence and give at least 25% of the reward.
The 2014 strategy for investors in Indian equities would depend on whether the investor is like an athlete waiting for the race to begin or a car racer in the middle of the race.
We feel the investors who have been waiting on the sidelines for past few years should continue to be so despite some visible signs of economy bottoming, because (a) the cyclical recovery is now a consensus and so is “cyclical overweight” trade; there is no thrill left in this and (b) market has mostly discounted the cyclical recovery in past three month’s outperformance of cyclical, leaving no fruit on the lower branches.
However, the investors who have been investing over past few years should stay put, as the risk reward at this stage looks positive, though not spectacular. 15% earnings CAGR over FY15-16 and market trading at average of 15x might provide ~15% CAGR over next couple of years.
Inarguably, the investors’ sentiment at present is positive about the cyclical recovery. But never in history the cyclical recoveries have began with benchmark indices ruling close to their all time high levels and bond yields also close to their cycle peak. This time perhaps it is different.
The next cycle could therefore be shorter, shallow and volatile. Investor positioning and market internals are clearly pointing towards that. The divergence between large cap and small cap prices is high and rising. The market volumes and breadth continues to remain low. Implied volatility continues to remain low. The volume concentration in top 15 traded stocks is close to all time high.
Last but not the least, the primary catalyst for the positive investors’ sentiment is hope of a decisive mandate in 2014 general elections. So far it remains a hope, as none of the opinion polls has projected a decisive government. Most of hoping that conditions will improve as NDA gathers more momentum post recent assembly elections.

Monday, December 16, 2013

2014 - War continues

Thought for the day
“The Chinese seemed to be mourning Mao in a heartfelt fashion. But I wondered how many of their tears were genuine. People had practiced acting to such a degree that they confused it with their true feelings.”
-Jung Chang (British, 1952 - )
Word of the day
Repast (n)
Something taken as food; a meal.
(Source: Dictionary.com)
Shri Nārada Uvāca
Will Rajan preempt any pre-poll fiscal indulgence by hiking 50bps upfront?

2014 - War continues

If you can look into the seeds of time,
And say which grain will grow, and which will not,
Speak.
Shakespeare, Banquo -Scene III, Act I, Macbeth
The post Lehman period has seen an intense war between the forces of “Greed” and “Fear” in the global financial and political fields. So far most of the battles have been won by Fear. Potent fears of yet another collapse, mostly kept investors under check. The torrents of liquidity emitted by central banks in US, EU and Japan did occasionally come to aid of Greedy, but were found generally inadequate. In 2013 however, for the first time since 2008, Greed appeared to be having a winning edge.
The forces of Fear, as we write this today, appear to have exhausted most of their ammunition, e.g., EU disintegration, Grexit, PIGS default, hyper-inflation resulting from the Mints printing money incessantly, Iran reneging, Currency war erupting and endangering emerging economies, hard landing of Chinese economy, etc.
Whereas the forces of Greed have got fresh batch of ammunition – stable job market in US, housing boom in UK and US, stable financial markets in EU, stronger USD, Chinese growth crawling up, moderate or no inflation, US financials back in business, lower commodity prices, US energy revolution, and mostly stable & peaceful conditions in hot beds like Pakistan, Afghanistan, Iraq, Iran, Libya, Yemen, Sri Lanka (except smaller pockets like Syria).
The only immediate hope for the forces of Fear is a disorderly withdrawal of monetary injection by US Federal Reserve. Failing this 2014 may also belong to the Greedy ones.
It will not be before 2015 when further reinforcement for the Fearful arrives – the inflationary impact of QE may begin to appear on the horizon, US Fed begins to talk about tightening rates, EU and BoJ achieve their inflation targets and talk about moderating liquidity, US completely withdraws from Asia and a war for supremacy and control ensues between Asian forces, Emerging economies are challenged by inflation, trade imbalances created by US energy boom and stronger USD, etc.
Many battles of this ongoing global war have been fought in India too. Indian politicians have mostly sided with the Fearful, providing them with enough ammunition and food to survive. The Greedy ones have been supported by the global forces (FIIs), who have provided enough supplies to keep the hope afloat. Most Indian investors have watched this intense battle from the sidelines so far. The miniscule participation, if at all, had been from the side of Fearful.
However, since September 2013, when a new General (Narendra Modi) took charge of the forces of Greed in India, the domestic Indian participants have been rather ambivalent. Some of them have actively joined the Global network of Greedy, but most are still undecided.
In next few days, we will make an SWOT analysis of the forces of Greed and Fear as they are positioned in Indian markets, and suggest what would be an appropriate strategy for the Indian investors.

Friday, December 13, 2013

Get back to the business, as usual

Thought for the day
“What a good thing Adam had. When he said a good thing he knew nobody had said it before.”
-Mark Twain(American, 1835-1910)
Word of the day
 Cusp (n)
A point or pointed end.
A point that marks the beginning of a change.
(Source: Dictionary.com)
Shri Nārada Uvāca
Is Raghuram Rajan already frustrated with politics?

Get back to the business, as usual

Nifty has given up all the gains made in the wake of recent state assembly election results. The ‘gap’ (6260-6415) created at the opening on Monday, the 9th December, has been completely filled yesterday. Incidentally, the opening level of Monday (6415) is also the highest ever level for Nifty. Technically, Nifty should correct a little more to fill up the ‘exit poll’ gap (6160-6262) of 5th December also.
A close below 6150 would however negate the entire up move, pushing Nifty back in neutral territory (5850-6300 with occasional violation on either side). In our view this is more likely scenario for January-April 2014 period.
The end of the last working Parliament session for 15th Lok Sabha next week, will abort all hopes of policy reforms that need legislative approval. With no major policy initiative expected till July 2014 (when first session of 16th Lok Sabha will be held) the market would mostly take guidance from global monetary and liquidity conditions (QE, FII flows, USD, Bond yields) and to some extent from RBI’s policy response to the political vacuum.
There are no positive political events are likely to occur till next elections. On the other hand, the rising decibel of rhetoric could actually prompt investors to slowdown or completely wait on sidelines.
In next few weeks we shall see the QE debate erupting all over again. However, in our view, there is not much economic evidence to warrant an imminent tapering. We fully agree with what Rich Yamarone, Chief Economist, Bloomberg and author of Bloomberg Orange Book, recently noted:
Economically speaking, existing conditions are cloudy with a chance of a storm. According to the latest entries in the Bloomberg Orange Book, we should expect to see more of the same – that is, sub-par economic activity with a propensity toward a downturn.
The economic data are poor given that the economy is 54 months into the expansion – the post-WWII average length of expansion is 60.5 months. The looming fiscal and monetary issues certainly aren't likely to be stimulative. In fact, both are set to be more restrictive. Meanwhile, households remain plagued by inadequate real incomes and lacking employment prospects. Businesses are saddled with heavy government regulation and uncertain economic prospects – both domestically and globally.”
The currency and bond markets in India are not sharing any of the recent optimism expressed by large global brokerages. Recent iterations of RBI governor also highlight that (a) inflation continues to be a serious challenge and (b) though economic growth seems to be bottoming out, more evidence would be needed to confirm any reversal in trend.
Though 1st January is merely an indiscreet point in ad infinitum, conventionally it is celebrated as a chance to begin ab initio. Accordingly, we are expected to spell out our views for the 365 days period beginning 1st January every year. We shall abide by the convention and outline our views about the likely market directions in 2014 and an appropriate investment strategy.