Vijay Kumar Gaba

After FY09, the current financial year (FY21) has been the most eventful year in most respects – social, economic, financial, ecological, science, and geopolitical.

Socio-economic disaster: The spread of SARS-CoV-2 (Covid-19) virus that started sometime in last quarter of 2019 was declared a global pandemic in March 2020. The pandemic engulfed the entire world in no time, causing tremendous loss to human life and global economy. The mobility of people was restricted in most countries substantially. The economic activities were also curtailed only to the “essential” activities. Consequently, the global economy faced a technical global recession as most major economies recorded negative growth during 1HFY21.

The pandemic this had disastrous socio-economic consequences. Millions of jobs were lost and workers displaced; smaller businesses which could not bear the cost of lockdown faced closure or were further scaled down; loss of lives traumatized families; and millions of poor children who could not afford cost technology access were rendered out of schools. The inequalities rose sharply, further widening the social, economic and technology divide that has been hindering the global growth since the global financial crisis (GFC, 2008-09). It is estimated that millions of families across Latin America, Eastern Europe, Asia, Africa, and Indian subcontinent, that were brought out of poverty in past couple of decades face the specter of slipping back into the abyss.

Financial profligacy of gargantuan proportion: The pandemic and consequent economic lockdowns evoked unprecedented response from governments and central bankers across the world. The amount of fiscal and monetary stimulus created is unprecedented; even much higher than the quantitative easing done post GFC. This has certainly put question marks over sustainability of global debt (over $15trn still yielding negative return); ability of governments to support the poverty alleviation efforts.

Ecological awareness: One of the positive outcomes of the pandemic has been the rise in awareness about the ecological conservation. The partial lockdown of commercial activities demonstrated how the mother nature could heal itself within few weeks. The urban population which was moving away from the nature was reconnected with roots. This awareness may certainly accelerate the execution of global climate change action plans, saving the planet from imminent disaster.

Scientific advancement: The pandemic prompted a vaccine development program at unprecedented scale and speed. The scientists world over worked to develop an effective vaccine for the SARS-CoV-2 infection in no time. Never in the human history an effective antidote to a potent virus has been developed at such alarming speed. It is estimated that in next 3-5years the entire global population could be inoculated against this virus. The experience gained in development and administration of Covid-19 vaccine may be extremely useful in fast tracking the efforts for development of vaccines for other major infections like HIV and H1N1 etc. It shall also help in eradicating or controlling many deadly diseases in African continent, thus bringing the most endowed and most poor continent in the global economic mainstream.

Trade and Geopolitical tension: An intense trade war between the two major trade partners, viz., USA and China, had started couple of years ago. Besides, trade tensions were also rising between China-Japan, India and China and US and EU. The conspiracy theories behind origination of SARS-CoV-2 virus from Wuhan province of China, further deteriorated the trade conflicts into geopolitical tension. Some major economies and global corporations decided to reduce their dependence on imports from China; and use of Chinese technological firm’s services and equipment. India and China also had a material buildup at Northern borders. China intensified the efforts to build strategic block with allies like Iran, Sri Lanka, Pakistan, North Korea etc. These developments shall have a far reaching impact on the global economic and geopolitical situation. The full impact of this may be known in next decade or so only.

Indian markets

The initial reaction of Indian markets to the pandemic was that of panic. The prices of equities and bonds crashed precipitously. The panic however subsided soon as the government took some strong measures to control the spread and mitigate the damage due to economic slowdown. The FY21 journey of Indian markets could be summarized as follows:

Nifty rallied hard, catching the participants by surprise

Nifty is ending FY21 (all Nifty data till 29 March 2021) about 20% higher than its December 2019 closing level. Nifty rallied hard in October –December 2020 quarter as the unlock exercise started and earnings upgrade cycle kicked in. By November 2020 all Covid-19 related losses were erased.

The strong market rally in fact caught many participants by surprise as the divergences from the real economy became too evident. The rally was apparently supported by the fact that the large organized players have not only survived the lockdown well but gained material market share from the smaller unorganized players. Multiple stimulus packages announced by the government and consequent abundant liquidity also have helped the rally.

The rally however appears to have tired in 4QFY21, for lack of triggers.

India with over 75% (Nifty TRI) gains is the second best market (after South Korea 78%) amongst all global major markets. It outperformed peers like Brazil (21%), China (25%), and Indonesia (40%); and developed markets like UK (21%), US (48%), France (37%) and Europe (36%), .

The momentum however has slowed down considerably in 4QFY21. In the current quarter, India (up 4%) is sharply underperforming US (8%), Japan (7%). Germany (8%). Even though it is still outperforming its emerging market peers like Brazil, China, Indonesia etc.

Consumption lags, cyclicals, IT & Pharma shine, smallcap outperform; FPIs’ big buyer

Metals, IT, Auto, Realty and Pharma have been the top performing sectors in FY21. Consumers have underperformed massively. Financials performed in line with the benchmark indices.

Broader markets (small and midcaps) and Alpha strategies sharply outperformed the benchmark indices. The market breadth has been mostly good (8 out of 12 months).

Net institutional flows were not great (less than $9trn) considering the abundance of liquidity and lower rates. FPIs though poured over $27bn in secondary equity market alone.

Gold disappointed; broader markets underperform on 3yr basis

Despite the huge rally in benchmark indices and broader markets, the household investors continue to be disappointed. One of their favorite asset class ‘gold” has underperformed majorly. Intuitively, gold ought to have done well in a crisis marred year. Gold ETFs have returned almost nothing in FY21 and are down over 10% in the current quarter.

Mid and small cap stocks have given superlative return in FY21. However, if we account for the massive underperformance of preceding two financial years, the performance of broader markets continues to remain below par.

Debt market jittery about large borrowing program

The government has managed the FY21 borrowing program well without any noticeable damage to bond markets or private credit. The bond market returns for FY21 have therefore been more than decent. However, in past 3months, rising global yields and huge Rs12trn borrowing for FY22 has kept the debt market on the tenterhook. A steeper yield curve due to abundant liquidity and RBI’s efforts has further queered the pitch for bond investors.

The Reserve Bank of India managed the markets well. It avoided direct monetisation of government borrowings and supported the government borrowing by all means available to it. At end of the day, RBI may close FY21 with a ballooned balance sheet equal to the size of 30% of GDP.

INR recovers from panic fall, stable around Rs73/USD

On announcement of lockdown, INR had a panic fall upto RS78/USD. It however recovered the entire lost ground within 5 months, and has been mostly stable around Rs73/USD in 2HFY21.

India’s macro conditions remain challenging despite the complete recovery from recession. Pre pandemic, Indian economy was growing at the long term rate of ~6% (5yr rolling CAGR). Due to collapse of growth in FY21 (-8%), the trajectory has slipped to ~4%. Recovering back to even subpar ~6% trajectory may take upto 5 years (FY26). Considering that India’s demographic needs require consistent 8-9% growth, led by high job creating construction and manufacturing sectors, the growth challenges may not abate anytime soon.

To make the matter worse, the inflation has become sticky and persisting close to upper bound of RBI’s tolerance range. Though RBI has made it abundantly clear that Indian economy cannot tolerate rise in interest rates at this point in time, any further easing of policy rates is virtually ruled out.

Quasi stagflation (for lack of a better term), has therefore emerged as a major policy challenge in FY21.

Conclusion

To sum up, FY21 had been a challenging year. It has dented the core of global as well Indian economy. The markets have come out from it mostly unscathed. It would be interesting to see how FY22 unfolds. I will share my investment strategy for FY22 tomorrow.

 The recent order of the Supreme Court regarding classification of NPAs and payment of compound interest for the period of moratorium has reignited a debate on the state of Indian financial sector. The order of Supreme Court has been received by markets as a relief, as it removes a regulatory overhang and paves way for the banks to proceed with recovery of NPAs. Nonetheless, the next few quarters need to be watched closely for any precipitous rise in bad loans; especially if the recovery appears faltering.

Past few years have been quite challenging for Indian financial services sector. A decade of massive infrastructure building exercise (1998-2008) resulted in significant advancement of demand and therefore unviable projects in key sectors like housing, roads, power, civil aviation, metal & mining, SEZs, Ports etc. resulted in a multitude of stalled and unviable projects. Administrative and regulatory irregularities in allotment of natural resources to private parties led to judicial action, compounding the problem of failed projects. Demonetization (2016) and implementation of nationwide uniform Goods and Services Tax (GST, 2018) led to permeation of stress of MSME sector, especially the unorganized sector. The lockdown induced by Covid-19 pandemic (2020) further exacerbated the stress in this sector.

The process of recognition of the stress in sectors like infrastructure, metal & mining, telecom etc. started with changes in rules in 2014 & 2015. However, the real impetus was provided by implementation of Insolvency and Bankruptcy Code in 2017. The process started in right earnest with identification of top 12 (dirty dozen, 2017) non performing accounts by RBI and initiation of resolution process under IBC. Closer scrutiny of large stressed accounts resulted in collateral damage in terms of exposing of frauds and fraudulent lending at some NBFCs (IL&FS & DHLF) and Banks (Yes Bank, PNB, PMC etc.)

In past 4years, the process of NPA recognition and resolution accelerated; though not at the desirable speed. This entire process has resulted in emergence of some key trends in financial markets:

·         Many weak banks have been identified. Some in public sector of these have been merged with relatively stronger banks. Some in private or cooperative sector have gone under rehabilitation (including management change) process.

·         Most banks have resorted to raising fresh capital to strengthen their capital adequacy. The government has also provided fresh capital to stronger banks.

·         Couple of large non banking financial companies (IL&FS and DHFL) have faced action under IBC. This resulted in massive losses to mutual funds who had been a major lenders to these companies. This has resulted in tightening of funding of NBFCs by mutual funds.

·         The restructuring of perpetual bonds (AT-1) of Yes Bank, triggered a rethink on the risk profile of this important source of capital for banks; thus narrowing the window of raising capital for banks.

·         In view of the elevated stress level, most banks have materially tightened the credit assessment standards. This has resulted in sustained slow-down in credit growth, especially to low rated companies and MSMEs.

·         To manage the rise in deposits, due to fiscal & monetary stimulus and lower consumption during stressed times, many banks have resorted to increased emphasis on high margin personal loans. This trend threatens to put incremental stress on bank’s finances if the recovery falters due to relapse of pandemic or otherwise.

As per the latest Financial Stability Report (RBI, January 2021):

·         Macro-stress tests for credit risk show that SCBs’ GNPA ratio may increase from 7.5 per cent in September 2020 to 13.5 per cent by September 2021 under the baseline scenario. If the macroeconomic environment deteriorates, the ratio may escalate to 14.8 per cent under the severe stress scenario.

·         Stress tests also indicate that SCBs have sufficient capital at the aggregate level even in the severe stress scenario but, at the individual bank level, several banks may fall below the regulatory minimum if stress aggravates to the severe scenario.

·         The overall provision coverage ratio (PCR) improved substantially to 72.4 per cent from 66.2 per cent over this period. These improvements were aided significantly by regulatory dispensations extended in response to the COVID-19 pandemic.

·         At the aggregate level, the CRAR of scheduled urban co-operative banks (SUCBs) deteriorated from 9.70 per cent to 9.24 per cent between March 2020 and September 2020. NBFCs’ credit grew at a tepid pace of 4.4 per cent on an annual (Y-o-Y) basis as compared with the growth of 22 per cent a year ago.

·         In the latest systemic risk survey (SRS), respondents rated institutional risks, which comprise asset quality deterioration, additional capital requirements, level of credit growth and cyber risk, among others, as ‘high’.

As per the rating agency ICRA’s estimates, gross NPA worth Rs 1.3 lakh crore and net NPA worth Rs 1 lakh crore were not recognized as of December 31, 2020 due to Supreme Court interim order. These NPA may get recognized in 4QFY21. A recent note ICRA mentioned,

“In ICRA’s outlook for the banking sector for FY2022, we had estimated the Tier I capital requirements for PSBs at Rs. 43,000 crore for FY2022, of which Rs. 23,000 crore is on account of call options falling due on the AT-I bonds of PSBs while the balance is estimated as equity.

“In the Union Budget for FY2022, the Government of India (GoI) has already announced an allocation of Rs. 20,000 crore as equity capital for the recapitalisation of PSBs. If the market for AT-I bonds remains dislocated for a longer period for the reasons discussed earlier, and the PSBs are unable to replace the existing AT-Is with fresh issuances, this would mean that the PSBs could stare at a capital shortfall based on the budgeted capital.

ICRA also expects that the GoI will provide requisite support to the PSBs to meet the regulatory capital requirements, which means that the recapitalisation burden on the GoI could increase, or the PSBs could curtail credit growth amid uncertainty on the capital availability. Apart from Tier I, as mentioned earlier, there could be reduced appetite from mutual funds along with a rise in the cost of issuing Tier II bonds as the limited headroom for incremental investments in Basel III instruments.”

In my view, the theme to play in financial sector may be “consolidation” and “market share gain” by the larger entities (banks and NBFCs) rather than economic recovery and credit growth. Attractively valued smaller entities may be vulnerable to extinction.

 The first monetary policy statement of FY22, scheduled to be made on 7 April 2021, is awaited more for the signals and body language, rather than any monetary policy action.

It is almost a consensus that RBI, like any other major central banker, may not be in a position to cut rates from the present levels. On the other hand, RBI governor has made it clear that “...there is no way the economy can withstand higher interest rates in its current state. It is recovering but certainly not out of the woods yet”. The governor has gone way out of his way to assure the bond market and committed “orderly evolution of yield curve” in public interest.

The bond market has calmed down a bit after aggressive assertions made by RBI governor, but the traders have not retraced their steps. The benchmark 10yr yields are now stable close to 6.2%, much higher than the 5.8% to 5.9% sought by RBI.

Next couple of policy statements would therefore be watched to assess (i) how deep is the RBI’s commitment to keep the yield curve orderly and liquidity ample; and (ii) when RBI would be ready to hike rates.

The equity markets usually do not have a strong correlation with the bond market. However, a negative correlation emerges in months preceding the turning of rate cycle. The current tentativeness and loss of momentum in equity market is indicating that equity traders are also anticipating a turn in rate cycle sometime in 2021. A rate hike or a clear indication about the policy path by RBI could therefore be a positive support for the equity market.

Internationally also financial markets are focused on tapering of bond buying programs of major central bankers and eventual hike in policy rates. As per current estimates, FED tapering may begin sometime in 2022 and rate may not be hiked at least until mid-2023. Notwithstanding the expectations, the markets are definitely indecisive.

In my view, we shall have an extended period of indecision and sideways movement in equity markets before the monetary policy makes its next move. Till then happy trading.

 A visit to local fruit and vegetable market last evening was quite revealing. The summer seasonal fruits like muskmelon (Rs140/kg); safeda mango (Rs180/kg) and watermelon (Rs45/kg), mulberries (Rs350/kg) all appeared becoming unaffordable for common households. Even if we assume that it is still early season and the rates will correct in next few weeks, my experience is that peak season rates are usually not less than 50% of the early season rates. Similarly none of the seasonal vegetables was available less than Rs50/kg.

An article in March Bulletin of RBI highlights that the rate of financial savings of household may have contracted to 10.4% of GDP in 2QFY21 from 21% in 1QFY21. It is also suspected that the household savings rate may have further declined in 3QFY21. The article reads that “The Covid-19-induced spike in household financial savings rate in Q1:2020-21 waned substantially in Q2 in a counter-seasonal manner. While households’ deposits and borrowings picked up, their holdings of currency and savings in mutual funds moderated.” The article suspects that “This reversion is mainly driven by the increase in household borrowings from banks and non-banking financial companies (NBFCs), accompanied by a moderation in household financial assets in the form of mutual funds and currency. Nonetheless, households’ financial savings rate for Q2FY21 ruled higher than that of 9.8% witnessed in Q2FY20.”

The AMFI data on mutual fund flows over past 8 months also corroborates this trend.

The persistent fall in net household savings, especially due to higher household debt must be a matter of serious economic study. While some argue that this fall is a healthy corrective trend indicating towards improving financial inclusion of Indian households. Better access of debt is leading to higher household borrowing and therefore lower net savings rate.

This could be music to the ears of managers at retail banks, consumer finance NBFCs and MFIs; but certainly not a good news for household savers, who are struggling with negative interest rates on their savings (when deflated by their respective household inflation not the official headline CPI data).

I have stated this couple of time household savings is one of the most critical elements of Indian economy. Ignoring it or undermining it, is certainly fraught with grave risk.

During five year period between FY15 and FY20, annual household savings in India have grown 64% from Rs24.4trn to Rs39.91trn. However, in this period the household debt has increased 133% from Rs10trn to Rs23.4trn.

Traditionally, domestic savings, especially household savings, have been a stable and sustainable source of funding for both private as well public investments. Though liberalization of capital controls has opened the doors for foreign capital. It still is not a major source of funding for domestic enterprise. More particularly, the decline in financial savings of households that begun in early 2000's has accelerated in recent years. This has serious implications for the economy and therefore equity markets.

I sincerely believe that the government and policymakers have not taken a holistic view of the problem and the steps taken so far are not only inadequate but to some extent misdirected also.

I feel the issue needs to be analysed comprehensively for making any worthwhile step to augment household savings, especially financial savings. For example, the following questions may need to be answered:

The key cause for this trend, in my view, could be listed as follows:

(a)   Fall in average age of house ownership. Higher income levels in urban areas, rise in nuclear families and rise in real estate prices has prompted people to buy houses earlier in their life cycle.

(b)   Rise in personal automobile ownership.

(c)    Low growth in white collar employment opportunities as compared to growth in workforce has led to phenomenal rise in self owned enterprises leading to diversion of savings to physical assets.

(d)   Rise in gold prices in 2000’s and subsequent rise in household gold holdings.

(e)    Persistent negative real rates in pst two decades.

(f)    Stagnant real wages for past one decade.

There are reasons to believe that the rate of household savings may stay lower or even diminish further. For example, consider the following:

(a)   Consumer prices for households may remain high, even if the rate of yearly inflation moderates. Expenses on items like education, health, energy, transportation, communication, rental, protein, and fruit and vegetable shall continue to rise disproportionate to rise in income. Hence the savings rate may remain lower.

(b)   Material rise in income and wealth disparities post demonetization and GST implementation. Lockdown induced by pandemic has further accelerated the trend of rising disparities.

(c)    Factors like lower investment growth, higher productivity gains through automation & elimination of redundancies, restructuring of PSUs shall continue to impact the employment growth, especially for skilled labor.

(d)   Lower employment opportunity may force more and more people towards self-enterprise, leading to higher household debt.

(e)    Last but not the least, the trend for changes in consumption pattern shall continue. Bicycle and Transistor Radio have already given way to motor cycle and smart phone as essential marriage gift (dowry) in hinterland. The running expenses are to be paid by someone after all - be it the bridegroom, his parents or the bride's parents. Consumption of services like telecom, transportation, health and education may continue to rise, leading to even lower savings.

The economic growth will have to find an alternative source of funding (no capital control) or a way to grow household savings (lower taxes, higher real rates, cheaper houses/rent, good public health/education/transport, and farm employment).

In the meantime, the authorities will have to make some effort to ensure that due to unaffordability of fruits, vegetables and milk, lower middle class does not shifts majorly to unhealthy eating habits. If this happens (if not already happened) the health of Indian society may worsen further. Remember, we are already struggling with very high incidence of diabetes, tuberculosis, hypertension, cardiovascular diseases, cancer and female health issues like PCOD.

As per the latest data available, the capital expenditure (capex) growth the new project announcements were down significantly in 3QFY21, the quality of projects has improved materially. The new public sector projects are mostly in infrastructure sector, with state governments taking the lead over central government. The private sector projects are mostly in manufacturing sector driven primarily by the production linked incentive (PLI) scheme announced by the central government.

On the consumption side, the real wages for non-government non-financial sector have continued to decline for fourth successive quarter in 3QFY21. The employee cost for this sector is presently at lowest level in a decade.

I note the following trends from some recent brokers’ reports relating to new capex.

Phillips Capital analyzed the recent capex data published by CMIE and noted the following:

·         New projects announced in 3QFY21, at Rs 801bn, were lower 22% qoq/89% yoy due to large changes in base quarters coupled with continued challenging environment. Private sector accounted for 86% of new capex announcements. Renewables and mining witnessed strong growth while manufacturing declined sequentially.

·         The execution was poor in 3QFY21, with project completion declining sequentially. Road sector was the only sector that witnessed strong execution.

·         Stalled projects were flat yoy and qoq. These projects now account for 11.5% of all projects under execution. Lack of funds (17%), raw material supply (17%) and other issues (41%) were key reasons for project stalling.

·         The quality of projects remains high. Recent government initiatives on PLI’s have begun reflecting in new projects, particularly in the consumer electronics sector. This trend is expected to gather pace as PLI’s are finalized for Bulk Drugs manufacturing and Automobiles sectors over the next few months. This may further push up the share of manufacturing from c. 30% of new projects in the last three years and result in growth in project announcements in FY22.

As per IIFL Securities “corporate India capex outlook is looking up again (14% Cagr over FY21-23ii) after two years of continuous decline (9% Cagr drop in FY19-21) driven by PLI linked investments and growth in emerging segments like data centres. Telecom, Cement, Auto, Pharma & Healthcare, Consumer Electronics, and Chemicals are the key sectors driving investments.”

The brokerage forecasts “incremental investments worth Rs700bn under the PLI scheme, for various manufacturing sectors. However, given the quantum of incentives doled out and capex intensity, Electronics, Auto and Pharma are likely to be the largest sectors. • Most PLI-related capex will be spread out over 3 years (FY22-24).”

The brokerage notes that most of the PLI segments are light engineering sectors, but will require higher deployment of automation and robotics across various applications (especially in sectors involving large-scale electronics manufacturing from foreign players).

The State Minister for Finance, recently informed Lok Sabha that the government had stopped printing of the currency notes of Rs2000 denomination in 2019 itself. This step has been taken to prevent hoarding of currency and curb the circulation of black money in the economy. It is pertinent to note in this context that Rs2000 denomination notes were introduced in 2016 post cancellation of the then prevalent currency notes of Rs1000 and Rs500 denomination. That step, in the first place, was also apparently taken to curb the circulation of black money in the economy.

Besides, the color of money {white, black, pink (Rs2000), green (INRUSD) etc.} which remains an active topic of discussions, the temperature of money is also becoming a topic of interest. Rise in the stock and flow of “hot money” is becoming a worry for authorities. “Hot money” could be loosely defined as the liquid money that flows very fast across asset class and jurisdictions in search of short term trading opportunities. This money usually has no commitment to any asset class (debt, equity, commodities etc.) category (emerging markets, developed markets etc.) or country. Both, the entry and exit of hot money to any class, category or country usually are disruptive, due to high speed and force of such flows.

Multiple bouts of stimulus provided by governments and central banks to counter the slowdown induced by the pandemic related safety measures, seems to have created billions of dollars in “hot” money. This hot money is apparently fueling the asset prices world over. The prices of most liquid assets, like publically traded equities, crypto currencies, precious metals have gained maximum; though the prices of physical assets like metals, real estate etc. have also gained materially.

As per some reports, recently “Beijing officials and policy advisers have been highly critical of US President Joe Biden’s newly signed US$1.9 trillion American Rescue Plan, warning that it could cause massive capital flows and imported inflation that could exacerbate domestic financial risks from already high debt levels."

Zhang Xiaohui, former assistant governor of the central bank, was reported to have said that “The [US Treasury bond] yield hike driven by inflation expectations will lead to a revaluation of asset prices, or even turmoil in financial markets. Domestic markets are unlikely to remain unresponsive.” This is seen as a caution that Chinese domestic markets will respond to rising rates, and should rates spike even more, Chinese assets face a world of pain.

Relative to China, India has not received much of hot money in 2020 and 2021 (YTD). The total FPI flow in India in past 12months (net flows in equity plus debt in secondary markets) is less than US$5bn. Much of this flows are apparently through ETF route, which is usually not hot money.

In past couple of years the securities’ market regulator the Securities and Exchange Board of India (SEBI) has amended many rules and implemented some new ones to bring the functioning of Indian securities markets further closer to the international standards. Being a signatory of the International Organization of Securities Commissions (IOSCO), a global body of securities market regulators, SEBI is mandated to implement global standards of market regulations in India, especially in the area of investor protection, systemic safety, and prohibition of unethical and fraudulent market practices.

Some of the more discussed and criticized latest standards introduced by SEBI are –

(a)   Segregation of financial intermediation and advisory functions. In line with the best global practices, to avoid potential conflict of interest and bring objectivity in advice, Investment Advisors have been prohibited from offering financial intermediation (MF distribution, brokerage etc.)

(b)   Tightening of norms relating to margining of leveraged trades and financing of such trades. This has been apparently done to minimize the systemic risk of markets; improve financial stability and minimize the cases of risk taking beyond capacity by traders and brokers.

It is important to note that in past 25years, in times of crisis, Indian securities market functioning has been commendably stable.

To put this discussion in context, few readers have asked about my views on the recent listings of couple of financial intermediaries. While as usual I would refrain from commenting on individual stocks. However, I have some strong views on this sector, which I would like to share with my readers:

1.    The financial intermediation sector is set to transform in next five years. The changes that started a decade ago will accelerate at dramatic speed.

We shall see accelerated elimination of marginal and smaller players and consolidation of mid-sized and larger intermediaries, as Technology begins to overwhelm the manual execution and even advisory function.

2.    The experience of telecom sector will be replicated in securities’ market. The execution services will become “free”, just like voice calls, and come as part of bundle of services. The primary service will be “advisory” and “access” to global markets and products.

3.    Debt market will become bigger than equity market with most of the development and innovation happening in that segment.

So far the skills for debt trading are limited mostly to the primary dealers, their associated entities and a handful of intermediaries specializing in mobilization of corporate debt. The biggest opportunity for intermediaries perhaps lies in this segment.

4.    Financialization of agri produce trade would be another large opportunity that will unfold on next decade.

5.    Mutual Fund Industry shall be dominated by low cost passive investing (ETFs). Index making and management services will become prominent and dominant (ala MSCI).

After some exciting action post presentation of Union Budget for FY22, the benchmark indices have moved sideways with heightened intraday volatility. The broader markets have definitely outperformed suggesting some superlative returns for the investors. However, when assessed from the rout of small and midcaps in 2018 and 2019, it is clear that broader markets may not have actually yielded much return, even to the investors who have stayed put for 3year. For example, Nifty Smallcap100 index has not yielded any return for past 3years; and Nifty Midcap100 return is only slightly better than the bank deposit return since March 2018.

Notwithstanding the massive visual gains recorded by equity prices in past 12 months, the portfolio returns for most investors may have been below par.

The returns on debt part of the portfolio have been poor, with real returns being negative in many cases. For a large proportion of investors, debt part is usually equal to or more than the equity part.

Since global financial crisis (2008-09), gold has also found prominent place in asset allocation of numerous investors. The efforts of government to popularize financialization of gold through gold bonds etc., have also motivated household investors to invest in gold. For past one year, the return of gold funds is close to zero. The three year return of gold funds is less than savings bank accounts.

Regardless of the outperformance of small and midcap stocks, it is important to assimilate that usually these stocks are much smaller part of an average portfolio. Any superlative return on this part of the portfolio, may not necessarily translate in outperformance of overall portfolio.

A simplified analysis of sectoral performance of Indian equities highlights the following:

(a)   The euphoria created by the brave and revolutionary budget has not lasted much. Nifty is almost unchanged for past five weeks.

(b)   Optically, it appears that budget ignited risk appetite for growth trade. It is believed that big money rotated towards cyclical sectors like commodities, infrastructure, automobile, etc. post budget. The aggressive disinvestment agenda underlined in the budget also attracted huge interest in public sector stocks. Consequently, metals, energy, infra, PSEs, and Realty sectors have outperformed since presentation of budget. Whereas, the favorites of post lock down period, i.e., consumers, pharma and media have yielded negative return since then. IT has also underperformed YTD.

The fact is that metals are participating in a global rally (reflation trade) and may not have much correlation to budget proposals. Energy sector performance is highly skewed due to Reliance Industries performance, which is popular due to its retail and telecom ventures rather than its energy business. Infra outperformance has actually diminished post budget, as compared to past 12months performance.

Auto sector has yielded no return since budget; and financial services have actually underperformed Nifty.

(c)    Assuming that most household investors and fund managers believed in this Cyclical growth trade story and have started to rotate from the defensive and secular businesses like IT, Pharma and Consumers in post budget period and the rotation may be completed in next couple of months. I would like to wager that it will be time for outperformance of IT, Pharma and Consumers by the time monsoon hits the Mumbai coast.

(d)   Private sector banks have underperformed their public sector peers over past one year period. Much of this outperformance of PSBs has occurred post budget. Valuation gap, promise of reforms and recapitalization, improving balance sheets are some of the primary reasons for this outperformance. Watch out for any disappointment on these parameters.

Bond market is obviously not happy with the state of fiscal and macroeconomic factors. Recent sharp rise in Covid cases has also raised the specter of “relock”. Year end “adjustments” may also play some part in markets in next couple of weeks. In my view, it’s time for some extra caution rather than exuberance. Preserving wealth should be a priority at this point in time over maximizing profit.

The history appears to be repeating itself for the n^th time in the stock market. The small time enthusiasts, who normally join the band wagon right at the top of the market cycle, have once again jumped into the market arena. Completely overwhelmed by the left-out syndrome, they are queuing in hordes in front of the counters where they had lost their fortunes, not long ago. Many of these scrips are trading at a fraction of the price they were trading 3years ago. Some notorious stocks that have inflicted huge losses to the investors and traders in past decade are also topping the volumes charts again. A strong urge to prove a point, rather than greed, appears to be the dominating factor here. Everyone wants to prove that it was their bad luck rather than lack of financial acumen, which caused them loss last time. I wish luck favors these traders this time. But in my heart I know for sure, this is not going to be the case. They will again lose! No regulator, no matter how strong and vigilant, can protect them.

There is a poplar fable in the stock market literature. Usually it is narrated by the market seniors after the bubble has already burst. Like every time before, this fable aptly summarizes the present state of affairs of stocks markets world over. The story goes like this:

“Once upon a time in a village a man appeared and announced to the villagers that he is willing to buy monkeys @ Rs. 10 each. The villagers lured by his offer, went out in the forest and started catching monkeys. The man bought thousands @ Rs. 10 and as supply started to diminish and villagers appeared tiring in their effort, he revised his offer. He announced that now he would buy monkeys @ Rs. 20 each.

This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The man increased his offer rate to Rs. 25. The villagers would now spend hours in the forest to catch even a few monkeys. Soon no monkey was left in the forest. The man would coax the villagers every day to go and get more monkeys. The villagers would try their best but in vain. As the frustration grew, the man made the offer even more lucrative. He announced that he would now buy monkeys @ Rs.50 each! But there was no monkey.

The man left his servant in the village and left for the city. In the absence of the man, the servant told the villagers, "Look at the monkeys in the big cage that my principal has collected. To help the poor villagers, I am willing to cheat my master. I will sell these monkeys to you @ Rs. 35 each, so that you could sell them back to my master @ Rs. 50 when he comes back from the city.”

The villagers queued up with all their saving to buy the monkeys. Soon the servant had sold all the monkeys back to the villagers. He then also left for the city with all the money he had collected. Thereafter, no trace of the man or his servant could be found by the unsuspecting villagers. They were left with a large troop of monkeys and hope of selling them back to a willing buyer someday. In the meantime, they would be forced to feed and take care of simians.”

 Notwithstanding the buoyancy in stock market, the economy has shown some clear signs of fatigues in February. The post lock down recovery from September onwards appears to be pausing, as pent up consumer demand has subsided and rise in raw material prices has dampened the sentiments. Some signs of economy pausing could be read from the following:

(a)   GST payments in February (for collections in January) have declined after rising for three consecutive months.

(b)   E-Way collection in February were also much below the December levels.

(c)    Exports have been mostly flat for the month of January and February; while imports have declined from the December levels.

(d)   Non food credit growth slowed down further in January.

·         The Industrial credit contracted -1.3% in January. The contraction was led by large industrial credit, which constitutes ~82% of industrial credit and de-grew 2.6% YoY. Within industrial credit, sectors such as infrastructure (led by telecom), metals and all engineering saw persistent YoY de-growth.

·         Service sector credit growth slowed to 8.4% (yoy) in January against 9.5%

·         Personal loan growth slowed down to 9.1% (yoy), the slowest rate in 10year. Home loan growth 7.7% was lowest in a decade despite easing rates.

·         MSME credit grew at meagre 0.9% (yoy), despite all the incentives, programs and schemes for promoting and protecting the credit flow to MSME sector.

(e)    In January the eight core sectors’ output growth slowed down to 0.1% (yoy) from 0.2% (yoyo) in December.

·         Cement production fell by ~5.9% YoY in January 2021 according to the core industries data released by the Government of India. The YTD demand continues to be weak with the fall of ~16.6% as indicated by the data.

·         As per a recent report of Nomura Securities, “Indian steel demand dropped 6% m-m for Feb-21 (though 7% y-y) as buying interest from large construction majors turned sluggish on high prices. Key infra names have slowed down execution. Further, major stockists and distributors are holding decent inventories and seem reluctant to procure material at higher prices. Demand growth y-y has been boosted by double digit demand growth in key segments like autos, white goods and consumer durables, according to Steelmint.”

(f)    As per another recent report by Nomura securities, “The Nomura India Business Resumption Index (NIBRI) fell to 95.2 for the week ending 7 March vs 98.1 in the prior week, indicating that the gap from the pre-pandemic normal has slipped to 4.8pp from only 0.7pp a fortnight earlier. Both the Apple driving index and the Google retail & recreation indices have taken a hit, while workplace mobility continued to improve. Power demand fell by - 8.5% w-o-w (sa) vs 4.2% in the prior week, while the labour participation rate also fell to 39.8% from 40.6% previously.”

A visit to here tier two cities of Uttar Pradesh over last weekend was quite educating. I came back with few new learnings and stronger conviction in couple of themes that I have been following for past couple of years.

We visited the temple of our family deity in Agra. The temple is being renovated completely from the inside. The donations for the renovation are being accepted in digital mode. The devotees, many of them from lower middle and poor families were pleased to pay Rs10-50 through UPI etc. It was very clear that people across the socio-economic strata have internalized the digital mode of payment. Another evidence of this trend was available at Fatehpur Sikri monument.

The CNG bus that takes the tourists from parking upto the monument charges Rs10 as fare. The bus operator was accepting payment of Rs10 through digital mode. All tourists, villagers and urbanites alike, were happy to scan the QR codes. The monument entrance fees Rs45 per person, is payable only in digital mode now and even the ticket needs to be booked online. This may be a temporary Covid-19 measure, but no one seemed bothered about this. All tourists appeared happy about the procedure as it saved them from standing in long ticket queue. Poor phone connectivity though was an annoyance with some. WiFi enabled smartphone was no issue as all tourists were carrying one. The local tourist guide, the local handicraft shop and local dhaba all accepted digital payment as if it was a norm.

I came out even more convinced that digitalization of financial transaction shall become a norm rather than exception in net 5-7years. A further simplification of the procedure and improvement in digital connectivity may even accelerate the process. Cash economy that is believed to have impeded the growth of Indian economy for past 7 decades shall shrink materially with this. The government however needs to make sure that the cost of digital access does not increase from the present level and quality of digital access improves materially.

The second theme that has bothered me for past few years is the general public attitude towards respect for intellectual property rights of others. Use of pirated software, photocopied books, spurious books sold on traffic signals and footpaths, unauthorized copies of branded clothes etc. is unapologetically common. Propriety and ethics are not taught in schools. It is common to see parents encouraging their wards to buy the “cheaper” alternative regardless of its legality and authenticity.

Travelling to Moradabad from Agra via Ghaziabad and Hapur, I registered something that I would usually ignore.

In Ghaziabad there is a fast food joint called “Bhatura King”. The name and logo used by this chain is cannily similar to the global chain of quick service restaurants, “Burger King”.

On 25kms stretch from Hapur to Garh Mukteshwar, there are at least 50 Shiva Dhaba, each claiming to be the “original”. The people who have traveled on NH24 from Delhi to Moradabad, Rampur etc. would remember that Shiva Dhaba is a popular food joint having a strng recall value. Similarly, there are over 50 Gulshan Dhaba, each claiming to be “original” between Mathura and Palwal. Panchhi Petha is a world famous brand of Agra. In Agra city itself there over 500 shops claiming to be Panchhi Petha stores. Similar is the story with Bikaner Sweets, Aggrawal Sweets in Delhi NCR region.

There are two points in this:

(1)   The respect for the intellectual property rights of others is scant.

(2)   The recognition of brand value and need for its protection is also scant, though it has started to grow in recent times.

I have highlighted this earlier also that many mega Indian business ideas are nothing but poor copies of the globally successful businesses. Some examples are, PayPal – PayTM; AirBnB – Oyo; Swiggy – Zomato; Walmart – Big Bazaar; Amazon – Flipkart; etc.

The theme in this is Jugaad.

The culture of Jugaad, in my view, has harmed Indian economy and society much more than it has helped. This culture has hampered the growth, innovation, scalability, and competitiveness significantly, in my view.

For investment purposes, I have been consciously avoiding business, ideas and themes that are based on Jugaad and/or violate the IPRs of other entities. I would like to see a strong and comprehensive initiative on part of the government, civic administration, academia etc. to change this culture.

On a side note, I wonder which sector the Fintech companies will fit in – IT or Financials; or we will have to define a new sector for all new business that help in digitalization of our lives.

 There are lots of events happening in global markets which cannot be full explained through conventional wisdom or empirical evidence. In my view, lot of these events are unintended consequences of policy actions, geopolitics and trade conflicts.

For example, there is a massive rally in the global commodity prices, despite poor demand and growth outlook for next few years at least. The recovery to pre Covid level may not entirely explain the rise in commodity prices much beyond the 2019 levels. Popularization of electric mobility etc. can explain gains in some commodities, but not in steel, coal, crude etc.

The forecasts of a commodity super cycle sound mostly unconvincing, given (i) worsening demographics of the world; (b) restricted mobility; (c) seriously impeded purchasing power of people; (d) already stretched limits and diminishing marginal utility of fiscal and monetary stimulus; (e) technology evolution focusing on reversal of trends in labor migration; and (f) diminishing chances of a full-fledged physical war amongst large countries; etc.

Material changes technologies related to construction, manufacturing and transportation etc. also leading to material changes in the demand matrix for various commodities like steel, cement, copper, coal etc.

The outrageous rise in economic inequalities globally also mean that investment rate in poor countries will continue to decline for next many years, as the economic power gets more and more concentrated in the hands of few rich nations.

I therefore feel that the price trends in the global markets are deeply influenced by the factors other than economics. Even though the defeat of Donald Trump in US presidential elections has taken the trade conflicts away from headlines and front pages; the trade war that started few years ago is far from over. Besides, geopolitics is also playing a large role in global markets.

In past two years, China has been making conscious efforts to reduce its holdings of US Treasuries and building large reserves of physical industrial commodities. The global investors appear selling Chinese assets (leading to massive tech rout in China) and buying other emerging markets, in line with the global enterprises’ China+1 policy.

The unintended consequences are that world is facing shortages of rare earths, semi-conductors, and shipping containers and struggling with the rising prices of commodities. China which had been exporting deflation to the world for the past 10years has suddenly become exporter of inflation to the world.

The markets focusing more on US yields and USD cross rates, might be missing the point that Chinese aggression on commodities can derail the entire AI led Tech revolution for at least 4-5yrs, if it continues to choke supply of rare earths and semi-conductors. This derailment of global trade and therefore growth is a bigger worry than inflation at this point in time.

It is pertinent to note in this context that today China is hosting its annual gathering of National People’s Congress, its biggest political meeting, to approve the plan to propel Chinese economy to the top of the world, ahead of US. At the center of the new plan will be Beijing’s push to develop new technologies and cut the nation’s reliance on geopolitical rivals such as the U.S. for components like microchips. As per some experts, that should mean allocating more resources to science and technology, with spending on research and development targeted at around 3.5% of GDP over the period

Another case in point is the sharp rise in the price of sugar in global markets. This rise has occurred despite the higher than expected production in India and over 10.6MT carry over stock. But for MSP of Rs31/kg mandated by the government, the glut should have resulted in domestic prices falling to much below the cost of production. Also, but for export limitations and logistic constraints, Indian supplies could bring down the global prices to much lower levels. Visualizing this as signs of impending global food inflation cycle may not be appropriate.

The semi-conductor shortages are hurting manufacturing of white goods, electronic items and automobile, etc. This could have meaningful second round impact on other sectors of economy. Thankfully, the border conflicts and political rhetoric have not impacted the Indo-China trade materially. But India gaining advantage at the expense of China due to China+1 policy could have some repercussions in the short to medium term. The capacity building in India needs to take place now. A delay of even one year could potentially render much of this capacity redundant as global enterprises find alternatives or reconcile with China.

The short point is that US bond yields and USD exchange rate, etc. are least of the worries for our markets and economy, presently. Laying too much focus on these may only distract us from bigger threats and even bigger opportunities.