Vijay Kumar Gaba

In this context, the following trends may be pertinent to note, especially for the equity investors.

Negative divergence in OECD debt and yield

The elementary principle of economics is that the price of anything is a function of demand and supply equilibrium. Higher demand pushes the equilibrium to a higher price point and vice versa. However, the bond markets in developed economies have been defying this principle for the past 25yrs. The debt of OECD countries rose sharply post the global financial crisis (GFC) in 2008-09; but the yield on government bonds fell till 2022, creating a negative divergence in bond supply and bond prices.

The situation has shown some signs of reversal in the past one year, but this may not last if the US Federal Reserve decides to begin easing rates sometime in the next 12months, while the latest debt ceiling deal results in a massive rise in bond supplies.

This trend is relevant for equity investors, since this could keep the cost of capital lower, affording much higher price earnings multiples to various businesses.

Deflationary pressures to persist

Post the GFC, the developed economies in particular have struggled with persistent deflationary pressures. Despite unprecedented new money printing and near zero (and negative) rates, major economies faced strong deflationary forces. Consequently, the prices of financial assets and real estate witnessed strong bull markets. The reported debt deal would result in further strengthening of deflationary forces which are structurally aided by the adverse demographic changes and changing consumption patterns.

Indian debt no longer lucrative to USD investors

The spread between US and India benchmark 10yr G-Sec yields (318bps) is presently at its lowest level, at least since the GFC. Given the hedging cost and just 2 notch above junk rating for India G-Sec, presently the Indian bonds may not be very attractive for the USD investors. Though there is not much empirical evidence available to substantiate this, there is a probability of rise in flows to Indian equity, which has been witnessing strong FPI selling for the past couple of years.

Credit-Deposit ratio to moderate after withdrawal of large currency (CARE Ratngs)

RBI announced to withdraw Rs. 2,000 denomination banknotes on May 19, 2023. The total value of these banknotes in circulation constitutes Rs. 3.62 lakh crore as on March 31, 2023.

The addition to the banking deposits due to withdrawal of Rs 2,000 banknotes is not anticipated to be material even under various scenarios which assume that 25%-50% of the currency remains as deposits with the banks. In percentage terms, the additions are expected to be 0.5%-1% of overall deposits in the banking sector. The banking system liquidity was already in surplus at the end of April 2023. The addition of Rs 1.0 lakh crore to 1.8 lakh crore over a period of four months (June 2023 to September 2023) will inject significant short-term liquidity into the banking sector over the next 2 quarters and is likely to reduce the banking sector’s dependence on short term CDs in the near term to some extent and the short-term deposit rates may ease a bit thereby muting the impact of rising deposit rates on NIMs. Even though the time frame of four months is given, CareEdge expects this to be front loaded due to the behavioural pattern of the masses. The banks may use incremental deposits to increase credit growth. Liquidity increase may impact RBI’s OMO during Q1FY24 and Q2FY24.

Credit offtake rose by 15.5% y-o-y for the fortnight ended May 5, 2023, compared to 11.8% from the same period in the last year (reported May 6, 2022). Sequentially, it increased by 0.3% for the fortnight. In absolute terms, credit outstanding stood at Rs.139 lakh crore as of May 5, 2023, rising by Rs.18.6 lakh crore from May 6, 2022, vs 12.7 lakh crore in the same period from the last year. The credit growth continued to be driven by a lower base of the last year (which will likely abate in FY24), unsecured personal loans, housing loans, auto loans, higher demand from NBFCs, and higher working capital requirements.

Credit offtake has remained robust even amid the significant rise in interest rates, and global uncertainties related to geo-political, and supply chain issues. The growth has been broad-based across the segments.

Personal Loans and NBFCs have been the key growth drivers, while other manufacturing-oriented segments could also drive growth. Meanwhile, credit growth is expected to be in sync with the GDP growth in FY24. A slowdown in global growth due to elevated interest rates, and geopolitical issues could impact credit growth, however, the Indian financial system is on more robust footing, vis-a-vis its global peers.

Rural checks: Q1FY24 starts on a weak note (Elara Capital)

Decline in crop prices drags realization: Our rural channel checks show rural demand remains sluggish in April and in the early parts of May as delayed harvest and a decline in the price of key Rabi crops have dragged farmer realization. While the impact of unseasonal rains is not found to be significant, the quality of output has been hampered. Relaxation of quality norms for crop procurement domestically and the decline in global prices have had an impact with prices of key crops declining.

Fall in key input prices yet to be reflected on the ground: The sharp decline in input prices of key agrochemicals is yet to be felt on the ground except in South India, as there was high-cost inventory in the system. We expect the impact of lower agrochemicals prices to be felt from the Kharif season.

Sluggish FMCG demand; Summer portfolio hit in the early days: Delayed harvest and weak realization have dragged FMCG sales. Our distributor checks show volume offtake was weak in April. Further, unseasonal rains and lower-than-usual mercury levels have led to a sharp demand contraction for a usual Summer portfolio for FMCG brands, such as beverages, which saw a huge reduction. Demand sensitivity to prices was found to be high for entry-level stock keeping units (SKU), especially for INR 5-10. Price hikes were passed on in higher SKU, suggesting entry-level demand remains weak. We expect FMCG companies to report sluggish volume in Q1FY24. Moreover, our checks suggest price cuts of inputs have yet to be passed on fully to end-consumers even as grammage hikes have been reported in soaps, detergents, biscuits, and processed food. Unless there is a sharp rise in spend on ads, promotions and freebies, FMCG should be able to report healthy margin in Q1FY24 as well.

Milk prices near their peak; expect a decline from CY24: Our checks show milk output is catching up gradually, with the deficit likely to reduce materially by end-CY23, resulting in lower prices. The impact of COVID-19 and lumpy skin disease on milk supply is beginning to wane and supply is set to rise materially during November-December 2023. This should provide a respite to companies, such as Jubilant FoodWorks, which have seen significant raw materials inflation due to rise in cheese prices.

Good start to the marriage season gives fillip to 2W demand: Our checks show the marriage season has seen a good recovery in demand; hence, entry-level demand for bikes should see improvement on sequential basis. The traction also was good in the two-wheeler category this marriage season as there was preponement of marriages, owing to Adhikmas (additional month in the Hindu calendar), which has reduced the number of auspicious dates in the later part of the year. Supply chain issues for brands, such as Honda, seem to be having a positive impact on demand for Hero MotoCorp bikes.

Currency outlook (Bank of Baroda)

INR under pressure: After remaining stable for most part of the last few months, INR has come under pressure in the last few sessions. In May’23, INR has depreciated by 0.9%. However, bulk of the weakness in INR can be traced back to the last couple of sessions. In fact, since 12 May 2023 (when INR was last below the 82/$ mark), INR has depreciated by 0.6%. Prior to this, INR was fairly steady in a narrow range of 81.5-82/$. This was underpinned by robust macro fundamentals, improvement in external position, lower oil prices and buoyancy in FPI inflows.

So what are the reason behind INR’s rather abrupt and sharp fall?: The most compelling reason for the rupee depreciation is a strength in dollar. In the last few sessions, dollar has once again strengthened amidst strong macro data from the US and hawkish Fed-speak.

This has resulted in markets repricing the trajectory of Fed rate path. While markets widely anticipated that the Fed was done with its rate hike cycle after a final 25bps rate hike last week, macro data since then has dimmed those expectations. Strong labour market, rebound in housing sector, more than expected uptick in households’ inflation expectations as well as positive developments surrounding US debt ceiling have all contributed to the belief that the Fed rate may still be behind its peak.

Reinforcing this view, several Fed members have gone on record to say that inflation still remains a big challenge, warranting even higher rates. As a result, DXY has strengthened by 1.1% in the last 3 trading sessions alone. Most global currencies have seen depreciation.

Another reason, though not as significant, is a moderation in FPI inflows. FPI inflows which were showing some traction since the beginning of the month have lost momentum amidst a weakness in domestic equity markets and safe haven flows.

Will the trend continue?: With the changing narrative around US Fed rate path, some short-term pain for the INR cannot be ruled out. However, the extent of INR deprecation is likely to be mild, aided by effective intervention by the RBI. Fed Chair’s testimony, due later today, will be key in determining the future trajectory of rates and dollar. While the dollar may strengthen in the short-term, as investors await more clarity on the Fed rate trajectory, it is likely to be temporary. Hence, we continue to remain bearish on the domestic currency over the long-term. This will be reinforced by improvement in external outlook, range-bound oil prices, foreign inflows and buoyancy in remittances and services receipts.

Copper price slides as global demand drops sharply (Financial Times)

The price of copper has widened to the biggest discount against its futures equivalent in almost two decades, in a warning sign of a sudden weakening in global demand as China’s economic rebound stalls.

Copper for settlement in two days was $66 cheaper on Monday than buying a contract to deliver the metal in three months’ time, a difference that traders said reflected concerns that China’s industrial rebound was not materialising. The gap between the two prices is the largest since 2006, according to the London Metal Exchange.

The sharp fall in spot price reflects a rapid rise in stockpiles of the metal outside China in LME warehouses, as US and European industrial activity begins to slow after a year of rapid interest rate rises.

Known as Dr Copper for its ability to gauge the health of the global market, the metal is widely used in buildings, infrastructure and household appliances.

Natalie Scott-Gray, base metals analyst at broker StoneX, said that copper prices were starting to be driven by real world signs of weak demand rather than big macroeconomic factors, such as the US dollar and sentiment towards China’s reopening.

“It’s the first physical evidence we’re seeing that demand is being impacted worse than expected in the west,” she said. “It’s the pace of change that has caused the gap”.

The price of copper has fallen 11 per cent in a month to almost $8,000 per tonne, its lowest level since November, in part because China has not grown as fast as expected since it lifted its tough coronavirus restrictions near the end of the last year.

Positive sentiment around the reopening of Asia’s biggest economy helped leading industrial metals to rally more than a quarter between November and January.

“It hasn’t been as dire as this for many a year,” said Al Munro, metals strategist at Marex, a London-based broker. “The bullish scenario was all based on a China rebound which hasn’t materialised as we in the west suffer from an economic slowdown.” (Read more)

India steel index remains in negative zone; near-term outlook bleak (SteelMint)

SteelMint's flagship India Steel Composite Index, a barometer of the domestic steel market, edged lower by 0.8% w-o-w to 150.4 points on 19 May, 2023 compared with 151.6 points, as assessed last on 12 May.

Notably, the Flat Steel Composite Index slipped sharply by 1.2% while the longs composite index witnessed a drop of 0.3% w-o-w.

Amid the general weakness in the domestic steel market, prices have been on a decline; however, flat steel prices seem to be more influenced by global trends, partly due to export market exposure. Long steel prices, on the other hand, are also battling weak demand but the upside comes from low availability of ferrous scrap.

·         Domestic steel prices subdued amid global downturn

·         Coking coal prices drop sharply, bottom not in sight

·         Scrap shortage likely to keep IF/EAF steel market supported

Agri input: NPK producers better placed than DAP (Elara Capital)

The Ministry of fertilisers has reduced H1FY24 Nutrient Based subsidy (NBS) on nitrogen (N), phosphates (P), Potash (K) and sulphur (S) by 22% to INR 76.5/kg, 39% for INR 41.0 per kg, 33% for INR 15.9/kg and 54% to INR 2.8/kg, respectively, vs Q3FY23 subsidy. Based on existing DAP inventory, our channel checks show manufacturers stand to make hardly any profit. NPK remains profitable for the industry.

DAP manufacturers to have a hard time: DAP manufacturers that have an inventory of existing finished goods or raw materials may not incur any material profit. If they are producing through new raw material stock, especially ammonia, then profitability may sustain, given ammonia prices have fallen by more than 50% since March to ~USD 250/tonne. Increased competition from importers is putting pressure on liquidation of domestic stocks.

Imported DAP more profitable than domestically manufactured: At the current subsidy rates, DAP imports below USD 600/tonne are more profitable than domestically manufactured ones. In the past week, DAP prices fell to USD 500/tonne from USD 550/tonne. With declining ammonia prices globally, DAP prices may fall further, implying imports are likely to continue to rise in India in FY24.

NPK manufacturers to make good profit, but lower than H2FY23: NPK manufacturers continue to make good profit even on existing stocks as the phosphate component is lower in other grades except in DAP (18:46:0:0). Profitability would increase further based on newer stocks of ammonia.

Moreover, the discount between spot prices three months future at LME widened to the largest since 2006, indicating poor outlook for copper demand in the near term.

Copper prices have fallen over 10% in the past one month alone on disappointing growth data from China. The hopes of a sharp recovery in Chinese growth in near term are fading as more downgrades are indicating. Goldman Sachs reportedly revised its average copper price forecast for 2023 by over 11% to US$8698/t from US$9750/t earlier. Though the optimism over Chinese growth and consequent firmness in copper prices is not lost completely. For example, Bank of America is still maintaining its US$10,000/t copper price forecast for 2023 end in the hope of large demand ramp up as China accelerates spending on its power grid. Nonetheless, the general mood is drifting towards accelerated slowdown in demand.

Since copper is used in infrastructure (power, shipping, buildings etc.) machinery and discretionary consumption (housing, vehicles, appliances etc.) its demand is widely accepted as a lead indicator of the direction of the economy. For its ability to provide a correct prognosis of the health of the economy, the bright metal is popularly known as Dr. Copper.

So, if the latest prognosis of global economy by Dr. Copper is correct—

·         We shall see an accelerated slow-down in global economic activity with little support from China, in the next few months. This shall reflect in poor export demand for India also.

·         The inflationary forces may weaken as tighter money constricts demand further; eventually leading to the next round of monetary easing by the end of 2023 or early 2024. RBI’s growth forecast for FY24 may also get moderated resulting in change in the present “withdrawal of accommodation” monetary stance.

·         Deflation, rather than inflation, could again emerge as the major concern of global policy makers by the end of 2023. Japanese markets that have majorly outperformed the developed peers on easing deflationary pressure could again face pressures.

·         Notwithstanding the Debt Ceiling tantrums and political rhetoric, for global investors bonds may emerge as preferred asset class in near term over equities.

·         Overall, a foundation for a decent equity rally in India over 2024-25 could be laid in the next 6months.

(Inputs from Copper price slides as global demand drops sharply published in the Financial Times)

As per Fortune Business Insight The global big data analytics market size was valued at $271.83 billion in 2022 & it is projected to grow @13.5% CAGR to become $745.15 billion by 2030. Compared to this, as per Stockholm International Peace Research Institute (SIPRI) report, in 2020 the global arms trade is estimated to be US$112bn (actual figures may be little higher). Clearly, data and data analytical services are emerging as one of the most product categories globally.

Obviously, most businesses and states who want to do business would be interested in data pertaining to Indian population and markets. Historically, the census conducted every ten years has provided valuable insights into the potential high growth demand areas in Indian markets. Indefinite postponement of the 2021 census by the government is therefore quite intriguing, given that the product (data) this census shall produce would be much more valuable than the cost incurred.

The census is even more critical, if we consider some very points raised by Yi Fuxian in his latest article “China and India Have Fewer People Than the UN Thinks”.

Yi argues that UN’s World Population Prospects (WPP) data about the population of India and China, relied upon by most global agencies, states and businesses, may be far from accurate. As per Yi, “India’s development indicators have improved markedly since its previous census. From 2011 to 2021, the country’s infant mortality rate fell from 44 deaths per 1,000 live births to 27. The secondary-education gross enrollment rate rose from 66% to 78%, and the mean years of schooling among adults aged 20 and older increased from 5.8 to 7.2 years. The contraceptive prevalence rate rose sharply from 54% in 2013-15 to 67% in 2017-19. Consequently, India’s fertility rate may be as low as 1.6-1.7 in 2024, with its population ranging between 1.37 to 1.39 billion, compared to the 1.44 billion projected by the UN.” Accordingly, the UN might be wrong in declaring India as the most populous country.

Yi highlights that the fertility rate of Indians living in countries such as Singapore and Malaysia etc., is similar to the Chinese population living there. Therefore, with social indicators continuing to improve at the current pace, it might be erroneous to believe that Indians will have fertility rate different from Chinese. As per Yi, it is likely that India’s fertility rate will drop below 1.2 by 2050, and its population will peak below 1.5 billion, rather than the 1.7 billion projected by the WPP. Fast-forward to the dawn of the twenty-second century, and the numbers paint an even bleaker picture. While the UN report estimates that India’s population will reach 1.5 billion by 2100, the country’s population could actually fall below a billion.”

It is important to note that “The WPP’s projections of Chinese demographic trends are even more exaggerated. For example, the 1992 WPP estimated that China’s population will reach 1.54 billion by 2025. While the 2022 report revised this figure down to 1.42 billion, the actual figure will likely be closer to 1.27 billion.”

The latest episode of political squabble over raising the limits within which the US government could borrow to meet its fiscal deficit, reminded of this inspiring fable. In the past two decades we have seen multiple “debt ceiling crisis” in the US. In the 15 years period from 2001 to 2016, the US Congress raised the debt ceiling 14 times. During President Obama’s tenure of 8 years, the debt ceiling was raised 11 times. Prior to that President Bush’s tenure saw 7 hikes in the debt ceiling. It is also pertinent to note that in the past 100 years, the debt ceiling has only been increased. It has never been reduced, even when the US public debt was reduced.

It is important to clarify that the Gephardt rule, as per which passing of the budget was deemed as an automatic hike in the debt ceiling to meet the approved deficit, was repealed by the Congress in 1995. Since then, appropriation in the budget and means to fund such appropriations are voted separately by the Congress. If the Congress does not vote to hike the debt ceiling in accordance with the appropriation bill, the government will run out of money to meet its interest, salary, social security and other obligations. A default on debt service would inevitably entail a rating downgrade and hike in interest rates that could impact US bond holding of all investors; besides resulting in overall higher interest rate burden on the economy.

Prior to almost every hike in the debt ceiling there had been intense politicking and aggressive posturing by both the parties. The president and treasury secretary contend that not hiking the limit may result in total collapse of the global financial system; while the majority in Congress seeks multiple assurances and concessions before agreeing to the demands.

Going with the tradition, the treasury secretary Janet Yellen has recently stated that “Waiting until the last minute to suspend or increase the debt limit can cause serious harm to business and consumer confidence, raise short-term borrowing costs for taxpayers, and negatively impact the credit rating of the United States”. She further added, “In fact, we have already seen Treasury’s borrowing costs increase substantially for securities maturing in early June.” Also, there has been usual “huge cost to American Public” and “risk of global financial instability” rhetoric being played from the Capitol Hill.

In the past, markets would usually take these warnings seriously and turn jittery. This time however, markets appear relatively much calmer; as if calling the bluff of the politicians. The collective wisdom of the market appears believing that like every previous instance, both the parties would agree to hike the debt ceiling before the 1^st June deadline. Few traders seem to be taking the customary warnings being issued by rating agencies like Moody’s; investment bankers like Jamie Dimon; and Democrat leadership.

The point is whether wolves will actually come this time and eat the complacent traders? Hard to imagine, given the historical context. But would you continue to assign a zero probability to this 8-Sigma event? More on this next week.

The narrative presented by these so-called finfluencers is clearly oblivious of the fact that there are not more than a hundred companies in India that have operationally performed consistently for more than a decade. Number of companies that become redundant in each business and market cycle is very high.

There are numerous research reports and messages which rely on “low per capita consumption in India” and “moat” in India. Based on this many “new businesses” (and some established businesses) are given astronomical valuations. In this context, it would be pertinent to note the following:

In the early 1990s, the number of Indian citizens using air transport for travelling purposes was extremely low. There was only one public sector civil airline, viz., Indian Airlines. Then the civil aviation business was opened to private competition. Within a span of 2yr several private airlines started business, e.g., Sahara, NEPC, Damania, East West, Modiluft etc. All these ended as bankrupt in less than a decade. In the second tranche, some more private airlines started business, e.g., Jet Airways, Kingfisher, Deccan Airlines etc. Soon they became very popular with Jet Airways acquiring more than 50% market share (“moat”). These also ended bankrupt, along with Indian Airlines (later Air India).

Similar has been the story with private banks and telecom operators. Many first-generation private banks (Global Trust Bank, Time Bank, Bank of Punjab, Centurion Bank etc.) ended up merging with larger banks. Numerous telecom operators and ISPs ended shutting the shop in less than a decade. This all happened in spite of very low telecom density and poor financial inclusion.

Steel and power sectors have been another anti-thesis for this “moat” and “low per capita consumption”. India still ranks amongst the lowest per capita consumers of steel and power. If we carefully analyze the banking sector crises during the 1990s and 2010s, these two sectors have been largely responsible for huge credit costs to the banks. There have been numerous bankruptcies and debt restructuring in these sectors in the past four decades. Even the sector leaders like SAIL and Tata Steel have been responsible for massive investors’ wealth destruction multiple times in these four decades. Power producers like JP Power, Reliance Power, Lanco, ended bankrupt, while the leaders like NTPC and Tata Power have not yielded any noteworthy return over the past two decades.

I would not be surprised if many of the new age digital businesses also wind up in the next one decade, despite huge scope for growth in businesses like ecommerce, fintech, food delivery, etc.

The point is that arguments like “per capita consumption” and “moat” may not necessarily work in a country where about 60% of the population is dependent on government support for necessities like food, cooking fuel, primary healthcare, education, and transport; and government is constitutionally mandated to keep policy framework largely socialist.

Investors accordingly need to adjust the denominator (total population) appropriately to calculate a realistic per capita number. The “moat” premium should be assigned to a business only after applying appropriate policy risk discount. On the positive side, per capita income for the total addressable market will also be much higher than the official number.

In particular, notwithstanding the finfluencers claims, the investors must consider the following while evaluating a company for investment:

1.    It is not sufficient to only evaluate the debt servicing capabilities of the company. The ability to pay the cost of other factors of production (e.g., wages, rent, dividend, plant and technology upgrade etc.) must also be evaluated.

2.    It is important to assess the dependence of the company on the global economy, especially the stressed developed economy consumers and over regulated Chinese businesses.

3.    Policy risk, especially related to “sin consumption”; competition; business with the government; and economic offences, etc.

4.    Risk of obsolescence of products, technology and IPRs.

Indian IT: Precariously Placed (Jefferies Research)

An unexpected decline in revenues: During 4QFY23, aggregate revenues for Top-5 IT firms declined by 0.8% QoQcc - first QoQ decline in 11 quarters - the key disappointment. While revenues in 4Q were especially impacted by sequential decline in Communication and Tech verticals, growth across verticals moderated sequentially. In local currency terms, Americas and Europe both witnessed de-growth, indicating weakness in both regions. Aggregate growth for mid-sized firms was a bit better than large IT firms though they all disappointed in 4Q. TCS and Coforge disappointed the least while Infosys' reported the weakest results.

... derails margin recovery: Aggregate margins for our coverage universe contracted by 20bps QoQ and were 40bps below our expectation, mainly due to revenue miss. Employee cost (-120bps) weighed on margins due to muted growth, while Subcontracting costs (+50bps) and others overheads (+40bps) supported margins. Margin contraction was due to a 40bps compression in margins for large sized firms, partly offset by 100bps margin expansion for mid-sized firms. All large IT firms disappointed on margins, with TechM and Infosys being the weakest. LTIM drove aggregate margin expansion for mid-sized firms.

Intensifying pain in the sector: IT firms continued with cautious commentary on demand environment, highlighting a cut in discretionary IT spends. While bookings were supported by cost takeout and efficiency deals, revenue growth is being impacted by project deferrals, delayed ramp-ups and project cancellations. While Europe seems to be holding better than muted expectations, the worsening sentiment in America (~60% of aggregate revenues) was the key negative. Furthermore, IT firms have turned more cautious on the pricing environment.

Among verticals, IT firms highlighted weakness in Communication, Tech, BFSI, Retail and Mfg verticals.

Slower growth remains a risk: Aggregate headcount for IT firms declined by 8k in 4Q – the second straight quarter of decline - similar to the decline seen in 2020 during Covid. Declining headcount along with a pricing outlook suggests sharp moderation in FY24 - also evident from the FY24 revenue growth guidance given by Infosys/HCL Tech/LTIM. Additionally, IT firms expect a soft 1H, also evident from Wipro's guidance for 1QFY24 of -3 to -1% QoQcc.

A weak exit and a soft 1H implies a tougher ask for 2HFY24, which would necessitate large deal wins/ramp-ups - the absence of which could drive disappointments to consensus US$ revenue growth expectations of 7% in FY24. Our aggregate FY24 revenue growth is 110bps below consensus.

Stay Selective: A weak 4Q and heightened caution led to a 1-6% cut in FY24/25 consensus EPS estimates. The back-ended growth implies further risks to consensus estimates, which could drive further derating. Our FY24/25 EPS estimates are 1-11% below consensus and with the sector still trading at 8% premium to its 10-yr average and 13% premium to Nifty, we remain selective 

Three make-or-break crises impacting the US (ING Bank)

There is a thread running between the three crises being felt in the US right now. The inflation crisis was borne from the pandemic, a politically toxic one. The looming debt ceiling crisis stems from politicking that is more aggravated than ever. And the third crisis is a banking one, in part brought on by a Fed reacting to the inflation crisis. Where now?

Banking crisis development as measured by the Regional Bank Index and FRA / OIS – risky but tolerable

There are a number of indicators that we can track to help assess where we are and where we are likely to get to. Let’s start with the banking story, and the small and regional bank stress on deposits in particular. Here the US Regional Bank Index tracks sentiment. It was at 120 a couple of months back. It’s now at 80. In the rear view mirror the pandemic took it down to 60. Before that, the Great Financial Crisis saw it dip to 40. That’s the potential doom leap, from 80 to 40 ahead. The question is, will it?

So far the answer is probably not. We look here at the 3mth FRA / OIS spread for guidance. It essentially measures the premium that banks impliedly need to pay over risk free rates in forward space. Currently the 3mth FRA / OIS spread is at about 40bp. It spiked to 60bp when Silicon Valley Bank went down. Having journeyed back down to the low 20’s bp, the crescendo in the First Republic story saw it re-edge higher. As the Great Financial Crisis broke some 15 year ago the FRA/OIS spread quickly got up to 70bp, and then gapped to over 150bp.

We’re nowhere near that. The simple reference of neutrality would be the 20’s bp. We are practically double this right now. Troubling, but not discounting a collapse of the system or anything like that.

Inflation crisis resolution as measure by market breakeven inflation rates – reasonably optimistic

The genesis of bank stresses in part reflects the switch in the stance of Fed policy to tightening on mounting inflation concern. Such concern has eased but has not gone away – latest core PCE readings still identify the US as a “5% inflation” economy.

But there is some good news coming from market inflation break-evens, as derived from the difference between conventional Treasury yields and real yields on inflation protected securities. These inflation break-evens not only have 2% handles right along the curve, but moreover are far closer to a big figure 2% than 3%.

In fact, the 2yr breakeven has just this week dipped below 2%. If that’s what gets delivered, the Fed’s hiking job is done and dusted, and indeed the ground is laid to rationalise future cuts. While interest rate cuts likely coincide with higher consumer delinquencies and corporate defaults, and there is a feedback loop to the stresses in the banking system, where pressure in the commercial real estate sector remains under immediate scrutiny. This would become further acute should these inflation expectations not be realised, making in more difficult for the Fed to execute those cushioning cuts.

Debt ceiling crisis as measure by US sovereign Credit Default Swaps – Concerning but fixable

And as we navigate this course, we face into a debt ceiling dilemma laced with political menace that is so intense as to risk a default. Just one missed interest rate payment would imply a default. Market concern on this front is quite elevated, with 5yr Credit Default Swaps now in the 75bp area. This is the highest since the Great Financial Crisis, and is at the widest spread over core eurozone, ever. While there is no cross default in Treasuries, where one defaulted bond pulls the rest into a defaulted state, there would still be a material tarnishing of the Treasury product even if just one interest payment were missed.

Many players would not want to take on the risk of having a defaulted bond on  their books, and the collateral value of Treasuries would come under scrutiny. One default should not take down the system if holders are immediately made whole through a swift resolution of the debt ceiling. But at this same time things could unravel quite quickly and uncontrollably. In essence the entire global financial system is at threat. Note though that while US CDS is indeed elevated, it’s also far from discounting an actual default, it’s just playing the (mild) probability of default.

India strategy: Improved macro, unchanged micro (Kotak Securities)

The market has lapped up the recent improvement in India’s macro—(1) peaking interest rates and (2) better external position (BoP). We hope that the improved macro percolates into better micro over the next few months. 4QFY23 results and management commentary underscored subdued domestic demand in consumption and weak global demand in the outsourcing (IT) sectors. We expect a gradual recovery in domestic consumption over the next 2-4 quarters. Valuations are at risk without a quick recovery.

Improving outlook on global inflation, but muted growth outlook: The global inflation outlook has improved in recent months, as a result of monetary tightening across major DMs, although core inflation has stayed high (see Exhibits 1-2). The progress on inflation has allowed the US Fed to pause its rate hike cycle, but bond markets are pricing in cuts after a brief pause.

We believe the growth outlook may weaken as DM central banks will likely keep rates at peak levels for an extended period of time. Economic conditions are still fairly strong in most DMs.

India’s macroeconomic outlook has improved: India’s macroeconomic outlook has improved with (1) peaking inflation and comfortable inflation trajectory and (2) an improving external sector outlook.

The country’s interest rates may have peaked in the current cycle, which may address concerns about the negative impact of higher interest rates on housing demand. The RBI had already paused its rate hike cycle at its April meeting on expectations of moderation in inflation.

Micro outlook remains muted: Domestic micro remains subdued, with 4QFY23 earnings slightly ahead of our muted expectations. The beat is largely because of lower-than-expected tax rate in the case of RIL. In fact, both consumer and IT companies reported weak results.

We note continued weakness across most consumption categories in 4QFY23), although lending remained robust. Outsourcing companies were impacted by a weak global demand environment.

We expect moderate earnings growth over FY2024-25 (see Exhibit 13), with low scope for earnings upgrades across sectors. We would not rule out earnings downgrades in the consumer discretionary space, as the underlying factors for the current spell of weak demand may sustain for another 2-3 quarters.

‘Rich’ valuations of ‘growth’ stocks may result in further de-rating: The Indian market is trading at reasonable valuations compared with recent history and bond yields after lackluster returns over the past 18-20 months. However, most ‘growth’ stocks, especially in the consumption, investment and outsourcing space, are trading at expensive valuations, despite increasing near-term demand issues and medium-term risks of disruption. Financials remain reasonably valued and appear attractive in the context of a likely healthy credit cycle over the next 1-2 years.

India: Credit offtake remains robust in April’23

Credit offtake rose by 15.9% year on year (y-o-y) for the fortnight ending April 21, 2023. In absolute terms, credit offtake expanded by Rs.19 lakh crore to Rs.138.6 lakh as of April 21, 2023. The growth has continued to be driven by personal loans, NBFCs, and higher working capital requirements.

•      Deposit witnessed a slower growth at 10.2% y-o-y compared to credit for the fortnight ended April 21, 2023. The short-term Weighted Average Call Rate (WACR) has reached 6.70% (as of April 28, 2023) from 3.63% as of April 29, 2022, due to a rise in policy rates and lower liquidity in the system.

•      The Credit to Deposit (CD) Ratio as of April 21, 2023, rose sequentially to 75.7% from 75.0% in the previous fortnight due to incremental credit offtake at Rs 0.1 lakh crore compared to a fall in incremental deposit at Rs 1.4 lakh crore.

India Steel: Healthy spreads despite recent price cut (ICICI Securities)

Major steel companies have pruned their HRC list price by Rs2,000-3,000/te in order to restore the parity wrt imports. Traders were anticipating a price cut in May23’ over the last few weeks, resulting in domestic HRC price progressively reducing by Rs1,000/te in the month of Apr23’. HRC export price from India was down sharply by US$40/te last week, tracking China’s FOB price. Spot HRC spread, however, continues to remain healthy. Factoring in the latest price cut, it is still at Rs33,000/te (Q4FY23: 26,375/te). Hence, we expect profitability of steel companies to improve in Q2FY24.

In China, the focus is shifting from demand revival to possible production cuts in H2CY23 which might undermine global iron ore prices further, but may lead to lower exports. That said, in their respective Q1CY23 result commentaries, global players have indicated an improving demand environment with higher margins in Q2CY23. We maintain our positive outlook on ferrous space led by higher spot spreads; we would keep a close tab on exports from China.

India Chemical: Export witnessing revival, demand stability maintained (SMIFS)

Our chemical channel checks suggest that pickup of demand is gathering with most factories operating at 60-65% utilization up from 35% and expect it to gather pace because supply channel inventory is minimum & demand is witnessing uptick. Majority of commodity chemical prices are witnessing a rebound from the bottom on anticipation of strong demand in the coming months.

Despite global headwinds, India remains on a strong footing in chemicals led by increasing interest of global companies to source from India to de-risk their supply chain, increasing share of speciality chemicals in overall product mix and robust capex aligned by chemical companies to capture future growth. For Indian chemical companies, the coming quarter i.e Q4FY23 is witnessing improvement in margins sequentially owing to rebound in exports volumes and domestic demand firming up. The full recovery in margins should be visible in Q1FY24.

Pharma segment is witnessing rebound in demand & correction of major API prices seems to be over. Agrochemicals demand is steady owing to higher crop prices, though high channel inventory could impact sales in the near term. Shipping rates and container availability have reached pre covid levels. Currently, crude oil prices are trading in a narrow band which will provide stability in downstream chemical prices of basic chemicals which will aide margins in the coming quarters. Valuations of most chemical companies seems reasonable factoring in largely the pain gone by & seems ripe for bottom fishing opportunities for those investors who wish to play on the recovery cycle going ahead. The cautious approach in chemicals is the impact of the global slowdown amid lingering recession worries which remains a watchful factor.

India Building Materials: A stampede to paint the town? (Investec)

Building material proxies have sought to widen Total Addressable Market (TAM) citing variety of reasons. We highlight moat for each category is different and often beyond demand push vs. brand pull. Bundling, store economics and business to applicator to take centre stage going forward and only few winners to emerge. Our new trademark / ROC database highlights more entrants into attractive paints category and concur with house view on increasing competitive intensity here.

Chasing TAM – push or pull: BM names have sought to widen TAM by venturing into multiple categories and have cited rationale of a) growth optionality, b) channel synergies, c) connect with influencers, d) connect with applicators, e) better capital deployment (vs higher pay-outs) and e) incremental RoCE. Based on our checks with channel/ influencers, the mantra is simple, brand pull works where products are visible post installation (faucetware, paints, even tanks); if not, applicator/ store economics (bundling) dictate push. We cite companies with healthy B/S have resorted to cash burn or chase volumes at cost of quality, not the best proposition.

TAM isn’t enough, need enablers to execute same: While cumulative TAM for BM categories (paints, construction chemicals, adhesives, consumer durables, bathware, ceramics, plumbing, wood+) is at $30b+ and headline growth rates/economics attractive, we find underlying enablers often lagging. For e.g., we cite ceramic plays who forayed into bathware ~7-8years back, and despite strong brand/distribution have achieved little (<Rs3b revenues p.a.).

We cite multiple reasons for disappointment in above case: a) Applicator: mason doesn’t fix a faucet, it’s a plumber (i.e., mason isn’t a plumber and DIY is still some time away), b) Ceramics is a dead product vs. faucet, a live product. Hence, after-sales is key, c) Channel’s willingness to cross-sell: Despite bathware potentially offering better margins and return ratios, selling bathware implies more hassle (vs. ceramics), given after-sales and number of parts.

Trademark/ROC checks: Based on our new proprietary database, we find several new players ready to foray into paints as a category, which is large attractive segment with incrementally high competitive intensity. We find Pidilite (brand: Haisha), Adani (into TiO2), Hyderabad Industries (HIL IN, NR), Wonder Cement as potential entrants, besides, known ones like Grasim.

Few winners: Several coverage plays have ventured into the paints category, and we expect only a few to thrive.