Vijay Kumar Gaba: November 2023

Thursday, November 30, 2023

Conquering the guilt and normalizing

Last year, the former Japanese prime minister Shinzo Abe was assassinated while he was addressing a public meeting. This is perhaps the first of its kind of act of violence since assassination of Inejirō Asanuma, the then Chairman of the Japan Socialist Party, in 1960. The visuals of Abe’s assassination may have shattered the image of Japan, most people would be carrying in their mind, viz., the image of most courteous people showing remarkable patience and calmness in their public behavior.

The post WW2 generation had only witnessed Japanese people who were extra polite, patient, courteous, and cooperative. These Japanese were very different from the pre-WW2 Japanese, who took pride in their martial and imperialistic traditions. Political assassinations were commonplace. The Japanese Army was considered one of the most brutal forces. The imperialist Japanese occupied parts of Russia, China, and Korea; plundered their wealth, and enslaved their women. The 1945 nuclear attack on Nagasaki and Hiroshima perhaps overwhelmed the Japanese society, burdening it with the guilt of being one of the main characters in the two disastrous world wars and losing its pride to the allied forces led by the US and Russia.

In fact, this is not only in Japan. After decimation of the manifest fascist forces (e.g., Germany, Japan and Italy) and imperialistic forces like Great Britain and Austro-Hungarian empire post WWII, the world has been a rather peaceful place as compared to the preceding 2000yrs. The conflicts post WWII have mostly been contained. Even during the height of the cold war between NATO and Warsaw Pact countries, and shenanigans of star-wars, there had never been a threat of escalation to the scale of a larger World War.

However, if we correlate some of the events and trends in the past couple of years, the picture that would emerge is not very comforting. For example, consider the following events and trends:

· Assassination of Shinzo Abe.

· Numerous acts of violence across USA and Europe, apparently perpetrated by random people who are not radicalized.

· Blatant violation of international laws by Russia in invading Ukraine, and botched attempts of NATO allies to internationalize the issue (contrary to the containment during earlier Crimea invasion).

· Internationalization of recent hostilities between Israel and Hamas.

· China is aggressively threatening its neighbors’ territorial and economic integrity.

· USA handing over Afghanistan to Taliban.

· Hyper nationalist right aligned leaders/parties winning elections in Italy, Argentina, Netherlands; while hardline leftists won elections (re-elections) in many jurisdictions, e.g., Germany, France, Australia, Chile, Mexico, Bolvia, Brazil, Peru, Honduras, and Columbia, etc. Both the Chinese premier Xi Jinping and Russian premier Vladimir Putin are firmly entrenched in respective offices for as long as they wish, and actively working to polarize the world.

· Reliance of population on governments for meeting basic needs rising exponentially along with the rise in the financial and fiscal vulnerabilities across the globe.

· Frequency of mass public protests rising in various jurisdictions.

· Tendency of governments to overregulate and over govern increasing across jurisdictions.

Besides, the commodity producing emerging economies which felt that they have been at the mercy of the financialized western world due to overwhelming dominance of USD on global trade, have been grouping (expansion of BRICS, BRI of China, etc.) to be in a position to command terms of trade.

I get a sense that the world is now in the last phase of erasing the guilt of the two world wars. In the next two decades, the real threat humanity faces is the threat of the human race returning to its normal self – unabashedly intolerant, violent, greedy, imperialist, as they were mostly in the pre-WW2 era, ending the era of prolonged peace since 1945.

The recent Russia-Ukraine and Israel-Palestine episodes have already demonstrated that territorial occupation is becoming acceptable, just like 19^th century. It is common to hear about imminent alteration of status quo in Taiwan and Pakistan occupied Kashmir. Blatant defense of merciless killing of innocent children and women in Gaza, acceptance of suppression of women by Taliban in Afghanistan, and killing of Uighur Muslims in China indicate the change in global thinking. Regrouping of Arabs with Russia and China alliance against the interest of the western world is also a pointer to the potential shape global order might be taking in next couple of decades.

Where does India stand in this transition of global order and what small investors like me should be doing under these circumstances?

Will share my thoughts on this in the coming weeks.

Wednesday, November 29, 2023

To buy gold or not?

The first tranche of Sovereign Gold Bonds (SGB 2015-I), issued in November 2015 are maturing tomorrow (30 November 2023). The final redemption price of the bond has been fixed at Rs6132 per SGB unit. SGB carries a coupon rate of 2.5% p.a, payable at six-month intervals. The investors in SGB (2015-I) have thus earned a 12.7% CAGR on their investment.

To put this return in context, the Nifty50 index has grown at 12.4% CAGR in this period. An average Large-cap mutual fund has yielded ~13.75% CAGR; an average Small-cap fund has yielded ~23% CAGR and an average Gilt fund has yielded ~7.25% CAGR over the past eight-year period.

Of course, the return of equity and gold are not comparable as equities carry much higher risk and entail significantly large volatility. The risk profile of SGB and a normal gold ETF is different since SGB bears a coupon of 2.5% p.a., has no management fee, and carries an implicit sovereign guarantee. It may be considered better than holding physical gold as it is offered in dematerialized form and thus has no holding cost or theft risk; though there is a potential roll-over risk. Besides, if held till maturity, the return on SGB is exempt from capital gains tax, unlike Gold ETF and physical gold which are subject to usual capital gain tax.

The household investors who shall receive the redemption amount in a day or two therefore face two questions —

(i) Whether they should maintain their allocation to gold, reduce the allocation, or increase the allocation under the current circumstances?

(ii) Whether they should wait for the next issuance of SGB and redeploy the redemption proceeds in such bonds (last SGB issue happened in September 2023 @Rs5923)?

I would like the household investors to consider the following data points in answering these two questions:

· A significant part of return on gold is due to the depreciation in the INR as compared to USD. Adjusted for USDINR variation, SGB (2015-I) return would be ~10.3% as compared to the present 12.7%. A weaker USD, as widely expected, could negatively impact the SGB returns in future.

· The current USD gold price is almost the same as it was in July 2020. In this period Indian gold prices have risen ~20%. Adjusted for USDINR changes and hike in custom duties, the Indian gold prices have hardly changed since then. So, investment in gold has been more of a currency and duty arbitrage than anything else. Remember, the last three years have seen pandemic, massive monetary dilution, unprecedented fiscal profligacy, four-decade high inflation in the developed economies, worst geopolitical crisis in Iraq war, huge gold buying by central banks – all catalyst for a super bull market in gold, if we analyze from a historical perspective.

· At the current price, SGB issued in August 2020 are yielding ~5.5% CAGR only, less than an average gilt fund. Considering that interest rates might have peaked, return in gilt funds could improve further in the coming years.

· Bitcoin, which is gaining popularity as an alternative asset, has massively outperformed gold in the past eight years, three years and one-year timeframes. It is widely forecasted to continue to outperform the yellow metal in future also.

Friday, November 24, 2023

Some notable research snippets of the week

Global Economics Intelligence executive summary, October 2023 (McKinsey & Co)

The global outlook is unchanged despite weaker readings in trade, consumer confidence, and business activity. Still-elevated inflation and interest rates are acting as headwinds to economic growth.

According to the International Monetary Fund’s (IMF) October World Economic Outlook, global growth is forecast to slow from 3.5% in 2022 to 3.0% in 2023 and 2.9% in 2024 (Exhibit 1). This is similar to April’s report, which forecasted global growth of 2.8% in 2023 and 3.0% in 2024. Furthermore, the October report states that, although the likelihood of a hard landing has decreased over the past six months, China’s property sector crisis could deepen. Near-term inflation expectations have increased and, in turn, could contribute to the persistence of core inflation pressures. Furthermore, more than half of low-income developing countries are in or at high risk of debt distress. The Conference Board shows that US real GDP increased by 4.9% in the third quarter. In the eurozone, third-quarter economic growth was weaker than expected, with GDP falling by 0.1% quarter-over-quarter (for a 0.1% year-over-year rise). In the emerging economies, China’s GDP growth in the third quarter slowed to 4.9% year-over-year (compared with 6.3% in the second quarter), reflecting the fading influence of the base effect. During this time, GDP expanded by 5.2%.

There are mixed signals from global trade. Exports rose for Russia and the United States but fell for Brazil, China, and the eurozone; imports increased for Brazil, Russia, and the United States but fell for China. In China, cross-border trade continued to decline in the third quarter, with a year-over-year drop of –10.2% (–6.0% in the second quarter), exports dropped by –10.8% in the third quarter (compared with a –5.4% decline in the second quarter). Imports decreased by –9.4% (–7.0% in the second quarter). In addition, the Container Throughput Index increased to 129.6 points in August, compared with the previous month (128.0 points revised). European throughput fell, while Chinese ports continued to strengthen.

Overall consumer confidence declined, primarily due to elevated interest rates. Notably, households in Brazil are the exception because they remain more inclined to spend than save. On this point, consumer confidence in Brazil increased to 97.0, the highest reading since February 2014. By contrast, confidence deteriorated in the eurozone, dropping 17.8 after recovering from last year’s historic low. The United Kingdom also saw steep decline. There, the cost-of-living crisis, a slowing jobs market, and the uncertainties posed by the conflict in the Middle East are contributing to a growing unease in consumer sentiment. The view is a bit more nuanced in India. The sales growth for September was 9% year-over-year, which suggests that consumer sentiment remains optimistic, despite economic uncertainties.

The manufacturing sector has been in contraction for 13 consecutive months. In the eurozone, purchasing managers’ index (PMI) numbers for manufacturing remain in contraction primarily because of declining demand.

Similarly, momentum in services is weakening, with most countries experiencing either stagnation or contraction (only India and Russia are exceptions). In the United States, the services PMI decreased to 50.1 (50.5 in August).

Q2FY24 Review: In-line earnings despite topline miss (Elara Capital)

Earnings growth continue to be fueled by domestic cyclicals

Aggregate topline performance of Elara coverage universe (235 stocks) disappointed, up just 3.6% YoY, falling short by 2.6% versus our expectations. Earnings growth of 65.8%, however, was in-line, led by Energy. Ex-Financials EBITDA margin stood at 17%, expanding 609bps YoY and 10bps sequentially.

A 6.3x profit surge for Energy, led by oil marketing companies (OMCs), spiked earnings of Elara coverage universe by 66% for Q2FY24. Excluding Energy, earnings growth was healthy at ~32%, primarily led by domestic cyclicals sectors such as Auto and BFSI.

Earnings for Auto, ex-Tata Motors, grew 57.4%, led by a combination of better product mix, lower commodity costs and operating leverage.

Earnings growth for BFSI was broadly in line, owing to steady loan growth and robust asset quality even as margins compressed further.

Elara Cement universe reported double-digit YoY volume growth for the second quarter. A YoY uptick in realization and a YoY drop in operating cost (due to normalization of fuel cost post the spike during the Russian-Ukraine war) sharply improved YoY margin.

Beat-to-miss ratio improved to 1.1x in Q2

Within Elara coverage universe, 36% of the companies saw earnings beat (actual results exceeded estimate by >5%), while 32% of the companies saw an earnings miss. The beat-to-miss ratio improved marginally from 1x in Q1 to 1.1x. This uptick was primarily driven by Banks, Industrials and Metals that outperformed expectations.

Diving deeper, large-cap companies demonstrated stronger resilience, with a beat-to-miss ratio of 1.5x. Mid-caps also fared better with a ratio of 1.4x. But small-caps underperformed with a beat-to-miss ratio of 0.8x.

Earnings see upgrades but breadth low

We raise FY24E earnings expectations for Elara coverage universe by 3.3%. Commodity-oriented sectors saw the highest earnings upgrade of 9.1%, but the breadth of revision remained concentrated in Energy and Cement. Industrials and Real Estate were the other notable sectors to see healthy earnings upgrades, while Metals and IT were the main laggards, with 60% and 36% of the companies seeing earnings downgrade.

We increase our earnings growth expectations for FY24E by 3.3ppt to 35.7% and for FY25E by 2.8ppt to 11.9%.

Twenty-two companies have seen ratings upgrade post Q2 results, of which six are large-caps. Seventeen have seen ratings downgrade. Within large-caps, Tata Motors, Ambuja Cements, Bharat Petroleum, ONGC, Cholamandalam Investment and Larsen & Toubro have seen a ratings upgrade, while SBI Cards and Payment Services and Tata Power have seen a ratings downgrade, in Q2.

Quant Research: Mean-reversion and momentum – a dynamic duo (Kotak Securities)

There are two major driving forces in financial markets: mean reversion and trend. We have written at length about momentum portfolios. In this note, we look at how to create mean-reversion portfolios. We try to strip the stock-specific return component from the total returns of the stock and run the mean-reversion strategy on it. We divide our universe into different clusters and create a long-short portfolio that picks stocks from each cluster.

Mean reversion and momentum

Mean reversion and momentum are the two major driving forces in financial markets. Mean reversion is the tendency of recent winners to underperform and recent losers to outperform. On the other hand, momentum is the tendency of the winners to continue to outperform, while the losers continue to underperform. We have written in detail about momentum in the past (Strength in Diversity). In this note, we use similar principles to create a mean-reversion portfolio.

Focusing on stock-specific returns help

While constructing a mean-reversion here, we use stock-specific returns only. The key idea is that returns that are not affected by the key market themes (e.g., re-opening after Covid-19 lockdowns, some sectors catching a tailwind, ‘value’ stocks having a strong recovery) are more likely to revert. To strip out the stock-specific returns, we use a technique called Principal Component Analysis (PCA). PCA is a statistical method used to reduce the dimensionality of data by identifying the most significant patterns and relationships among variables.

It achieves this by transforming the original variables into a new set of uncorrelated variables called principal components. This process aids in identifying the key factors driving variability and facilitates a more straightforward analysis of the underlying structure within the data. We also divide the universe in clusters and pick the best-performing stock from each cluster in the short portfolio and the worst-performing stock in the long portfolio. The portfolios are weighted in the inverse of the stock volatility, giving higher weight to lower-volatility stocks. While constructing the long-short portfolio, we short 0.8 units of the short portfolio for a 1-unit long.

Long-short mean-reversion portfolio delivers consistent returns

The long-short mean-reversion portfolio delivers close to 12% annualized returns with a volatility of 12%. These returns are uncorrelated to the market. In addition, there has been only one calendar year where the returns of the long-short mean-reversion portfolio have been negative. The long-mean reversion portfolio outperforms the index significantly, delivering 18.2% annualized returns, compared to 10.2% annualized for the Nifty-50 index. When we combined the optimized momentum long-short portfolio as described in Strength in Diversity with the mean-reversion long-short portfolio, the combined portfolio delivers ~12% annualized returns at 7.5% volatility.

Logistics: Continuous optimism in sight (ICICI Securities)

Q2FY24 was a mixed bag. Key points: 1) Rail companies trumped surface express companies. 2) Volume growth across companies. 3) Street raises TPs for BlueDart Express (BDE), CONCOR and Gateway Distriparks (GDI), but slashes for Mahindra Logistics (MLL) and VRL Logistics (VRL). 4) Street lowers EBITDA estimates for all companies. 5) Post- results, stock reaction was best for CONCOR but subdued for MLL and VRL. We believe that earnings for most of the companies in this space could improve in Q3FY24 with the quarter being dotted with festivities. Additionally, we will keep an eye on the EXIM trade imbalance.

A mixed big

Performance of the companies under our coverage was mixed with rail companies having a distinct edge over surface express ones. Key points: 1) Shipments/volumes increased across all the companies, especially, BDE (up 13.6% YoY), VRL (up 8.4% YoY) and CONCOR (up 7.6% YoY). 2) Profitability improved for all the companies under coverage, except MLL and VRL. 3) In the case of ICDs/CFSs, weakness in EXIM volume (overall) and EXIM imbalance remain key concerns, though the demand scenario is improving.

Overall, we saw both profit margins and volume inching up across the companies (predominantly for CONCOR and BDE) though VRL’s performance was subdued, mainly due to delayed festive seasons. The companies across the spectrum retained their volume guidance for FY24 and expect Q3FY24 to be better owing to the festive season.

Street’s post-earnings moves

Post-Q2FY24 earnings, while Street has trimmed FY24 EBITDA estimates for most of the companies, especially MLL (12.4%), FY25 EBITDA estimates have been broadly retained, except for MLL (slashed by 8%). Similarly, TPs (largely based on FY25E performance) have been cut by 6-7% for TCIE and MLL, but, raised by 6% for CONCOR. In our view, street’s raised multiples for CONCOR and BDE are possibly due to better growth outlook; albeit reduced slightly TCIE‘s case.

Our post-earnings stance

We are now more positive on the industry as margins have seemingly troughed for most of the companies under coverage and volume growth will likely remain healthy. Except notably for CONCOR (up 8.6%), factoring in the sharp upswing in its domestic business.

NBFCs: Customer acquisition driving growth; asset quality healthy (ICICI Securities)

New customer acquisition has gathered pace post covid and, more specifically, it has accelerated during the past six months. This is reflected in 6mn unique borrower addition between Dec’22 and May’23, implying a monthly run-rate of 1.2mn customers’ vs 0.7mn between Mar’22 and Dec’22. As a result, bulk of incremental AUM growth during the past one year was driven by new customer acquisition and flattish average ticket size. AUM grew 18% since Mar’22, of which growth driven by new borrower stood at 16% and the rest 1% was contributed by an increase in the outstanding per borrower. Notably, underlying asset quality trend continues to be robust as reflected in PAR 30-90 DPD bucket at system level of 1% as of May’23.

New customer acquisition gathers pace

Incremental growth in industry has been largely driven by accelerated new customer acquisition since Mar’22. MFI industry has witnessed robust 18% AUM growth between Mar’22 and May’23, of which 16% growth was driven by new customer acquisition. As a result, outstanding per borrower broadly remained flat at ~INR 50,000 between Mar’22 and May’23. During covid phase (Mar’20-22), AUM grew 11% and was entirely driven by higher ticket size as reflected in outstanding per borrower increasing to INR 50,000 by Mar’22 from INR 40,000 in Mar’20, implying an increase of 12% between Mar’20-22.

New customer acquisition run-rate increased to 1.2mn per month between Dec’22 and May’23 from 0.7mn per month during Mar-Dec’22. Unique borrower base at industry level increased to 70mn by May’23 vs 58mn in Mar’22 and 59mn in Mar’20. Net borrower base between Mar’22 and Sep’23 has grown by highest 23% for Fusion, followed by 13% for CA Grameen and 10% for Spandana.

Underlying asset quality trend continues to be robust as reflected in

collections (ex arrears, including NPA) at ~97-98% ...

Collection efficiency remained robust in FY23 and sustained in Q2FY24. Broadly, collection (ex arrears but including NPAs) remained at around 97%-98% with collections for CA Grameen at 98.7%, Spandana at 97.7%, Utkarsh at 97%, Fusion at 95.5% and Bandhan at 94%. Robust collections also led to PAR 1+portfolio (ex Bandhan) settling at average 3% with 1.3% for CA Grameen, 2.6% for Ujjivan, 3.2% for Satin, 3.4% for Spandana and 6% for Utkarsh.

...except Punjab and Haryana

While collection efficiency remained robust across states, industry data suggests Punjab and Haryana are facing some challenges as reflected in PAR >30 increasing to 6.6% by Jun’23 from 6.3% in Mar’23 for Punjab and 5% from 4% for Haryana. PAR >30 for rest of the states has either improved or remained flat QoQ between Mar’23 andJun’23.

Our view

Cleaner balance sheet, negligible stressed asset pool as of Jun’23 and revised MFI regulations (removal of pricing cap and mandatory comprehensive bureau report) would continue to act as strong industry tailwinds going ahead.

Chemicals: 2H to be better than 1H – Unanimous guidance (Centrum)

Q2 was a disappointing quarter all across the chemicals segment however agrochemicals results were a mixed bag. Severely impacted by demand weakness in exports markets coupled with pricing pressure, chemical companies reported their weakest performance in past several quarters. China dumping slowed down, however inventory destocking still continued in global market impacting the exports performance. Agrochemicals, reported mixed performance and were impacted by dry spell in August. Fluorochemicals too suffered from export demand weakness coupled with pricing pressure. ECU decline continued in Chlor-Alkali segment with average ECU at ~Rs26,000/ MT. In Q2, on 2^nd August, domestic Soda Ash prices were revised downwards by ~6% to Rs29,800/ MT (Tata Chemicals). Soda Ash prices averaged at ~Rs30,400/ MT while demand was impacted due to increasing imports particularly from Russia, US, and Turkey. For chemicals sector some pain from exports market may prevail in Q3FY24E due to lean inventories by global companies. However, generally managements unanimously guided 2HFY24E to be better than 1H.

Management comments on operating environment

RM environment – High cost inventories are largely exhausted during 1H and now the low cost RM shall start reflecting in financial performance. China dumping has slowed down, however, volatility due to volatile crude prices still remains.

Energy/ power/ coal costs – Power/ coal costs have again started moving up which were on a downward trend since past few quarters. Utilities cost has thus started going up slowly. Both domestic and international logistics costs have been normalised.

Exports – Exports remained under pressure in Q2 as the global inventory destocking continued. However, the destocking in chemicals is now approaching the end and normalised demand shall start in near future. Agrochemicals still faces inventory challenges and is likely to remain under check at least for the next couple of quarters.

CRAMS/ CSM/ Fluorochemicals – Fluorochemicals demand in exports market suffered in Q2 and prices also remained under check. CRAMS/ CSM other than fluorochemicals reported mixed performance.

Agrochem – Erratic rainfall and dry spell in August impacted demand for agrochemicals during the Kharif season. Pricing pressure due to lower generics prices globally too impacted overall performance. Some agrochemical companies witnessed good demand for their products with leaner channel inventories while others suffered from higher channel inventories coupled with pricing pressure in certain generic molecules.

Operating performance of Chemical companies in Q2FY24

Total 38 (excl. Tata Chemicals) – Gross margins (GMs) contracted 128bps QoQ and 54bps YoY signifying some pricing pressure despite lowering RM cost inflation. EBITDA margins contracted 25bps QoQ primarily impacted by GM pressure. Despite YoY contraction in GMs, EBITDA margins expanded 61bps YoY signifying benefits from lower opex including lower energy, power, fuel, and logistics costs

Large 17 (excl. Tata Chemicals) – Gross margins contracted 103bps QoQ and 173bps YoY while EBITDA margins contracted 45bps QoQ and expanded marginally by 6bps YoY

Mid-size 14 – Gross margins contacted 14bps QoQ while expanded 75bps YoY (benefit from YoY RM cost deflation). Lower operating costs led to EBITDA margin expansion by 101bps QoQ and 171bps YoY

Small 7 – Gross margins expanded 117bps QoQ while contracted 229bps YoY, EBITDA margins expanded 68bps QoQ while contracted 221bps YoY

Operating performance of Agrochemical companies in Q2FY24

Total 10 (excl. UPL) – Gross margins expanded 318bps QoQ while contracted 76bps YoY while EBITDA margins contracted 71bps QoQ and marginal 6bps YoY

Financial performance in Q2FY24

Total 39 chemical companies – Revenues declined 9.3% YoY impacted by demand challenges and pricing pressure, however remained flattish QoQ. EBITDA declined significantly by 20.4% YoY led by operating deleverage. Sequentially too EBITDA declined 6.5% impacted by demand issues particularly in exports market. PAT plummeted 30.3% YoY while 6.2% QoQ

Steel: India imported highest steel in Oct’23 in one year (Centrum)

The steel price in domestic market was able to hold its ground while China was facing demand slowdown leading to fall in prices. This resulted a premium of >10% compared to landed cost of imports from China and South Korea. Due to huge profitable arbitrage, buyers preferred imported steel over domestic and hence total steel imports in October 2023 stood highest at 0.73mt in last one year. Currently, the difference has closed down to just 1.7% over landed cost of imports.

Steel production in China has declined for the fifth month in a row; below 80mt mark first time in 2023 In October 2023, Chinese steel companies scaled back their steel production by 3.7% MoM/1.8% YoY, reaching a total output of 79.09 million tons. China steel production is consistently reducing highs of 95.7mt in March-2023. Steel production in the country fell majorly due to soaring iron ore and coking coal costs along with dampness in demand from real estate sector.

International iron ore price shoots up despite demand weakness in China; China iron ore inventory at 7 years low Iron ore price has been above USD100/t throughout CY2023. Further, despite bleak demand outlook owing to stress in housing, it has surged to 8 month high and is up by 10% MoM. The primary reason is due to falling demand, the supply chain stayed away to build inventory while steel production remain steady and is up 2.5% YoY YTD resulted into iron ore inventory touched 7 year low to 105mt in mid-November. Along with series of stimulus efforts and recent announcement of selling 1 trillion yuan bonds for infrastructure projects boosted demand recovery prospects and supported sharp surge in iron ore prices. Concerns over disruption in supply due to possible strike in BHP Australia has also played its role. However, uncertainty on demand recovery, steel production cuts and any steps taken by government to curb spike in prices could add bearish risk for the iron ore market.

ArcelorMittal expects Europe steel consumption to turn negative in CY23 ArcellorMittal expects Europe’s apparent steel consumption to further degrade in Q4CY23 and can end in negative growth territory for 2023. The steel consumption is expected to be below bottom end of its forecast between 0.5% decline and 1.5% growth due to weak demand and construction activity. Although, global ex China apparent steel consumption is expected to remain on positive front of 1-2% in 2023.

Thursday, November 23, 2023

Is a bull market forming in commodities?

I have been tracking the news flow and experts’ opinions regarding the developments in global commodities markets for the past couple of years. Of course, I am a novice in matters of global economics, trade, and finance; but the commodities markets are particularly something I could never understand.

From my elementary understanding of economics and human behavior, I understand that aging demography, deeper & wider penetration of dematerialization & digitalization in human lives, rising awareness about climate change, and deteriorating growth potential of the developed economies, and perhaps China also, definitely do not augur well for the commodities’ demand in the long term (10-15yrs). However, the opinion of experts is overwhelmingly in favor of a bull market in commodities in the short term (2-5yrs).

The key arguments presented by experts in favor of a bull market in commodities could be summarized as follows:

(a) Energy prices have corrected back to the pre-covid period. European power prices, US gas prices, natural gas prices, coal prices, and crude oil prices are back to more “normal” levels. The latest inventory, consumption, and production forecasts for 2024 and 2025 are indicating further easing in energy prices over the next couple of years. Energy being one of the major costs in the production of commodities, lower energy costs and adequate supply is a bullish argument for commodities.

(b) Focus on the use of clean energy, particularly for mobility and electricity production, is changing the demand mix for metals. The demand for metals like copper, aluminum, lithium etc. is rising much faster than the supply. The stockpiles are diminishing fast.

(c) Commodity producers, mostly emerging economies, are getting stronger in global strategic balance. The expansion of BRICS to include more commodity producers in the emerging market alliance is just one instance. These economies are now in a much better position in determining the terms of trade, which are dominated by the financialized developed world in the extant global order.

(d) The geopolitical conditions are worsening. Presently, two fronts (Palestine and Ukraine) are witnessing open war. The fear is that more fronts could open in the next couple of years as the political stands are hardening and no one is showing signs of backing out. Wars have been traditionally bullish arguments for commodities as demand for war equipment and reconstruction work need more metals and building materials.

(e) There is not much consensus on this point, but a strong view is that USD as a global currency may have peaked and could potentially see a steady decline over the next many years. The share of global trade invoiced in USD terms and USD reserves of global central bankers have witnessed a consistent decline in recent years. Moreover, the cross-border flow of funds from the US has witnessed a sharp rise in 2023. Unsustainable US public debt has led to a downgrade of the US sovereign rating outlook. Besides, the trade conflict with China has led to a conspicuous shift of technological advantage from the US to China. These trends may consolidate the position of commodity-producing emerging economies enabling them to seek favorable terms of trade.

(f) Bloomberg Commodity Index is presently at the same level it was in November 1995.

I have avoided investment in commodity producers for a few years now. I think more study of trends in the commodities market, and a review of investment strategy is due.

Wednesday, November 22, 2023

Are financial services getting commoditized

Have you recently received calls, emails, and/or text messages from banks and NBFCs offering a variety of products and services? If the name of the institution making the offer is removed, would you be able to differentiate which call, email, or message came from which institution? Do they all not look and sound the same?

· They all offer credit cards with attractive cashback offers, discounts, access to airport lounges, flexible limits, and purchase protection.

· A few years ago, Yes Bank started offering higher rates on saving accounts (with conditions). Many other banks like RBL, AU, Kotak, IDFC First etc. followed suit.

· There is not much to differentiate between SME, Housing, and personal loan offerings of various banks and NBFCs.

· Most banks have made retail/consumer business a priority and announced a strategy to increase the portion of retail credit in their overall credit slate.

· They offer tech-driven solutions, claiming their platform to be the best in class; though there is not much to differentiate in the tech platforms of the top 15 banks, which account for about two-third of the total credit market.

This was not the case three decades ago, when the process of privatization of banks and liberalization of NBFCs started. The new-age banks came out with materially differentiated offerings.

ICICI Bank and IDBI Bank, due to their origins, were specialists in project finance. Kotak Bank, having graduated from a leasing NBFC, was considered a specialist in equipment financing. HDFC Bank was a pioneer in capital market business, corporate salary accounts etc., and housing finance. The large public sector banks were specialists in social and priority sector financing as well as funding of large infrastructure and industrial projects with long gestation and payback periods. Small PSU Banks would focus on consumer finance and personal loans. Foreign banks like CITI, Standard Chartered, HSBC etc. serviced large corporates, mostly with foreign trade linkages, MNCs, and HNIs. Private Banking (and credit card) was mostly a domain of foreign banks with CITI having a majority share. Now all banks offer all services. The share of foreign banks has gradually reduced.

Points to ponder over for investors are (i) When the financial and banking services become commoditized, Is there a case for a sharp valuation differential in banks and NBFCs? and (ii) Is there a strong case for the cyclical and commoditized Indian financial sector to trade at a significant premium to its global peers, especially the ones that are much larger and better capitalized?

Some may argue, these doubts are too premature and should be put to rest for at least another decade. I see some merit in this argument insofar as the valuation of Indian financials relative to the global peers is concerned. The Indian financial system and financial services may continue to grow at a much faster rate as a significant part of the population is still underpenetrated and underserved, and the segment of the population that lives from paycheck to paycheck and relies heavily on rolling credit is growing fast. However, insofar as the valuation differential of the top 15 banks is concerned, the question might need to be examined much earlier.

Tuesday, November 21, 2023

Investment strategy challenge - 2

Before going on the Diwali break, I had mentioned some of the investment strategy challenges (see here) that a tiny investor like myself is facing due to sharp divergence in the macroeconomic evidence and market performance. Speaking specifically in the Indian context, the macroeconomic evidence is not particularly strong to support the investors’ enthusiasm.

The market participants are spinning new stories to overcome every new challenge. For example, consider the following—

Overheated consumer credit market

Last month, the Reserve Bank of India expressed concerns about the overheating consumer finance market. His statement read, “Certain components of personal loans are, however, recording very high growth. These are being closely monitored by the Reserve Bank for any signs of incipient stress. Banks and NBFCs would be well advised to strengthen their internal surveillance mechanisms, address the build-up of risks, if any, and institute suitable safeguards in their own interest.”

It is pertinent to note that the “Personal loan” segment of the overall credit has been growing at the fastest pace in the past eighteen months. In particular, the credit card outstandings witnessed over 25% growth in this period, as compared to the about 15% growth for the overall credit.

The unsecured personal loan growth has come on the back of mostly stagnant real incomes for households, declining personal savings, a sharp rise in household energy, education, and healthcare inflation, poor consumer non-discretionary spending growth, and strong discretionary (mostly aspirational) spending. Obviously, the unsecured personal loan growth is unsustainable as it is accompanied by a deterioration in the servicing capability.

The Governor’s concerns were ignored by the lenders as well as borrowers, forcing the regulator to take strict measures to put a leash on the runaway consumer credit growth. Last week, the RBI increased the risk weights for the consumer credit exposure of banks, NBFCs, and credit card outstandings, lowering their lending capacities.

In light of these developments, the natural reaction of the markets ought to have been “caution” on consumption and consumer finance. The actual market performance is however nowhere closer to this assumption. As against ~8.7% YTD rise in the benchmark Nifty50, Nifty Auto has risen ~33%, Nifty FMCG has risen ~19%, and Nifty India Consumption is higher by ~16%.

Belying the expectations that some part of the unsecured consumer loans is being used to facilitate margin trading in the stock market, and this segment could get impacted materially, in the last week, NSE witnessed the highest average daily volume in the past six weeks.

Moreover, the Realty sector should be impacted materially by the stricter norms for consumer loans and restrictions on the lending capacity of the lenders, is the best-performing sector YTD, with Nifty Realty rising over 60% YTD and ~4.5% in the past week.

Instead of reducing exposure to the financial sector per se, the market participants seem to have moved some exposure to non-lending financial companies like Insurance companies, asset management companies, etc. This sounds even more counterintuitive, considering that insurance and savings in mutual funds are mostly a discretionary option for Indian households.

Ignoring the impact on consumption and the deteriorating debt servicing profile of households, rating agencies have chosen to focus on the stronger risk-absorbing capacity of the lender due to RBI’s restrictive move. They have also ignored the impact on profitability (hence a case for de-rating) as the growth in the most profitable segment gets restricted.

Ignoring bad news

The market has been ignoring all the negative news flows about a leading business group for the past many months. It also ignored the banning of two key products (contributing 19% of its customer base) of a leading consumer lending company for non-compliance, arguing it is a short-term concern. The market has received positively all news relating to the divestment of government’s stake in PSEs through FPOs, taking advantage of unsustainable high prices, ignoring the total failure to make even one strategic disinvestment. Multiple disasters in Himachal Pradesh, Uttarakhand, Sikkim etc. have not evoked any change in the estimates for spending on road and hydroelectric projects. Not many appear to have made revisions in USDINR estimates due to the worsening current account position.

…and latching on to hopes

The minister made a random statement that the government is planning to start 3000 new trains to make sure that everyone gets a confirmed ticket. The railways related stocks zoomed 5-20% on this statement. No one questioned where these 3000 new trains would run? Could the existing rail infrastructure support so many new trains when we are hearing about one train accident almost every week. The dedicated freight corridor projects have been running late for many years. The Udhampur-Kashmir valley train project is running behind schedule for about two decades. How much time would this new plan take to implement is anyone’s guess.

Moving away from the core

Not long ago, divesting non-core business was a major re-rating argument for many stocks. Recently, many companies have announced diversification into unrelated businesses; but the market participants have either ignored such diversifications or built arguments to support these. For example, an adhesive manufacturer and a metal pipe manufacturer have started lending business but the market appears nonchalant about this. A few years ago, an electric appliance company starting an NBFC was punished so severely that it had to abandon the plans within months.

Under these circumstances it is a serious challenge to stay calm – not get carried away by the market momentum; overcome FOMO; and find appropriately valued stocks for small investors with limited resources and information. It is a daily struggle to suppress the demon of greed; face the agony of a sharp underperformance as compared to the peers, who are swimming with the current; and be content with a reasonable (and sustainable) return.

Thursday, November 9, 2023

Investment strategy challenge

Wishing all the readers, family, and friends a very Happy Diwali. May the Lord enlighten all of us and relieve everyone from pain and misery.

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The growth is slowing across the world. The engines of global growth - India and China – are also expected to slow down in 2024. Most European countries are flirting with recession. Canada is technically in recession. The US growth is stronger than estimates but not enough to support the

Growth decelerating

As per the latest World Economic Outlook report released by the World Bank, global growth has slowed down to 3% in 2023 from 3.5% recorded in the year 2022. The global economic growth is expected to further decelerate to 2.9% in 2024. The advanced economies have grown by 1.5% in 2023 against 2.6% in 2022. Their growth is likely to further decelerate to 1.4% in 2024. Economic growth in Emerging economies is also not accelerating. These economies are expected to grow at the rate of 4% in 2023 and 2024, against 4.1% in 2022.

Though the likelihood of a hard landing in the US may have receded, the risks to the growth still remain tilted to the downside.

Inflation persisting

The growth slowdown could be largely attributed to the effects of the monetary tightening measures taken since 2022. However, despite the sharp growth deceleration, global inflation is likely to stay above 5% in 2024 also. The World Bank expects global inflation to ease to 6.9% in 2023 and 5.8% in 2024, against 8.7% in 2022. In recent weeks, the inflationary expectations have risen again and could contribute—along with tight labor markets––to core inflation pressures persisting and requiring higher policy rates than expected. More climate and geopolitical shocks could cause additional food and energy price spikes.

Geoeconomic fragmentation – risks rising for emerging economies

The rising geoeconomic fragmentation is seen as a key risk to global growth and financial stability. Intensifying geoeconomic fragmentation could constrain the flow of commodities across markets, causing additional price volatility and complicating the green transition. Amid rising debt service costs, more than half of low-income developing countries are in or at high risk of debt distress.

No room for policy error

Given the still high inflation, unsustainable fiscal conditions and high cost of disinflation, there is little margin for error on the policy front. Central banks need to restore price stability while using policy tools to relieve potential financial stress when needed. effective monetary policy frameworks and communication are vital for anchoring expectations and minimizing the output costs of disinflation. Fiscal policymakers should rebuild budgetary room for maneuver and withdraw untargeted measures while protecting the vulnerable.

However, if we juxtapose these economic realities with the market performance, the dissonance is too stark. Formulating an investment policy that balances the macroeconomic and market realities is extremely challenging under the current circumstances.

I shall share my thoughts on this after the Diwali break. I will post next on 17^th November.

Wednesday, November 8, 2023

Delhi - gasping for breath

Pollution has been a key challenge for 70 million plus people living in the National Capital Region (NCR) for more than two decades. People have been suffering from the consequences of air, water, and noise pollution. In the past decade, in particular, air pollution in the autumn and winter months has become a major crisis.

The air quality of Delhi and surrounding areas deteriorates to the severely poor category, requiring several restrictions, including school shutdowns, mobility restrictions, construction ban, etc. Pollution has become a serious impediment to the health, life, and productivity of the local population. Besides, since this is the peak tourist arrival season for North India, it also negatively impacts the local economy.

Every year, governments and administrations pretend to take serious note of the problem and promise to take effective steps to control the air quality. However, the problem is worsening every year.

In my view, air pollution is a major issue that requires a mission scale effort to handle. Random and ad hoc measures that are usually taken every year have minimal effect on the air quality level. In many cases, like the ban on diesel vehicles and power generators, these prove to be counterproductive. I suggest the following 10 measures that may be taken as part of the long-term sustainable solution for the air pollution problem in the Delhi NCR area.

1. Develop a 2 km wide ring forest encircling the NCR area. Forest may have dense trees like banyan, need, peepul, and amaltas on govt land and fruit trees like Mango, Jamun, etc. on the farmland falling on the way. Farmers may be provided an adequate subsidy to undertake these fruit plantations on their farmland.

2. The entire Aravali hill range must be declared a protected land. All illegal mining in the area must be punished severely. Intensive reforestation activity must be taken on the hill range.

3. All households must take a pledge to not use personal vehicles at least 2 days in a week, unless there is a medical emergency.

4. All civil work contractors must be required to ensure that no dust is scattered around or flies from their work projects.

5. All roads must be made pothole free to avoid traffic slowdown.

6. All encroachments on public roads, including unauthorized parking that slows down the traffic, must be immediately removed with severe penalties for any recurrence.

7. Govt may allow the removal of crop stubble using MNREGA workers till a viable tech is available to dispose of crop residue from farms to minimize burning of crop residue.

8. Airports in NCR may be expanded to ensure there is no air traffic jam over NCR skies during peak hours.

9. Large industries with material emissions may be systematically relocated away from NCR.

10. Empty grounds may be developed as city forests. The horticulture department may identify institutional, commercial & residential areas where threes could be planted and partner with the owners to plant and maintain trees.

Tuesday, November 7, 2023

This is not progress.

The latest festival season has started on a rather buoyant note, in Indian cities. As per initial reports luxury cars, smartphones, luxury watches, jewelry, home appliances, apparel, etc. are witnessing good consumer demand in most cities. Several high-end cars reportedly have a waiting period of one month to twelve months. Several stores have reported shortages of expensive smartphones and large-sized televisions.

On the other side, rural markets are reporting a noticeable slowdown in demand. Most companies catering to the rural sector, like farm chemicals, farm equipment, consumer staples, building materials, etc., have commented in their presentations about the slower rural demand.

The Reserve Bank of India, several commercial banks, and other lenders have highlighted rising stress in personal loans, credit card outstandings, and micro-lending. Two wheelers and entry-level cars are also not quite reporting encouraging numbers. There are reports about common households downtrading in staples, personal care, home care, and textile spending.

These trends are, in fact, not recent. Many reports and commentaries have highlighted the acceleration in the “K” shaped trend in economic growth in the past decade or so, especially after the demonetization. Moreover, these trends are not India-specific either. It is well documented that several emerging economies and some large economies like the US, are also witnessing a sharp rise in income and wealth inequalities.

In my view, whatever the statistics might suggest, what we are doing is definitely not progress. Several businesses doing well; their stock prices rising; and more and more middle-class households trying to capture a small piece of the growth of these businesses is inarguably a good omen for the country. But in no way it can camouflage the broader picture, i.e., the risk of India failing to become a middle-class country as the growth becomes even more unsustainable.

Without elaborating further, this morning I want to share three experiences I had over the last week. These experiences highlight that we may be treading on the wrong path of economic progress; the administrative machinery recognizes the problems but is mostly clueless/incompetent in suggesting a course correction; and the people are fast losing their empathy and sensitivities towards fellow citizens and becoming ominously self-focused.

1. I was sitting in a friend’s office, interacting with a few field executives in his company. Fifteen minutes into the discussions, a young field executive (39yrs of age) indicated some breathlessness and asked for a glass of water. However, before someone could bring water he fell from his chair and collapsed. He was immediately taken to a near by private hospital, where the doctors on emergency duty refused to examine him, declaring him dead on arrival. This apparently healthy man has two young daughters (8yr and 11yrs old) and a non-working wife. He was earning a salary of fifty thousand, but had almost no savings. His life is also not insured.

This instance is not rare. There have been several such instances of young people dying suddenly. It raises serious questions on the health consciousness of our society – poor life style, preventive care and emergency help; social security of the workers in unorganized and SME sector; insensitiveness and incompetence of the hospital staff, etc.

2. A friend (56yrs) felt unease in the chest while working in his office in NOIDA. He rushed to a reputed hospital in South Delhi, where he was examined and advised a procedure involving the insertion of two stents in his heart arteries, immediately. The problem was that there was no room available in the hospital. The entire hospital was fully occupied. He was operated, on and, kept in the ICU for three days. On checking I discovered that most of the NCR hospitals are currently operating at near full capacity. Respiratory complications, dengue, and waterborne diseases like typhoid, and heart and kidney diseases are afflicting young and old alike.

So, it is not only diabetes and cancer that is a matter of concern for the Indian population. The heart, lungs, liver, and kidneys - all vital organs are getting weak. Overall immunity and stamina of a common Indian youth may not be optimal. As a country, we may idolize Virat Kohli, but only a handful of us can claim to be striving for a fitness regime like him.

3. Having traveled to various hospitals in NCR for two days, when the average AQI level was more than 500, I am feeling severe itching in my eyes and my throat is almost choked. Obviously, millions like me are suffering like this. The government has shut down schools, and imposed restrictions on driving vehicles and construction activities. Productivity is taking a massive hit. I am told that conditions in Mumbai are also not much better.

I strongly believe that the statistics we claim to be indicating progress are mostly meaningless. It is not progress. It is simply regression.

Thursday, November 2, 2023

Fed leaves it to markets to find their equilibrium

As widely expected, the Federal Open Market Committee (FOMC) of the US Federal Reserve, unanimously decided to keep the key fund rates at 5.00% - 5.25% for the second consecutive time. The FOMC had last increased the rates in July 2023.

The Committee noted, "Economic activity expanded at a strong pace in the third quarter". It also acknowledged “the tighter financial conditions faced by businesses and households”. Upgrading its outlook for the US economy, Fed Chairman Jerome Powell remarked, “The process of getting inflation sustainably down to 2% has a long way to go”.

After the last meeting in September 2023, the monetary policy statement issued by the FOMC had noted that “credit conditions have tightened” consequent to the eleven consecutive hikes delivered by the Fed. This time, the Committee added “financial” to the credit conditions, noting the rising stress in the financial system as a consequence of rising bond yields.

Caught between the resilient economy and building stress in the financial system, the Federal Reserve seems to have decided to stay on the fringe and let the markets find their equilibrium.

Though, the post-meeting FOMC statement reads, “committee is still determining the extent of additional policy firming” and “The Committee will continue to assess additional information and its implications for monetary policy,” the consensus in the market is leaning towards “a long pause” followed by a series of cuts; assuming the Fed is done with hiking and it will now wait for the market forces to find an equilibrium on prices and growth.

Whitney Watson, co-CIO of fixed income and liquidity solutions at Goldman Sachs Asset Management, reportedly commented it’s likely the Fed will keep its policy unchanged into next year. “There are risks in both directions,” Watson said. “The rise in inflation expectations, owing to higher gas prices, combined with strong economic activity, preserves the prospect of another rate hike. Conversely, a more pronounced economic slowdown caused by the growing impact of higher interest rates might accelerate the timeline for transitioning to rate cuts.”

Post the release of the FOMC statement, the yield on the two-year Treasury, which is more sensitive to Fed policy, fell 12.5 basis points to 4.93%, the lowest level since September 2023. Stocks also rallied with S&P500 and NASDAQ ending the day with over one percent gains.