Vijay Kumar Gaba

In earlier times, diversification was a rather simple exercise. This usually involved allocating money to asset categories (equity, debt, commodity, real estate, etc.) that carried divergent risk profiles. During low inflation, easy money periods equities and real estate outperformed the debt; while in high inflation tighter money periods, bonds and commodities did better.

However, as the markets became more globalized, financialized, and dematerialized, the performance of various asset classes started to become more correlated. With more and more assets offering a similar risk profile diversification of portfolios started becoming a complex and complicated exercise.

In the past decade, we have seen sovereign bonds carrying more risk than equities; multiple geographies carrying the same risks; gold and silver not providing any hedge against monetary debasement; and bonds worth trillions of USD carrying a negative yield while the major central banks were printing unprecedented money.

In an attempt to resolve the complexity in diversification, further complications were added in the form of Art, Diamond, Luxury Yacht, digital token (NFT) and cryptocurrencies etc. Many of these lacked objective value parameters. Some of these were even depreciating assets. Some others did not have explicit legal sanction to trade freely.

In the past three years in particular, diversification tools like geographical diversification, debt-equity diversification, growth-value diversification, emerging-developed diversification; sovereign-private bond diversification; etc. did not always provide the desired results for the investors.

The reason is simple. Most assets, geographies, and economies have become much more correlated to each other. For diversification, it is critical that the assets in the portfolio are mostly uncorrelated. If the assets are reacting (or not reacting or that matter) in the same manner to a macroeconomic or geopolitical occurrence, their risk and return profile cannot be expected to be much different.

My recent interactions with multiple investors, money managers, and advisors indicate that the understanding of the concept of diversification as a risk management tool in Indian markets may be extremely poor. In the name of diversification, investors are being lured to invest in bonds that are riskier than equity; multiple mutual fund schemes holding a similar basket of stocks; and gold that has mostly been a currency and import duty hedge rather than inflation, interest rate or market risk (see here).

In the name of diversification, investors are many a time sold a variety of mutual fund schemes which not only are similar in risk profile, and sectoral exposure but contain the same securities.

To make my point clear, I would like to highlight the case of an investor XYZ. This investor claims to be very conservative with moderate return expectations. The advisors told him to have a “simple” and well-diversified portfolio. Out of Rs350, he was advised to invest Rs100 each in a Nifty50 ETF, BankNifty ETF and Nifty500 ETF and keep Rs50 cash for direct equity opportunities to optimize overall returns. This Rs50 was recently invested in HDFC Bank stock (considering it to be very safe and promising in terms of return.)

On the face of it, this appears a simple, safe, well-diversified portfolio. But a simple analysis would tell you that this is perhaps one of the riskiest portfolios one can construct under the current circumstances. This investor has effectively invested ~61% of his money in financial sector stocks, and worst, ~29% in just one stock, i.e., HDFC Bank. Regardless of the attractive valuation, recent underperformance, future prospects of a company, no risk manager can justify this type of asset allocation for a conservative investor with moderate return expectations.

(Note: HDFC Bank has a weightage of 13.5% in Nifty50; 29.4% in Bank Nifty and ~8.4% in Nifty500) 

Since my posts are mostly my personal views and observations, criticism does not affect me. I usually politely agree to disagree. I would thus avoid responding to criticism or the views to the contrary. Nonetheless, I may reemphasize my views as follows:

·         In the short-term (5-7 yrs) any business or investment strategy that assumes substantial decoupling of China from India’s trade specifically, and Western countries in general, may not be successful.

·         Presently, China+1 trade is confined to a few businesses (not sectors), where (i) China has explicitly implemented capacity shutdown, (ii) there are serious IPR violations or data security threats, (iii) Innovators have developed new markets and find it profitable to produce a part of overall production close to the new market, (iv) local government has offered meaningful incentives for building local capacities, and/or (v) a local partner has offered better terms/infrastructure as compared to the Chinese counterpart. All these situations are very normal business propositions and have little to do with geopolitics.

·         Increase in tariffs by the US post 2017 on the imports from China has reduced the US imports from China by ~5% (from 21.6% in 2017 to 16.3% in 2022). However, it has not changed the US dependence on China, as the new import partners have meaningfully increased their trade with China. (Read more)

·        In fact, China’s trade surplus with proxy countries (countries used by many countries to indirectly import from China) has increased meaningfully, implying some rerouting of trade. 

·         Insofar as geopolitics is concerned, it is important to note that China’s trade surplus with India and Western countries has not shown any meaningful change post Covid. Overall, China’s goods trade surplus has more than doubled since the pandemic, going from $400 billion a year to $900 billion (read more).

Also read China+1 ...rhetoric apart

https://www.investrekk.com/2024/01/china1-rhetoric-apart.html?m=1

I also expressed a view that “The trend in the financialization of economies may reverse. Physical resource ownership and localized manufacturing may become the primary focus again.”

A team of the International Monetary Fund (IMF) analyzed the economic impact of the fragmentation of commodity trade, in a working paper titled Geoeconomic Fragmentation and Commodity Markets (Jorge Alvarez, et. al., October 2023). The conclusions of the research are pretty scary. The following are some excerpts from the IMF paper.

Concentration of Production

Unlike manufactured goods, the first stage of production of commodities depends on natural endowments that can be concentrated geographically. As a result of natural endowments’ concentration, there is a significant concentration of production at the country level, with the top three producers accounting on average for about 65 percent of the global output of agriculture, about 50 percent of energy, and about 75 percent of minerals commodities.

For minerals, production is concentrated both at the mining stage due to the geographic concentration of deposits, but often also at the processing stage, with a few countries (most notably China), having developed a strong comparative advantage through the deployment of capital intensive facilities, efficient technological solutions, lighter environmental regulations, and relatively cheaper labor.

Low Elasticities of Supply and Demand

Commodities exhibit low elasticities of supply and demand, particularly in the short run.

On the supply side, scaling up production often requires large investments and long permitting processes that can delay a supply response to price changes. For example, it takes on average 16 years from exploration to the opening of copper mines. Discovering new deposits is also costly and takes time.

On the demand side, many commodities are inputs for key technologies and products or are essential to household consumption, making them hard to substitute, and attenuating the demand response to price changes.

Trade Dependence

With production highly concentrated and demand often spread across many countries, commodities are heavily traded. Their homogeneity and fungibility also contribute to market integration. As a consequence, the share of production that is traded internationally across commodity types is consistently higher than the ratio of world trade to gross output. Across agricultural commodities, around 40 percent of output is exported, around 30 percent for energy and almost 50 percent for mineral commodities are exported. more than 80 percent of lithium, or potash produced cross borders, with the share increasing over time for most raw commodities.

Fragmentation and Commodity Prices

Events of the past few years suggest that the Western Economies and Russia/China led (or controlled) economies are drifting apart, getting divided into separate trade blocks. The Covid-19 pandemic exposed the fault lines of global manufacturing. If commodities cannot be transported between China, the West, and Africa, much of the modern manufacturing may halt. For example, Congo supplies two-thirds of the global Cobalt requirement. Disruption in supply chain could halt production in various manufacturing units that use cobalt as a raw material.

A model examines how much prices of 48 key commodities would change in the Western bloc and the Russia/China bloc if trading between the two blocks stopped altogether. In such an eventuality, the Western bloc would end up with a surplus of some commodities like iron ore or copper where there is more production than is needed in the region. Hence, steel prices would drop a lot in the West and rise dramatically in China, which undoubtedly would put an end to a lot of the growth in infrastructure and real estate in that country. Prices for magnesium and graphite, used extensively in the production of batteries and other renewable energy equipment as well as platinum, group metals, and rare earth metals would skyrocket in the West since we would be cut off from supply from China.

Prices of various commodities could move dramatically in the event of geopolitical decoupling of the West from China and Russia.

Obviously, the current geopolitical standoff is an invitation to mutually assured economic destruction for both blocs. The whole rhetoric of China+1; the isolation of Russia and China and the emergence of India at the expense of China appears fraught with danger.

Investors who are positioning for a secular growth of India’s economy over the next decade and the success of China+1 strategy may want to review their strategy in my view.

The principle of ‘economic efficiency’ is at the core of the globalization of trade and commerce. Countries have their strengths regarding resources (man, material, money etc.), technology, infrastructure, policy framework, etc. Affording countries to produce goods and services according to their strength means optimum utilization of the available resources for the benefit of all the trade partners. However, local political and geopolitical considerations impede the achievement of full economic efficiency.

The globalization of trade and commerce in the past five decades resulted in a shift in the production of goods and services to Asia with abundant human and mineral resources. First Asian tigers and subsequently, China, Vietnam, Taiwan, and India became major producers of goods and services and Western economies took charge of research & development, technology, financial services, and logistics, etc. Even the production of fossil fuels, to support the rising consumption of energy, was outsourced to Middle East Asia, Australia, Africa etc. The trend has arguably contributed to a structural downward shift in global inflation, despite a relatively loose monetary policy regime.

The arrangement has worked well for most of the economies that opened up to participate in the process of globalization. In particular, the past three decades have been an era of overall peace and prosperity. However, logistic challenges and geopolitical developments in the past 3 years are threatening to reverse the trend. The question to examine is whether we are going to witness geopolitics and political ambitions triumph the globalization based on the principle of economic efficiency; or it’s just a passing phase.

As per FAE, the Nominal GDP (GDP at Current Prices) in the year 2023-24 is estimated at ₹296.58 trillion (USD 3.56trn), as against the Provisional Estimate of GDP for the year 2022-23 of ₹272.41 trillion. The growth in nominal GDP during 2023-24 is thus estimated at 8.9%, much slower than 16.1% in 2022-23.

It is critical to note that most statistical numbers relevant to the financial market investors are benchmarked to the nominal GDP. For example, corporate profits, tax collections, fiscal deficit, wage growth, and government borrowings are correlated to the nominal GDP. Market capitalization to GDP, a popular stock market gauge to assess overheating (or otherwise), also uses nominal GDP as a denominator. A slower nominal GDP growth therefore could impact many of these parameters adversely.

Some of the key points worth noting in FAE are as follows:

·         Consumption has slowed down considerably. Private consumption is estimated to be 56.9% of real GDP (58.5% in FY23 and 58.6% in FY22) and Government consumption is estimated to be 9.6% of real GDP (9.9% in FY23 and 10.6% in FY22).

Per capita real consumption expenditure in FY24 is estimated to be Rs70,065, a growth of 3.5% over FY23. This is one of the lowest real consumption growth rates in many years.

Per capita Real GDP is estimated to be Rs1,23,144 (USD1479), a growth of 6.4% over FY23.

Considering that per capita real GDP is estimated to grow at 6.4%, there is a deceleration in the propensity to consume. In FY23 per capita consumption grew 6.4%, higher than the 6.1% growth in per capita real GDP. It would be interesting to see whether the lower propensity to consume is due to a sharp rise in inequality of income or a higher propensity to save.

In nominal terms, there is no noticeable change in consumption as compared to FY23.

·         The share of Investments in GDP continues to grow. Gross Fixed Capital Formation (GFCF) is estimated to be 34.9% of real GDP (34% in FY23 and 32.7% in FY22).

In nominal terms, GFCF is estimated to be 29.8% (29.2% in FY23).

·         Trade deficit to widen. Exports will likely slow down to 22.2% of real GDP (23.5% in FY23) while imports may grow faster to 26.9% of real GDP (25.6% in FY23).

In nominal terms, however, imports are estimated to slow down to 23.7% of GDP (26.4% in FY24.

·         Agriculture crashes, manufacturing & construction lead the growth. Agriculture and allied sectors are estimated to grow 1.4% (4% in FY23). Rice production is estimated to fall 5.4%.

Manufacturing growth recovers to 6.5% (1.3% in FY23). Construction sector growth sustains at 10.7% (10% in FY23).

Trade, hotel, transports and communication sector growth slows down to 6.3% (14% in FY23).

It is noteworthy that nominal growth in manufacturing is slower at 4.4% as compared to 7% in FY23. WPI of manufactured goods is estimated to deflate -2% against 7.5% inflation in FY23.

·         Higher indirect taxes. In real terms, Net taxes on products are estimated to grow by 12.5% (10.1% in FY23)

·        
USD 5trn in 2029. If the nominal GDP of India grows at a CAGR of 7%, net of USDINR depreciation, India will be a USD five trillion economy in five years, i.e., by the end of FY29. A faster growth or USDINR appreciation can take us there a couple of years early, maybe.