Vijay Kumar Gaba: 2020 Mid Year Review

Friday, June 26, 2020

2020 Mid Year Review - Investment Startegy review

Year 2020 has been a very eventful year so far (see here). In past six months many events have taken place which will have long term repercussions. In that sense these six months could be compared to the period between May 1990 and December 1990 (see here). While long term implications of these events will unfold over many year to follow; in the immediate term we have seen the global economy slipping into one of the worst recessions since the great depression of 1930s (see here). The corporate earnings have been greatly impacted in 4QFY20 and 1QFY21 by the COVID-19 induced lockdown; and the visibility of next few quarters is also clouded. The earnings estimates for FY21 and FY22 have been significantly moderated accordingly.

The performance of stock markets however appears materially diverging from the economic and corporate performance. A sharp outperformance of midcap stocks, especially those with relatively poor earnings stability and outlook has raised concerns about bubble like conditions in the stock market (see here). On the other hand it has also made many investors who choose to change their asset allocation in favor of cash and high quality debt, anxious about sharp underperformance of their portfolios. I had also tried to address this dilemma of investors' (see here) besides outlining my strategy in the present circumstances (see here).

After completing the midyear review of the markets, economy, corporate performance, my portfolio performance, and extant investment strategy, I am quite satisfied with my investment strategy and no need to make any changes. I may share the main features of my current investment strategy as follows:

Assumptions

Lock down restriction may be fully lifted before 30 September 2020 and normalcy may return in businesses and logistics by 31 December 2020.
Interest rates may remain lower for longer.
Chemical manufacturing in India may see great impetus as global supply chain looks to shift from China.
Poverty shall rise and so shall the efforts to alleviate it, bringing greater focus on food production and availability.
India will be able to become part of some meaningful trade blocks that may emerge post lockdown

Asset allocation

Equity investment strategy

Continue to focus on a mix of large and mid cap stocks, with decent liquidity, solvency ratios and operating leverage.

(a) Overweight on healthcare services and IT services sectors with 35-40% allocation to these two sectors.

Be mindful of the possibility that India may actually just participate in the global trend and not much may be achieved on the ground in the areas of healthcare services. So buying established businesses at reasonable valuation would be a key consideration.

(b) Underweight financial services and discretionary consumption.

(d) Target 12%-13% price appreciation from my equity portfolio in next 12 months.

Thursday, June 25, 2020

2020 Mid Year Review - Economic review

As I mentioned yesterday (see here), the stock markets have shown commendable resilience to the COVID-19 induced lockdown, the economies around the world have unfortunately not been so defiant. The global economy is witnessing its worst economic collapse since the great depression of 1930. Unlike 2008-09 meltdown, this time the Indian economy is no exception to the global trend and is witnessing the worst ever slowdown in the history of post independence period. In past 40yrs, since FY80, when Indian economy declined by 5.2%, we have not seen any year of negative growth.

Economic growth collapses, long term growth curve shift downward

The economic growth in India has been declining structurally since the global financial crisis (GFC) of 2008-09. For couple of year, monetary and fiscal stimulus given by the extant government to mitigate the impact of global crisis supported the growth. However, post FY13, the growth trajectory never looked like retracing to pre GFC levels. The down trend just got accelerated by the COVID-19 induced lockdown of economic activity. In FY21 India is widely expected to record its worst ever recession with a negative growth rate of -6% or worse. The more worrisome part is that the long term growth curve in India has shifted down. The potential growth in India is no longer 8% plus. The pivot is somewhere close to 6%. A strong number in FY22 would be purely a base effect.

The worst part is the collapse of nominal GDP growth to multi decade low level. Even the nominal growth is likely to witness a sharp correction in FY21.

The government's budget, revenue and expenditure targets, sectoral allocations, and all allocation for all social and development programs is usually based on the nominal growth numbers. The benign inflation post GFC has resulted in a faster decline in nominal GDP growth as compared to the real GDP growth. However, now the nominal growth has reached the level where a decline would directly result in lower wages, lower rental and lower returns on savings.

A sustained downward trend in nominal growth may result in some dramatic adjustments in socio-economic structure. The effective rate of taxation may have to be raised considerably to meet the social development targets. The household savings that have been a traditional source of safe and steady funding for both corporate and government may decline widening the gap for fiscal and corporate funding. The socio-economic inequalities may rise materially as the poor and middle classes become sustenance households (earning just to meet the expenses, just like developed economies) without any material social security benefit.

Infrastructure investment had been on the decline since FY13. The lockdown has accelerated the decline further. The private sector investment in infrastructure building has declined materially.
Domestic demand has collapsed to worse since GFC at least. GVA (ex Agri and Govt Expenditure) has declined much faster.
Capacity utilization is worst in decades, though it has seen some marginal improvement in June.

External vulnerability though less pronounced this time

Despite the severe economic down trend and sovereign rating downgrade, the external vulnerability of India have been significantly less pronounced as compared to previous episodes of downtrend.

The trade balance has show significant improvement.
INR has been very resilient despite the FPI selling and rising outward remittances.

Fiscal condition worsens materially, monetary easing accelerates

The fiscal gap for FY20 increased to 4.6% of GDP, the worse since FY13. The gross issuance by state and center is expected to top Rs20trn, almost 50% higher than FY20. However, ample liquidity and sharp easing by RBI has ensured that rates continue to remain benign and funding of fiscal gap does not become much of a problem.

In past five years, since July 2015, RBI has halved its benchmark repo rate 8% to 4%, lowest level seen in decades. Despite this we have not seen any signs of acceleration in economic growth. The credit growth has remained low and is expected to plunge to zero by end of this year; as the supply of money (deposits) continue to outpace the demand (credit)

Wholesale prices enter negative territory in May 2020

The wholesale price index (WPI) based inflation in the month of May 2020 slipped into deflation for the first time in nearly 4 years. (Important to note that WPI for May, 2020 has been compiled at a response rate of 75% and will undergo a revision). WPI cooled off mainly due to broad based deflation seen in all segments viz; primary articles, fuel and power and manufactured products. The rate of inflation based on WPI Food Index decreased from 5.2% in March, 2020 to 2.3% in May, 2020, the lowest in the past 16 months.

First synchronized global recession since 1930

The global economy is expected to shrink more than 5% this year, in the most synchronized slowdown since the great depression of 1930s. The global trade has collapsed; delinquencies are rising and the central banks are doing whatever it takes to prevent markets from freezing, learning a lesson from 2008-09 global financial crisis.

To sum up, the economic realty looks ugly and the chances of any V shaped recovery appear remote. Especially in case of India, the economic slowdown that started many years ago may end in next few quarters, but the recovery will be feeble and Indian economy may not attain a sustainable 8%+ growth potential for many years.