Vijay Kumar Gaba

 The past 10yrs (2013-2022) have been a period of great uncertainty and turbulence for the global economy, financial system and markets which were considerably weakened by the global financial crisis in the preceding five years.

Supported by abundant liquidity and lower rates, the markets weathered Tapering 1.0; Brexit; Covid-19 pandemic; Sino-US tariff war; remarkable shift in weather patterns; handing over Afghanistan to Taliban; Russia-Ukraine war; out of control inflation; and burst of technology stock bubble rather well. The end of near zero rate regimes and monetary tightening in the past one year has however made the markets jittery.

The current generation of the market participants (investors, bankers, analysts, intermediaries, and policy makers etc.) who are in their 20s and 30s have never practically experienced persistently higher inflation and consistently rising interest rates. They might have read case studies of the 1970s and 1980s era; but that is usually not a good substitute for personal experience. No surprise that their response to the situation, in terms of strategy, has so far not been adequate.

Despite historically low rates and unprecedented liquidity, the economic growth has been dismal and returns on various asset classes are not commensurate with the risk involved. Emerging markets which are usually beneficiary of lower rates and easy liquidity conditions have struggled, in terms of growth, asset prices and price stability.

Commodities performance subdued

Commodities that are considered proxy to growth, e.g., copper and crude oil, have fared poorly over the past decade despite near zero rates and abundant liquidity. Nymex crude oil prices have yielded a negative 2.3% CAGR; while copper has growth at a CAGR of 2.5%.

During 2020 we saw a massive anomaly in crude markets when Crude Oil futures traded at a massive negative US$37/bbl price for a day. Similarly, the Russia-Ukraine war and subsequent NATO sanction on Russia, created massive uncertainty over availability of gas to major European countries, sending them on a gas hoarding spree. Natural gas prices rose over 100% within 6months of the beginning of war; only to correct 80% from the recent highs closer to 2020 Covid lows.

India has held well

In all this turbulence and mayhem Indian economy and markets have held up strong and steady. Though things have been challenging in the past six quarters; over the past decade Indian assets (Equities, INR gold, bonds and USDINR) have yielded decent returns, outperforming most emerging markets and developed market peers.

The benchmark Nifty50 yielded an 11.3% CAGR in local currency over the past 10yrs. Even in USD terms, it yielded a decent 7.7% CAGR, much better than Chinese, Japanese, and European equities. USDINR depreciated at a CAGR of 3.4% over the past decade, making it one of the most stable currencies amongst larger emerging economies.

Cryptoes emerging as popular asset class

Cryptocurrencies have emerged as a major asset class over the past one decade. The value of the top cryptocurrency, BITCOIN, has grown at a CAGR of ~75% over the past one decade. Of course, given the poor understanding, still lower acceptability and strong challenges from governments, central bankers and traditional bankers, the volatility in prices of cryptocurrencies has been extremely high. Of late we have seen gradual rise in acceptability of Bitcoins.

A number of unscrupulous and untested business models emerged in trading, custody, and/or otherwise transfer of cryptocurrencies; causing tremendous losses to the unaware and greedy investors. This may reduce over a period of time as acceptability and awareness about cryptocurrencies improves.

Trend may continue in medium term

Currently a number of developed economies are struggling with demographic challenges; massive monetary overhang; unsustainable public debt; geopolitical tensions, and leadership vacuum. On the other hand, the Indian economy is gaining strength on the back of a favorable demography; disciplined fiscal; exemplary monetary policy; a decade of massive investment in capacity building, especially in physical infrastructure and import substitution (also see Time for delivery is nearing). It is therefore likely that Indian assets may remain steady and offer decent returns over the next decade also.

 “Kaya lag raha hai?” (How is it looking?) I am sure most of the financial market participants must be overwhelmed by this question in the past week. Obviously there is no accurate answer to this question in the present uncertain and volatile times. Regardless, every market participant is trying to answer this inquisition to the best of their ability and understanding of the situation. As the situation is still evolving and new complexities are getting added with each passing day, it is natural that the answers to this question will keep changing every day, and sometimes even within the same day.

 Struggle with nature has been an integral part of the evolution of homo sapiens. The Man has not only braved the inclement natural conditions for a million year, but also emerged victorious under most circumstances. They have crossed oceans; scaled mountain peaks; tamed raging rivers; built oases in deserts; braved extreme cold at the poles and extreme heat at the equator; and still survived and continue to evolve.

Cockroaches are an insect group that is believed to have originated 300-350 million years ago. They have shown extreme tolerance for a variety of climate – from arctic cold to tropical heat, and thrived.

The common saying is that only the human race and cockroaches may manage to survive an Armageddon due to their adaptability and strong survival instincts.

Many young investors may not have heard the term “peak oil”. This term was popular till the global financial crisis in the later part of the first decade of this century. The term was essentially used to denote that crude oil supply will soon peak out to catastrophic consequences for the global economy; which relies heavily on fossil fuels for their energy requirement. The term has however become redundant in the past one decade. Most producers have cut the production of fossil fuels in the past few years, as most economies have started to move away from fossil fuels towards cleaner sources of energy. The factors like demographic changes in developed countries and technological advancements may also have contributed to lower fuel consumption.

I clearly remember discussing this with a group of investors in mid-2008. This was the time when top global brokerages were aggressively selling the theme of hyperinflation. Brent crude was trading at US$130/bbl and Arjun N. Murthi, an analyst at Goldman Sachs, had just created a sensation by forecasting the crude oil prices to top US$200/bbl in the not so distant future. Fortunately, most of the assumptions made by Mr. Murti did not materialize and a few months later, in December 2008, the research team at Goldman Sachs cut their 2009 crude price target to US$45/bbl. (Actually, oil prices peaked in July 2008 at US$148 and fell to US$37/bbl by end of 2008).

In mid-2008 when oil prices had crossed US$125/bbl for the first time, the Indian economy was struggling with the mounting oil subsidies, impact of global financial crisis and rise in bad loans at banks. The group of investors I was interacting with was unanimous in their view that oil will be the nemesis of the Indian economy in particular and global economy in general. “Peak Oil” was the Bogeyman scaring them. I narrated this small bit of history of Man and Cockroaches to the group. My point was, if we are not worried about the pile of Nuclear weapons with hostile neighbours like Pakistan and China, why should we be worried about “Peak Oil”. The human race which has never accepted defeat from nature, how would it lose to dirty fuel! My view was that the world will find an alternative much sooner than what most people might be expecting presently.

No surprises that less than 15 years later, no one even hears the term “peak oil” any more. Non-fossil sources are already beginning to dominate the energy landscape of many developed economies. Many large emerging economies are targeting to become carbon neutral in the next 25-30 years.

I considered narrating this instance at this point in time to draw attention towards the euphoria building in Electric Vehicle space. The prices of Lithium, carbon, rare earths used in Lithium batteries, stock prices of EV makers/potential makers and their ancillaries/potential ancillaries have seen sharp rise in the last one year.

I fail to understand how transition to electric mobility will increase the sale of cars. For how many customers, the only criteria for buying a car is the fuel cost; because this is the only potential increment to the customer base.

Assume lower fuel cost adds 20% to the existing customer base. A car manufacturer which sells 10000 conventional fuel cars a year, other things remaining the same, it may potentially sell 12000 cars 10years later if we transition completely to electric mobility. As of now it is not clear, but if we assume 20% higher manufacturing margins for electric cars, this would mean 40% higher profit after 10 years. ROCE may not rise as much due to incremental capex required for the complete transition.

This sounds like a great proposition for the OEM as well as ancillaries. But what if technology changes in 10 years? Hydrogen cells become more viable and popular and battery cell fuelled vehicles meet the fate of Nano. Multiple experts have already mentioned that Lithium based batteries may not work for truckswith over 50tonne capacity.

I would consider that transition to electric vehicle manufacturing is a survival endeavour for most of the OEMs, rather than a more profitable diversification. It is the same as your local Kirana store owner putting up a computer in his shop for accounting and billing. Insofar as gains are concerned, this would be a transformative transition, the gains of which will accrue to the entire economy, not only the auto sector. For example, saving on fuel cost may boost spending on health and entertainment.

Some more thoughts on the new disruptor ‘ Green Hydrogen” tomorrow.

In past couple of weeks, some news items, and market & economic trends have attracted my attention. All these news items & trends somehow reflect on the reflation trade that has dominated the global markets for past few months.

The rise in commodity prices in past one year is seen mostly a function of a combination of demand and supply side factors. Post global financial crisis (GFC 2008) the investment in new capacities had slowed down considerably. The economic lockdown due to outbreak of pandemic further curtailed the supply of many industrial commodities. The logjam at Suez Canal further impacted the supply chain. The supply of commodities obviously could not match the recovery in economic activity as the economies began to open up.

The trillions of dollars in pandemic related stimulus further boosted the demand, as all three activities, viz., consumption, capex and trading got boost from worldwide stimulus. The US government’s plan to invest US$1trn in building nation’s deteriorating roads and bridges and fund new climate resilience and broadband initiatives is also expected to lead the further rise in demand for industrial commodities like steel and copper.

1.    A newspaper reported that HDFC Bank has received Rs300bn in prepayments in the quarter ended June 2021. These prepayments were reportedly made primarily by the companies in commodities and infrastructure sectors.

2.    A famous Kolkata based investment manager publically made a very persuasive case for investment in a public sector steel company, implying that in the given circumstances the share price of the company could potentially see a 3 fold rise in next one year. He also claimed that their portfolio schemes are presently invested in all metal stocks.

4.    The analysts at Phoenix Capital Research noted that “One of the key drivers of stocks prices since the March 2020 bottom has been the Fed’s interventions. The Fed spent a total of $3 trillion between March and June 2020. It briefly dipped between June and July 2020 but has since increased at a steady pace courtesy of the Fed’s $120 billion per month Quantitative Easing (QE) program.

However, all signs point to the Fed reducing these interventions going forward. With jobs numbers like those from July (900K+ jobs were created), the unemployment rate down to 5.4% again, and inflation roaring (CPI is clocking in over 5%), the Fed is effectively out of reasons to continue its month interventions at the current pace. Add to this the fact that numerous Fed officials are calling for a taper to QE and even rate hikes, and it’s clear the Fed is on the verge of announcing that it will be reducing its money printing very soon.”

It is pertinent to note that the GDP estimates for another large economy (India) have also been revised downward at least twice in past 4months, by almost all global agencies.Obviously, this cannot be good news for the traders staking their money on continuing reflationary trade.

The International Energy Agency (IEA) cut forecasts for global oil demand “sharply” for the rest of this year as the resurgent pandemic hits major consumers, and predicted a new surplus in 2022.

The announcement led to sharp correction in crude oil prices to the three months prior levels.

7.    The last move of about half of emerging market central bankers was hike in policy rates or policy tightening. Obviously, the days of monetary easing are behind. This shall definitely check the runaway inflationary expectations and therefore impact the reflation trade. 

8.    A BollombergQuint report highlighted that “Indian companies are running out of room to absorb rising raw material costs, which could force the central bank to unwind stimulus faster-than-expected and threaten a stock market rally that has earned billions for investors. Companies from the Indian unit of Unilever Plc to Tata Motors Ltd., the owner of the iconic Jaguar Land Rover, are increasingly complaining about pricier inputs and are frustrated at not being able to fully pass on costs to consumers reeling from the pandemic-induced economic shock. But it is only a matter of time before the pass- through happens, warn economists.

While its a tough balancing act, companies are mindful that something will have to give in eventually. In this case, it could mean higher prices being passed to consumers gradually as a recovery gets stronger in Asia’s third-largest economy.”

10.  Earlier this week, the US Senate gave bipartisan approval to a US$1 trillion infrastructure bill to rebuild the nation’s deteriorating roads and bridges and fund new climate resilience and broadband initiatives.

The plan reportedly includes, US$550 billion in new federal spending, to expand high-speed internet access (US$65bn); build/rebuild roads, bridges, etc (US$110 billion); airports (US$25 billion); and the most funding for Amtrak since the passenger rail service was founded in 1971. It would also renew and revamp existing infrastructure and transportation programs set to expire at the end of September.

11.  Back home, financials have are sharply outperforming the commodities since past three weeks. The market is telling that metals, sugars etc. have reached their peak margin and peak valuations. Using the strong price cycle, many large commodity companies have repaired their balance sheets. Consolidation by way of IBC process has also helped the larger companies. It is time that these companies may be thinking about the next capex cycle. Sugar companies have already embarked on a major capex cycle to set up new ethanol capacities. Steel companies are already planning major capacity additions. As per media reports SAIL is looking to expand capacities by 12-14 mt at its steel plants at Bokaro and Rourkela.

The popular inflation hedge trade (gold and silver) has done much worse than the overall commodity universe; whereas Bitcoin (perceived to be one of the most riskiest and volatile asset presently) has done very well.

Conclusion

These are still early days to conclude anything from the above cited news items and trends. Nonetheless, in my view, the following deductions from viewpoint of investment strategy may be considered reasonable:

·         The sharp run up in commodity prices is factor of supply constraints and demand stimulus. There are indications that supply constraints may ease as economies open up further; demand may cool down as monetary stimulus are gradually withdrawn and pent up demand subsides.

·         The commodity price inflation is now testing the limits of the industrial consumers (manufacturers). Any further rise from here shall be passed on to the last consumers, who would have much lower absorption capacity in absence of further stimulus checks. It is reasonable to assume that normal demand supply equilibrium will settle at a lower level only.

·         The balance sheets of commodity and infrastructure companies have seen substantial improvement in past one year. These two sectors accounted for more than half of the stress in the banking system. Besides, the credit growth is likely to pick up as companies rush to augment capacities to meet the increased demand and avail new government incentives for manufacturing sectors.

·         The conventional wisdom suggests that now it’s the turn of financials and capital goods manufacturers to do well. Commodities can wait for FY24 to have their turn again.