Vijay Kumar Gaba

This is further to “No clouds on the horizon” posted last week.

 In a press release issued last week, the Indian Meteorological Department (IMD) cautioned that during the upcoming hot weather season (March to May (MAM), above normal maximum temperatures are likely over most parts of northeast India, east and central India and some parts of north west India. Normal to below normal maximum temperatures are most likely over remaining parts of the country. IMD forecasts show an enhanced probability for the occurrence of heat wave over many regions of northwest and central India. As per the latest forecast of IMD, the currently prevailing La Nina conditions are likely to weaken and turn into a o El Nino Southern Oscillation (ENSO) neutral condition during the pre-monsoon season.

It is pertinent to note that La Nina conditions are known to cause normal to above normal rains in India, while El Nino conditions are known to cause rain deficiency in India. Neutral ENSO conditions help a normal (+ 10% of long term average) monsoon.

In India La Nina conditions have prevailed during the past three monsoon seasons (2020-2022), resulting in good overall rains; though spatial (regional) and temporal (time wise) distribution of the rains was erratic causing floods in some regions and drought in some other regions. The most populated Gangetic plains are suffering from severe drought conditions since last summer.

Kharif (monsoon) crop sowing suffered due to delayed or deficient rains in many parts of the country. Besides, the 2022-23 Rabi season has witnessed deficient rainfall in most parts of the country (see here).

Even though so far El Nino conditions have not developed for India, some professional forecasters have predicted development of these conditions as early as June 2023, resulting in deficient monsoon rains in India. For example, the US government weather agency, National Oceanic and Atmospheric Administration (NOAA), has said that El Niño is expected to begin within the next couple of months and persist through the Northern Hemisphere spring and early summer.

Skymet Weather has said that “El Nino threat during the Indian monsoon 2023 is growing big.” It further said, “El Nino projection based on initial conditions of Feb 2023 is finding semblance with Feb 2018. Both are evolving El Nino, albeit 2023 appears to be stronger than 2018.  El Nino share starts with 30% in June, reaches 50% by July and climbs to >/= 60% during 2^nd half of the season.”

Admittedly, it may still be early to conclude about a deficient monsoon this year. Nonetheless, the erratic weather pattern and early onset of summers across north, central and western India is indicating prevalence of unusual weather conditions over the next few months. Obviously, this will have implications for the economy and therefore financial markets.

Economy and monsoon

Over the past seven decades the share of agriculture and allied activities in the overall GDP of India has consistently declined. Agriculture and allied services accounted for almost two third of India’s GDP at the time of independence; and now it accounts for less than one sixth. The proportion of population relying on agriculture and allied activities for their livelihood has also declined from about three fourth to two fifth. The declining importance of the agriculture sector in the overall economy has resulted in under investment in the sector over the past 3 decades in particular.

The importance of monsoon for the Indian agriculture sector has seen a steady decline. Self-sufficiency in the area of food grains broadly means that impact of a deficient monsoon is mostly limited to (i) temporary food inflation; (ii) financial stress for small and marginal farmers’; (iii) additional burden on fiscal condition (loan waiver and food subsidy); and (iv) consumption demand of the affected population. Adequate food grain stock and an effective public distribution system minimises the cases of starvation in case of drought.

Besides, in the past seven decades the crop area fully dependent on rains for irrigation has fallen from ~80% to 50%. Out of a total of 141 million hectare net sown area, only about 70million hectare is rain fed; the rest of the area uses water supplied by irrigation channels. (see Under the Shadow of Development: Rainfed Agriculture and Droughts in Agricultural Development of India, R. S. Deshpande, NABARD)

Regardless, drought can hurt some areas and some crops disproportionately. For example, in the state of Maharashtra still over 81% agriculture area is rain fed. Besides, rain-fed areas produce nearly 90% of millets, 80% of oilseeds and pulses, 60% of cotton and support 60% of our livestock.

Adequate water in reservoirs

As per the latest bulletin of the Central Water Commission (CWC) as on 02 March 2023, , the live storage available in 143 reservoirs is 93% of the live storage of corresponding period of last year and 116% of storage of average of last ten years. States of Odisha (-20%), Bihar (-38%), UP (-21%) and West Bengal (-44%) have water availability in reservoirs which is below normal range; while most other states have large surplus.

Regardless, the current storage is significantly lower than the total reservoir capacity in all the regions. Thus in case of a severe drought the hydro power generation as well as area irrigated through channels could also suffer.

 

I would like to review my investment strategy in light of the probability of a poor monsoon. I shall share my thoughts on this coming Tuesday.

In the past one year, inflation has been one of the primary concerns for most countries across the globe. Rising prices of food and energy in particular have materially impacted the lives of common people on all continents. The central bankers of most major economies have hiked policy rates in the past one year to control inflation. In the current year 2023 so far, 13 major central bankers have taken policy action(s) and all of these actions have been hike in policy rates.

However, in recent weeks inflation has shown some tendency of cooling down. It is difficult to assess how much of this cooling down is due to tighter monetary conditions; and how much could be attributed to other factors like restoration of supply chains that were broken during the pandemic and warmer winters resulting in lower energy demand in the northern hemisphere, etc. Nonetheless, some central bankers have adjusted the pace of tightening to smaller hikes. Most of them, though remain circumspect about the persistence of inflation. While the debate continues over the trajectory of price hikes in the next few quarters; an overwhelming majority of experts believe that prices may remain high for much longer.

The global growth forecasts have witnessed some downgrades in the past six months as tighter monetary conditions and higher prices are seen hurting demand for consumption and investment. As per the latest assessment of the World Bank, in 2023 “the world economy is set to grow at the third weakest pace in nearly three decades, overshadowed only by the recessions caused by the pandemic and the global financial crisis….Major economies are undergoing a period of pronounced weakness, and the resulting spill-overs are exacerbating other headwinds faced by emerging market and developing economies (EMDEs).” 

With this background, three key issues that could influence the future trajectory of global prices and therefore interest rates are geopolitical situation; impact of China ending Covid restrictions and the impact of the emergence of El Nino on global food production.

Geopolitical conflict in Eastern Europe (Russia-Ukraine) has materially influenced the prices of energy and food in the past one year. Any worsening or this conflict or expansion to Western Europe could make things worse. Some events in the recent weeks have indicated that Sino-US relations may not improve anytime soon. NATO countries hardening their stand on Russia; Russia retaliating with a cut in energy output; and some key OPEC members openly expressing disagreements with US oil pricing has materially increased the uncertainty in the energy market.

China has been gradually relaxing the covid restrictions for the past many months. This has eased the logistic logjam across the world. The supply chains that were broken due to congestion at major ports, shortage of containers, short supply of key raw materials, and poor take-off have mostly been repaired. The freight rates that had become prohibitively high have eased to pre Covid (2019) levels. The debatable question however is whether China reopening will be inflationary (higher demand) or deflationary (complete supply chain restoration and consequent destocking; improved mobility of workers etc.).

As per the latest forecast of various weather agencies (see here), the probability of El Nino conditions developing in the coming summer could impact the agriculture production in major countries like India, this year. If these forecasts come true, we may see food prices remaining at elevated levels.

A variety of views prevail on these three issues and their outcome. In my view, China reopening will indubitably be deflationary for the global economy, especially metals and other raw materials).

I am however not sure about the geopolitical conditions. I would therefore continue to expect elevated crude oil prices through 2023. By the way, the RBI in its latest statement has assumed the price of Indian basket of crude oil to be US$90/bbl for FY24, against the current price of US$84.19/bbl (see here).

It is little early to talk about weather conditions in the forthcoming summer and its eventual impact on global food prices. For now, the Rabi crop in India appears to be good; and there is enough food in the Indian granaries. Thus availability of food should not be a problem for sure even if we had a poor monsoon year after three normal/excess monsoons.

 The benchmark indices in India are now trading at their highest ever levels. In fact, in the past one year, India (+9.6%) has been one of the best performing equity markets in the world, in line with the emerging market peers like Brazil (+8%), Russia (+9%), and Indonesia (+7.5%) etc. Only a few emerging markets like Venezuela (+107%), Argentina (108%), and Egypt (+15%) have done much better.

For many Indian investors these statistics could be meaningless. To some it may actually be annoying as the performance of their individual portfolio may not be reflecting the benchmark performance. Regardless, largely the equity market returns have been reasonable, considering the challenging environment. It is therefore a moment to celebrate.

Once the celebrations are over, it would be appropriate to ask ourselves “whether at ~18700, Nifty is adequately taking into account all the factors that may impact the corporate performance, risk appetite, liquidity and financial stability in 2023?” In particularly, I would like to assess the risk-reward equation of my portfolio especially in light of the factors like the following:

Stress on discretionary spending

In the recent months several companies have rationalized (or announced the plans) their workforce. A significant number of highly paid workers are facing prospects of job loss. Anecdotal evidence suggests that the uncertainty created by a 2% workforce rationalization could temporarily impact the discretionary consumption plans of at least another 48% employees who retain their jobs.

Reportedly, IT hiring from the top colleges in India are likely to witness a 50% fall in 2023 (see here). We might see similar trends in other sectors also as most management have guided for a moderate growth in next few quarters.

My recent visits to several rural areas indicated that discretionary consumption in farmer households has already been impacted by poor income in the 2022 Kharif season. As per reports La Nina (excess rains) conditions that impacted crops for the past four seasons, are likely to persist through Rabi season, while the 2023 Kharif season might witness El Nino (drought like) conditions. (See here)

Erosion in wealth effect

On the last count India had more than 115 million crypto investors (see here). About two fifth of these investors were below the age of 30, thus having a strong risk appetite. These investors had seen sharp gains in their crypto in 2020-21m but apparently they are now sitting on material losses in their portfolio.

A significant number of new listings, especially from tech enabled businesses, are trading at material losses to their immediate post listing prices. These businesses typically have a material part of their employee compensation in the form of ESOPs. Many employees who had seen substantial MTM gains in their ESOP values have witnessed material drawdowns in their portfolio values. A few of them might be facing double whammy of material MTM losses and tax liability.

A number of small and midcap stocks that jumped sharply higher in 2020-21 have corrected significantly in 2022.

Obviously, the wealth effect created by the euphoric movement in stock and crypto prices has subsided to some extent. This submission of wealth effect shall also reflect on risk appetite, consumption pattern and investment behaviour of the concerned investors.

Tightening fiscal conditions

Lot of market participants are betting on continued fiscal support to infrastructure & defence spending, and incentives like PLI etc.

It is pertinent to note that the forthcoming budget would be the last full budget before the general elections to be held in 2024. It is likely the government chooses to increase the social sector funding at the expense of capital expenditure next year. The disinvestment program might also be slowed down to avoid adverse publicity for the government. Imposition of additional tax(es) or hike in capital gains tax could also be considered. All these events could impact the investors’ sentiment.

Rising external vulnerabilities

The external sector has been weak for a few quarters now. The trade deficit in October 2022 widened to a worrisome US$26.91bn. Exports dropped ~17% in October 2022 on slower global demand; while imports were still higher by ~6%.

Notwithstanding the efforts of the government to improve trade account by import substitution and export promotion; the exports have grown at a slow 4.3% CAGR in the past three years; whereas the imports have registered 14.3% CAGR in the same period, resulting in larger trade deficit. The external situation thus remains tenuous.

It is pertinent to note that the World Trade Organization (WTO) has projected a sharp slowdown in world trade growth in 2023. (see here) Obviously, the pressure on balance of payment will remain elevated in 2023.

Cash on sidelines may protect the downside

Overnight (liquid) funds are now yielding a return of ~5% p.a. Bank deposits are offering 5.5-6% return. Under the present circumstances, at ~18700, the upside appears limited to 8-10% while the downside could be much more than 10%. Obviously, the risk-reward equation is not favorably placed at this point in time, and the opportunity cost of holding cash is not bad. This could keep a lot of money waiting at the sidelines.

Higher cost of carry and margins have also resulted in lesser leveraged positions in the market. 

The cash on the sidelines and lower leverage may keep the downside somewhat protected.

In past couple of months a number of research reports have expressed concerns over the rural demand in the wake intense second wave of pandemic and subsequent lockdown of economic activities. Some consumer facing corporates have also expressed similar sentiment in their interaction with analysts and investors. The popular views seems to be that unlike last summer, when the rural demand remained resilient despite a wider and stringent lockdown, this year the demand may not show similar resilience. Wider and deeper spread of infection this time is one of the primary reasons behind these concerns. Rising stress in household and unorganized sector is also expected the discretionary spending in check.

In this context, there are few points that need to be noted by investors before forming a negative view on consumption theme.

Record production in crop year 2020-2021

Firstly, as per the third advance estimates for the 2020-2021 crop year, the agriculture ministry has expected record foodgrain production for 5^th consecutive year. India's foodgrain production is estimated to rise 2.66 per cent to a new record of 305.43 million tonnes in the current crop year 2020-21, on better output of rice, wheat and pulses amid good monsoon rains last year.

In the non-foodgrain category, the production of oilseeds is estimated at 36.56 million tonnes in 2020-21 as against 33.21 million tonnes in the previous year. Sugarcane production is pegged at 392.79 million tonnes from 370.50 million tonnes in the previous year, while cotton output is expected to be higher at 36.49 million bales (170 kg each) from 36.07 million bales in the previous year.

Given the remunerative pricing and higher volume of crop conventionally augur well for the overall rural income.

Normal monsoon forecast for 2021

The India Meteorological Department (IMD) has forecasted a normal monsoon for 2021. As per IMD’s latest forecast, Southwest monsoon, starting in June, is expected to be normal at 98 per cent of the Long Period Average (LPA).

This week, the widely-respected Australian Bureau of Meteorology (BOM) has also ruled out the likelihood of the rain-disrupting El Nino phenomenon over the next six months. Meteorologists say that a low probability of El Nino is certainly good news for the monsoon, although the complex weather system depends on many other factors.

A good monsoon usually means another year of good bumper farm production and consequent positive impact on the rural economy and consumption demand.

Second wave weakening and economy unlocking

In past one week, the second wave of pandemic has shown a clear tendency to decline. Further improvement is expected over next couple of weeks. It is likely that the mobility restrictions may begin to ease as the Kharif sowing season approaches. It is therefore likely that the income loss and spending curbs (due to mobility restrictions, health concerns, curtailed marriage spending etc.) seen in 1QFY22 may not spill over fully to the next quarter.

Indubitably, full reopening of economy and normalization of household spending may take at least 3 to 4 more quarter, till a significant proportion of the population is inoculated. Consequently, the economic growth for FY22 earlier projected to be in the range of 11-12%, may get constricted to 7-8%. This implies that Indian economy will attain the FY20 level of economic activity only in 2F2022 only.

My personal assessment of the rural and some semi urban areas in UP, MP, Punjab, Haryana, and Chhattisgarh is as follows:

·         Household finances have been damaged across the state, especially in the lower income group families. Lower income and medical expenses have eaten up savings and overall debt level has risen (most of it informal or friendly). The expenses on education and health have risen for a common household. For 5% households these trends may be structural due to loss of life or permanent employment. Lenders (formal or informal) will have to share some burden of this in near term.

·         The consumer confidence for discretionary spending is materially lower. However, two wheeler and smart phone/tablet may not be discretionary in most cases. Clothing, jewellery, home renovation, wedding, etc are some of the discretionary items that may cut material cuts. Down-trading in staples, personal care, shoes, home appliances, personal vehicles is also clearly visible.

·         The credit worthiness of an average household has diminished. The personal loan segment has been witnessing maximum growth in past few years. A slowdown in this segment may be inevitable.

·         The demand for farm input remains robust. Farm credit disbursement however may have slowed. The worst impact is from contraction in farm credit from informal sources. How efficiently this conundrum is resolved, may have material impact on the growth of rural economy. Implementation of farm laws in letter and spirit would be critical in resolving this situation.

·         The loss of life is unfortunate in any case and under any circumstance. In rural area, the Covid fatality rate is materially more in second wave as compared to the first wave. However, given the disguised unemployment and underemployment, the economic impact may not be as severe as many analysts might be anticipating. Not more than 5% households in rural areas have borrowed money to get treated at private facility in towns.

·         Pandemic has actually resulted in upgrade of healthcare facilities in many tier2/3 towns and villages. Hopefully much of this improvement will stay post pandemic also which will be a major positive for rural economy of India.

·         In rural and semi urban areas there is resistance to vaccines. Much of this resistance is result of misleading propaganda by ignorant, mischievous and/or malevolent elements. So far the institutional effort to counter this misinformation campaign in grossly inadequate. Recover would largely depend on how fast we convince people to get vaccinated and actually vaccinate them.

Based on my assessment I would not be too worried about consumer staples beyond couple of quarters. A material correction post 1QFY22 results could actually be a good entry opportunity. I would be extremely cautious about retail lenders, especially unsecured loans, and sale of premium vehicles. Appliances sales may miss this summer season, but might see a near normal festival season post monsoon.