Vijay Kumar Gaba: India

Showing posts with label India. Show all posts

Thursday, May 2, 2024

Why to emulate Chinese investors?

Gold prices hit an all-time level in April and have corrected marginally since then. Again, this is the time when self-proclaimed investment gurus commemorate Indian households, especially the women, who have traditionally parked their savings in gold ornaments. They highlight how the uneducated and unaware “mothers” have managed to earn more return than savvy investors who invested in index funds etc. In my view, this narrative is completely flawed and does not merit any comment.

The all-time high gold prices in international markets have also triggered a deluge of reports forecasting a strong performance of gold in the coming years. The key arguments in favor of a strong rally in gold prices are (i) technical breakout; (ii) central banks amassing gold reserves in anticipation of the diminishing role of USD in the global economy; and (iii) the Dilemma of the Bank of Japan whether to protect bond yields or Yen. The traders have however pointed out that the higher gold prices are currently supported by the strong investor demand from China. The gold imports, other than the central bank buying, into China, have surged sharply in recent months and so have the trading volumes of gold in China.

In my view, gold is a declining asset and as such should offer sub-optimal returns in the decades to come. Particularly, for investors in a fast-growing economy like India, investment in gold makes little sense for household investors. It may be a bad idea for Indian investors to emulate their Chinese peers and invest in gold. Those advising Indian investors to invest a material part of their wealth (10% or more) in gold, because gold prices are likely to move higher due to buying by central banks and Chinese consumers/investors must consider the following:

· Chinese households are much richer and more protected as compared to Indian households. China’s per capita GDP (US$13136) is almost 5x of India’s per capita GDP (US$2731). Chinese households enjoy much more social security and a higher standard of basic amenities like education and health.

· The Chinese economy (US$18trn) is 5.3x in size as compared to the Indian economy (US$3.4trn). It is expected to remain much larger than India for the next 50 years at least, despite slower growth.

· China has forex reserves of US$3.23 trn as compared to India’s US$640bn. Though both countries have reserves close to 18% of their respective GDP, India runs a current account deficit of appx. US$100bn as compared to current account surplus of US$253bn for China. China needs to diversify from US and European treasuries and USD assets to protect its reserves from depreciating. For now gold is one of the popular option for it. India on the other hand does not have similar needs, given our current account deficit.

· The per capita income in China has grown at a CAGR of 6.1% over the last decade. In this decade, Chinese equities have provided a CAGR of 3.5% and real residential prices have barely risen. Whereas Gold in CNY terms has yielded a CAGR of 7.75%. However, for Indian investors, per capita income has grown at a CAGR of 5.3%, real property prices have grown 1.1% and equities have yielded a return of 11.4 CAGR. Chinese investors therefore have reasons to buy a hedge against inflation and negative real rates. The Indian investors on the other hand have little reason to diversify from high-yielding equities and positive real rate offering debt. Besides, they need to invest heavily in their education and health, unlike their Chinese peers.

Tuesday, April 23, 2024

Laying BRICS for the future

Early this year BRICS, a bloc of leading emerging economies, announced the induction of five new members, viz., Egypt, Ethiopia, Iran, Saudi Arabia, and the United Arab Emirates, to its fold. The ten-member bloc has a significant presence in global trade. More specifically, it exercises significant control over the global energy markets, controlling 42% of global oil production and 35% of total oil consumption.

In July 2023, the then President of BRICS, South Africa claimed that over 50 emerging nations have expressed their desire to join the group. Recently, Russia’s Federation Council Committee on International Affairs, stated that BRICS would be expanded further as more than 40 countries are desirous of joining the group.

The cooperation between BRICS members is free, and flexible and extends to a variety of subjects of common interest amongst members. The members and other countries desirous of joining the group, view BRICS as an alternative to global bodies viewed as dominated by the traditional Western powers and hope membership will unlock benefits including development finance, and increased trade and investment.

Defining the vision of BRICS, President Putin said, “BRICS is attracting an ever increasing number of supporters and like-minded countries that share its underlying principles such as sovereign equality, openness, consensus, aspiration to form a multi-polar international order and a fair global financial and trading system.

The expansion and strengthening of BRICS could, therefore, be interpreted from different perspectives. From the geopolitical perspective, it could be seen as a vote of no-confidence in the extant global order, dominated by Western developed countries (especially the US), by the emerging economies. A larger BRICS could undermine the dominance of NATO, the UN, and even the IMF.

From India’s perspective, it could act as a strong resistance to any material escalation between India and China. We have already seen the traditional rivals Iran and Saudi Arabia bridging the differences and coming together on the Palestine issue. We have also witnessed ineffectiveness of the NATO sanctions against Russia over the Ukraine invasion issue. BRICS and other developing countries have increased their trade with Russia materially in the past couple of years, as reflected in a larger current account surplus for Russia.

From an economic perspective, a larger and stronger BRICS could play a significant role in determining the terms of global trade. Its present and prospective members would control a significant proportion of the global human, mineral, and manufacturing resources. Besides, helping in securing better terms of trade, ensuring energy security is seen as another key advantage of a stronger and larger BRICS.

From a financial perspective, post global financial crisis, a large number of developing countries have reported a slowdown in financial aid from developing countries. The conditions appear to have deteriorated further post the Covid-19 pandemic. A deeper and wider cooperation between the enlarged BRICS grouping, the humanitarian aid to the developing nations could be restored.

From a monetary perspective, there is an intense debate about limiting the role of USD in global trade. A BRICS agreement on adopting a common independent currency or increasing the bilateral trade in local currencies could help in achieving this objective. There is strong evidence of a material rise in yen trade between Saudi Arabia-China and Russia and China. India has also made some advances in promoting INR trade with traditional trade partners like UAE and Russia. We might see more developments on this front in the next couple of decades.

These may be the early days to term BRICS as a foundation for change in the post-USSR unipolar global order to a multipolar world order that shall facilitate much-delayed reforms in the global institutions like the UN and IMF etc. Nonetheless, the developments are encouraging and offer hope.

Tuesday, April 16, 2024

I am not worried about US public debt

The issue of high and rising US public debt is a subject matter of public discussion in Indian streets. Using a common Dalal Street phrase I can say that every paanwalla, taxi driver, and barber is now discussing how unsustainable US public debt is. For example, listen to this boy .

From top economists, analysts, and global strategists to a common man on the street, all are worried about an imminent US default and its impact on the global financial system, especially the developing and underdeveloped countries.

Currently, the US public debt is close to US$35trn (Appx 125% of annual GDP) and is projected to double in the next eight years. The current US government's annual interest payments are more than US$1trn (Appx 20% of annual federal revenue; 14% of annual federal spending and 4% of GDP). The average interest rate on the entire debt is less than 3% p.a.

As of June 2023, 43% of this debt was owned by the Federal Reserve System and State and Local Governments. 32% of the debt was owned by various domestic institutions (MF, Insurance, Pension, and Depositories, etc.) The balance 26% was owned by other institutions including foreign governments. Almost the entire debt is denominated in USD.

This debt level is a matter of concern but does not prima facie appear to be at a disaster level. The worrisome part is that about one-third of US public debt is short-term (12 months or less maturity). However, considering that a large part of this debt could be owned by the government institution and the Federal Reserve System, refinancing of this debt should not pose a significant problem. In my view, US debt could be sustained with 3-4% inflation, 20% USD devaluation, 5% revenue growth (higher taxes), and rationalization/reimbursement of various war funding expenses, this debt could be sustained, reduced, and serviced. It is of course going to be hard for US savers and middle classes for a decade or so. USD losing its reserve currency status may be collateral damage.

For context, as per the interim budget for FY25, India’s central government debt was ~Rs172trn as of 31^st March 2024. This is approximately 58% of GDP. 3% of this debt is held by foreign entities. However, using the standard IMF definition India’s Debt to GDP ratio is ~82%. Since most of this debt is INR-denominated and RBI is holding a strong US$650bn forex chest, servicing is not an issue.

However, as per FY24BE, interest expense would account for 25% of total government expenditure, after material cuts in subsidies. For a developing economy, this interest expense to government revenue expenditure is considered worrisome, as it hampers investments, keeps fiscal deficit high, makes interest rate cuts difficult, leads to lower social expenditure affecting the quality of life, and hampers further market borrowing capability of the government.

The small point is that investors in Indian securities should be more concerned about seemingly unsustainable public debt in India rather than the high debt levels of developed countries.

As a small investor with zero risk appetite, I keep a cushion for lower subsidies, late payments of government dues, higher effective taxes, small probability of higher rates in my investment strategy.

Thursday, January 11, 2024

EM vs DM

One of the key factors that may influence the performance of Indian equities in the current year would be how the global asset managers rebalance their portfolios in light of the changes in interest rate trajectory, movement in USD and JPY, geopolitical tensions, disinflation/deflation, etc.

2023 has seen significant disinflation in most developed and emerging economies. Most central bankers are well on course to achieve their inflation targets. Global growth, especially in advanced economies, commodity-dominated emerging economies, and China has taken a hit.

Presently, many European economies are struggling with stagflation. Japan is witnessing positive real rates after a decade. US COVID stimulus has faded, leaving consumers vulnerable. Higher positive rates are impacting discretionary consumption and investment in many other economies.

It is to be watched whether the current trend stops with disinflation or pushes the major economies to a state of deflation. Particularly, since the strong deflationary forces like the use of artificial intelligence to replace semi-skilled and skilled workforce; aging demographics, dematerialization of trade and commerce, etc. continue to gain strength.

If deflationary forces gain material ground, we may see the policymakers loosening money policy to calibrate controlled inflation. This will see the Japanification of major economies like China, the US, and the EU. Emerging markets and independent currencies (e.g., Bitcoins) could be major beneficiaries in such a case. The asset managers might therefore change their allocation strategies for EM vs DM, Equity vs Debt, China vs Japan, Physical Assets vs Financial Assets, Gold vs Bitcoin, etc.

Presently a majority appears to be favoring soft landing (no recession), gradual rate cuts (50-100 bps in the US), lower bond yields, and strong earnings growth. Equity valuations and allocations are congruent to this view.

In recent years, domestic equity flows have materially increased in India. The relative importance of the foreign flows has thus diminished. Nonetheless, for the overall growth of the Indian capital markets, global flows remain important.

Many global investment strategists have indicated their preference for Indian equities in recent weeks citing resilient economic growth, stable macro indicators, supportive political regime, and robust earnings growth momentum as the primary reasons for their positive view. This augurs well for the optimism over foreign flows and supports the positive view of domestic asset managers and strategists.

In this context, it may be pertinent to note that—

· Emerging market equities have massively underperformed the US equities in the past decade. The current relative underperformance of emerging equities as compared to US equities is the worst in fifty years.

· Emerging markets are about 40% cheaper as compared to their developed market peers, and the earnings momentum is likely to gather more pace.

· The sharp rise in the EM discount relative to DM is driven to a significant extent by China’s low valuations. Ex-China, however, EM discounts are in line with the 10-year average. Currently, the price-to-earnings (P/E) ratio for the MSCI EM Index is trading at approximately 12x over the next twelve months, or slightly above its long-term average of 11.3x.

· Within emerging markets, Chinese stocks have recorded their worst-ever performance. Currently, Chinese equities are at the lowest-ever level as compared to their emerging market peers.

· Indian equities are presently trading at a significant premium to their emerging market, especially Asia ex-Japan, peers.

· The earning momentum is expected to slow in India over the next couple of quarters, while Developed markets ex-US, offer attractive valuations.

Friday, December 15, 2023

Some notable research snippets of the week

COP28: Initial headway, some hiccups, still a long way to go (Kotak Seurities)

COP28 kept the hope of achieving climate goal under the Paris agreement alive. While initial headway was seen in the form of adoption of Loss and Damage Fund (LDF) plan, conclusion of first Global Stocktake (GST) and commitment to transitioning away from fossil fuels, a lot more is yet to be done as we progress toward the 1.5°C goal.

LDF plan approved; climate finance needs more commitments

The adoption of LDF plan by the members was the silver lining of COP28. However, the announced contributions of US$792 mn for LDF significantly lagged the recommended initial floor funding of US$150 bn per annum.

The climate funding provided by developed nations continued to increase to US$89.6 bn in 2021 and is likely to have reached the US$100 bn/year (by 2020) goal in 2022. COP28 urged the developed nations to up their mitigation as well as adaptation finance commitments in line with the growing requirements. IEA estimates that US$4.5 tn of climate finance and clean investments will be required annually by early 2030s to achieve net zero by 2050.

The Global Goal on Adaptation (GGA) agreement called upon COP members to establish and implement national adaptation plans by 2030).

GST: Step in the right direction for making NDCs more ambitious

The first GST concluded at COP28 called for more ambitious actions on mitigation, adaptation and climate finance. It pushed for more ambitious 1.5°C aligned NDCs while recognizing that the full implementation of the latest available 168 NDCs will lower emissions only by ~2% before 2030 from 2019’s levels versus the ~43% reduction required to achieve the 1.5°C goal.

The GST outlined eight key recommendations and signed various declarations (see Exhibit 8), focusing on reducing emissions primarily by scaling up renewable energy and energy efficiency, among others. While it has ‘called on parties to contribute’ to phasing down of unabated coal and transitioning away from fossil fuels in energy systems, a tougher absolute stance on ‘phasing out/down’ fossil fuels was left out of the agreement.

India: Makes no big bang announcements; on track to meet its current NDCs

India made no big announcements at COP28 after it set forth its net zero target and Long-Term Low Emission Development Strategy (LT-LEDS) in the last two COPs. While India is progressing well on its current NDCs, it refrained from signing the Global Renewables & Energy Efficiency Pledge for tripling renewable energy generation capacity and doubling the rate of energy efficiency alongside phasing down of unabated coal-based generation by 2030.

We believe India currently is striving to fulfill its growing energy needs by adding more thermal capacities, while also continuing to add renewable energy capacities in line with its NDC targets. We expect India to announce more ambitious NDC targets in 2025 by (1) increasing the non-fossil fuel electricity generation capacity target to 65% by 2030 (versus 50% as per current NDC), in line with the Ministry of Power’s goals, and (2) increasing the ambitiousness of emission intensity reduction target.

CPI Inflation picks up to 5.6% (CARE Ratings)

CPI inflation rose to a 3-month high of 5.6% in November, reversing the downtrend seen during the previous three months. This was mainly because of the spike in certain vegetable prices as well as sticky inflation in non-perishable food items such as cereals, pulses and spices. Additionally, support from a favourable base was absent last month. The upside was contained, to some extent, with the continued deflation in fuel and light category and moderation in core inflation.

While the trajectory of headline inflation has been uncertain, core inflation has been consistently trending downwards since the beginning of this fiscal. A combination of factors including the impact of RBI’s monetary tightening on aggregate demand as well as improved supply conditions have supported this trend.

Way Forward

The consistent fall in core inflation in line with easing commodity prices and subsiding demand-side pressures is a positive. However, persistently elevated inflation in certain food categories such as cereals, and pulses pose a risk of potential generalisation of price pressures. Given the lingering uncertainty around Kharif production and Rabi sowing prospects, high food prices cannot be shrugged off as entirely transient and could further feed into the inflationary expectations. Hence, supply-side interventions by the government become crucial at this juncture to ensure sufficient buffer stock of essential food items.

An unfavourable base is further expected to push CPI inflation higher around 5.8-6% in December. However, with arrival of fresh crops in the market during January-March, the headline inflation could ease to 5.1% by the fiscal year end. For the full fiscal year, we expect inflation to average at 5.4% with risks tilted to the upside.

IIP Growth up 11.7% in October (CARE Ratings)

India’s industrial activity accelerated to a 16-month high of 11.7% in October (following 6.2% growth last month) underpinned by the statistical effect of a low base. This is better than our projection of 8.5% growth. While the growth number for the month was largely on account of a supportive base, some improvement in momentum (at 1.8%) is a positive.

Manufacturing output increased by 10.4% in October following a growth of 4.9% in the previous month. A decomposition of the growth number by base-effect and momentum reveals that growth has been primarily driven by a favourable base along with a marginal improvement in momentum. A component-wise evaluation reveals that an annual (y-o-y) increase in output was witnessed in 19 out of 23 categories. Basic metals (major component with a weight of 12.8%) logged double-digit growth for the seventh successive month rising by 11.9% in October.

Among export-intensive components, an uptick was seen in growth of textiles (6.6%) and leather and related products (16.5%) while output of wearing apparel continued to remain in the contractionary territory. Among the discretionary purchase components, output of computer, electronic and optical products have shown persistent weakness staying in the contractionary zone for the eleventh successive month. However, continued optimism is visible in the automobile component recording double-digit growth for the third month in a row.

Way Forward

Going ahead, while the prospects of infrastructure and construction goods segment remain encouraging, the strong base effect has masked the weakness in the consumer goods segment. The inching up of inflationary pressures, lower Kharif production and uncertain prospects of Rabi output are headwinds for the consumption scenario.

Additionally, given the weak global demand outlook, the trajectory of industrial activity hinges on a durable consumption recovery.

RBI: On track for a cut in Apr’24 (ICICI Securities)

There was no surprise in the RBI’s decision to persist with existing policy rates. Although its stance remains ‘withdrawal of accommodation’, the RBI governor also cautioned against the ‘risk of over-tightening’ - implicitly a more balanced stance. With the banking system’s liquidity already stretched (at a loan-deposit ratio of 79.8% in Nov’23), the RBI has had to inject liquidity almost daily for the past two months, after having had to drain liquidity for the previous 3.5 years.

The MPC warned about the risk of vegetable inflation; its forecast of 5.6% YoY headline inflation in Q3FY24 implies a spike to 6% YoY CPI inflation in Nov-Dec’23. However, with core inflation likely to ease below 4% YoY by Dec’23, and cereals disinflation from Jan’24 onwards helped by an artificially high base, we continue to expect headline CPI inflation to abate to 4% YoY by Mar’24 (several months before the RBI’s forecast of 4% inflation in Q2FY25). Consequently, we expect a 25bp rate cut in Apr’24.

Rate cut will be necessary once real policy rate hits +2.5%

A real policy rate of 2.5% (which is what India is likely to have by Apr’24) will naturally entail a cut in the policy rate. Subsequent rate cuts are likely to follow the US Fed, which we expect to cut its Fed Funds rate no sooner than Jun’24. However, the easing cycle will provide a timely boost to India’s economy, enabling real GDP to accelerate to 8.4% growth in FY25.

Trend growth is 7.5% now; stronger GFCF can boost it further

Evidence over eight of the past nine years (i.e., excluding the covid year) suggests that 7.5% is India’s new trend rate of real GDP growth, so we weren’t surprised by the upward revision to the RBI’s growth forecast for FY24. Periods of stronger fixed-investment spending (such as the past 6 quarters of over-8% YoY growth in GFCF) inevitably boost productivity, and take growth above the trend.

We consequently expect real GDP growth of 7.9% in FY24. We were forecasting 7.2% growth for FY24 from the start of the fiscal year, revised it up to 7.6% in Oct’23, and recently upped it further to 7.9% after the release of the Q2FY24 real GDP growth numbers.

Fed Prepares To Shift To Rate Cuts In 2024 As Inflation Eases (Bloomberg)

The Federal Reserve pivoted toward reversing the steepest interest-rate hikes in a generation after containing an inflation surge so far without a recession or a significant cost to employment.

Officials decided unanimously to leave the target range for their benchmark federal funds rate at 5.25% to 5.5%, the highest since 2001. Policymakers penciled in no further interest-rate hikes in their projections for the first time since March 2021, based on the median estimate.

Updated quarterly forecasts showed Fed officials expect to lower rates by 75 basis points next year, a sharper pace of cuts than indicated in September. While the median expectation for the federal funds rate at the end of 2024 was 4.6%, individuals’ expectations varied widely.

A tweak to the Fed’s post-meeting statement on Wednesday also highlighted the shift in tone, with officials noting they will monitor a range of data and developments to see if “any” additional policy firming is appropriate. That word was not present in the November statement from the US central bank’s policy-setting Federal Open Market Committee.

Federal funds futures markets are now pricing in six rate cuts for next year, up from four earlier this week, and traders have fully priced in a rate cut at the Fed’s March meeting.

While economic data in recent months has generally aligned with what the Fed would like to see — a cooling in both inflation and the labor market — figures released in the past week or so have painted more of a mixed picture.

Airlines: How long will demand-supply balance last? (IIFL Securities)

In our recent report, we had highlighted that YoY growth of domestic passenger traffic is coming off, down from +20% YoY in 1HFY24 to high single-digit growth in Nov. The industry situation from a supply perspective has been favourable so far, with capacity growth (ASK) averaging 10%. GoFirst’s bankruptcy and SpiceJet’s ‘capacity cuts’ have partly off-set the capacity growth of other carriers.

However, SpiceJet has secured equity funding of Rs23bn, which may help the company get past balance-sheet issues and possibly scale up capacity. If SpiceJet is successful in adding capacity, we may see industry capacity growth outpacing demand growth.

Unless volume growth stays strong, this may lead to pressure on load factors and/or fares. Fall in crude should support profitability in the near term, but medium-term profitability will depend on whether the favourable demand-supply equation sustains.

GoFirst’s capacity has gone to zero. SpiceJet’s capacity is declining 40% YoY. On the other hand, Indigo’s domestic capacity has been growing at about 20% YoY. Other carriers (excl. Indigo, GoFirst, SpiceJet) are growing capacity at ~30% YoY, mainly driven by Akasa. Overall, the average YoY capacity growth is about 10%.

Domestic traffic growth has moderated

Domestic passenger traffic has decelerated from +20% YoY in 1HFY24, to +10% Oct and +8% in Nov. We estimate December volume growth to be at 8-10% YoY. We recently trimmed our FY24 domestic passenger traffic growth to 12% vs 15% earlier.

GoFirst’s bankruptcy, SpiceJet’s capacity cuts supported demand-supply balance so far

GoFirst filed for bankruptcy in May 2023 and ceased operations. SpiceJet’s capacity is declining 40% YoY. On the other hand, Indigo’s domestic capacity has been growing at about 20% YoY. Other carriers (excl. Indigo, GoFirst, SpiceJet) are growing capacity at ~30% YoY, mainly driven by Akasa. Overall, the average YoY capacity growth in the industry post GoFirst’s bankruptcy has been about 10%. Against 10% capacity growth, volume growth was close to 20% till Sep, supporting YoY improvement in load factors. In Oct and Nov, capacity growth and volume growth converged.

Demand-supply balance may turn adverse if SpiceJet adds capacity aggressively

The benefit from GoFirst bankruptcy will enter the YoY base in May. If SpiceJet starts adding capacity aggressively, the industry level capacity may start increasing at more than 10% very soon. If volume growth does not stay strong, it may lead to pressure on load factors and/or fares.

SpiceJet reported losses in 2QFY24; Equity raise may support capacity growth

SpiceJet reported revenue of Rs14.3bn in 2QFY24, down 29% YoY and 27% QoQ. Although gross margin (revenue, less fuel) was higher YoY, there was significant negative operating leverage due to the sharp fall in revenue. Now that SpiceJet has secured equity funding of Rs23bn, the company may look to scale up operations.

Indigo’s market-share gains may pause

Indigo has been the biggest beneficiary of the financial troubles at GoFirst and SpiceJet. Indigo’s market-share has improved from 56-57% in the early 2023 to 63% in recent months. If Indigo’s capacity growth rate comes off due to P&W engine inspections, and other carriers add capacity, the upward trajectory of Indigo’s market-share may take a pause.

Technology: Exploring impact of GenAI on IT services industry (ICICI Securities)

With Gen AI gaining prominence, in this report, we dive into the strides IT companies, hyperscalers and SaaS players are making, and also assess its upshots on revenues/margins for IT companies. Industry reports peg Gen AI as disruptive technology. Prima facie, our analysis suggests a possible deflationary impact, to begin with, owing to productivity benefits. Yet, stronger volumes could be an offsetting factor, albeit with a time lag. Mid-tier IT firms could be better positioned to adopt this disruption due to their nimbleness, allowing rapid upskilling of their relatively smaller 20k-50k talent pool (vs. 100k-600k for large caps) – quite like how they were ahead in digital adoption. Clarity of timing of the impact is still not established with no major impact to CY24/FY25 financials, in our view.

Gen AI’s impact on IT services

Based on our preliminary analysis, we believe that Gen AI can influence revenue and margins of IT companies, driven by: 1) productivity benefits (~20-30%), which need to be passed on to customers leading to pricing pressure; 2) scope compression due to insourcing by clients and substitution by SaaS players; 3) increase in volume of work due to the emergence of new Gen AI service offerings, as well as boost to existing cloud, data and analytics services that serve as the basic foundation for implementing Gen AI; and 4) SG&A gains.

Nasscom’s industry report, coupled with project-level examples cited by IT companies, suggests that there could be a deflationary impact of ~20-30%, to begin with. However, based on our conversations with IT companies, productivity benefits stemming from the implementation of Gen AI at an enterprise scale in real life scenarios may be just ~5%, initially, due to challenges related to data quality and efforts required around compliance. Clarity on the impact’s timing is foggy; RoIs are far from established, and we see no major impact to CY24/FY25 financials.

IT companies’ efforts around Gen AI

Winners and losers IT companies are putting in efforts to leverage Gen AI, in terms of: 1) the number of people trained in Gen AI and its use cases; 2) partnering with hyperscalers, SaaS and various other players in the ecosystem; 3) embedding Gen AI in existing products and platforms; and 4) investments in IT software, infrastructure, research and intellectual property, and ratings by analyst agencies such as HFS Research and IDC. Based on these efforts, we believe that Infosys is slightly ahead of peers among large caps; Persistent is leading the mid-caps pack, followed by LTIMindtree.

Hyperscalers and SaaS players seeing strong Gen AI demand

Hyperscalars and SaaS platforms are infusing Gen AI into their tech stack and are seeing stronger interest for Gen AI embedded products. For example, Salesforce’s AI enabled Pro version saw 50% YoY growth in Q3CY23 – it expects Gen AI Pro-plus’ pricing to be at least 60% higher. Hyperscaler’s and SaaS’s multiples have re-rated as street is factoring in positive impact from Gen AI. However, there has been no significant change in consensus revenue estimates for CY23/CY24. Therefore, we do not see major uptick in revenue for IT companies due to Gen AI in the near term i.e. CY24/FY25.

Difference between traditional AI and Gen AI

AI refers to algorithms that can perform tasks that previously required human intelligence. Typically, such tasks involve perception, logical reasoning, decision-making, and natural language understanding (NLU). Machine learning is a subset of AI that focuses on discriminative tasks such as making predictions or decisions based on data, without being explicitly programmed to do so. Gen AI is a subset of machine learning (ML) that focuses on creating new data samples that resemble real-world data.

Friday, June 16, 2023

Some notable research snippets of the week

Economic momentum further gained; Inflation and IIP at 4% (Phillips Capital)

CPI eased to a 25-month low: CPI for May slowed to 4.25% (PC/Consensus estimate: 4.26%/4.31%) vs. 4.7% in the previous month and 7% a year ago. Sequentially, CPI registered 51bps increase as in the last month. Core CPI stable at 5.2% yoy as in the last month with sequential pace lower at 40bps vs. 60bps in the last month. Food inflation (heavy-weight) up by 62 bps mom vs. 51bps hike in the last month led by higher price for vegetables (3%), condiments (2%) and egg (2%). Fuel prices up by 0.6% mom vs. -0.1% deflation in the last two months. Clothing inflation pace stable at 0.3% mom as in the last month while pan/tobacco and housing price increase pace slowed to 0.2%/0.2%. Services inflation pace eased to 0.3% vs. 0.5% in the last month with highest increase in price for personal care (0.6%), medical care (0.4%), education (0.3%), recreation (0.3%), household requisites (0.3%) and transport & communication (0.2%).

IIP well above expectation: April IIP saw 4.2% yoy growth (PC/Consensus estimate: 1.5%/1.4%) vs. 1.7% in the last month (revised up from 1.1%) and 7% a year ago. Mining/Manufacturing registered 5%/5% yoy growth; electricity fell by -1% vs. 8%/6%/12% growth in April’22. Among the use-based segments, 5/6 were stronger yoy. Infrastructure (13%) saw the strongest growth followed by consumer non-durables (11%), capital goods (6%), primary goods (2%) and intermediate goods (1%). Consumer durables (-4%) contracted yoy.

Sector wise: 12/23 sectors progressed yoy. Growth was noted in pharmaceuticals (25%), other transport equipment (12%), machinery (11%), basic metals (10%), electrical equipment (10%), motor vehicles (4%), chemicals (3%), food products (2%) and fabricated metals (1%). Production declined among tobacco products (-21%), computer & electronics (-11%), beverages (-10%), paper products (-8%) and textiles (-6%).

China data disappoints (CNBC)

China’s youth unemployment rose to a record in May, while major data missed expectations, according to data released Thursday by the National Bureau of Statistics.

The unemployment rate for young people ages 16 to 24 rose to 20.8% in May, a record and above the high set in April. The jobless rate for people of all ages in cities was 5.2% in May.

Retail sales for May rose by 12.7% in May from a year ago, below expectations for 13.6% growth forecast by a Reuters poll.

Industrial production rose by 3.5% in May from a year ago, slower than the 3.6% expected by the Reuters poll.

Fed pauses, no pivot yet (CNBC)

After a two-day meeting, the Federal Reserve decided to leave interest rates unchanged.

“Holding the target range steady at this meeting allows the Committee to assess additional information and its implications for monetary policy,” the central bank’s post-meeting statement said.

The surprising aspect of the decision came with the “dot plot” in which the individual members of the FOMC indicate their expectations for rates further out. The dots moved decidedly upward, pushing the median expectation to a funds rate of 5.6% by the end of 2023.

Equity Strategy: OWT Banks vs UWT IT — Still more room (Jefferies Equity Research)

The financials & IT sectors together account for c. 50% of Nifty & are key for any India portfolio. Past ~14 year data shows that both move in the opposite direction 70%+ of the time. We believe that there's still a lot of room in the OWT banks / UWT IT call, given the fundamental trends & relative valuation. Also, empirically, this type of trend usually lasts for 3 quarters. We are just half-way into it currently. We would be sellers into the recent IT rally.

IT and banks perform in an opposite direction usually. Put together, financials & IT account for c.40% of MSCI India and 50% of Nifty. Our analysis of performance of Nifty IT and Nifty Banks since 2010 shows that the two indices tend to generally perform in opposite directions. As compared to the Nifty, on a trailing 3m or 6m basis, the relative performance of IT index and Banks index has been in the opposite direction 76% & 70% of the time, respectively. Even if we consider longer periods say 1/2 yrs; the opposite performance sustains for >60% of the time. The fundamental reason is that the banks tend to OPF during the times of favourable macro like stable / strong INR, falling yields, strong growth etc. While IT tends to OPF during weaker macro, rising yields/inflation and weakening INR.

We view the banking sector positively. The banking sector has seen strong performance in FY23 as system wide loan growth at 16% was at a multi-year-high. Moreover, asset quality is benign and fast transmission of rate hikes has helped to widen NIMs. The outlook for the sector is strong with 12-14% sector loan growth (higher for pvt sector at 18-20%) likely in FY24 partly, as India starts seeing a new private capex cycle (both housing and private corporate capex in upturn).

Strong macro also suggests OWT Banks. India's 4QFY23 GDP data beat on higher capex and RBI with construction activity showing early signs of the cyclical upturn; GDP forecasts are being upgraded; with RBI projecting 6.5% for FY24. Inflation has also declined to 2-3 year lows with WPI -ve and CPI below 5%. The RBI has also brought its rate hike campaign to a pause. INR is seeing support from improving CAD; with the same trending near breakeven. Despite new highs, valuations are still reasonable for the banks. Our model portfolio is OWT lending financials by 2ppt; while IT is the largest UWT 4ppt.

Negative view on the IT services sector. IT outsourcing demand has weakened substantially in 2023 with several tech majors reporting flat to declining revenues in 4QFY23. The outlook is weak as well with mid-single digit growth guidance and no increase in employee headcounts planned in FY24. Despite weak outlook, IT cos valuations are still above the historical averages. March quarter was the first quarter with some disappointments for IT majors. We believe that more disappointments are likely, especially in the mid-caps. For large caps our EPS estimates are 1-6% lower than consensus.

Other technical factors. The average instance of Banks or IT OPFing the Nifty lasts for a duration of 12 months and generates an OPF of 24ppt vs. the Nifty. The current period of Banks OPF started Feb23 and at 4mths /16ppt OPF &, in our view, still has a way to go.

India consumer: Disruption of valuation models too (Kotak Securities)

In our view, investors may need to reevaluate the extant valuation framework for consumer companies, given increasing risks to growth, the bulwark of current valuation models. Traditional valuation models essentially assume steady growth at high profitability for extended periods of time. This may not hold given rising disruption risks, which may alter the growth and profitability profile of most consumer sectors and companies.

Traditional valuation framework may no longer be reliable: We believe the extant valuation framework for consumer stocks based on (1) historical P/E multiples and/or (2) long-term DCF models, which simply extrapolate recent history of growth and profitability may be redundant given swift changes to business models of companies and sectors. The conventional framework of according high valuations for ‘assured’ high growth and profitability for an extended period of time (in effect, some variant of GAAP—growth at any price) may no longer work given declining visibility on both growth and profitability in an increasingly disrupted future.

A different framework for a new era: Investors may want to reassess the four traditional pillars of ‘assured’ growth and profitability of consumer companies in order to appreciate the resilience of their business models—(1) brand power, which accords superior profitability and returns, (2) distribution strength, which reinforces brand, (3) market structure, which determines the extent of competition and profitability; brand and distribution feed into this key variable and (4) product relevance, which determines the period and rate of growth.

Business models will be tested: As argued in several reports over the past five years, we see disruption across all categories of the consumer sector. The traditional moats of consumer companies will likely get eroded and even breached over time. (1) Brands will likely become less important, (2) traditional general (B2C) distribution channels may lose salience, being gradually substituted by other distribution channels, (3) markets will become more competitive with the entry of new players using different routes and technologies and (4) products (some of them) will lose relevance given changing consumer lifestyles and preferences.

High valuations of companies would suggest no concerns around disruption: The high valuations of most consumer companies would suggest that investors expect (1) a ‘business-as-usual’ outlook for companies for an extended period of time or (2) the companies to successfully navigate the ‘uncertain’ future without any negative impact or to even benefit from the emerging environment. In our view, it would be imprudent to dismiss disruption risks and impractical to assume that all or most incumbents will manage disruption well.

Paper Industry: Set to See Margins Moderate in FY24 (CARE Ratings)

The paper industry, including paper, newsprint, and paper products, witnessed a significant improvement in operating margins of 926 basis points (bps) in FY23 compared to the previous year for the top 10 listed companies based on market capitalisation. This improvement was primarily driven by revenue growth of 45%. The industry experienced higher volumes and a notable surge of nearly 40% in net realization, which contributed to the sharp improvement in operating margins. In the first three quarters of FY23, the paper industry demonstrated robust financial performance, fueled by pent-up demand and price hikes implemented by market players to capitalize on the surge in demand. However, during Q4FY23, the industry began showing signs of stabilization after achieving double-digit growth for eight consecutive quarters until Q3FY23. Factors such as China’s ban on paper waste and supply disruptions resulting from the Russia-Ukraine war led to a significant increase in Net Price Realizations (NPR) worldwide, soaring from Rs. 70,000 per tonne to Rs. 100,000 per tonne. Looking ahead to FY24, CareEdge Ratings anticipates moderation in both topline and operating margins by 200 to 300 bps. This expectation is based on the stabilisation of demand and the cooling down of raw material prices, which is likely to result in a corresponding moderation of net price realisations.

Textile Sector: On the cusp of an upcycle (Sharekhan)

The Indian textiles sector is strategically consolidating its position in key export markets such as home textiles and readymade garments, capitalising on opportunities arising from the US-China trade war. India has witnessed a notable increase in its share of exports in these segments to the US. After challenging and subdued FY2023 affected by muted demand, higher retailer inventory, supply constraints, and rising cotton prices, the textile companies believe the worst is over and anticipate a demand revival by Q3FY2024 with reducing inventories on global retailers’ shelves.

Further, factors such as the “China + 1” strategy, geopolitical uncertainties in competitor countries, and potential free-trade agreements (FTAs) with the UK and Europe offer promising prospects for consistent earnings growth and improved cash flows. With material capex already completed, textile players are poised to leverage their expanded capacities. Moreover, falling cotton and crude prices are expected to bolster margins and enhance India’s competitiveness in export markets. The Indian textile sector is well positioned to overcome challenges and looks forward to ride the next upcycle.

Near-term drivers: Likely recovery in demand for home-textile products and improved demand for garment products in key export markets from H2FY2024.

· India continues to gain market share in key export markets such as the US and Europe (with share gains in the past five years).

· Improvement in the capacity utilisation with higher capacities would boost volumes.

· A fall in cotton prices from its highs of Rs. 1,00,000+ per candy to ~Rs. 60,000 per candy will drive margins and will also provide competitive advantage in export markets.

Medium to long-term drivers

· Rising labour costs and geopolitical tensions have the potential to shift the focus of exports from China towards other countries.

· Some big global brands are reducing their exposure to China over time and continuing to develop alternate suppliers in other regions.

· The FTA with UK/Europe will be beneficial to Indian apparel exports.

· Government incentives and support from state governments for low-cost locations; PLI schemes to increase investments in man-made fibres and technical textile and FTAS with other countries.

…increase in Cotton MSP (Phillips Capital)

Indian Government has increased MSP for Cotton by c. 9% for medium staple from Rs 60.80 per kg to Rs 66.20 per kg and by c.10% from Rs 63.80 per kg to Rs 70.20 per kg for season 2023-24.

We believe cotton Minimum Support Price (MSP) increase is aggressive step to support cotton farmers to compensate for an increase in cultivation cost. India need to work on cotton yield improvement urgently to maintain cotton textile value chain globally competitive. The Government has continuously increased MSP without improvement in cotton yield, in fact Cotton yield has shown declining trend in past few years. We have highlighted this as serious issue and need to be addressed on priority basis.

Cotton prices has seen sharp correction from Peak of Rs 100,000 per candy in 2021-22 to Rs 57,500 per candy now which is close to MSP of 2022-23. MSP increase by c.10% will now structurally increase cotton price going ahead to c. Rs 63,500 per candy.

Steel: Healthy Domestic Demand; Sustainability to Take Centre-Stage (CARE Ratings)

During FY23, the domestic finished steel consumption grew by 13.3% y-o-y led by healthy demand from infrastructure, real estate and automobile industries.

• Steel exports declined sharply by 50.2% y-o-y due to the imposition of export duty on steel products from May-November 2022 coupled with weak global demand due to continued geopolitical tensions and inflationary trends.

• As the domestic industry looks to double the steel capacity and production by FY31 from current levels to cater to healthy domestic demand and export opportunities, sustainable availability of key raw materials – iron ore and coking coal, and enhancing export competitiveness will be critical.

• Further, the industry is becoming increasingly conscious of the Environmental, Social and Governance (ESG) aspects and significant investments are expected towards reducing carbon emissions and developing of cleaner production technologies going forward.

The domestic steel consumption is expected to grow at 8-10% in FY24 led primarily by infrastructure push in the pre-election year. The demand uptick from China has been slower than expected which is expected to have a bearing on steel prices in the near term. As Indian players prepare to cater to future demand, accelerating domestic iron ore production and identifying sustainable and cost-effective sources of import-dependent coking coal will be the key. While the transition to cleaner technologies such as green steel is desirable, these technologies require high capital investment and their adoption will depend on the support provided by the government and industry participants.

Auto: Steady Growth on Low Base; UVs are Clear Winner (Reliance Securities)

Domestic auto sales volume (excluding CVs) grew ~18% YoY (up 9% MoM) to 18,08,686 units in May’23. Notably, all segments of the automobile industry witnessed a decent performance in domestic market, supported by healthy urban sales and steady recovery in rural, supported by healthy agri output at higher MSPs. However, exports continue to remain laggards. Industry witnessed strong YoY as well as MoM growth across segments. Marriage season helped industry’s retail performance to some extent, while low base led to YoY growth. In PV segment semiconductor supply impacted production to some extent.

On the other hand, 3W segments recorded healthy double-digit growth of >70% YoY. UV segment remained clear winner with highest growth of 33.5% YoY, contributing 54% to industry’s PV volume.

Despite improvement, overall demand level remained below pre Covid level for 2Ws during the month. The wholesale volume was broadly in line with the retail. We expect volume improvement to continue gradually as nearly normal monsoon and higher water reservoir would support Kharif cropping and rural recovery in coming months. Recent IMD forecasting of normal monsoon further improves rural sentiment and likely better rural economy ahead. Industry would witness steady improvement in FY24 with decent agri output and cool off in inflation, turning customer sentiment positive coupled with stable pricing environment. EV penetration should improve further in 2023.

However, near term challenges due to monsoon delay and heat wave may spoil the show and may put some challenge for automobile industry. Therefore, we would monitor the situation closely to gauge the FY24 performance for various segments of the automobile industry, which would depend on timing and distribution of 2023 monsoon.

Chemicals: The biggest fear – Is there a downcycle in global ag-chem? (Axis Capital)

Indian specialty chemical players are highly skewed to the global agri space, supplying intermediates to global innovators, who in turn sell branded/ patented products. Given elevated global channel inventory (for generics’ agri inputs), softening crop prices, and slower export growth in last few months, there are investor concerns of a possible downcycle in global ag-chem. In this note, we look at key global indicators like crop prices, inventory data etc. and try to connect the dots with industry feedback. Prima facie, we see near-term earnings risk to domestic ag-chem companies. However, risks to specialty chemical revenue growth appear limited given client commitments, contribution from new product launches etc.

Crop prices softening in sync with a decline in input prices...

After a sharp rally in CY22, crop prices have softened over the last few months across corn, wheat, soya etc. – down 15-25% from the peak, though still up ~60% vs. pre-Covid. We note that the earlier price rally as well as the current price decline is largely led by the price trend of key agri-inputs/ fertilizers, which in turn were driven by global gas prices (sharp rally earlier, decline now). Fertilizer prices have declined 50% from the peak (+20-40% vs. pre-Covid), while key raw materials for fertilizers have declined 40-70% from the peak (+15-30% vs. pre-Covid). Weather concerns have also kept crop prices elevated.

...but rising alternate usage, exports to China restrict price decline

Globally, land under acreage is on a steady decline, while improving crop productivity has been able to largely maintain the demand-supply balance overall. However, with an increased use of crops for alternatives like ethanol blending/ biodiesel etc. and a rise in agri exports to China, crop demand has accelerated, keeping agri commodities inflationary. This is also visible in rebasing for the FAO index globally – led by cereals and vegetable oils. India has also raised its ethanol blending target to ~20% by CY25 vs. 5% earlier. Such alternate uses may keep agri-commodity prices more in tandem with global oil prices structurally.

Generic agri input inventory elevated globally; India relatively better off

Commentary from global ag-chem majors suggests (a) high global channel inventory in LATAM on drought-led impact in South America and resultant slower demand, and (b) sharp decline in RM and intermediate prices in China, driving lower prices of end-products, putting pressure on distributor margin (high-cost inventory). While agri majors expect normalization in 1-2 quarters, higher probability of El Nino (70%, as per Australia's Bureau of Meteorology) may delay global demand recovery

· India is facing higher inventory as well, especially in insecticides, but empirical data suggests absolute agri input sales declined only once in El Nino over the last 2 decades - possibly on improving irrigation and higher MSPs.

· Global majors expect good demand from new product launches, but demand revival for existing products may be backended in CY23. There is weak outlook from Adama, FMC, but strong commentary from Bayer, Sumitomo, Corteva.

Indian players continue to eye market share gains – confident on growth

Being pull products, branded/ patented agri inputs may not see much demand pressure, unlike generics. Despite slower exports in initial months, most Indian specialty chemical players (supplies agri-intermediates to global innovators) remain confident of 18-20% revenue growth guidance given discussion/ commitments with global majors, with no delays or cut in capex as they aim to gain market share globally (China +1/ Europe +1).

Wednesday, March 15, 2023

Exploring India – Part 1

Sitting on the banks of river Betwa, overlooking the majestic Orchha palace and Lord Raja Ram’s temple, I had a fascinating talk with two farmers from a nearby village. During the course of our discussion, I learnt that they are real brothers; have a family of 11 people, including grandfather, parents and five children aged 3yr to 13yrs including three sons and two daughters; own less than one acre of land and have been tilling another acre on rent; besides they own one cow. They mostly plant wheat during rabi season and vegetables in kharif and intermediate period. Caste wise they were from Kushwaha community that falls in other backward class (OBC) category. Their families are mostly dependent on government schemes for ration, education of children and healthcare. They live in a semi pucca house constructed five years ago with the help of government subsidy.

They have six bank accounts for their family members, mostly used to receive various benefits from the government and other institutions. They have 2-3 small pieces of gold ornaments each for all three women of the house; two bicycles for the men and one basic mobile phone. They collectively have less than twenty five thousand rupees in cash and bank deposits. They hire tractor for tilling their land; and they borrowed money from an MFI to buy a diesel pump for watering their crops.

The most striking part of the discussion was the effort made by these farmers to convince me that they are not “poor” people. They repeatedly alluded that they are amongst the better off families in their community in the village. Obviously their concept of poverty is very different from what is commonly understood by academicians, economists, analysts and policy makers.

Ompal, elder of the brother, mostly defined poverty philosophically. He believes that anyone who does not take what belongs to others and does not beg cannot be termed as poor. Shivpal, the younger brothers, adding a materialistic dimension, said that they have a roof on their heads, their children never go to sleep hungry, and they are able to take care of their elders – how could they be termed poor. Insofar as availing the benefits of the government schemes meant for the poor is concerned; both appeared convinced that being citizens of this country it is their right to enjoy these benefits. "The government does not oblige us by giving 5kg of cereals and basic education to our kids”, Ompal said, rejecting any suggestion of living on government alms.

To give this discussion a context, the policy makers and agencies use a variety of definitions to identify the poor that need to be helped. The Suresh Tendulkar Committee (2009) pegged the poverty level at consumption per person per day at Rs29 in urban areas and Rs22 in rural areas. Rangrajan Committee (2014) revised the limits higher to Rs1407/person month in urban areas and Rs972/person month in rural areas. This criteria is primarily based on the recommended nutritional requirements of 2,400 calories per person per day for rural areas and 2,100 calories for urban areas.

NITI Aayog uses multidimensional definition of poverty which considers health, education, and standard of living. As per NITI Aayog about 25% of the Indian population is poor. The World Bank counts poverty by measuring headcounts living below US$6.85/day in 2017 purchasing power parity (PPP). By this definition it is estimated that ~84% of the population in India lives in poverty.

Even if we ignore the data presented by private agencies like Oxfam, due to the allegations of political bias, there is no doubt that there exists massive inequality in terms of income, wealth, access to good education & healthcare and growth opportunities in India. For example, as per the latest NITI Aayog data, in Bihar 52% of the state’s population is poor; while Tamil Nadu has just 5% of its population below poverty line. MP has 37% of its population living below the poverty line. In fact the most populated four states – Bihar, UP and MP have the largest number of poor living in poverty.

What I concluded from my discussion with the farmer brothers is as follows:

1. Given the level of poverty, number of poor, and massive inequalities, India should ideally have a strong Communist movement. However, to the contrary, the communist movement has either got constricted to some elite educational institutions or has degenerated into an exploitative and violent Naxal movement in some pockets of central India. Most socialist parties have degenerated into feudal fiefdoms of the leaders.

2. The political system in India does not conform to any popular classification, i.e., socialist, communist, capitalist, monarchy, autocracy etc. We have a unique political system that incorporates some characteristics of socialism, capitalism, feudalism and monarchy. The elected leaders are considered Kings, and the public treasury is considered their personal wealth. They are thanked for cleaning drains, repairing roads and running schools.

3. Awareness about good life, constitutional rights and disguised exploitation amongst people is very low.

I shall be travelling extensively through the country for next one year; would be glad to share more such anecdotes and learnings. Readers’ views and opinions are welcome.